Auditing – Introduction and Planning – I-munotes-munotes

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INTRODUCTION TO AUDITING

Unit Structure:
1.0 Objectives
1.1 Introduction
1.2 Financial Statements
1.3 Definition and Objectives of Auditing
1.4 Errors and Frauds
1.5 Advantages and Disadvantages of Audit
1.6 Distinction
1.7 Principals of Audit
1.8 Summary
1.9 Exercise
1.0 OBJECTIVES
After studying this chapter, the students will be able to:
 Understand the Basics of auditing,
 Explain the errors and frauds,
 Discuss about the limitations of audit,
 Know the Auditors duties and responsibilities in re spect of frauds,
 Understand the principles of auditing and different auditing concepts.
1.1 INTRODUCTION
Origin of the term Audit is said to be in the Latin term auditor which
means to listen. In the Middle Ages whenever any fraud or
misappropriation wa s suspected in the books of accounts, there was a
system of appointment of an outside expert to verify the accounts. Such
expert used to first listen to what the concerned person in the accounts
department or The Manager has to say on the issue. In those d ays the
scope of Auditing was restricted to detecting errors and frauds in the
books of accounts only.
In simple terms auditing is nothing but verification of the correctness of
the books of accounts. After completing writing of books of accounts,
somebody else will go through them to check their correctness. This is
audit. So, it is said auditing starts after accounting job is over. munotes.in

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2 Auditor is an expert in accounts and he will check whether the books of
accounts are properly written and principles and rul es of Book -keeping
and Accounts are strictly followed. Entries in the bo0oks of accounts
should be properly supported by different documents like bills, receipts,
vouchers etc.
1.2 FINANCIAL STATEMENTS
1.2.1 Meaning
After the books of accounts like journ al, subsidiary books, ledger etc. are
written financial statements like Trial balance, Trading and Profit and
Loss account and Balance Sheet etc. are prepared. In addition, these days
cash flow statement is also prepared. These different financial statemen ts
are read not only by the owners of the business like the proprietors,
partners and shareholders, but also by the investors, Tax Authorities, Bank
officials, Trade Unions etc. From the point of view of all these people,
maintenance of books of accounts c orrectly is important. Owners want to
know whether their capital is being properly utilised, and adequate profits
are being earned. Trade union leaders are interested in knowing that
correct profits are shown by the company so that they can demand a
reason able bonus and rise in salary. Tax authorities are interested in
knowing the correct profit of the business and that proper tax on the same
is paid. Bankers who lend money, want to know that their loans are being
properly utilised and can be recovered easi ly on due date, So, from the
point of all these people maintenance of books of accounts correctly is
important. So, after writing the accounts they are checked by an
independent outside expert i.e., the auditor. Al these people go through the
financial sta temen ts from their own different point of view.
Even the customers of the products are also interested in the correctness of
the accounts because if the company is making huge profits, they can
demand for lowering the prices of the products produced by th e com pany.
Thus, all these persons read the financial statements and all of them are
interested in the correctness of them. This brings out the importance of
audit of the accounts.
1.2.2 Users of Financial Statements
Financial statement satisfies the info rmation requirements of a wide cross -
section of the society representing corporate managers, executives,
bankers, creditors, shareholders investors, labourers, consumers, and
government institution. Following are the users of Financial Statements:
1. Executiv es: Financial statements provide sufficient accounting
information to the executives and managers to enable them to decide
on important issues facing by them. The common issues faced by the
corporate managers are: efficient capital utilization, maintainin g the
profitability through cost control, dividend paying capacity of the
company and observing credit standards. The upper -level management
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3 2. Bankers: Bankers take precautions before advancin g loans to their
consumers. Every banker, before sanctioning credit, wishes to be
assured the borrower’s ability to repay the loans when they become
due. The bankers use the financial statements to ascertain the
company’s ability of repaying the dues and a lso the ability to pay
interest on time. Financial statements are useful to the bankers to
ascertain the liquidity, solvency, profitability of borrower’s business
and his financial strength.
3. Trade Creditors: The information obtained from the financial
statements b ecomes useful to ascertain the creditworthiness of the
company. The manufactures or wholesalers would not provide credit
facilities indiscreetly to everyone. Before providing such facilities the
manufacturer and wholesaler studies the financial sta tements of the
trader.
4. Shareholders and Prospective Investors: Shareholders, who have
permanent interest in the life and operations of the company, are ever
desirous of knowing about the company’s financial affairs. The
financial statements provide the sh are-holders all the information they
require.
5. Labourers: Labourers contribute to the earnings of the company and
they are the people who work on raw materials with the aid of capital
goods to produce wealth. They are also interested in their wages and
salaries, b onus and working conditions. As far as bonus, working
conditions and other incentives are concerned, they largely depend on
the company’s profitability and liquidity. The financial statements
become useful toe labourers to know the financial positi on of th e
entity.
6. Consumers and society: Consumers attempt to find out whether they
are being exploited by the producers. Society is interested in an
enterprise’s that result in the increase of employment opportunities,
wealth and standard of living of th e people . They are also concerned
about the enterprise’s contribution to social welfare, environment and
national wealth and prestige. Study of financial statements enables the
consumers and the society to gain knowledge on these matters.
1.3 DEFINITION AN D OBJECT IVES OF AUDITING
1.3.1 Meaning and Definition
Different authors have defined auditing in different words. We may
consider the following few important selected definitions :
1) Spicer and Pegler :
“Auditing is an examination of books of accounts a nd vouch er 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 of munotes.in

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4 affairs of the business and the profit and loss account gives a true and fair
view of the profit or loss for the financial year or period.”
2) Prof. Dickers :
“Audit is an examination of accounting records, undertaken with a view to
establishing whether they correctly and completely reflect the transactions
to which they purport to relate.”
3) Arthur W. Holme :
“Long range objectives of an audit should be to serve as a guide to
management’s future decisions in all financial matters such as controlling,
forecasting analysing and reporting. These objectives help the business
unit to improve its p erforman ce.”
4) R. R. Mautz :
“Auditing is concerned with the verification of accounting data,
determining the accuracy and reliability of accounting statements and
reports.”
Long range objectives of an audit should be to serve as a guide to the
management ’s future decisions in all financial matters such as controlling,
forecasting, analyzing, and reporting.
To put it in a nutshell, auditing is a through intelligent systematic and
critical examination of books of accounts. Audit may be done throughout
the y ear or pe riodically.
1.3.2 Objectives of Auditing :
Objectives of auditing are changing with the changes in the business
techniques. Earlier it was only checking of correctness of accounts. It was
then expanded to detection of frauds. The main objective o f audit i s to find
the reliability of financial position and profit and loss statement.
Objectives of audit can be divided in to two parts. Main and subsidiary or
secondary objectives.
Objectives of Audit

Main objects Subsidiary objects

1) Veri fication of accounts 1) Detection and prevention of
and financial statements Frauds
2) Detection and prevention of
Errors

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5 A) Main objects of Audit:
1. Verification of Accounts and Financial Statements:
The main or principal objective of audit is to ver ify and establish that at a
given date the balance sheet presents true and fair view of financial
position of the business and the profit and loss account gives the true and
fair view of profit or loss for the accounting period.
Under the Indian Companies Act Books of accounts must be kept
according to the provisions of the Act and they should reveal true and fair
view of the state of affairs of the company.
2. Checking of the entries with the relevant documentary evidences:
Audit involves checkin g the ent ries in the books of accounts with the
relevant vouchers and other supporting documents. This is the main job of
the auditor. Entries in the books of accounts are verified with the bill’s
vouchers and receipts. He will also check whether all the m oney recei ved
is accounted for or not and all payments made have proper supporting
vouchers. During such routine checking errors and frauds can be detected.
3. Taking independent review of the financial statements:
He conducts an independent review of financ ial statem ents. He has to be
personally satisfied about their reliability and he should be able to form his
opinion about them. He must examine the existing internal control and
internal check system prevailing in the organisation. He must check the
arithm etical acc uracy of the books of accounts. These days this aspect has
lost its relevance as machines and computers are mostly used for this
purpose by almost all organisations. Auditor has also to check the physical
existence of various assets shown in the accounts a nd see that they are
valued correctly.
In short, he has to assess the internal check system, check posting
balancing etc. and verify the correctness of the entries with supporting
documents. Capital and revenue items should be correctly classifi ed. In the
case of certain institutions, there are specific laws which contain rules
regarding maintenance of accounts. Then the auditor should see that those
legal provisions are complied in maintaining the books of accounts.
B) Subsidiary or Secondary ob jects of A udit :
1) Detection and prevention of errors and frauds:
The main difference between the two is that errors are committed due to
negligence or lack of knowledge and the frauds are committed knowingly
for some ulterior motive of getting some benefit.
2) Expressi on of Opinion:
After going through the accounts, the auditor should express his opinion
on the maintenance of books of accounts. If he finds any lacuna or defect
in the same, he must be frank enough to express his real opinion and munotes.in

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6 suggest to the managements the steps to be taken to set right the same.
Auditor should not come under anybody’s pressure. He should be bold
enough to call a spade.
1.4 ERRORS AND FRAUDS
1.4.1 Meaning of Error
Generally, they are committed due to negligence or lack of kn owledge or
ignorance of the principles of writing accounts of the person writing the
accounts. This is an important objective of an audit. Error is generally
taken to be innocent and not deliberate.
1.4.2 Reasons and Circumstances
R. K. Mautz, has classi fieds the re asons and circumstances of
errors and he has include fraud in the broad category of errors. The
classifications are the following.
1. Ignorance on the part of employees of accounting development,
generally accepted accounting principles, appropria te account
classification of the necessary reconciling subsidiary ledgers with
controlling accounts and of good accounting practices in general.
2. Carelessness on the part of those doing the accounting work.
3. A desire to conceal the effect of defalcations of shortage of one kind or
another.
4. A tendency of the management to permit prejudice or bias to influence
the interpretation of transactions or events or their presentation in the
financial statements.
5. An ever presents desires to hold taxes on income to minim um.
A sixth cause may be added to those Mr. Mautz has listed and that
is more serious in nature. It is the intentional effort committed by persons
in positions of authority to:
I. Show up the picture depicted by the statements;
II. Depress the picture depicted by the statemen ts; and
III. Convert the error to a personal benefit.
1.4.3 Types of Errors
Errors can be classified in to following five categories:
1) Errors of principle
2) Errors of omission
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7 4) Errors of duplication
5) Compensating errors
1. Errors of Principle :
These errors are usually committed due to lack of knowledge of science of
Book -keeping. E.g., wrong classification of expenses into capital and
revenue, treating personal income or expenditure as those of business or
vice versa, providing le ss or more dep reciation than reasonably necessary,
not taking into account all outstanding income or expenditure etc. Such
errors are not disclosed in the trial balance. They can only be detected by
thorough checking of each and every transaction in the b ooks of accoun ts.
Errors of principle affect the correctness and reliability of financial
statements. To prevent occurrence of such errors, the job of writing
accounts should be assigned to a duly qualified person only. He must have
good knowledge and expe rience in the field of dealing with accounts.
2. Error of Omission:
Here a particular transaction is not at all recorded in the books of accounts.
Such errors may be committed through oversight or even intentionally.
They affect the profit or loss of the yea r. Trial balan ce will tally in spite of
such errors. Hence it is difficult to defect them.
3. Error of Commission :
Here the transaction is recorded but recorded incorrectly. E.g., amount
received from A may be credited to B’s account or Rs. 890 received may
be recorded as Rs. 980. Some such errors may not affect the agreement of
the trial balance.
4. Errors of duplication :
Here the same transaction is written twice. This will also not affect the
agreement of the trial balance. Auditor can detect such errors o nly by
carefull y conducting the process of vouching. Such errors may be
committed due to oversight or even intentionally.
5. Compensating errors :
Here there are two mistakes of the same amount, one on the debit side and
the other on the credit side. The tot al effect of on e or more errors on either
side is the same. Such errors are difficult to detect as the trial balance will
tally in spite of such mistakes. Careful conduct of procedure of audit alone
can detect such errors.
1.4.4 Meaning and Types of Fraud s :
Fraud refer s to intentional misrepresentation of financial information by
persons in the management, employees or third parties. It may involve
manipulation or falsification of accounts, misappropriation of assets,
suppression of transactions, or misap plication of ac counting policies etc.
Frauds are intentionally committed by people in the higher authority. So, it munotes.in

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8 is more difficult to detect them than errors. Detection of frauds is one of
the principal functions of the auditor.
Frauds may be classified as follows:
1) Misappropriation or embezzlement of cash.
2) Misappropriation of goods.
3) Manipulation of accounts.
1. Embezzlement of cash :
Usually this is done by theft of cash receipts, Petty cash, cheques or by
showing bogus payments to workers, creditors etc . Fictitious pur chases
may be shown and the payment for the same may be embezzled. This type
of fraud is very easy where there is no proper control over the cash box.
So, in a smaller concern the cash box is handled either by the owner or his
nearest relat ive or by a very senior trusted employee. In a large business
there is no direct control of the owner in the day-to-day receipts and
payments of cash. So, embezzlement on a small scale can be easily done.
However, it is difficult in a smaller business whe re there is direct control
of the owner on the day-to-day transactions.
Embezzlement is done either by not accounting for the whole amount
received from a particular party or a lesser amount is shown in the
accounts and the difference is pocketed by the c ashier. Secondly fa lse
payments may be shown and the amount is pocketed. To avoid such
frauds, there should be strict control on the receipt and payment of cash
and the work of one should be routinely checked by the other. This is
called internal check sys tem. Another method of reducing such loss of
cash by embezzlement is to insure the fidelity of the cashier. You can take
an insurance policy and insure the fidelity or honesty of the cashier. If
there is embezzlement, then the insurance company will make g ood the
loss.
Different innovative methods are used to embezzle cash. Fictitious
purchases may be shown. Wages are shown as paid to dummy workers.
Old debt recovered or amount received by selling the scrap may not be
shown in the accounts. When an amount is received from a debtor or
customer, a lesser amount is shown as received in the counter foil of the
receipt book. Some of the cash sales may not be shown in the accounts
and so on.
2. Teaming and Lading :
This is method of temporary misappropriation of ca sh. Teaming and
lading means when an amount is received from one customer say A, it is
not accounted for in the books and the cash is used by the cashier for his
personal purpose. When the next customer say B, pays his dues it is shown
as received from A a nd so on. However, finally before closing the
accounts at the end of the year the money used is paid back and the cash munotes.in

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9 balance is correctly shown. Thus, here there is only a temporary
misappropriation of cash. Auditor should not allow or condone even such
frauds. They must be brought to the notice of the owner. The auditor can
easily detect such frauds by comparing the date on the receipt and the data
on which the transaction is written in the books of accounts, carefully.
3. Misappropriation of goods :
Where the goods produced or sold are small in size and light in weight but
of high value, such frauds are commonly committed. Normally in any
business there is higher and stricter control over cash than on goods. This
is a wrong policy. After all goods represen t cash. To prevent s uch frauds,
it is absolutely necessary to maintain proper record of purchases and sales
of goods in prices as well as quantities. There should be a good internal
control system regarding the movement of goods. Goods should not be
allowe d to leave the premi ses without the proper permission of some
responsible official. Stock on hand should be physically checked from
time to time. If there are any discrepancies, causes for the same should be
thoroughly investigated immediately. Bin card sy stem should be used to
maintain proper control over the stock. Remedial measures wherever
necessary should be immediately taken. Auditor should undertake surprise
check of the physical stock and tally it with the stock shown in the
accounts.
4. Manipulation of Accounts :
This t ype of fraud is committed by higher level management to mislead
certain parties. Such frauds usually involve a huge amount and are
intentionally committed after adequate preparation. Managers, Directors
etc. commit such frauds.
Here ac counts are falsified but no cash or goods are misappropriated.
False, incorrect or fictitious entries are made in the books of accounts. For
example, bogus sales, purchases or expenses are recorded in the books,
closing stock is not correctly valued. It ma y be over or under va lued.
Profitability of the business or the financial position of the business is not
correctly shown.
Profits may be shown as loss to reduce or avoid payment of income tax
and other taxes or to deter entering of view units in the busi ness. Value of
the sh ares of the company in the stock Exchange may also be inflated or
deflated. Profits may be shown higher than what they are to get more
commission or remuneration to the Manager. Another purpose may be to
deceive the investors and make them invest more fund s in the company.
Prices of the shares of the company in the market may be artificially
pushed up to sell the shares with the management and make more profits.
Financial institutions may be made to lend more money.
Falsification of ac counts may also be do ne by showing purchases or sales
more or less than what really, they are. Closing stock may be over or
under valued, outstanding or prepaid expenses and outstanding and
received in advance income are intentionally ignored or necessary munotes.in

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10 adjustment for them ma y not be made in the accounts. Assets may be over
or under depreciated, capital expenditure may be treated as revenue or vice
– versa.
5. Window – Dressing :
Showing the financial position better than what it is called window
dressing. It is done to attract more capital in the business or get more
remuneration for the manager etc.
6. Secret – Reserve :
Showing the financial position worse than what it is, is called creating
secret reserve. It is done to reduce tax burden or to see that no new
competitors enter in the field.
Thus, these manipulations are done with different motives and by using
number of different methods. So, it is rather difficult to detect the
manipulation of accounts as it is systematically committed with the
connivance of the top management. But never the less, it is an important
duty of the Auditor to detect manipulation in accounts. If he fails to do
this, he will be held responsible for certifying the false accounts and legal
action may be taken against him.
1.4.5 Risk of Frauds and Error in Audit
The following events may increase the risk of fraud or error -
1. Internal Control Faults: Weaknesses in the design of internal
control system and non -compliance with laid down control
procedures, e.g., a single person being r esponsible for receipt of all
pasts/ mails and marking it in the relevant sections or two persons
responsible for receipt of all posts/ mails but the same is not
followed in the practice.
2. Doubts about the integrity or competence of the management,
e.g., domination by one-person , high rate of employee turnover,
frequent change of legal counsels of Auditors, significant and
prolonged understaffing of the accounts department, etc.
3. Unusual pressures within the entity, e.g., industry is doing well
but the Compan y’s performance is poor, he avy dependence on a
single line of product, inadequate working capital, need to show
more profit to support the share market price, etc.
4. Unusual transactions e.g., transactions with related parties,
excessive payment for certain services to lawyers, etc.
5. Problems in obtaining sufficient and appropriate audit evidence:
E.g., inadequate documentation significant differences between the
figures as per accounting records and confirmation received from
third parties. Etc.
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11 1.4.6 Audit or's Duties and Responsibilit ies in respect of Fraud
The primary objective of an auditor is to express an opinion on the
financial statements. However, the auditor while conducting the audit is
required to consider the risk of material misstatements in the financial
statements resulti ng from fraud or error.
An audit conducted in accordance with the auditing standards generally
accepted in India is designed to provide reasonable assurance that the
financial statements taken as a whole are free from material misstatement,
whether caused by fraud or error. The fact that an audit is carried out may
act as a deterrent, but the auditor is not and cannot be held responsible for
the prevention of fraud and error.
Following are the Duties and Responsibilities of an Auditor:
1. In planning and perf orming his examination the auditor should take
into consideration the risk of material misstatements of the financial
information caused by fraud or error.
2. He should inquire with the management as to any fraud or significant
error which has occurred in the reporting period, and modify his audit
procedures, if necessary.
3. If circumstances indicate the possible existence of fraud and error, the
auditor should consider the potential effect of the suspected fraud and
error on the fi nancial information. If he is unable to obtain evidence to
confirm, he should consider the relevant laws and regulations before
expressing his opinion.
4. The auditor also has the responsibility to communicate the
misstatement to the appropriate level of mana gement on a timely basis
and consider the need to report to it then changed with governance.
5. He may also obtain legal advice before reporting on the financial
information or before withdrawing from the engagement.
6. The auditor should satisfy himself that the effect of fraud is proper ly
reflected in the financial information or the error is corrected in case
the modified procedures performed by the auditor confirm the
existence of the fraud.
7. The auditor should also consider the implications of the frauds an d
errors, and frame his repor t appropriately. In case of a significant
fraud, the same should be disclosed in the financial statement. If
adequate is not made, there should be a suitable disclosure in his audit
report.


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12 Check your progress:
1. Enlist the ob jectives of Auditing.
2. Define the following terms:
a. Auditing
b. Error
c. Frauds
d. Secret -Reserve
e. Window -dressing
f. Teaming and lading
3. Fill in the Blanks:
a. Recording of bogus sales, purchases or expenses in the books
means --------------------------------- .
b. Maintaining proper record of purchases an d sales of goods in
prices as well as quantities is essential to avoid the ------------------
------ of goods.
c. ------------------------- system should be used to maintain proper
control over the stock.
d. Fraud refers to ------------- ------------ of financial info rmation.
e. Teaming and lading mean temporary mi sappropriation of ---------
f. If the same transaction is written twice, it is the error of ------- .
4. Give the examples of following type of errors;
a. Error of commission
b. Error of omission
c. Error of duplication
d. Compensa ting errors
1.5 ADVANTAGES AND DISADVANTAGES OF AUDIT
9.5.1 Advantages of Audit :
Audit of accounts by a duly qualified Chartered Accountant is
compulsory for the registered joint stock companies, public trusts, bigger
co-operative societies only. Audit ing has also been made mandatory these
days for Income Tax and VAT payers above a particular limit. The limit
for Income Tax payers is income above Rs. 25 lakhs and for VAT payers
the limit is a turnover of above Rs. 1 Crore. T hese days even cost munotes.in

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13 Accounts are to be audited by a qualified Cost Accountant if the turnover
is above Rs. 1 Crore. In other words, it is not compulsory for all. However
though not legally compulsory, many business units these days, get their
accounts Audi ted because there are number of advantages of Auditing.
They can be enumerated as follows:
1) Audited accounts are considered more reliable by the general
public, Government authorities and financial institutions like banks.
2) Errors and frauds are detected i n time and immediately rectif ied.
Remedial action can be taken in time to avoid or prevent them in
future. Quick action can be taken against inefficient or negligent staff
and possible future loss can be avoided.
3) Employers will write the accounts in time or immediately and take
sufficient care to see that there are no mistakes. They will not be easily
tempted to commit frauds because they know that the accounts are to
be audited at an early date by the experts in the field and they may be
caught and punish ed.
4) Auditor is an expert in the science of keeping books of accounts. He is
familiar with different laws governing different businesses. So, he can
guide the accounts department in time. Such timely advice is very
valuable for the business . Now a day the re are number of laws and
new laws are added to them from time to time. A busy businessman
even though highly educated cannot keep track of such ever changing
laws. Businessmen have neither time nor inclination to study and
understand these laws. Auditor w ill come to their rescue.
5) Shareholders of joint stock companies are laymen and scattered all over the country and in the case o f certain companies even
all over the world. The auditor audits the accounts of the business
on behalf of these shareholders and submits his report to them. From
such reports the shareholders come to knows how their company is
functioning and how their hard-earned money is being used . They can
also take a decision about retaining or selling their shares in the
company.
6) Government and different tax authorities like Sales Tax officers.
Income Tax officers, Service Tax and Excise officers etc . readily
accept the audited accounts and the matter of assessment of tax
becomes simple and less time consuming.
7) When there is loss due to theft, fire, floods etc. claim of loss from the
Insurance Company is settled quickly if the accounts are audited.
8) In the case of Pa rtnership Firm, when any par tner retires or dies, his
account can be easily and quickly settled.
9) Banks and other financial institutions sanction loans quickly on
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14 10) Trade unions will demand bonus an d rise in salary for a
reaso nable amount only because the workers will believe in the
accounts kept by the management if they are duly audited. If the
accounts are not audited, the trade union leaders feel that the
company’s accounts do not reveal the real profits made by the
company and they are not getting reasonable remuneration and bonus.
Due to all these advantages business organisation like sole traders and
partnership firms, where audit of accounts is not legally mandatory,
mostly get their accounts audited by a duly qualified Auditor.
1.5.2 Limitations of Auditing
1) Non-detection of errors/frauds: - Even though the accounts are
carefully audited by the auditor. Sometimes the auditor fails to detect
certain mistakes and frauds . After the entire Audit or is a watchdog and
not a b lood hound. So, if the accounts are prepared intentionally and
thoughtfully with flaws to commit frauds, the auditor may not be able
to detect them. Thus, you cannot guarantee that there are absolutely no
errors or frauds in the accounts that are audited.
2) Dependence on explanation by others: - Auditor has to depend on
the explanation, clarification and information given by the client or his
staff. This information may not be necessarily always correct. Audit
report is affected ad versely if the explanation a nd information prove to
be false.
3) Dependence on opinions of others : - Auditor has to rely on the views
or opinions given by different experts viz Lawyers, Solicitors,
Engineers, Architects etc. he cannot be an expert in all the fields Such
opinion given b y the experts may not be flawless.
4) Conflict with others: - Auditor may have differences of opinion with
the accountants, management, engineers etc. In such a case personal
judgement plays an important role. It differs from pers on to person.
5) Audit is a pos t mortem examination. Things have already
happened and nothing much can be done now. Usual reply given by
the Government Authorities for different Audit objections is “Noted
for future guidance.”
6) Under the Indian Companies Act, the real owners are the shar eholders.
They appoint the Auditor in their Annual General Meeting. This is
only in theory or on paper. In practice, he is appointed by the
Directors only. So, he may not necessarily act independently . He
may try to avoid disple asing the Directors to conti nue to get the
business.
7) Corrupt practices to influence the auditors: The management may
use corrupt practices to influence the auditors and get a favourable
report about the state of affairs of the organisation. Many Auditors are
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Introduction to Auditing
15 clients. So, they may give a clean chit or favourable opinion even
though there are errors or frauds. They are not prepared to displease
their clients and lose their business.
8) No assuran ce: - Auditor cannot give an y assurance about future
profitability and prospects of the company.
9) Inherent limitations of the financial statements : - Financial
statements do not reflect current values of the assets and liabilities.
Many items are based on p ersonal judgement of the own ers. Certain
non-monetary facts cannot be measured. Audited statements due to
these limitations cannot exhibit true position.
10) Detailed checking not possible : - Auditor cannot check each and
every transaction. He may be required to do test checking.
However, in spite of the above limitations, there is no alternative to Audit
and its advantages outweigh the disadvantages. So, all business units
mostly get their accounts Audited by a qualified Auditor.
Expressing Opinion:
After com pleting his Audit work, Audit or finally expresses his Frank
opinion on the quality of the accounts maintained. He suggests ways and
means to further improve their quality.
1.6 DISTINCTION
1.6.1 Accounting v/s Auditing
Points of
difference Accounting Auditing
1. Meaning
It is r ecording of all the
day to day transactions in
the books of accounts
leading to preparation of
financial statements. It is the critical
examination of the
transactions recorded in
the books of accounts.

2. Nature
It is con cerned with
finalization of a ccounts. It is concerned with
establishment of
reliability of financial
statements.
3. Objects
The object is to ascertain
the trading results. The object is to certify
the correctness of
financial statements.
4. Commenceme nt Accounting commences
when book keeping ends. Auditing begins when
accounting ends.
5. Scope
It involves various
financial statements. It It depends upon the
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Auditing (Introduction and
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16 involves maintenance of
books of accounts. It does
not go beyond books of
accounts. provisions of l aw. It
goes beyond books of
accounts.

1.6.2 Auditing v/s Investigation
Points of
difference Auditing Investigation
1. Objects
The object is to find out
whether balance sheet and
profit and loss account
exhibit a true and fa ir
view of business. It is un dertaken to know
the essential facts about a
matter under inquiry. It is
done with some special
purpose of view.
2. Period It usually covers one
accounting year. It may cover more than
one accounting year.
3.Conducted It is conducted for proprietors on ly. It is carried out on behalf of any party
interested in the matter.
4.Scope
It is restricted to
balance sheet and profit
and loss account. It is wider in scope It may
be carried out beyond
balance sheet.
5. Compulsion
Audit is legally
compulsory for
companies. It is voluntary. It requires
under certain
circumstances
6. Time
It may be conducted at the
end of the year. It may be conducted at
any time in case of
suspicion about any transaction
7. Report
Form of re port is
prescribed. It is
presented to the
shareholders. Form of report is not
prescribed. It is presented
to the client.
8. Appointment Owners appoint the
auditors. Even third party can appoint an investigator.
9.
Qualifications
The statutory auditors
must possess proper
qualific ations.
Even an employee preferably a chartered
accountant may be
appointed as investigator.
10. Rework Re–audit is not generally
undertaken Re-investigation may be
undertaken.
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Introduction to Auditing
17 1.7 PRINCIPALS OF AUDIT
Following are the im portant concepts of Auditing :
1. Materiality
2. True and Fair
3. Independence
4. Going concern
As per the syllabus students have to study the first two concepts:
1. Materiality Concepts:
Material here means important. The auditor should verify every important
transac tion. Which is important and which is trivial or not important is to
be decided by the Auditor. Here his past experience in the Audit field and
his discretion will help him. In every business different things have
different degree of importance. Auditor sh ould be able to decide which
things are important and which are not in a particular business unit which
he is auditing. He should devote sufficient time and verify toughly all-
important transactions. At the same time, he should not unnecessarily
waste his time in verifying small and u nimportant transactions. An auditor
can achieve all objects of audit by properly following this principle.
Information is material if its misstatement or omission will affect the
financial or economic decision to be taken by t he users of this information
i.e., Auditor’s report. Materiality depends upon the size and nature of the
transaction. Some matters are individually or in the aggregate are
relatively more important than others in presenting a true financial
position of the concern. Materiality may also be decided by some legal
and regulatory requirements.
The concept of materiality is fundamental to the process of accounting.
This concept is applicable in planning as well as performing audit. Auditor
will insist upon more reliable evidence for passing material transactions.
He will see that such items are properly and distinctly disclosed in the
financial statements.
2. True and Fair :
According to Indian Companies Act, the auditor has to report whether the
account statements give a true and fair view. Ba lance sheet should show
true financial position and profit and loss account should reveal true
profits made or losses incurred.
Companies Act 1913 contained the words true and correct. However,
subsequently these words were s ubstituted by True and Fair. M any a times
it was found that though the accounts were true and correct, they did not
disclose the position of the concern in a fair manner if they were not
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Auditing (Introduction and
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18 The phrase True and Fair has not been defined by the companies Act.
However, t he Auditor is expected to report in these words. So, the auditor
should check the full background of each and every transaction. He must
not restrict his attention only to the documents produced before him. He
must probe deep in to the matter.
In order to show a true and fair view the auditor should ensure that:
1. The final accounts agree with the books of accounts.
2. The provision for depreciation is proper.
3. The closing stock is physically verified and valued properly.
4. Intangible assets like goodwill, patents , preliminary expenses or
other deferred revenue expenses are written off properly.
5. Proper provision is made for bad and doubtful debts.
6. Capital expenses is not treated as revenue expenses and vice versa.
7. Capital receipts are not treated as revenue receipt s.
8. Effect of changes in rate of foreign exchange on value of assets and
liabilities is recorded in the books properly.
9. Contingent liabilities are not treated as actual liabilities and vice
versa.
10. Provision is made for all know n losses and liabilities
11. A res erve is not shown as a provision and vice versa
12. Cut off transactions are recorded properly, so that all sales invoices
are matched with goods delivered and all purchase invoices are
matched with goods received.
13. Transactions ar e recorded on accrual basis, i.e., outstanding
expenses, prepaid expenses, income accrued and advance income are
recorded properly.
14. Expected or anticipated gains are not credited to the profit and loss
account.
15. Effect of events after the balance sheet date on the value of an asset
and l iability is disclosed in the accounts properly
16. The exceptional or non -recurring transactions are disclosed
separately in the accounts.
17. If there is any charge on the assets, that should be disclosed clearly. .
18. In the case of a ssets, the auditor should see t hat they are neither over
valued nor undervalued.
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Introduction to Auditing
19 20. Similarly, liabilities should not be under or overstated and no
liability should be omitted. Accounting policies should be
consistently followed , and all legal requirements should be complied
with.
This is one of the fundamental concepts in auditing In short what
constituents true and fair view is a matter of an auditor’s judgment.
However, all legal requirements s hould be strictly complied with.
1.8 SUMMARY
This chapter deals with the basic concepts of Audit. The Audit has come
from a Latin term Auditor which means to hear. When a fraud was
suspected, an outside expert was appointed to check the accounts. He use d
to hear or listen to different c oncerned parties before fixing the
responsibility of the fraud on any one person. Hence the term Auditor
which then became audit. In simple terms audit means critical checking of
the account books. Audit begins, where acco unting ends.
Trial balance, profi t and loss account and balance sheet prepared at the
end of the year are called financial statements. Besides owners, these
annual statements are read by investors. Government taxation authorities,
Trade Unions, financial institutions etc. They will readil y believe in the
accounts if they are audited by a qualified auditor. So, even where auditing
is not compulsory, business people go in for auditing.
The term audit has been defined by different people in different words.
The auditor has to check the accou nts and report whether they are
prepared properly and there are no errors or frauds. He must also report,
whether they reflect a true and fair view of the financial position of the
concern.
Main object of audit is to chec k the accounts and the subsidiary objects are
detection and prevention of different types of errors and frauds. Window
dressing and creation of secret reserve both should be avoided.
There are number of advantages of Audit and it has some inherent
limitat ions also. However, the advantages outweigh the disadvantages.
There is difference between accounting and auditing and auditing and
investigation. There is also difference between book – keeping and
accounting.
Auditor should have good knowledge of the s cience of keeping books of
account s and also different laws concerning different types of business. He
must be straight forward and honest and think independently. He must be
bold enough to frankly expense his mind in his report. He must not reveal
the bus iness secrets to outsiders or comp etitors.
He should plan his work in advance and complete the same in time. He
must be able to decide what is material or important and what is not. He
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Auditing (Introduction and
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20 assumpti on that the business is going to b e continued for a considerable
future period.
1.9 EXERCISE
1. What do you mean by auditing? Discuss its objects.
2. Distinguish between accounting and auditing.
3. Write short notes on :
i. Compensating errors
ii. Principles of Auditi ng
iii. Window dressing
iv. Secret reserve s drop
v. Going concern concept.
vi. Methods of selecting sample items
vii. Error of principle.
4. Define and explain the term auditing
5. Distinguish between auditing and investigation
6. What is a fraud? What are the different types of fr auds?
7. Explain the concept of True and Fair view.
8. What are the advantages and limitations of auditing?
9. Explain in brief different types of errors.
10. Objective type questions :
1. Select the appropriate option and rewrite the following sentences :
i) The main o bject of an audit is ------------- ------- .
a) To ensure that the final accounts are prepared.
b) Detection and prevention of frauds and errors.
c) Verification of accounts and financial statements.
d) To ensure future viability of the concern.
ii) The main objective of window – dressing is --------------------- .
a) To reduce tax ability
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Introduction to Auditing
21 c) To understate profits
d) To avoid payment of bonus to workers
iii) Auditing commences after ------------------------ .
a) Invest igation is over b) Accounting wor k is over
c) The General Meeting is over d) None of the above
iv) --------------------- is not an error of commission.
a) Arithmetical error b) Compensating error
c) Posting error d) None of the above
v) Misapp ropriation of goods is generally d one by -------------------- .
a) Auditors b) Employees
c) Shareholders d) All of the above
vi) The responsibility of adopting sound accounting policies and
maintaining adequate internal control rests with ------------- -----.
a) Chief Accountant
b) Company Management
c) Company’s internal audit department
d) Statutory Auditor
vii) Audit conclusions and reporting is -------------------- .
a) Advantage of audit
b) Technique of audit
c) Limitation of audit
d) Principle of audit
2. State wheth er the following statements are True or False.
1. An error of principle will not affect the trial balance.
2. The term audit has been derived from the Latin term Audire.
3. The allocation of amount between capital and revenue ex penditure is
a compensating error.
4. Audited accounts are free from errors and frauds.

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22 2

TYPES OF AUDIT

Unit Structure :
2.0 Objectives
2.1 Introduction
2.2 Interim Audit
2.3 Continuous Audit
2.4 Annual Audit / Final Audit
2.5 Concurrent Audit
2.6 Balance sheet Audit
2.7 Statutory Audit
2.8 Exercise
2.0 OBJECTIVES
After studying th e unit, the students will be able to
 Meaning, Advantages and disadvantages of Balance sheet audit
 Meaning, Advantages and disadvantages of Interim Audit
 Meaning, Advantages and disadvantages of Continuous Audit
 Meaning, Advantages and disadvantages of Ann ual Audit
 Meaning, Advantages and disadvantages of Statutory Audit
2.1 INTRODUCTION
In the forms of business organization where the owners are not involved in
the management of the organization, they cannot ensure about the
performance of the business org anization. Being the owners of the
organization, they can also have interest in the firm’s performance. In
response to this, the legislator has made a decision that limited firms are
obliged to be under constant control of auditors. Auditors are assigned a t a
firm’s general meeting. The role of the auditor is more than to control the
firm. Advising on how the firm can advance its decisions and activities is
a vital part of the auditor’s role. Auditing consists of a review of a firm’s
annual reports. Auditin g commences with a selection of areas to observe
and assess. Principally, the area with the greatest risk for errors and munotes.in

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Types of Audit
23 inaccuracies should be reviewed most intensively. As each firm is unique,
the audit needs to be adapted to be applicable to each firm’s special
features. The chosen way to audit a firm should reflect the most cost-
efficient process of accomplishing the aim of the audit. An audit is a
systematic and independent examination of books, accounts, statutory
records, documents and vouchers of an organization to ascertain how far
the financial statements as well as non -financial disclosures present a true
and fair view of the concern. Audit is an appraisal activity undertaken by
an independent practitioner ( e.g., an external auditor) to provide as surance
to a principal ( e.g., shareholders) over a subject matter ( e.g., financial
statements) which is the primary responsibility of another person ( e.g.,
directors) against a given criteria or framework ( e.g., IFRS and GAAP).
Classification of Audit
Audi t may be classified into two categories mainly ; -
(a) according to organizational structure of a business; and
(b) from practical point of view.
According to Organizational Structure of a Business
1. Statutory Audit
In case of many unde rtakin gs, audit is made compulsory under statute
because these undertakings are established by statute. The audit of their
accounts is termed as statutory audit. The following are the examples of
such an audit:
By virtue of the organizational pattern, some busin ess institutions appoint
auditors who are made responsible to have a constant and regular review
of their accounts.
From Practical Point of View :
All those forms in which audit is often conducted practically by business
houses are as follows : -
1. Continu ous Audit or Detailed Audit.
2. Periodical audit or Final Audit or complete Audit.
3. Interim Audit.
4. Occasional Audit.
5. Partial Audit.
6. Balance Sheet Audit.
7. Cash Audit.
8. Cost Audit. munotes.in

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24 2.2 INTERIM AUDIT
2.2.1 Meaning and Definition
Interim a udit i s the audit which is conducted between the two annual
audits for the purpose of finding the interim dividend. It may be monthly
quarterly or half yearly. For knowing the reliable results during the
financial year such type of audit may be applied.
In larg e-scale business concern, the performance may be checked for a
particular part of the year. Depending upon the amount of work the auditor
may check the figures of a month or a quarter. It involves a complete
examination or a review of the accounts an d reco rds of the business upto
the date of the interim audit.
DEFINITION OF INTERIM AUDIT
“An interim audit is one when the auditor completes an audit up to the
date of a set of interim a ccount s, for example quarterly or half -yearly
accounts.
G. William
R. Howard defines interim audit, as this is when an audit is conducted to
a particular date within the accounting period.
2.2.2 OBJECTIVES OF INTERIM AUDIT
1. To know profit or loss of inter im per iod.
2. To declare interim dividend.
3. In case of partnership there may be admission or retirement of a partner
during the year.
4. To get loan on the basis of interim account.
5. To get information about the financial position of interim period.
6. To take mid -term dec isions about prices, investments or profits.
2.2.3 ADVANTAGES OF INTERIM AUDIT
1. Suitable For Big Firms: Interim audit is very suitable for large and dynamic
type of business organizations.

2. Moral check: There is a moral check on the staff of the clie nt as the
accounts are checked after three or six months. An auditor checks the work
of every person. It creates moral pressure on the employees to perform
accounting jobs effectively.

3. Detection of frauds and Correction of errors: It helps to eliminate
mistake s and frauds. The time between compiling and checking accounts is
very short. Therefore, location of fraud is possible, as sufficient time is not
given to employees. The interim audit is also helpful for correction of errors.

4. Helpful for Final Audi t: The interim audit is helpful for the early
completion of the final audit.
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Types of Audit
25 5. Interim dividend: The interim audit is conducted to declare the interim
dividend. The management can prepare interim accounts for dividend
purpose.

6. Publication of Interim Figu res: In some cases, the publication of interim
figures is compulsory. So, in such cases interim audit is very useful.

7. Admission, retirement or death of a partner: The admission or retirement
of a partner during the year is possible due to interim audit. A partner may
expire at any time during business life. Due to the interim audit to determine
the fair value of assets and liabilities during the year becomes possible. Thus,
interim audit helps all partners to settle conditions.

8. Convenient for the manageme nt: Interi m audit provides midyear financial
information. Therefore, it becomes helpful for the management to take the
price or profit related decisions.

9. Encourages Investment : -Due to interim audit investor rely more on the
company performance. He purch ases and se lls the shares keeping in view the
audit report.

10. Up to date record: The benefit of the interim audit is that accounting record
is kept up to date. The accounting staffs have a duty to complete their work
for interim audit. Thus, delay in accoun ts is not po ssible.

11. Suggestions Implementation: The accounting staff can follow auditor’s
suggestion. In case of interim audit auditor's suggestions can be quickly
implemented.
2.2.4 DISADVANTAGES
1. Additional work: The interim is not a part of the final a udit. Final audit
must be conducted after conducting this audit too. So, it is an additional
workload on audit staff.

2. Alteration of Figure: Already audited accounting figure may be changed by
a dishonest employee. It may create difficulty in final audit. It will mean that
the audit staff will have to prepare notes when they finish the interim audit.

3. Unsuitable For Small Firms: Interim audit is not suitable for small business
organizations with less financial transaction.

4. Work Burden: Audit notes have to be prepared after the completion of
interim audit. It increases the burden of work.

5. Disturbance at Work: Interim audit disturbs the working environment in
the office. Regular office activities may be hampered because of audit work.
6. Increase Expenses: Interim audit ma y prove expensive because it involves
addition work on the part of the auditor. Thus, it increases the expenses of
the business as it is not compulsory by law.

7. Not useful for third parties: The demerit of the interim audit is that it may
not provide a guid eline to third parties. The interim accounts are not final so
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26 2.3 CONTINUOUS AUDIT
2.3.1 Meaning and Definition
The audit which remains continue throughout the financial year is
called co ntinuous audit . In this case an audit staff may carry
audit work for the whole year with equal or unequal intervals. He checks
each and every transaction. The large -scale companies require constant
review of their business matters or there may be a declar ation of divid end
during the year, it is of great help. In case the volume of the transaction is
very large, the management can follow the policy of continuous audit. If
the internal control system is not satisfactory then to apply continuous
audit will be the best opti on in order to show a true and fair view of
accounting record. This audit is very costly but minimizes the errors. A
continuous audit is applicable in the following cases.
DEFINITION OF CONTINUOUS AUDIT
1.R. G. Williams says that continuo us audit is on e where the auditor, or
his staff is consistently engaged in checking the accounts during the whole
period, or where the auditor or his staff, attend at regular or irregular
intervals during the period.
2. Waiter W. Bigg says that continuous audit is one m ember of auditor’s
staff is occupied continuously on the accounts the whole year round or
where they attend at frequent interval, fixed or otherwise during the
current of the financial year.
3. L. R. Howard says that continuous audit work is conducted throu gh at
the course of the financial year but is not taken to a specific accounts
period as in interim audit .
2.3.2 DVANTAGES OF CONTINUOUS AUDIT
1. Continues and through checking: This is the main advan tage of the
continuous audit. The audit clerks remain busy throughout the year. The
work is checked on the spot. Auditor has sufficient time to check the books
of accounts thoroughly.

2. Quick discovery of errors: Errors and frauds can be d iscovered easil y and
quickly as the auditor checks the accounts at regular intervals and in detail.
As an auditor visits the client regularly and the number of transactions will
be small and hence, the errors will be detected easily and quickly.


3. Quick pres entation of acc ounts: As most of the checking works are already
performed during the year, the final audited accounts can be presented to the
shareholders soon after the close of the financial year at annual general
meeting.

4. Prompt filing of returns: The continuous audi t is beneficial for the prompt
filing of returns as the accounts are prepared as well as audited at the end of
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27
5. Interim dividend: Here it is easy to prepare the accounts for six months.
Hence Continuous audit is helpful to declar e interim divid end.

6. Moral check on the client's staff: The continuous audit is useful to develop
moral check on employees. As the time between recording and checking the
entries is very short, the staff cannot think to plan any fraud. As well the
auditor can surprising ly visit to the client’s office therefore it will have a
considerable moral check on the clerks preparing the accounts.

7. In time Auditor’s advice: The continuous audit is beneficial to seek
auditor’s advice. The weakness of business functio ns can be remov ed during
the year by taking the guidance of the auditor.

8. Convenient for auditor: The continuous audit is helpful for the audit staff
for distribution of workload. The work is distributed over the whole year.
The audit staff can prepare the ir programme on the basis of time allocated to
one business. The auditor gets sufficient time for important and ambiguous
matter to draw a conclusion.

9. Regularity in the staff: The continuous audit is beneficial for business. The
accounting employees beco me regular. The accounting record is maintained
on regular basis for showing it to audit staff.

10. Upto Date Accounts : - Accounts of the business are kept upto date by the
staff because they know that auditor may visit and check the accounts at any
time.
2.3.3 ISADVANTAGES
1. Small business: Continuous audit is not fit for small -scale business
concerns. A small business has a few transactions so there is no need of audit
for the whole year. As well the continuous audit is an expensive system of
audit.

2. Alteratio n of figures: Figures in the books of account which have already
been checked by the auditor at previous visit, may be altered by a dishonest
clerk and the frauds may be committed. Also, the changed figures can show
different results.

3. Disturbance in the c lient's work: The frequent visits by the auditor may
disturb the work of the client. When the audit work starts, the work of
accounting staff suffers, as the books are not spare.

4. Staff intimacy: The accounting staff and the audit staff work side by side f or
the whole yea r. Friendship among the employees and auditors may lead to
errors and frauds. The sympathetic view of audit staff may fail to show true
and fair view.

5. Queries may remain outstanding: The queries raised by the audit staff may
not be answere d on the same da y. The audit clerk may lose the thread of
work and the queries may remain outstanding as there might be a long
interval between two visits.
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28 2.4 ANNUAL AUDIT / FINAL AUDIT
2.4.1 Meaning and Definition
This is also known as final audit or Peri odical audit. Thi s audit is carried
out often at the close of the accounting year. The final audit takes place
only after the end of the trading period when all the transactions for the
whole year are completely recorded and final accounts have been
prepar ed. Therefore, there is no clash among the duties of accounting and
audit staff. Here t he auditor examines the accounts of the whole
accounting year in one continuous session. Normally the small
concerns audit their accounts under this system. If internal control i s
effective then the auditor can use the sampling method, otherwise cent
percent checking becomes essential. The audit staff can complete the audit
work within shortest possible time. There is continuit y of work in
checking the financial and other relevant records.
The various definitions of Final audit are as below:
DEFINITION OF FINAL AUDIT
1. R. G. Williams says that final audit is one which is not commenced
until after the books have been closed at the end of the financial year,
or which is not commenced towards the end of the financial year and
carries through to completion after the end of the year.
2. Walter W. Bigg says that, a final audit is an audit which is not
commenced before the end of financial period, and is then
carried on until completed.”
3. L. R. Howard says that final audit is carried through to completion in one
continuous session. Although it may be commenced before the end of the
accounting period, it is completed at least after the end of the financial year.
The basic characteristics of Final or Annual Audit are as below:
1. In case of Annual audit, generally audit work commences after the close
of the financial year.
2. Audit work is carried on and completed in a continuo us session.
3. Aud itor visits the client’s office only once in a year and keeps on doing
the work until it gets over.
4. It is suitable for small scale concerns.
2.4.2 Merits of Annual audit
The following are some of the main advantages of Annual audit
1. Econ omical:
Periodical audit is economical and suitable particularly small sized
business units. In this type of audit, the auditor makes test checking and munotes.in

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29 whole work is performed once only. Hence, it is possible for the auditor to
check the accounts of vario us business concerns at a time, and so the fee
charged by audit staff is less as compared to continuous audit
2. STAFF DUTIES:
The audit work is started after the completion of accounting work. T here
is no clash of duties of accounting and audit staff. The accounting staffs
remain busy for one year. But the audit is started after the end of
accounting work.
3. PLANNED WORK:
The work of audit is completed under planning. The audit programme
provides the schedule of time for audit work. According to planned work
the auditor can control the audit of many business units.
4. Work continuity:
The flow of audit work goes on without any break from start till its
completion. The continuity of work is beneficia l for audit staff to clear
their questions. The doubts become clear on the same day
5. Convenient for management:
The benefit of the final audit is that is convenient for management as well
as audit staff as the auditor starts and completes an audit in one s ession
and the queri es can be cleared on the same day.
6. Less Chance to Alter Figure:
As the audit is completed in one continuous session, and once the records
are delivered to the auditor, they are not accessible by the accounting staff,
so there is less ch ance to alter figure which minimizes the chances of
frauds.
7. No relations:
The merit of the final audit is that it provides no chance to audit staff to
develop friendly relations with accounting staff. The accounting staffs are
not in a position to get un due benefit from audi t staff.
2.4.3 Demerits of Annual Audit
Followings are the disadvantages of periodical audit:
1. Unsuitable:
Big organization having large number of transactions it takes more time to
complete the audit and hence presentation of accounts to the share holder
may be delayed. The share holders are usually very anxious for dividends
which cannot be declared until the completion of the audit. So, this type is
unsuitable for big organization.
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30 2. Possibility of Leaving Errors
Detail checking of bo oks of accounts is not possible under this method.
So, the auditor applies test check. Thus, there are chances of leaving errors
and frauds.
3. Difficult to Detect Planned Frauds
Generally, the frauds are committed in the direction of top-level
management. So , such frauds are commit ted in planned way. In this type
of audit, the auditor uses the sampling method and does not check in
detail. So, such planned frauds cannot be detected.
4. Late correction:
The demerit of a final audit is that errors are located afte r the end Of the
year. Th e corrections of errors take time so long errors are not corrected
the accounts are incomplete.
5. Low moral check:
The drawback of a final audit is that it has less moral pressure on
employees of the business concern. The audit staf fs come after one year.
The employees are free to commit errors and frauds for the whole year.
6. Thorough checking:
The drawback of a final audit is that there may not be thorough checking.
Audit sampling may be u sed to complete work.
7. Delay in the future planning:
As the audit work is started after the end of accounting year it takes time
to check the accounting records. The audit work is completed late. So, the
budgets and estimates for future may not be prepared in time.
8. In case of Final audit only the declaration of final dividend is possible
declared
2.5 CONCURRENT AUDIT
2.5.1 Meaning
The word concurrent itself defines its meaning, concurrent means
happening at the time. Concurrent Audit means doing the exam ination of
the financial transactions at the time of happening or parallel with the
transaction. The concept of Concurrent Audit has been introduced to
reduce the time gap between occurrences of transactions.
2.5.2 Objectives of Concurrent Audit
1. Concurren t audit is a Systematic and timely examination of financial
transactions on a regular basis to ensure accuracy, authenticity,
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31 2. The emphasis under concurrent audit is not on test checking but on
substantial checkin g of transactions.
3. The concept of concurrent audit has been introduced to reduce the time
gap between occurrences of transaction and the overview or checking
of the transactions
4. The concurrent audit serves the purpose of effective control as it is
normally conducted by external agencies like chartered accountants’
firms.
5. It attempts to shorten the interval between a transaction and its
examination by an independent person not in its documentation.
6. In concurrent audit, there is an emphasis in favour of subs tantive
checking in key areas rather than test checking.
7. The concurrent audit is essentially a management process integral to
the establishment of internal accounting functions and effective
controls and setting the tone for a v igilance internal audit to prevent
the incidence of serious errors and fraudulent manipulations.
8. The focus of concurrent audit is on adherence to laid down systems,
procedures and safeguards, therefore a concurrent auditor may not sit
in judgment of the d ecisions taken by a branch manager or an
authorized official.
9. The main objective of concurrent audit is to bring to light any violation
of procedure.
2.6 BALANCE SHEET AUDIT
2.6.1 Meaning
In this type of audit, the audit is commenced from the balance she et,
working back to the book s of original entry and relative documents. In this
type the work of audit does not start with the verification of primary
books, it verifies the items appearing in the balance sheet, so this is
basically a partial audit. This t ype of audit can be successf ul in those
organizations where an effective internal check is in operation.
Verification of all items included in the balance sheet combined with the
examination of related income and expenses accounts is known as balance
sheet audit. Under such an audit, the auditor checks capital, reserves,
assets, liabilities, etc., given in the Balance Sheet. In this audit the items of
Trading and Profits and Loss Account which have a relation with the
Balance Sheet items are also checked. F or example, the purchase of goods
on credit will increase the liabilities to creditors, increase the stock and
will be shown in the Trading Account as an increase in purchases and
closing stock. So, this item will have to be verified. In short Balance shee t
audit means checking the ac curacy of information found in a company's
balance sheet. Such an audit is popular in U.S.A.
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32 2.6.2 Purpose of conducting Balance Sheet Audit
In large organizations the trading transactions are numerous and mostly
they are enti rely computerized. In such ca ses, the routine checking may be
completely dispensed with. Where the computerized accounting system is
coupled with effective internal control, detailed vouching can also be
dispensed with, in such organizations; auditor condu cts the balance sheet
audit.
The purpose of balance audit is to making sure that:
1. The assets shown in the balance sheet are really owned by the
organization.
2. All assets owned by the organization are included in the balance sheet
at the correct value.
3. All liabilities are included at th e appropriate values.
4. Accepted accounting principles are followed to prepare the balance
sheet.
5. All items are appropriately classified as capital items and revenue
items and treated accordingly.
6. All the requirements of law are duly complied with. For examp le, in
the case of companies, the issue of share capital is correctly recorded
in the books.
7. All the adjustment en tries and journal entries rel ating to the closing of
accounts and preparation of balance sheet are examined.
2.7 STATUTORY AUDIT
2.7.1 Meaning
It is a type of audit which is mandated by a country’s Law. A statutory is
also known as financial audit. It is b asically an audit of the fina l
statements of a company, i.e., the profit and loss and the balance sheet.
The main purpose of this type is to ensure that the books of accounts
presented to the regulators and public are true and fair and the balance
sheet of the company is showing an accurate picture of the company’s
current financial position.
Statutory audit is mandatory if certain criteria are being met by the
business. It is carried out by independent external auditors. In India, the
statutory audit is re commended by Companies Act. I n this audit the
reports are reported to the company shareholders by the auditor. In his
reports, the statutory auditor expresses his outlook on the fair values of the
company’s final accounts. He also confirms the observance of the
financial statements ac cording to the provision of the act. The purpose of
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33 records. The auditor’s appointment, his remuneration, duties are assigned
by the provisions of the law, as pertinent to the orga nization.
2.7.2 Objectives of Statutory audit
1. Statutory audit is mandatory in case of the company because the share
holders are the owners of the company, however, they do not run or manage
the day-to-day affairs of the compa ny. The management of the comp any is
done by the board of Directors. So, the shareholders need assurance that the
accounts maintained and published by the company are authentic and
genuine. The independent auditor has full authority to check the financial
records of the company and publ ish his findings via an auditor’s report.

2. Other stakeholders like creditors, employees, potential investors etc also
benefit from the statutory audit. They too can base their decisions on these
accounts, since they are authe ntic.

3. An annual report is the most important basis of the decision -making process
for stakeholders and is therefore expected to be correct and trustworthy. An
auditor’s task is to ensure that annual reports are executed correctly by
applying appropriate r egulations and show an accurate picture of a firm’s
financial situation.
2.7.3 Advantages of statutory audits
A statutory audit offers the following benefits:
1. It assures the management that their duties in statutory performed
perfectly.
2. Statutory audit imp roves the reliability of the pu blished financial
statement.
3. It provides internal control’s efficiency.
4. The statutory audit ensures the management that they have to abide by
non-statutory requirement say Corporate Governance requirement.
5. When the internal controls are poor in a company, the statutory auditor
will give the suggestion for the company’s improvement which will
help the company from risk and improves the company’s performance.
6. It enhances the trustworthiness of published financial statements.
2.7.4 Disadvantages/Limitations o f Statutory Audit
1. The cost associated with an audit can be very high. But if any audit
firm is already engaged for looking after the day-to-day work
including accounts preparation etc then it will charge relatively very
less amount to conduct the audit as compared with the firm which is
not engaged for doing the same.
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34 2. The employees might get disrupted for performing their normal work
in order to answer the day-to-day query of auditor or while providing
the auditor any reports or data required to them. This might result in
stretching the work of the employees beyond office hours and may
sometimes cause distress among the employees.
3. The financial statements include judgemental as well as subjective
matter. Judgemental issues may vary with persons. Sometimes
personal business is also included.
4. There are inherent limitations of audits like it has to be done in due
time, internal control within the organization, limited power of auditor,
etc. One has to understand that auditors are watchdogs and not the
bloodhoun ds. There reporting is based on the sample data and not the
total data. Moreover, as frauds are the planned one so it will be more
difficult to find the same.
5. There are many areas in which auditors are left with no other opti on
than to take representation from management. This is a danger if
management itself is involved in frauds as in that case they will give
the manipulated representation.
6. The auditor does not assess and review the 100 % transactions.
Auditor merely expresses his opinion on the financial statements and
data provided to him and at no point gives total assurance.
7. An auditor comment upon the going concern of the organization but
nowher e assures for its future viabil ity. Stakeholders should not vest
their money only seeing that the organization’s data are being audited.
2.8 EXERCISE
Write short notes
1. Interim Audit
2. Continuous Audit
3. Concurrent Audit
4. Annual Audit
5. Statutory Audit



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AUDIT PLANNING AND PROCEDURES
AND DOCUMENTATION

Unit Structure:
3.0 Objectives
3.1 Introduction
3.2 Meaning and Objectives of Audit Planning
3.3 Preparation for Audit
3.4 Sources of Obtaining Information
3.5 Factors to be Considered While Preparing Audit Plan
3.6 Audit Programme
3.7 Audit working paper
3.8 Audit Evidence
3.9 Audit Notebook
3.10 Summary
3.11 Questions
3.0 OBJECTIVES
After studying this chapter, the students will be able to:
 Understand the meaning and importance of audit planning a nd audit
programme
 Know the advantages and disadvantages of Audit programme.
 Explain the Meaning and importance of Audit working paper.
 Discuss the factors determining form and contents of audit working
paper.
 Explain the Ownership, custody, access of ot her parties to audit
working papers.
 Understand the Auditor’s lien on working papers.
 Know the Auditor’s lien on client’s books.
 Explain the Main functions, importance, features, contents of
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36  Understand the Meani ng, structure, conte nts, General informa tion,
current information, Importance of Audit Note book.
3.1 INTRODUCTION
In simple terms, planning is thinking before doing. We all think before
doing any importance work. We think about the best method of doing th at
job successfully and in time. Audit o f accounts being an important job, the
auditor thinks in advance before starting any audit and prepares a detailed
programme to be followed to complete the job successfully in time.
Institute of Chartered Accounts is sued detailed instru ctions in this regar d
in 1989. The Auditor should plan his work to enable him to conduct an
effective audit in an efficient and timely manner. .
3.2 MEANING AND OBJECTIVES OF AUDIT
PLANNING
3.2.1 Meaning
Audit planning means plannin g of his work by the auditor. It will hel p him
to conduct the audit in an efficient manner and complete it in time. He has
to plan about the area, scope, depth of transactions to be audited, time to
be devoted for each job, persons to be deployed for diffe rent operations
etc.
Audit plan should i nter-alia cover the following:
1. Acquiring knowledge of the client’s accounting system, policies and
internal control procedures.
2. To what extent reliance should be placed on the internal control
system.
3. Deciding nat ure timing and extent of the audit proced ure to be
performed.
4. Coordinating the work to be performed by different individuals.
The audit plan prepared should not be rigid. As and when necessary, it
should be altered to suit the changed conditions. Plannin g should be
continuou s throughout the eng agement. It involves developing an audit
programme, showing nature, timing and extent of audit procedures.
Changes in surrounding conditions may require revision of the overall
plan. However, when there are signific ant changes, the audi tor should
state the reasons for the same. He must give reasons in support or
justification of the changes made and they should be documented.
3.2.2 Objectives of Audit Planning :
Planning the audit work will immensely help the audito r to complete the
work successfully and i n time. Objectives or benefits of planning audit can
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37
1) If he thinks in advance, he can decide which things are important and
which are not. Accordingly, he can devote more time and attention to
important matters while actually cond ucting the audit.
2) If any problems are likely to crop up, the auditor can find or seek
solutions for the same well in time.
3) Planning will help him to conduct his work efficiently.
4) This will also help him to select a suitable team of a ssistants and
proper ly distribute the job amongst them. Each member of the team
should get that part of the job which he likes and which he can
complete in time. Every person has his own likes and dislikes. If a
person gets a job of hi s liking, he will alw ays perform it more
efficiently and find pleasure in doing the same. In other words, he gets
work satisfaction which is very important. Members of appropriate
levels of capabilities and competence can be selected in the team.
5) Planned w ork can be supervised easily. Suitable di rections and
instructions can be given to the staff in time.
6) Co-ordination between the work done by different members of the
team can be easily done.
7) Audit planning will help the auditor to utilize the services of all
assistants fully and properly.
3.2.3 Factors to be considered while preparing the audit plan :
While preparing the audit plan the auditor should consider the following
factors:
1) Complexity of audit
2) Environment in which the business is working at pres ent.
3) Personal nature of the client. What is the previous experience?
4) Special features of the client’s business.
Before actually framing the programme, the auditor should personally
discuss with the client the proposed programme and consider his
suggestio ns and amendments in this connection. The aud itor should
discuss with the client the overall plan and the procedure he wishes to
follow while conducting the audit. Client’s convenience should also be
taken into account.
Audit plan cannot be formulated by sitting in isolation. It’s a brain -
stormi ng e xercise. The auditor should use his wisdom, foresight,
professional knowledge, previous experience knowledge about the
industry and the particular unit etc. in preparing the audit plan. The plan munotes.in

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38 once prepared, s hould be altered as a nd when there are ch ange s in the
circumstances and a change is warranted.
3.3 PREPARATION FOR AUDIT
Proper execution of any work requires appropriate planning and
programme of action. Before commencing any new Audit, Auditor should
take the following ste ps.
1) Ascertain the s cope of his duties.
2) Procure engagement letter.
3) Acquire complete knowledge about the business of the unit and the
accounting system followed by the concern.
4) Obtain a list of responsible officers.
5) Knowledge of tec hnical details.
6) Inquiry into special cir cums tances.
7) Instructions to the client.
1) Scope of duties :
To begin with the auditor should ascertain the exact nature and scope of
his duties. This question does not arise in case of statutory audit because
his du ties are enumerated i n the concerned law only. E.g., when an auditor
is appointed to audit the accounts of a joint stock company, there are
provisions in the Companies Act about his duties , rights and liabilities.
However, if a concern in which audit is no t legally mandatory, appoints an
auditor, audito r should get clear instructions about the work expected from
him by the appointing authority, so that he can plan his work accordingly.
Auditor should discuss the scope of his duties with the person who is
going to hire his servi ces.
2) Procure engage ment le tter :
Before starting his work, the auditor should obtain his appointment letter
from the client. Such letter should clearly mention amongst other things,
his duties, remuneration, period allowed to complete the job etc. In othe r
words, such letter leads to an audit contract. Such a letter or contract is
highly desirable to avoid any misunderstanding with the client in future.
Such a letter will also help if the client accuses him of not performing the
work p romised.
3) Knowledge ab out business :
Every type o f business has its own special features. So, every business
follows an accounting system that suits its needs. There is no one uniform
accounting system that can be followed by every business unit. So, the
auditor before starting his work of audit s hould s tudy the special problems
of the business unit and the system of account followed by it. If necessary, munotes.in

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39 the auditor should visit the factory and acquaint himself with the
production procedure followed by the f actory. He must acqui re knowledge
about t he raw m aterial and the machines used in production.
An auditor should understand the broad economic environment in which
his client is working. He must also study the different regulatory
provisions and taxes paya ble by the client.
Auditor should obtain a list of all books of accounts and registers etc.
maintained by the firm. He must also study the internal control system
followed. If the internal control system in the concern is adequate and
reliable, he need no t check each and ever y transaction. He ma y adopt test
check system and audit only few selected items in detail.
4) List of Principal officers :
In an Accounts department there may be different officers in charge of
different books of accounts. Auditor should obtain their list so that while
going th rough th e audit procedure, if the auditor needs any information or
clarification on any specific point, he can directly contact the concerned
officer. Auditor should also obtain information about the extent and scop e
of authority of eac h one of them.
5) Know ledge of technical details :
He should also acquire some knowledge about the technical details if any
of the business. This will enable him to grasp easily the nature of the
transactions while auditing them.
6) Enquir y into special circum stances if any :
An auditor should also enquire into special circumstances surrounding his
appointment. He is required to be careful about the implications of such
special circumstances. In case he is appointed in place of another audi tor,
it is his profes sional duty to commu nicate w ith him.
7) Instructions to the client :
After making above preparation, he should issue following instructions to
his client:
a. Accounts should be finalized and kept ready for audit.
b. Necessary schedules be pre pared and made availa ble to him. E.g.,
schedules o f debtors and creditors, bad and doubtful debts, fixed
assets, outstanding and prepaid expenses, outstanding incomes and
incomes received in advance, investments, cost of acquisition and
market price, stock sheets, statements o f deferred revenue e xpenditur e
etc.
Then the auditor should ask for final accounts of last 2 -3 years with
auditor’s reports.
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40 3.4 SOURCES OF OBTAINING INFORMATION
As we have seen earlier, the auditor should acquire full information about
the business of the client before t he actual commencement of audit. He has
to collect this information from the following sources.
Sources of information can be classified into two parts.
1. Internal sources
2. External sources.
1. Internal sources :
Exam ples :
a. Annual reports sent to the share holders.
b. Minutes of Annual General Meetings and those of Directors’ Board
Meetings and Directors’ Committee meetings.
c. Budget forecasts and projections.
d. Auditor’s last year’s working papers.
e. Policy manuals
f. Internal Audit reports.
2. Exte rnal sources:
Exam ples :
a. Trade journals, magazines and news papers.
b. Text books on different subjects.
c. Publications of different professional bodies
d. Industry publications
e. Websites
3. Discussions with the management :
Next source of info rmation is actual dis cussion with the m anagement . The
auditor should meet the senior management staff and discuss in detail
about the special issues relating to the business of the client. He should
obtain information on the following points in particular.
a. Changes in manageme nt, organisational structur e and activities, if any
during the year.
b. Current Government legislation, rules and regulations regarding the
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41 c. Current business developments affecting client.
d. Current or expected fin ancial difficulties o r accounting probl ems.
e. Plant facilities available.
f. Recent changes if any in technology, types of products or services and
production and distribution methods.
g. Important matters arising from previous years’ financial statements,
audit reports and managem ent letters.
h. Chan ges in ac counting policies procedures and internal control made
in the year under review if any.
4. Visit to client’s premises for a personal discussion.
The auditor may personally visit the client’s premises and get f irsthand
information about the plant la yout, pro cess of manufacturing and different
registers etc. maintained. It is always useful to have a personal discussion
with the client about his method of writing accounts and his other
accounting policies.
He may ask to balance all t he accounts in the ledger a nd prepare a trial
balance as on the closing date of the accounting year. On the basis of the
trial balance, the client may prepare Trading and Profit and Loss account
and Balance sheet. Auditor may ask his c lient or his staff to prepare the
follo wing stat ements before he actually starts his work of audit.
a) Bank Reconciliation statement.
b) Arrange the vouchers chronologically or serially.
c) Statement of cash or goods in transit if any.
d) A statement of cheques ret urned from banks.
e) A schedule of Debtor s and cre ditors.
A separate statement may also be prepared of aging debtors i.e., Debtors
outstanding for a long time. All debtors may be sent a copy of their
account with the client and they may be asked to confirm the correctness
of th e balance. Replies received from the debtors may be kept
systematically.
f) A statement of Bills Receivable.
g) A schedule of investments on hand and a statement of investments
sold and purchased during the year. A statement of divid end received
and rece ivable.
h) List o f inventor ies and their location and valuation.
i) A schedule of fixed assets and details about new assets purchased and
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42 j) A schedule of prepaid expenses and outstanding expenses. Similarly, a
schedule of income o utstanding and the income rec eived in advance.
k) A list of long-term liabilities etc.
If the client keeps all the above statements prepared in advance, the
auditor can complete his work within a short time and submit his report to
the client.
3.5 FACT ORS TO BE CONSIDER ED WHILE
PREPARING AUDIT PLAN
While preparing the audit plan the auditor takes into account the following
factors:
1. Terms of appointment :
If audit of the unit is compulsory, terms and conditions of audit are
containe d in the concerned Ac t itself. If audit of a firm is done voluntarily,
then the client should give him a letter of appointment stating the terms
and conditions of his appointment scope of his work etc. Auditor will take
these terms in to account while prep aring his audit plan.
2. Audit Report :
Auditor has to prepare his report at the end of his work. The contents of
the report will vary according to the terms of his appointment. In some
acts is making appointment of the auditor where mandatory, the format of
the report is also g iven and the audit or has to s ubmit his report to the client
in that format only. Copies of his report are also to be sent to certain
parties as per the provisions of the concerned act. E.g., A copy of the
auditor’s report of a Joint St ock Company is requir ed to be submitted to
the stoc k Exchanges along with annual returns.
3. Legal requirements :
If there are any special provisions in the concerned law regarding the
Audit, Auditor should take them into account while preparing the audit
plan.
4. Accounting Polic ies :
Every concer n may adopt certain accounting policies to suit their needs.
These policies, once decided are not usually frequently changed. However,
when it becomes necessary, the firm may change these policies. The
auditor should take in to account th ese existing polic ies and chan ges made
in them during the year under consideration. If such changes, affect the
final results of the year, the auditor should mention the effects of these
changes in his final report.

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43 5. Changes in the A ccounting standards :
The Institute of Chartered Ac countants has prescribed certain accounting
standards. Changes are made and new additional standards are added by
the Institute from time to time. Business people have to keep their books
of accounts accor ding to these standar ds. So, the audito r should tak e in to
account the prevailing accounting standards while preparing his audit plan.
6. Deciding the possible areas of errors and frauds:
While conducting the Audit, the auditor should decide, on the basis of his
past experience the possible areas where fraud s are likely, and the auditor
should check these items in greater details. This fact should be taken into
account while preparing the audit plan.
7. Reliance on internal control system :
Though the accounts are audited at the en d of the year, eve ry concern h as
its own internal check system in at least some areas to prevent errors and
frauds. A simple definition of internal check system is to follow a routine
wherein the work done by one person is routinely ch ecked by another.
E.g., in a department al store, one man sells the goods on the counter, next
man prepares its bill third man packs it and finally the cashier at the
counter collects the price. All these 4 people independently maintain a
record of goods so ld. At the end of the day records thus maintained by
different employees are tallied with each other. Thus, there are checks and
counter checks on sales. Auditor will study the prevalent internal control
system and will decide how much to rely on it. Where there is a reliable
internal check sys tem, the audit or need not check every item in detail. He
can adopt test check system and audit only certain items selected at
random. Auditor should devote more time to check these items where
frauds are more likely.
Considering the natu re and volume of w ork, the audit or should decide the
number of staff members required to complete the work within the time
limit. He should select the staff with appropriate skill and efficiency.
Check your progress:
1. Give the examples of Internal and Exte rnal sources.
2. Enlist the points to be considered while preparing the audit plan.
3.6 AUDIT PROGRAMME
3.6.1 Meaning
The auditor should prepare a written programme containing procedures
needed to implement it. It should also contain a udit objectives. Detai led
instructions s hould be inclu ded so that the assistants can properly
implement the programme. If the assistants follow this programme, it will
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44 While preparing such a programme the audito r has to decide to what
extent h e can rely on the internal control system being used by the
business unit. If there is a proper internal control system, auditor need not
check each and every item in detail as possibilities of errors a nd frauds are
rare. If he feels that the system is not sufficiently reliable, he must insist
on production of appropriate reliable evidence for every transaction
entered in the books of accounts. The auditor may also decide the timings
for different proced ures to be followed. H e must also take i nto account th e
number of assistants he can spare for this particular assignment.
Usually, the auditor has enough freedom to decide the timing. However
sometimes he was no such option. E.g., If he has to check the c losing
stock, he has t o do it on the las t working day on ly.
The auditor may have to make changes in the plan if there are significant
changes in the circumstances. In other words, the Audit plan should be
flexible.
 Audit Programme :
To complete his work successfully in time, the auditor should draw up an
audit programme for every audit especially in the case of audit of a large
concern. Audit programme is a sort of a time table containing the
sequence in which the auditor wants to verify the books of acco unts of the
firm and t he time he allots to each operatio n.
3.6.2 Development of an Audit Programme :
While developing an audit programme the auditor should pay special
attention to the following points :
1. Internal Control :
Before preparing the audit progra mme the auditor should study the
interna l control system prevalent in the organisation and to what extent it
is reliable. In the field in which the system is found to be reliable, the
Auditor need not verify each and every item in detail. He can pick and
choose some items at ra ndom and adopt tes t checking. However, in the
fields where the control system is not found to be strictly followed or is
not sufficiently reliable the auditor should go and check each and every
item in detail and insist on reliable ev idence in support of s uch entries.
E.g., If there is prope r internal control system on purchases and sales and
perpetual inventory system is in vogue, the auditor need not spend more
time on verification of closing stock.
2. Business of the Client :
The audi tor should study the s pecial features of the client’s busi ness and
develop a suitable audit programme. E.g., Audit programme for a service
industry like a bank will be entirely different from the audit programme of
a factory. While auditing a bank, the aud itor should pay more a ttention on
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45 should pay more attention on purchase of machinery and its proper
depreciation, purchase of raw material and its utilization etc.
3. Cost benefit :
Audi tor cannot neglect the cost factor. He m ust take in to acco unt the cost
involved in following the procedure and the benefit that accrues.
Procedure which costs the least should be naturally selected.
4. The auditor should consider all the possibilities of er rors.
5. Different proce dures adopted shou ld be suitably coordinated .
6. Assistants available :
The auditor should take into account the number of assistants he can make
available to complete this assignment.
7. Other Auditors :
If services of internal auditor, Branch Auditor or outs ide experts are
available, the audit or should decide to what extent he can rely on the work
done by them.
3.6.3 Advantages of an Audit Programme.
1) It will ensure that each and every book of account and the register is
verified. Th ere is absolutely no p ossibility of any book being left ou t
through oversight.
2) If facilitates the work of distribution of the job by the chief auditor
amongst his subordinates. He can make proper distribution of the work
amongst different audit assista nts. While dividing th e work amongst
different persons, th e Auditor should take into account each person’s
past experience, qualifications, efficiency, likes and dislikes, level of
understanding and work habits etc.
3) Chief auditor can see the day-to-day progress of the work at a glance.
4) As the work is care fully planned in advance and distributed, control
over the work of the assistants becomes easy.
5) It facilitates timely completion of the work. If on any day any assistant
is absent another person can continue the work as he can easily know
what work the earlier person has actually completed on the previous
day.
6) If later on any mistakes are noticed responsibility for the lapse can be
easily fixed on the concerned person and suitable action can be taken
against him. Remedial action ma y be taken immedia tely if necessary.
7) This years’ programme is very useful while preparing the programme
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46 8) Audit programme contains instructions to the concerned staff about
carrying out their work.
9) It makes th e job of selection of suitable perso ns for different jobs easy.
10) It facilitates systematic auditing.
11) It serves as a guide for audit work in future.
12) In future if nay case is filed against the auditor for negligence in du ty
etc. it an be produ ced in the court a s an evidence to p rove the actual
work done.
13) There is uniformity in the audit work done.
14) It enhances the efficiency of audit staff.
15) It is very useful to the Auditor, while preparing his final audit report.
16) Due to s ystematic working, the auditor may g et more clients.
17) Potential problems are promptly identified and services of assistants
can be fully and properly utilised.
18) Co -ordination of the work done by different persons becomes easy.
3.6.4 Disadvantages of an Audit Progra mme :
1. The work may become mechanical. A part of the audit programme
may be carried out without understanding the importance of that part
in the complete work of audit.
2. Programme may become rigid and inflexible. Ther e are continuous
chang es in the business world. If Cognisa nce of these changes are not
taken in to account in time, original programme itself may be carried
out.
3. A hard and fast programme may kill the initiative of efficient and
enterprising assistants.
4. Elaborate programming may not be necessa ry in the case of the audit
of a comparatively smaller concern. Here programming may just
amount to unnecessary waste of time and energy.
5. The job may be finished hurriedly to complete it within the time
schedule. So , the quality of the w ork may be affecte d.
6. A uniform aud it programme cannot be used in the audit of every
company. A fresh programme unit is to be prepared for each and every
audit every year. Thus, it becomes a time-consuming activity.
7. Assistants may no t verify anything more than what is give n in the
programme .
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47 All these disadvantages may be eliminated by imaginative supervision of
the work carried on by the assistants. Assistants should be encouraged to
suggest changes in the programme as and when nec essary.
Secondly if w e take an overall view, the advantag es outweigh the
disadvantages and programming is absolutely necessary atleast in the case
of audit of bigger concerns.
3.6.5 Method of Work:
In order that an audit may be carried out in a systemati c and efficient
manner , the following st eps should be take n:
1) Work may be carried on regularly. Record of time of arrival, and
departure of the staff should be maintained with the actual work done
by each member of the staff every day. Entries should be mad e in the
audit note bo ok.
2) Definite port ion of the work sh ould be completed every day.
3) Different coloured pencils should be used and different types of ticks
should be done for different jobs. These should not be disclosed to the
staff of the client.
4) Vouchers examined should be immediately can celled so that the same
may not be produced again.
5) Staff members should not discuss amongst themselves or with
outsiders the details of the client’s affairs. They should maintain
absolute secrecy about these matters .
6) The auditor should collect sufficient evidence to enabl e him to form an
opinion about:
a. Truth and fairness of the accounts and that
b. They are kept regularly following all necessary legal
requirements.
7) All assets and liabilities should be properly class ified and mentioned.
8) Details of mortgag ed assets must be clearly stated.
9) Income and expenses should be properly classified and stated.
10) No material omissions should be done.
11) Errors and frauds are avoided.
12) Books of accounts should be properly kept.

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48 3.7 AUDIT WORKING PAPER S
3.7.1 Meaning
Audit working pa pers constitute the link between the auditor’s report
and client’s records. Documentation is one of the basic principles. SA 230
audit documentation refers to the record of audit procedures perform ed,
evidence obtained a nd the conclusions reached by the au ditor.
 Information contained in the working papers:
Audit working papers are also called working papers or simply work
papers. They contain a record of the audit work done Inter alia (amongst
other things) they contai n information on t he following point s:
a) Evidence of audit work performed
b) Schedules prepared
c) Additional items in the accounts.
d) Information in short about the business of the client and its recent
history.
 Working papers include:
Working papers of audit of diffe rent concerns are different. But usually
they contain the following:
1) Memorandum and Articles of Association in the case of a company
audit, partnership deed in the audit of a partnership firm and Trust
Deed in th e audit of a Trust.
2) Extracts from min ute books of meeti ngs of managing committee.
3) Trial Balance Sheet and profit and loss account.
4) Letter of appointment or engagement given to the auditor etc.
5) Correspondence done between the auditor and out siders like banks,
Insurance companies, d ebtors, creditors etc.
6) Details regarding valuation of stock.
7) Certificate from the management regarding stock and its valuation.
8) Bank Reconciliation statement.
9) Adjustment entries passed.
10) Details o f investments.
12) Contingent liabilitie s.
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49 14) Certificate from the management regarding accrued liabilities.
15) Any other working papers.
3.7.2 Importance of working papers:
1. The auditor can understand the sincerity of his a ssistants.
2. They are us eful to the audito r when he finally drafts his report.
3. If there is a change in the Audit staff the new incumbent can easily
continue the work i.e., link up his work with the work done by the
earlier member of the staff.
4. These paper s provide training to t he audit staff.
5. Auditor can plan his next years programme on the basis of these
papers.
6. Auditor can understand the weaknesses of the internal control system
in the organisation.
7. In future, if there is a suit against the auditor acc using him of
negligence in his duties, he can easily defend himself in the court of
law on the basis of these papers.
8. Exercising control over the audit work is facilitated.
9. If any mistakes are noticed subsequently in the work carried on by the
staff the auditor can easily fix responsibility of the same on the
concerned staff member and take suitable action against him if found
necessary.
In view of their importance, the auditor should keep these papers in a safe
custody and retain them for a reasonable p eriod of time.
3.7.3 Classification of working papers :
Working papers should be properly organized. All significant matters
which require the exercise of judgement by the auditor should be included.
The conclusions drawn by the auditor on the basis of t hese papers should
also be recorded. Some schedules he gets prepared by the client’s staff and
some he prepares himself with the assistance of his own staff. Clients are
mostly permanent. They do not frequently change their auditor because
the auditor has secret information abou t their business. So, the working
papers collected are classified into two parts.
1) A permanent audit file
2) The current file

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50 1) Permanent File:
A permanent audit file normally contains papers which can be used every
year. The file is updated as and when necessary. It includes the foll owing
papers:
Contents of Permanent Audit file
a. Memorandum of association. Articles of association partnership and
Trust Deed etc.
b. Description of the business of the client.
c. List of books of acco unts maintained and nam es of concerned of ficers.
d. Informati on on accounting policies like method of depreciation,
valuation of stock etc.
e. Copies of continuing contracts
f. Copies of balance sheets of earlier years etc.
2) Current file or Audit administrati ve Papers:
These papers are concerned onl y with the current year’s audit. All the
work done in the course of audit planning, assignment of staff, evaluation
of internal control and audit programme are included in this group of
papers. Usually, this file co ntains the following pa pers :
a. Appointment letter
b. Discussion with the management and client.
c. Audit time budget
d. Internal control systems
e. Audit programme
f. Trial balance prepared
g. Adjustment entries passed
h. Copies of communications the auditor has with bank ers, creditors,
debtors etc. and replies received.
As worki ng papers are important and are to be preserved for a longer
period, there should be a standard form in which they should be prepared.
There should be proper layout and space for margin. They shou ld be
complete and ther e should be clarit y and accuracy. A g ood quality paper
should be used for this purpose.

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51 3.7.4 Ownership and custody of working papers :
There is a controversy amongst the different experts about the ownership
of these papers. An i mportant and relevant q uestion arises as to who is the
owner of these working papers. One set of experts say that their ownership
is with the auditor whereas others argue that they belong to the client.
First category of experts argues that they are prepa red by the auditor. So,
he has a right ov er them. He can use them in future as evidence in the
court of law if any case is filed against him for negligence of his duties.
He has spent his time and energy on them. So, naturally their ownership
should go to him.
People in the sec ond category argue that their ownershi p should go to the
client as these papers contain important and sometimes even secret
information about his business. So, to preserve or maintain trade secrets,
audit papers should be handed over to the client as soon as the job of
auditing his accounts is over. He is the agent of the client and should
surrender the papers to him.
Both the arguments have some substance or force in them. However, in an
English case in 1938 Soekoc Kinsky Vs Bright Grahm & Co. it was held
that the working papers belonged to t he auditor because they were
independent contractors and not agents of the client. In a second case
Chantrey Martin & Co Vs Martin in 1953 it was held that working papers
prepared by the Accounta nt for the sole purpose of producing a ba lance
sheet belonged to the client. The court opined that where the accountant
merely acted as agent of the client like in the case of corresponding
between the Accountant and Income Tax Authorities, the papers belo ng to
the client and no t to the accountan t.
On the basis of these judgements, we can conclude that generally an
Auditor as an independent professional is entitled to the working papers
prepared by him. However, where he corresponds with any third party as
an agent of the client , the papers right fully belong to the principal. But
where an auditor has not been paid his fees, he can retain such papers. He
has a right of particular lien upon the books of accounts and other
documents also.
According to the vie ws of the institute of Chartered Accounta nts, the
working pape rs are property of the auditor. Auditor should however
maintain confidentiality of the information in the papers and properly
maintain these papers for a reasonable period of time He can give co pies
of some papers if demanded by the cl ient.
3.8 AUDIT EVIDENCE
Audit Evidence are the information collected in the process of auditing. It
is an important tool to support the conclusion given by the auditor in the
audit repo rt to the shareholders of t he company . Audit evide nce is not only
useful to form an opinion but als o useful as a defence to prove that there
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52 defined as a term to protect investors by promoting transparent, accurate ,
and independent audit reports.

Chara cteristics of Auditing Evidence
Quality if the auditing evidence can be measured by the understanding
degree of the application of the following characteristics:
1. Sufficiency: Sufficiency takes into consideration the a dequa cy of the
data i.e . whether or not the documents and evidences provided is of an
adequate quantity for arriving at the jud gemen t. If an au ditor was
given details of only three branch out of t he twenty branches , it would
be considered as insufficient f or the financial standi ng of that
company.
2. Reliability: Reliability answers to the quer y that whether or not the
material can be trusted and can counted on for fo rming an opinion.
Reliability of the information is directly correlated to the source of the
information .
3. Source: As discussed earlier t he source of accounting evidence can be
obtained directly from the company or externally. External source s
are generally regarded as more trustworthy and hence preferred.
4. Nature: Nature refers to the type of inform ation that is received. For
example, the information can be provided through legal documents,
presentations, orally from employees, or through a physical
confirmation.
5. Relevance: Dep ending on the type of audit being conducted, how
pertinent the information received in its relati on to the overall analysis
is a guiding factor.

Audit procedures for obtain ing audit evidence :
There are seven types of audit procedures:
1. Inquiry : Auditors talk with the client’s senior management to gain a
deeper understanding of b usiness processes for t he auditing process.
Inquiry is however not restricted only to senior management; it may
be done even with lower -level employee or factory workers based on
the information required . Inquiry alone, however, is not considered
sufficien t audit evidence to red uce the audit risk.
2. Inspection. The process of inspection involves collect ion of evidence
by the way of inspecting physical assets, records, or documents.
3. Observation. Under observation, a uditors observe the client’s business
process es and operatio ns in or der to identify any lag or deficiencies
related to the business process which ca n lead to errorous output .
4. External confirmation. It is the process whereby th e auditors attempt
to seek the information from the third parties by variou s means like
telephonic confirmation, mail confirmation , letter confirmation etc., to
verify the financial information and accounting records provided by
the client. Ecxternal co nfirmation can be negative confirmation or
positive confirmation . In negative confirmation , the third party will
reply only i f he doesn ot
5. Recalculation. The auditors perform their own calculations to verify
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53 6. Reperformance. Auditors may reperform certain tasks or processes to
identify d eficiencies and discover opportunities for further
optimization.
7. Analytical procedures. Auditors analyze the client’s f inancial records
to find discrepancies.

3.9 AUDIT NOTEBOOK
An audit notebook is a component of audit working pape rs that keeps a
record of a wide range of issues that are observed during the course of the
audit and for which the client's answers are either inadequate or must be
included in the audit report. The au dit staff keeps a diary or register to
record any erro rs or irregularities discovered during the audit. When the
auditor sorts his work papers into permanent and current audit files. The
audit notebook is part of the current working paper file because it i s
required to keep a new audit notebook for each fisca l year. It is one of the
permanent segments of the auditor's records that is available for future
reference whenever necessary. It is divided into two parts:
a. One that records general information pert aining to the audit as a whole.
b. One in which audito r enters special points discovered during the audit
process of various years.

3.9.1 Contents of Audit Notebook:
Some of the points recorded in an Audit Notebook are as follows:
A. General Details:
(i) The nature of th e business conducted and the important documents
pertaining to the business's formation.
(ii) The client's name and the audit year.
(iii) A list of the books of accounts currently in use.
(iv) The names of the principal officers, as well as their duties an d
responsibilities.
(v) Specifics of t he accounting and financial system used, as well as the
internal
(vi) check -in procedure in the business.
(vii) Information about the company's accounting and financial policies.
(viii) A duplicate of the audit program me.
(ix) Business -related technical te rms.
(x) Any notes or queries that may be required during a subsequent audit.
B. Special Issues to be Documented in the Audit Note Book
(i) Routine queries that have not been resolved, such as missing receipts
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54 (iii) The issues raised during an audit that must be brought to the auditor's
attention, such as the company's failure to comply with the provisions
of the Companies Act or the Memorandum of Association, as well as
other legal requiremen ts.
(iv) Extracted from minute books and contracts, as well as other
correspondence with various government agencies, financial
institutions, debtors and creditors, and so on.
(v)The points that will be included in the audit report.
(vi) Points that requir e additional explanation and clarification, such as a
change in the basis of valuation of finished goods or the computation
of depreciation, etc.
(vii) Dates of audit commencement and completion

3.9.3 Importance of Audit Notebook
a. Assistance in Audit Re port: The audit notebook assists the auditor in
preparing an audit report. For each concern, a separate audit notebook
is kept.
b. Moral Check on employee: The audit notebook is used to assess audit
clerks' integrity and honesty. Auditing can be used to ex amine moral
and ethical values.
c. Check on the w ork of an audit sta ff: An auditor can appreciate someone
who comple tes his work on time. He may be held liable for any
outstanding work after the period has expired.
d. Record f or the future: The audit noteb ook aids in the retention of
information. The auditor can read the book on a daily basis.
e. Guidelines for the audit staff: Since the audit notebook is helpful for
future reference , it will be able to provide information to the audit staff
in the future.
f. Better understanding of the accounts in future : A new auditor will
benefit from the audit notebook. They can see the flaw in the past .
g. Defence in the cour t: The audit notebook aids an auditor's defence in
court. People can go to court to determine li ability for duty negligence.
The audit notebook is written proof of an auditor's work.

3.10 SUMMARY
This chapter deals with Audit Planning procedures and documentation.
Any important t ask to be completed successfully needs proper planning.
Similarly Audit of a firm needs proper pre planning before it is actually
performed. All the inf ormation of the client’s business is first collected.
His accounting system is studied. A list of books of accounts maintained
along with the names of the persons responsible to maintain each book is
obtained, Accountant of the client is then asked to clos e the books of
account s and prepare a Trial Balance and Trading and Profit and Loss
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55 system prevalent in th e organisation and decides to what extent he can rely
on the same. If the system is satisfactory, he ma y adopt test checking. In
such cases he need not waste much time on routine checki ng of each and
every item.
Auditor collects information about the cli ent’s business from various
sources – internal as well as external. He discusses relevant issues with t he
client. If necessary, he visits the client’s premises and his factory.
Accounti ng policies adopted by the client are noted down.
Auditor decides the number of persons to be spared for the particular
Audit assignment taking into ac count the volume of wo rk involved. The
task is divided amongst different assistants taking into account their past
experience, qualifications, degree of efficiency and likes a nd dislikes.
Time schedule is to be prepared. Dates of commencement and completio n
are decided. These d ates are decided in consultation with the client taking
in to account his convenie nce. Thus, an Audit programme is developed.
Audit programme has number of advantages. It ensures that each and
every book of account and register is ch ecked. Auditor can see the
progress of the work completed every day. Audit Assistants can follow the
instructions given in the programme and complete the work in time, work
is done systematically. Possible problems are properly dealt with Co -
ordination bet ween the work done by d ifferent assistants can be easily
done.
There are also some disadvantages for Au dit Programme. Work becomes
rigid inflexible and mechanical. It may kil l the initiative of the efficient
and enterprising assistants. However, by imagin ative supervision, the
disadvantages may be overcome. There is no alternative to planning and
programmin g specially for the efficient, systematic and timely completion
of audi t of large concerns.
Audit Working Papers :
There are two files of working pape rs – 1) Permanent file 2) Current file.
Permanent file consists of documents like Memorandum of Assoc iation,
Articles of Association, Partnership Deed, Trust Deed etc. Curr ent files
contain Bank Reconciliation statement prepared, contingent liabilities,
Adjustment entries pas sed etc.
Working papers are very useful to the Auditor while preparing his final
report. They can also be used as evidence in the court of Law if
subse quently any case is filed against the auditor for negligence in his
duties. They are the evidence of the work done by the Auditor and his
subordinates. They are carefully prepared and p reserved for a reasonable
period of time.
There is a controversy among st the experts about their ownership.
However, courts have held that they belong to the Auditor and not t he
client. However, the Auditor should not misuse the secret information
contain ed in them about the business of the client. He may at his discretion
give copies of the same to the client.
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56 3.11 QUESTIONS
1. Explain the importance of A udit Working papers.
2. What are the contents of Working Papers?
3. What are the contents of Audit Programme?
4. Write a short note on :
a) Audit Note Book
b) Audit Planning
5. Explain curre nt file. Give examples of its contents.
6. Elaborate the factors considered by an a uditor while preparing a n
Audit plan.
7. What do you mean by an Audit Programme? What are its contents?
8. Discuss the importance of Audit Note Book.
9. Explain “Permanent Audit File . Give examples of its contents.
10. Explain Audit Working Papers and Auditor’s lien on them.
11. Objective typ e questions:
A. Select most appropriate option and rewrite the following sentences.
a) Audit Programme should be –
i) Oral
ii) Rigid
iii) Flexible
iv) Oral and Flexible
b) Working papers are the property of the –
i) Client
ii) Auditor
iii) Client an d Auditor
iv) Equity Share holder
c) Audit programme must be prepared –
i) Before commencement of an audit.
ii) During the conduct of an Audit.
iii) After completion of an audit.
iv) After submission of an audit report.
B. Write True of False.
a) Audit plan should be primarily based on knowledge of client’s
business.
b) Permanent Au dit file includes Trust Deed.
c) Audit working papers constitute the link between the auditor’s report
and client’s records.


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57 4
AUDITING TECHNIQUES
Unit Structure :
4.0 Objectives
4.1 Introduction
4.2 Test Checking
4.3 Audit Sampling
4.4 Internal Control
4.5 Internal Check
4.6 Internal check system for business tractions
4.7 Distinguish
4.8 Summary
4.9 Questions
4.0 OBJEC TIVES
After studying this unit, the students will be able to:
 Understand the concept routine checking.
 Know in detail about Test checking
 Learn about Audit sampling.
 Know in detail about internal control system and its utility.
 Understand the differenc e between Internal Checks , Internal Control,
and Test Checks
4.1 INTRODUCTION
Routine checking involves checking of such common records and books
which is carried on by the auditor as a matter of routine. Routine checking
includes checking the casting car ry forwards and other calculations in the
books of original entry. Posting from these books to relevant accounts are
verified. Balancing and carry forward of different ledger accounts are also
verified. While doing this routine checking the auditor uses di fferent types
of ticks and different coloured pencils so that they may not be copied
easily by the staff of the client. Information about these ticks is kept secret
e.g., normally we use blue or black colour pen but to keep their separate
identify auditors use a green colour pen. The auditor uses special ticks for
each c lass of transaction checked. Like posting, casting, carry forward,
bank statement and vouching. As far as possible the same tick should not
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58 these ticks. While auditing each section, w ork should be completed up to a
certain point otherwise the chances of mistakes increase.
All important balances and totals and note worthy points should be noted
down in the Audit Note Boo k. Vouching work should be done by two
audit assistants together. The Auditor should not accept any figures
written in pencil because they can be easily changed after auditing. He
should insist on writing the figures in ink only.
4.2 TEST CHECKING
4.2.1 Difference between Test Checking and Routine Checking :
Test Ch ecking Routine Checking
Meaning
Here only parts of the transactions
are checked to form an opinion. Detailed checking of all
transactions at all stages.
Objectives
To obtain reasonable level of
satisfaction about all transactions
by verifying only a few
representative transactions To verify arithmetical accuracy,
accuracy of posting to ledgers,
correctly balance the ledger A/cs
Advantages
Volume of work is reduced, time is
saved Errors and frauds are easily
detected and trial balance can be
easily prepared
Disadvantages
Some errors and frauds may go
undetected as all the transactions
are not checked. There is doubt and
risk in the auditor’s opinion.
Highly mechanical process and
monotonous activity. If may lead
to boredom, compensating errors
and errors of principle will not be
detected

4.2.2 MEANING
The main objective of audit is to formulate an overall opinion on the
accounts and financial statements of a unit. This enables the auditor, to
finally submit his report to the party concerned. He has to express his
opinion on the quality of the accounts maintained and whether they give a
true and fair views of the profits earned and valuation of assets and
liabilities.
In a large o rganisation there are thousands or even lakhs of transactions to
be verified. It is practically impossible for any auditor to physically verify
each and every transaction. In such concerns if there is an effective
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59 system. He need not check each a nd every entry thoroughly. He can check
in depth few items selected at random and if he finds that there are no
errors in them, he can pressure that other entries are also correct and
procee d further.
Thus, test checking can be defined as “in depth checki ng of only few
selected items and form an opinion about the quality of the accounts”.
If the items selected are correct, he can presume that other entries are also
correct. For the success o f test checking system, representative number of
entries of each c lass is selected for checking. Test checking is an accepted
substitute of detailed checking. In many cases, hundred percent checking
of entries is neither possible nor necessary. It will als o involve lot of
unnecessary expenditure. Test checking is based o n the theory of
probability. If the sample is truly representative of the population, the test
checking will give reliable results.
4.2.3 Features of Test Checking
Test checking consists of selecting and checking a proportion of
transactions selected by t he Auditor. The salient features of Test Checking
are –
1. Scientific: It is a mathematical truth that a scientifically selected
sample would reveal the features and characteristics of the popu lation.
The statistical theory of sampling is based on a scientifi c law. Hence, it
can be relied upon to a greater extent than any arbitrary technique
which lacks basis and acceptability.
2. Estimation Process: Test Checking and Sampling can never bring
compl ete reliability; it cannot give accurate results. It is a process of
estimation. What error is tolerable for a particular matter under
examination is a matter of the individual's judgment in that particular
3. Coverage of material items : Entries involving la rge amounts or
relating to material accounts are seen exhaustively and other entries
are picked up for verification from the remainder according to a
certain plan. Sometimes entries are checked for a few specified months
exhaustively and the rest go unchec ked.
4. Full Coverage over a time period : Test Check is normally pla nned
in such a way that the audit programmes for 3 to 5 years cover all
types of transactions in case of a medium or large sized Company.
Thus, if in one year the months of January, June and December are
checked; April, July and September may be checked in the second year
and so on.
5. Surprise Element : The staff and management of the Auditee
Company should not be able to anticipate the pattern of test checking,
otherwise they will predict the areas and periods to be covered in any
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60 6. Flexibility : If test checking becomes routine, predictable and
mechanical, it loses its value. Hence, the Auditor should keep
changing the methods of test checking at reasonably frequent intervals.
7. Judgment Based : The extent of tes t checking would primarily
depend on the Auditor’s judgment of a particular situation. This
judgment in turn depends on the previous experience of the Auditor,
current developments and the e fficacy of Internal Control System.
Anyway, the auditor has to ver ify the financial statements with the help of
available evidence. He has to pay special attention to:
1) The method of presentation,
2) Information disclosed
3) Arithmetical accuracy,
4) Following principles of accounting
5) Complying the provisions of the laws applicable to that business.
There should be no errors and frauds in the books of accounts. The auditor
should know why errors and frauds occur and how they are committed. It
is his prime duty to detect them.
4.2.4 Factors to be considered while adopting Test Checking:
The numbers of transactions in any large concern are large. There will be
number of purchases and sales. Salary may have to be paid to thousands of
workers. There ma y even be overseas transactions. Bank loans, letters of
credit, ov erdrafts, bills discounted etc. may have to be verified. There is
the problem of volume and variety. So, selection of the items for test
checking should be carefully done.
It should be reme mbered that by adopting test checking the auditor only
reduces his physical labour. However, in no way it reduces his liability.
Subsequently if any error or fraud is detected in the accounting entries
which were not checked by the auditor due to adoption of test checking, he
will still be held personally liable for negl igence in his duties. So, he must
be doubly careful in selecting the items for test check. They should be
fairly representative items and he should be fully satisfied that they are in
order. If he comes across anything fishy, he must give up test checking
and check all the entries.
While selecting items for test check auditor should consider the following
points:
1. He should classify the transactions under appropriate heads.
2. He should thorou ghly study the system in the concern from
authorisation, documenta tion, recording and evidencing the same. The
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61 3. The auditor should carefully study the internal check system followed
by the concern. As we have seen earl ier, internal check system means
a system where the work of one is automatically checked by the other
as a matter of routine. Financial data provided by the system should be
reliable. If and only if the auditor is fully satisfied by the internal
check syst em, he should adopt test check. Not otherwise.
4. There should be ab solutely no bias in selecting items for test check.
5. Test check should not be adopted in the audit of such concerns where
there are only few transactions of large amount. E.g., A company may
have only 20 export or import transactions and each transaction m ay
be in crores of rupees . In such cases, 100% transactions should be
checked.
6. The number of transactions to be selected for test check is decided by
the degree of reliance on the internal check system.
7. It the auditor comes across any material errors; they sh ould be
properly and thoroughly investigated.
4.2.5 When test check can be used.
Test check can be used only under the following circumstances :
a) When the number of transactions to be audited is very large.
b) The auditor has limited time at his dispo sal.
c) There are number of identical transactions.
d) There is efficient system of internal control.
e) Audit history of the organisation in the past will also decide the size of
the sample. The areas requiring audit depend on the previous history .
4.2.6 Precautions to be taken:
Test checking means examination of few selected transactions from the
beginning to the end through various stages. The auditor has to take
following precaut ions while adopting this system:
1. For the success of the system of test checking, samples of transactions
selected should be fairly representative. It is a mathematical truth that
scientifically selected sample would reveal the features and
characteristics of the population.
2. There should be some surprise element. Clien t’s staff should not be
able to anticipate the pattern of test checking. Otherwise, they will
predict the areas and periods to be covered for audit and will be careful
only about those trans actions and neglect the others.
3. There should be flexibility. Audi tor sh ould change his method of
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62 appropriate transactions for test check, the auditor should use his past
experience and discretion current developments and changes made in
the internal c heck s ystem, should also be taken in to account.
4.2.7 Merits of Test Check
1. Effectively reduce Work Load: It is a partial record check from the
books of accounts. Because it is difficult to check all financial transactions
included in the books of accounts, it only examines specific financial
transactions. As a result, work loa d is reduced and auditing tasks can be
completed more quickly.
2. Time and labour savings: Checking a large volum e of transactions takes
more time and energy. Only selected transactions are examined during test
checking, which saves time and labour.
3. Cos t Effective: Performing a test check reduces the amount of work,
time, and energy required. It means that audit t asks can be finished in less
time and with less effort. As a result, the cost of auditing is reduced.
4. Suitable For Large Firms: Because it is difficult to test each and every
transaction, it is best suited for large corporations with a high volume of
financial transactions.
5. Accuracy and Reliability: Sample transactions are carefully and
intelligently chosen with special care. As a result, it ensures the accuracy
and dependability of record checking.
4.2.8 Demerits Or Disadvantages Of Test Check
1. Err or Probability: In test checking, financial transactions are examined
at random. As a result, there is a hig h likelihood of undetected frauds and
errors in the books of accounts.
2. Unsuitable For Small Businesses: Test check is unsuitable for small
busine sses with few financial transactions.
3. Internal Check And Internal Control: If the organisation lacks a st rict
internal check and internal control system, it is impossible to conduct an
internal check because it may report false data.
4. Doubtful And Sus picious: The audit report is prepared on the basis of a
few sample transactions that have been reviewed inte rnally. As a result,
auditors are always skeptical and suspicious.
4.3 AUDIT SAMPLING
4.3.1 Meaning:
"Audit sampling" means the application of audit procedures
to less than 100% of the items within an account balance about some
characteristic of the items selected in order to fo rm or assist in forming a
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63 It is important to recognise that certain testing procedures do not come
within the definition of sampling. Tests performed on 100% of the items
within a population do not involve sampli ng. Li kewise, applying audit
procedures to all items within a population which have a particular
characteristic (for example, all i tems over a certain amount) does not
qualify as audit sampling with respect to the population examined, nor
with regard to th e popu lation as a whole, since the items were not selected
from the total population on a basis that was expected to be representat ive.
Such items might imply some characteristic of the remaining portion of
the population but would not necessarily be the b asis f or a valid
conclusion about the remaining portion of the population.
4.3.2 Purpose of Aud it Sampling
Audit sampling must be u sed regardless of whether the audit is internal,
external, or government in order for auditors to complete their audits
without wasting resources checking every singl e item. The following are
the audit sampling objectives:
a. Collect sufficient evidence to fo rm an audit opinion.
b. Reduce the number of resources used
c. Provide auditors with the basis for forming a conclusive audit
opinion
d. Detect potential errors or fraud.
e. Ensu re that audit completely in accordance with auditing standards.
f. utilised as a research too l

4.3.3 Methods of selecting Sample Size:
SA 530 deals with Audit sampling. (S.A. standards on auditing issued by
the institute of chartered accountants of India). There are two methods of
select ing the size of the sample and individual items. They are:
1) Judgmental sampling
2) Statistical sampling
Whichever method is adopted it should be particularly noted that the
sample selected must be representative. It should be closely similar to t he
whole population. It should be large enough to provide statisti cally
meaningful results. Sample should be selected in such a manner that it is
representative of the whole population. Each item in the population should
have an equal chance of being inclu ded in the sample.
1) Judgmental Sampling Method :
Here size and composition of the sample are decided on the basis of his
past experience and knowledge by the auditor. It is decided at his
discretion. The method is simple. So, it was adopted for several years.
Auditor may decide the number of pages or personal accounts in the
purchase or sales ledger to be checked. E.g., January, April, July and
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64 May, August and November months maybe selecte d next year. However
usually a large number of items at th e close of the year are selected for
detailed checking.
Some people criticize this method. They say that the method is neither
objective nor scientific. Risk of personal bias cannot be comp letely
eliminated. Statistical techniques are not used. Selection of items is
entirely left to the discretion of the auditor. But mostly, experienced
auditor will succeed in selecting right representative items.
2) Statistical Sampling:
The auditor should select sample items in such a way that the sample can
be expected to be representative of the population. This happens only
when all the items in the population have an equal opportunity of being
selected.
This is a scientific method of selection of samp les. Hen ce definitely better
than the earlier discussed judgment s ampling method which entirely
depends upon the discretion of the auditor. Statistical sampling methods
use mathematical laws of probability in determining the sample size in
different circu mstances . This method is widely used especially where the
populati on consists of large number of similar transactions. It is also used
for debtors’ confirmation, payroll checking, vouching of invoices and
petty cash vouchers. Readymade statistical tables a re avail able. So, the
auditor need not have knowledge of statistic s and mathematics to use this
method.
Methods of Selection of sample in Statistical Sampling are:
1) Random Sampling
2) Internal sampling or systematic sampling
1. Random Sampling :
There are two typ es of random sampling.
i. Simple random sampling:
Under sim ple random system each purchase or sales invoice has an equal
chance of being selected. Selection may be done with the help of
computers or by picking up numbers randomly from a drum. This m ethod
is simple and easy to use. This method can be used where the items are of
fairly similar nature. There is no wide difference between two items.
ii. Stratified sampling:
Under stratified sampling the whole population is divided in to some
groups and it ems are selected from each group. E.g., debtors may be
divided in to (a) Above Rs. 1,00,000, (b) Rs. 75,000 to 1,00,000, (c) Rs.
25,000 to 75,000 and (d) Below Rs. 25,000 etc. Then certain percentage of
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65 each group need not be the same. In the above example e.g., more items
may be selected from the 1st group and very few items from the last group.
2. Interval sampling or systematic sampling :
Here again there are two methods.
i. Block samp ling: Bloc k selection means say first 100 items of sales
of August , then first 100 sales of December etc. may be selected.
ii. Cluster sampling : means dividing the items in to groups called
clusters e.g., 500 to 540. 2015 to 2055 etc. These figures are again
selected at random.
a. Advantages of statistical sampling in auditin g :
It has following advantages.
1) Sample size will not increase in proportion to the size of the area
involved.
2) Selection is more objective as there is absolutely no personal element
involved.
3) The size of the sample is minimum.
4) Calculated ri sk is taken.
However, the system should not be universally applied. Sometimes other
methods may be more convenient or useful e.g., when exact accuracy is
required or there may be legal comp ulsions.
Factors determining Sample size :
The following factors determine the size of the sample –
1) Sampling Risk
2) Tolerable Error
3) Expected Error
4) Efficiency of internal control
1. Sampling Risk:
Auditor in auditing only the sample entries and ar riving at hi s final
conclusion no doubt takes risk. Because, if su bsequently errors or frauds
are noticed in those entries which he has not audited, he will still be held
responsible. Sampling risk means if he audited 100% entries, he may
arrive at a diffe rent conclus ion than the one he arrived by auditing only
sample of transactions.
The auditor is faced with sampling risk in both tests of control and
substantive procedure. In test of control, it may be risk of under reliance or
over reliance. In risk of substantive p rocedures. There may be risk of
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66 2. Tolerable Error :
Sample size is affected by the level of sampling risk the Auditor is willing
to accept from the results of the sample. If he is prepared to take h igher
risk, h e will select a smaller sample and if he is not and p repared to take
much risk, he will select a larger sample. Tolerable error is the maximum
errors in the population that the auditor is willing to accept.
3. Expected Error :
If the auditor exp ects error in the population, the size of the sample is
large and if no errors are expected, the size of the sample will be
comparatively small. Auditor should decide expected error taking into
account his past experience and changes done in the procedures etc.
4. Effici ency of internal control :
If the internal control sy stem is found to be satisfactory, the Auditor may
select a smaller sample. On the other hand, if he finds that it is not
effective, he may select a larger sample.
4.3.4 Evaluation of Sample Resul ts :
The auditor shall evaluate:
(a) The results of the samp le: An unexpectedly high sample deviation rate
in control tests may result in an increase in the assessed risk of
material misstatement, unless additional audit evidence substantiating
the initial assessment is obtained. In the case of details tests, an
unexpectedly high misstatement amount in a sample may lead the
auditor to believe that a class of transactions or accou nt balance is
materially misstated in the absence of additional audit evidence that no
material misstatement exists.

(b) Whether the use of audit sampling has provided a reasonable basis for
conclusions about the population that has been tested :

If the auditor concludes that audit sampling has not provided a reasonable
basis for conclusions about the population that has been tested, the audi tor
may request management to investigate identified misstatements and the
potential for further misstatements and make any necessary adjustments,
or may modify the nature, timing, and scope of those additional audit
procedures to best achieve the required assurance. E.g.: In the case of
control tests, for example, the auditor may increase the sample size, test an
alternative control, or modify related substantive procedures.
4.3.5 Auditor’s Liability in conducting Audit based on Sample
While auditing the selected sample entries, the auditor should take
maximum care in analysing the evidence produced b efore him in sup port
of the entry. Auditor should select the sample in a scientific manner. He
must use statistical rules of sampling. He should exercise his best
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67 opinion he has expressed . As far as poss ible the auditor should use test
check method only after selecting the samples scientifically. He must be
extra careful in using test check m ethod because by adopting test check
method, he only reduces his physical labour. His liability for errors and
frauds extends to the entries in the whole population. He cannot escape
from his liability saying that he had not audited that particular transac tion.
Check Your Progress
1. Define the following terms:
a. Routine Checking
b. Test checking
c. Judgment Samp ling
d. Stratified Sampling
e. Block sampling
f. Cluster sampling
2. Enlist the factors determining the Sampling size.
4.4 INTERNAL CONTROL
4.4.1 MEANING AND DEFINITION
Internal control is a broad term with wide coverage. It covers the control
of the whole management system. It may b e financial as well as non
financial. It involves number of checks and controls in order to ensure that
the business is carried on efficientl y. Only with the help of control,
efficient and effective management of business becomes possible. Internal
control system helps the business to achieve its goals effectively. Effective
internal control system is important from the point of view of the
management as well as auditor. It helps the auditor in devising a proper
audit procedure for the audit of a particular unit.
4.4.2 Definitions of internal control:
W.W. Bigg defines it as “internal control is best regarded as indicating the
whole system of controls, financial and otherwise, established by the
management in the conduct of the business inc luding internal check,
internal audit and other form of control.” This definition explains internal
control from the auditor’s point of view.
According to A merican Institute of Certified Public Accountants,
“Internal control comprises of the plan of organ isation and all t he co -
ordinate methods and measures adopted within a business to safeguard its
assets, check the accuracy and reliability of its accounting data to promote
operational efficiency and to encourage adherence to prescribed
managerial policies .” In this defini tion both accounting and administrative
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68 Internal control includes financial and administrative controls. It is
established by the management to run the business smoothly. Internal
control system is very important f rom the point of view of the auditor. It
will help him to select the right method of working.
4.4.3 Purposes of Internal Control:
Internal control system is beneficial or useful to both the client and the
auditor.
1. Usefulness to the client :
a. Reliable dat a is provided. On the basis of such data the management
takes its day-to-day decisions e.g., Fixation of selling price, quantity of
goods to be produced etc.
b. Assets and records are safeguarded. If there is no proper system of
control, the physical assets may be stolen, mis used or accidentally
destroyed. Same is the case of other important documents in the
business. Confidential records may be properly maintai ned. Now a
days lot of such documents are fed to the computers. If proper care is
not taken magneti c tapes can be des troyed.
c. Internal control system promotes operational efficiency. Business
resources are properly used. Business policies are strictly foll owed.
2. From the Auditor’s point of view :
The business will have competent and trust worthy personn el. This will
reduce the chances of errors and frauds and the job of the auditor becomes
safe and simple. There is scientific division of duties amongst diff erent
members of the staff. Every transaction is authorised by the competent
authority. Duties and responsibilities o f each member of the staff are
clearly stated. The internal audit is part of the whole system of internal
control.
4.4.4 Review of Interna l Control
An internal control revi ew ensures that your company's internal control
environment is effective. Internal controls protect the company from
financial loss, aid in the maintenance of accurate financial reporting, and
allow your organisations to o perate more efficiently and secur ely. An
internal control review typically determines whether your internal controls
are operating effectively or working as intended (design testing). Internal
control evaluation entails:
 Identifying the internal control ob jectives of your organisation
 Evaluating the relevant policies and procedures, as well as their
documentation standards
 Internal controls are being discussed with management and staff.
 Observing the environment under control
 Comparing control documentation to your expectations and
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69  Evaluating whether the control achieves its intended goals, also
known as "walkthrough testing."

4.4.5 Advantages of Internal Conr ols
1. Detection of Errors and Frauds: Because the work of one employee in a
proces s is checked by another without the former's knowledg e, any
fraud committed is exposed unless there is collusion among fraudsters.
2. Time Saving: The auditor can test or sample check the transactions to
ensure reliability and accuracy, allowing him to fin ish his audit work on
time.
3. Errors and Fraud: Each employee is only assigned a limited amount of
work, and the knowledge that his work is being independently checked
by another keeps him alert at all times. In such a situation, the chances
of committing an error or committing fraud are reduced.
4. Operati onal Efficiency: It promotes accountability, error -free work
performance, and accuracy reliability and authenticity of entries and
eradicate inefficiency, fraud, theft, etc. which help the management to
assess the performance of employees leading to enhanc e the operational
efficiency of organization as a whole.
4.4.6 Inherent limitations of Internal Control:
Standard auditing practice SA –6 issued by the Institute of Chartered
Accou ntant of India men tions certain inherent limitations of internal
control. They are :
1) The control system involves expenditure of time and money. If
attempts are made by the management to economise in this
expenditure, effectiveness of the control system is adversely affe cted.
2) Internal control system lays greater emphasis on routine transactions.
So, unusual and irregular transactions are likely to be neglected.
3) The possibility of human error cannot be ruled out. This may affect the
effectiveness o f the control sys tem.
4) Persons implementing the system may abuse the authority given to
them.
5) Whenever there are changes in the circumstances, the system also
needs to be changed. If such changes are not done in the systems from
time to time, the sy stem may lose its effect iveness.
6) Management may manipulate the system.
4.4.7 Scope of internal control :
Internal control is a broad term having wide coverage. It may normally
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70 1) Financial control : It includes proper system of accounting a nd prope r
supervision.
2) Cash control : There is proper control over receipts, payments and
balance kept in hand misappropriation of cash in any way by anybody
is not permitted.
3) Trading transactions : There will be proper control over purchase as
well as sal es transactions. Suitable procedures are laid down and
handling of goods is effectively controlled and properly accounted for.
4) Employee’s remuneration : Pay sheets are properly prepared. A
detailed record of work done by each wo rker is kept and used wh ile
preparing pay sheets. Salaries and wages must be paid to the
concerned workers regularly in time. There should be no scope for
payment to dummy workers.
5) Capital Expenditure : Capital expenditure involves heavy amount.
So, it should be autho rised by proper authority and wisely spent.
Amount should be used properly.
6) Others : Control is also in existence on maintaining proper
relationship with the staff, inventory in the factory and investment of
funds.
4.4.8 Internal Contro l and Auditor:
The manag ement of any business unit is duty bound to introduce a good
system of internal control. Existence of an efficient system of internal
control in the unit is very useful to the auditor. It helps him to reduce his
workload to a large extent. So, if h e finds any defect in the existing
internal control system the auditor can suggest suitable changes in the
same as he is an expert in the field. However, it should be remembered
that though he may suggest changes, his suggestions are not bi nding on
the cli ent. He can only help and guide the client.
4.4.9 AUDITORS DUTIES
Following are the duties of an Auditor considering the internal control
system:
1. Auditor will carefully study the existing system of internal control and
then decide to what exte nt he can rely o n the same. Then he can decide
the audit procedure to be adopted for auditing this particular unit.
2. The auditor has to decide to what extent he can adopt test check. The
auditor is expected to critically review the existing system before t he
commencement of his work. Where there is a good internal check
system; the work of the auditor, automatically becomes simple.
However, it should be distinctly remembered that adopting test check
will in no way reduce his liability. He should perform all his normal
dutie s as usual. If he performs his duties carelessly or negligently, he
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71 3. Necessity for Evaluation: The Auditor is interested in ascertaining
that transactions are executed in accordance wit h the Management's
authorisation, all transactions are recorded properly and assets are
adequately safeguarded. Therefore, the examination and evaluation of
the Internal Control System is an indispensable part of the overall
audit Programm e.
4. If the Auditor reviews the Internal Control System of the client, he will
be in a position to bring to the Management's notice, the weaknesses in
the system and suggest measures for improvement. During the course
of his audit, he may also ascertain how far the weaknesse s have been
removed.
4.5 INTERNAL CHECK
4.5.1 Meaning and Definition
Internal check is an important part of internal control. The whole
accounting system is so arranged that the work done by one is invariably
checked by another as a matt er of routine. No additional expenditure is
incurred for this procedure. Different methods of internal check are
devised for different types of concerns taking in to account the special
needs of each concern.
It can be defined as “an arrangement of the du ties of the membe rs of
the staff in such a manner that the work done by one person is
automatically and independently checked by the other.”
Each employee here works independently but it does not involve
duplicating the work of other. Frauds, errors or irr egularities are t hus
prevented. Under these circumstances if frauds are to be committed, a
collusion among different members of the staff is necessary which is
normally not easy.
Definition :
Spicer and Peglar “Internal check is an arrangement of staff d uties where
by no one person is allowed to carry through and record every aspect of
transactions, so that without collusion between two or more persons, fraud
is prevented and at the same time, the possibilities of errors are reduced to
the minimum.”
F.R.M . Paula “Internal check means practically a continuous internal
audit carried on by the staff itself, by means of which the work of each
individual is independently checked by other members of the staff.”
Ronald A Irish – “Internal check refers to the orga nisation of offic e
duties in such a way as to prevent or disclose both errors and frauds.”
Many other authors have defined the term in almost similar words but the
common idea is that here the system is internally organised in such a way
that the work of o ne employee is au tomatically checked by the other and
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72 4.5.2 Features of internal check system:
1) The work is divided amongst different assistants.
2) Work is divided amongst different persons, taking in to acc ount the
qualifications and ability of each member of the staff.
3) Only one person does not perform any task from the beginning to the
end.
4) The work done by one is independently and automatically checked by
the other. E.g., in the ca se of cash sales, the salesman will not receive
cash and deliver the goods to the customer. Price of the item is
received by the cashier. Gate keeper or goods clerk will deliver the
goods and the accountant will make entry in the cash book and so on.
4.5.3 Objectives of Int ernal Check System:
1. Internal check system is introduced to bring moral pressure on the
staff.
2. Reliable and adequate information is made available from the books of
accounts.
3. Valuable assets of the business can be saved and frauds and e rrors are
avoided.
4. Available work in the accounts department is suitably distributed
amongst the members of the staff.
5. If any error or fraud is subsequently found the responsibility for the
same can be easily fixed on the person concerned.
6. Staff becomes more alert and effi cient.
7. The firm can get all the advantages of division of labour.
4.5.4 Principles of a Good System of Internal Check :
1. Here the responsibilities of each member of the staff are clearly stated.
2. The available work load is equitably dis tributed so that no one is over
burdened with work and there is no dissatisfaction amongst the staff
on this issue.
3. People having custody of assets should not have access to books of
accounts.
4. Duties allotted to the staff should be changed from time to t ime.
Whenever a di fferent person takes charge of the table, the mistakes if
any committed by the earlier occupant of the table are easily detected.
If the same man remains at the same table for a long time, this is not
possible. Work done by one should be automatically chec ked by
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73 5. The management should not rely too much on any one person. Frauds
are normally committed only when there is over reliance in any person
in the organisation.
6. Cheque books important files etc. should be maintained safe un der
lock and key.
7. The management should carryout supervision from time to time to
ensure that the rules prescribed for internal check are being followed
meticulously by one and all.
8. Deviations from the rules should be permitted only by the top
authoritie s and only when it is absolutely necessary.
9. The system of internal check once introduced should be reviewed from
time to time taking into account any changes that have occurred in the
business in the interim period.
12.5.5 Advantages of Internal Check Sy stem :
The advant ages of the system can be enjoyed by the business,
auditor and also by the owner of the business. Let us study them one by
one.
1. Advantages for the Business :
The business enjoys number of advantages of internal check system. Some
of the m are :
i) Proper d ivision of work : -
Available workload is suitably divided amongst the different members
of the staff. Division of work is done taking into account the
qualifications, experience, likes and dislikes etc. of each member of
the staff.
ii) Detection of erro rs and frauds :-
Errors and frauds are easily detected and taking up of prompt suitable
remedial action becomes possible at an early date.
iii) Increased efficiency of the staff and economy :-
As each one is given the work he likes and capable of doin g, there is
increase in the efficiency of the staff and their efficiency will bring
down the administrative expenditure.
iv) Moral Check :-
There is a moral check on the staff because the work done by every
member is routinely and auto matically checked b y another. Members of
the staff will not be easily tempted to commit frauds.
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74 2. Advantages for the Auditor :
Internal check system is very useful to the auditor. It reduces his workload
to a large extent. Advantages to him can be enumerate d as follows :
i) Quick preparation of final accounts :
where there is an efficient system of internal check, the books of accounts
are regularly written. So, the auditor can readily prepare annual statements
like profit and loss account and balance sheet and start his work.
ii) Convenience :
Where there is an efficient system of internal check, the Auditor can adopt
test check and complete his work within a short time. He need not
undertake detailed checking of routine transactions.
3. Advantages to the Own er :
i) The owner c an rely on the accuracy of the books of accounts.
ii) Increase in profits. As there is increase in the efficiency of the staff,
there is economy in the cost of administration and this will lead to
increase in total profits.
4.5.6 Disad vantages of Interna l Check System :
Just like there are advantages, there are also some disadvantages of
internal check system. They can be enumerated as follows :
1) Costly :
Introduction of this system requires a large number of staff. Naturally the
cost of administration will increase. So, the system can not be introduced
in a smaller business unit.
2) Quality Sacrificed for promptness :
Here the quality of work may decline. Members of the staff may devote
more time to complete the work in time but may not devote enough t ime
towards the quality of the work.
3) Carelessness amongst high officials :
Higher officer may not strictly supervise the staff presuming that the work
is being done properly.
4) Risky for the auditor :
Relying too much on the system is sometimes likel y to be proved risky for
the auditor. If there is any laxity in the implementation of the system,
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75 In short, the system should be carefully and continuously implemented.
Auditor should use his tact and judgement whil e studying the system and
relying on it.
4.5.7 Auditor and Internal Check :
Scope of the Auditor’s work is largely decided by the internal check
system prevalent in the organisation. After studying the system, the
auditor decides to wha t extent he can ado pt test checking. Where there is
an efficient system of internal check, the auditor need not check all the
transactions in detail. The time thus saved an be utilized for more
important matters. However, the auditor should always keep in mind that
though hi s phy sical labour is saved, his responsibility is not at all reduced.
He will be held responsible if any errors or frauds are found subsequently
even in those transactions which he has not audited as he has not selected
those transaction s in the sample sel ected for test checking. He cannot
argue that he did not audit 100% transactions as there was an efficient
system of internal check. Thus, though a good system of internal check is
helpful to the auditor, in no way it relieves him of his contractual
respon sibilities. So, the auditor should take enough care before deciding
the extent to which, he should depend upon the internal check system
prevalent in the organisation.
4.6 INTERNAL CHECK SYSTEM FOR BUSINESS
TRACTIONS
4.6.1 Internal Check System for Sa les and Debtors :
Sales may be for cash as well as on credit. A businessman has to use both
the types of sales to increase his turnover and profit. However, here we are
considering only the internal check system for credit sales.
Exampl e of Internal check System for cash sales of the goods
The salesman will only complete the transaction of sale by showing the
goods to the consumer. He will neither receive cash nor deliver the goods.
He prepares 3 -4 copies of the invoice and sends the go ods to the packing
depa rtment. Packer packs the goods according to the invoice and forwards
them with a copy of the invoice to the cashier. Cashier receives cash from
the customer and sends a copy of the invoice to the accounts departments
for making entry . He also sends the goo ds to the delivery department,
which again verifies the goods with the copy of the invoice with the
customer and then hands them over to him. Thus, the work of selling the
goods is divided amongst so many members of the staff.
1. To st art with, different form s used in this connection like invoices;
delivery challans etc. should be standardised. They should be serially
numbered and kept in the custody of any responsible officer. If any of
them are missing, efforts should be made to trace them and causes fo r
their loss should be investigated. If not found even after all efforts,
duplicate may be obtained and this fact may be mentioned by the
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76 2. Credit control : No businessman can insist on cash sales only. To
incre ase his sales and t o mee t the needs of the customers, he has to sell
on credit. However, many a times, the recovery of the amount from the
customers becomes difficult. Its an unpleasant task. So, to avoid bad
debts, though sales should be done on credit ba sis also, all care should
be taken before extending credit to a new customer. Decision
regarding grant of credit, extent and period of credit, should be
decided by a responsible officer only. Before accepting an order for
credit sale, a suitable enquiry sh ould be conducted a bout t he credit
worthiness of the customer. Enquiries may be done about his credit
worthiness with his other suppliers and also with his bankers.
However, this should be done only after obtaining the permission of
the prospective custome r. It should always be re membered that selling
on credit is easy but the job of recovering credit is difficult and
unpleasant.
3. Different functions related with the sales should be allotted to
different persons e.g., preparing invoice, dispatching the good s,
recording the sa les in the sales book maintaining customers’ Ledger
Accounts or Debtors Ledger, preparing their list at the end of the year
etc.
4. Delivery challans should be tallied with the orders received . These
challans should be serially numbered an d kept in a separat e file by a
person who should not have any access to the stock.
5. Customers should be asked to acknowledge in writing the receipt of
the goods. These acknowledgements should also be serially arranged
and kept in a separate file.
6. Along wi th the goods, invoi ce for the same should be sent . Quantity
mentioned in the invoice should be the same as the one mentioned in
the order of the customer
7. If there is any transfer of goods from the Head Office to Branch or
from one department to another i t should be distinc tly rec orded.
8. Invoices should be prepared with proper care . There should be
strict rules regarding the discount to be allowed if any.
9. When the price of the goods is received from the customer, an
official receipt should be sent to him and entry for the s ame sho uld be
promptly done in the Cash book.
10. If there are any sales returns , they should be properly recorded in
the books and the causes for the return should be investigated. If the
return of the goods is found to be in order, a cred it note should be s ent
to the customer.
11. Debtors’ balances should be tallied with the balances in the control
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77 12. Reminders should be regularly sent to the customers whose
accounts are overdue. All possible eff orts should be done to rec over
the dues as early as possible, without displeasing the customer.
4.6.2 Internal Control System for Purchases and Creditors :
There are different stages in purchasing and there should be proper control
system of control at ea ch stage. Purchases are al so of two kinds’ viz. cash
purchases and credit purchases.
1. Different departments which need different items for consumption
or production send their requisitions in a prescribed form to the
purchase department. This department th en prepares purchas e order in
duplicate and sends the original copy to the supplier. Duplicate copy is
retained in the purchase department for future reference. In some
concerns the order is prepared in triplicate and one copy is sent to the
stores departm ent to keep space r eady fo r the receipt of the goods.
2. Orders are always sent only to the selected or approved supplier .
Supplier is selected after inviting quotations or tenders. Prices of
different suppliers and the quality of the goods are studied by ex perts
and then 2 -3 supplie rs whose rates are reasonable and quality is
satisfactory are selected as approved suppliers. Orders are sent only to
these approved suppliers, 2 -3 suppliers are selected instead of only one
who is the best amongst the lot, becaus e sometimes if the goods a re
not available due to any reason like strike etc. services of the
alternative suppliers may be utilized to avoid inconvenience.
3. Verification – On receipt of the goods, the stores department verifies
their quality, quantity and price with the copy of the order sent and the
invoice received with the goods, and then send the invoice to the
accounts department for making necessary entry in the books of
accounts and making payment as per the terms agreed upon. Stores
department then stores the goods in the re spective shelves or bins. If
the goods are not found to be of appropriate quality or as per the order
placed, they should be immediately returned along with a debit note.
4. Copies of the personal accounts of the suppliers should be sent to
them at re gular i ntervals for the confirmation of the balance.
5. When the invoice is received from the stores department with a
satisfactory remark, the accounts department sends a cheque to the
supplier. As referred to above a list of approved sup pliers is prepared
by ever y concern. However, if any supplier, fails to supply the goods
as per order in time his name should be dropped from the list. In other
words, this list is revised from time to time on the basis of the
experience.


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78 4.6.3 Internal c heck system for Sal aries a nd Wages :
Most common entry in the books of accounts of any concern after
purchases and sales is that of payment of wages or salaries. Payment of
wages or salaries in a large concern involves number of functions.
1. A record is kep t of Number of days or hou rs worked by each
employee. There is a punch card system and the card is punched when
the employee enters the office or factory and when he leaves.
2. On the basis of the above, pay sheets are prepared and wages or
salaries payable are calculated . Fro m the g ross amount of salary
there are different deductions to be made for items like Provident
Fund, Employees State Insurance, Income Tax, Profession Tax,
deductions for housing or other loans or advances etc. After
considering these d ifferent deductions net am ount payable to the
employee is arrived at. However, these days, the pay sheets are
prepared by the computer and directly sent to the bank. The bank will
then credit the net amount payable to each employee, to his bank
account.
3. When pay -sheets were manual ly prepared one person used to make
calculations. Second person used to prepare pay -sheets taking into
account leave taken, hours worked etc. These salary sheets were then
test checked by some higher authority. If a particular wor ker is absent
on th e date of payment, his packet was kept in the safe custody and
handed over to him personally when he returns to work. Actual
payments were done by persons different from those who prepared the
paysheets.
4. Many a times bogus or ghost work ers were shown and their s alary was
misappropriated. So, the Head of the Department should take proper
care to avoid such misuse of funds.
Previously there was a procedure of obtaining signature of each employee
on a revenue stamp. But such procedure is n o more prevalent as the
amount of salary or wages is directly credited to their bank accounts. So,
no other proof of payment is necessary.
Under the law wages are to be paid before 10th of every month. So, care
should be taken to see that the whole proced ure is completed in time.
Any way it should be remembered that there is no one standard internal
check system applicable to all types of units. Each unit has to evolve its
own system to suit its own needs.



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79 4.7 DISTINGUISH
4.7.1 Test Check v/s Internal C heck
Test Check Internal Ch eck
1) It means checking only
selected few items instead of
checking all transactions. 1) It means division of work in
such a way that work done
by one is automatically
checked by another.
2) It is used by the Auditor 2) It is instituted by t he
manag ement
3) Errors and frauds are detected
by checking only few items. 3) It helps to prevent errors and
frauds.
4) Management has no control
over it. 4) Management has full control
over it.

4.7.2 Internal Check v/s Internal Control
INTERNAL CH ECK INTE RNAL CONTROL
1) Internal check means the
arrangement of work different
employees in such a manner that
work of any person is automatically
checked by another person is doing
his duty. 1) Internal control is the whole
system of c ontrols, financial and
otherwise, established by the
management in order to carry on the
business of the company in an
orderly manner, safeguard its assets
and secure as far as possible the
accuracy and reliability of its
records.
2) It on going continuou s process 2) Intern al contr ol is a wider term
which includes internal check,
internal audit, etc.
3) It is applicable to both, small &
large organizations. 3) Generally, it is more applicable
to large organizations where there
are many departments.
4) Relatively it is c heaper. 4) Relatively setting up of internal
control system is costly and time
consuming.

CHECK YOUR PROGRESS:
1. Enlist the advantages and disadvantages of Internal check system.
2. “Internal control is a broad term having wide coverage”, Explain. munotes.in

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80 3. Define the terms In ternal Control and Internal Check.
4. Explain the examples of Internal Check System.
4.8 SUMMARY
Test check means the auditor selects at random some transactions and
checks them in detail. If he finds that there is nothing objectionable in
these ite ms, he will conclude that other tran sactions are also recorde d
properly.
Next technique of auditing dealt with in this chapter is sampling. There are
two methods of selecting samples viz judgemental sampling and statistical
sampling. In judgemental sampli ng, the auditor relies more on his p ast
experience and select s items at his discretion.
Size of the sample is decided by taking in to account sampling risk,
tolerable error, expected error and the efficiency of the internal control
system.
It should alwa ys be remembered that by adopting te st check of sample
item, the auditor only reduces his physical labour. His liability for
mistakes in auditing extends to the whole population of the transactions
and not only restricted to the items he has actually check ed.
The third important technique d iscussed in this chapter is that of internal
control. Internal control means dividing the work amongst different
members of the staff in such a way that the work done by one is routinely
and automatically checked by the other.
4.9 QUESTIONS
1. What is test checking? What are the advantages and disadvanta ges of
test checking?
2. What precautions are to be taken by the auditor while adopting test
checking?
3. What do you mean by internal check?
4. What are the duties of an auditor in respe ct of internal check?
5. Wha t are the principal aim s of audit by Test – checking?
6. Write short notes on :
a) Objectives of Internal control
b) Test Checking
c) Technique of audit
7. What is internal control? How is the auditor concerned a bout it? munotes.in

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81 8. Expla in the term s Internal control, Test check and internal check.
9. What is internal control? Suggest internal control system for credit
purchases.
10. What are the various techniques of au diting?
11. Select the approp riate option and rewrite the following statements :
i. Internal check is meant for ------------------ .
a) Prevention of fraud
b) Increase in the profits
c) Detection of fraud
d) Helping audit in depth
ii. ----------------- deals with audit sampling.
a) SA 530
b) SA 400
c) SA 610
d) SA 510

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82 5
AUDITING TECHNIQUES
Unit Structure :
5.0 Objectives
5.1 Internal audit
5.2 Basic principles of establishing internal audit
5.3 Objectives of the internal audit
5.4 Evaluation of internal audit by statutory auditor
5.5 Usefulness of internal audit
5.6 Internal check vs internal audit
5.7 Internal audit v/s external audit
5.8 Summary
5.9 Questions
5.0 OBJECTIVES
After studying this unit, the students will b e able to:
 Understand the concept of Internal Audit .
 Understand the Principles of Establishing Int ernal Audit
 Understand the co ncept and create ability to distinguish between
Internal Audit Vs External Audit, Internal Checks Vs Internal Audit
5.1 INTERNAL AUDIT
MEANING AND DEFINITION
The normal concept about audit is checking the books of accounts by an
outside expert to detect a nd prevent errors and frauds . In other words, the
auditor is an outsider and an independent expert. However, some concerns
get th eir accounts audited by its own staff and then presents the same to
the outside expert. This is in ternal audit. Internal audit is the review of its
records by its specially appointed staff.
Definition :
Watter B. Meigs defines Internal Audit as “Internal A udit consists of
continuous critical review of financial and operating activities by a staff of
auditors functioning as full-time salaried employees.”
Internal Auditor comments on the effectiveness of the internal check
system and suggests improvements in the same if necessary. Assets of the munotes.in

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83 firm should be properly accounted for and adequately safeguar ded.
Acquisition and disposa l of assets should be done on ly with the
permission of the proper authority. Internal Auditor will ensure that the
accounting poli cies laid down by the management are being meticulously
followed :
5.2 BASIC PRINCIPLES OF ESTABL ISHING
INTERNAL AUDIT
The b asic principles of establishi ng internal audit in a business concern
are-
1. Independence: the internal audit department should have an
independent status in the organization. It may be required to report
directly to the board of di rectors.
2. Objectives: the ob jectives of the internal audi t function should be
made very clear and unambiguous. The objectives should be properly
communicated so that internal audit is not viewed as "over -the-
shoulder check" by other departments.
3. Clarity in Scope: the scope of interna l audit department must be
specified in a comprehensive manner. The department must at all
times, have authority to investigate ever y phase of organizational
activity from the financial angle, under any circumstances.
4. Definition of Duties: The internal aud it Department's duty is to
review operations as part of the internal control system. It should not
be involved in performance of exe cutive actions.
5. Internal Audit Department: The size and qualification of staff of the
internal au dit department should be eq ual with the size of the busi ness.
The cost of internal audit department should not exceed the benefits
expected to be derived from it.
6. Reporting: The Programme of internal audit should be time -bound.
There should be provisions f or periodic reporting on va rious
operational and other a spects.
7. Follow Up and Review: There should be sufficient scope for the
follow up actions on the various points raised in internal audit report.
Top management should take active part in ensuring compl iance with
actions points r aised in the report.
8. Relation ship with statutory auditor: The copy of the internal audit
report should be made available to the stat utory Auditor, who can deal
with the same in the manner as he deems fit.
5.3 OBJECTIVES OF THE IN TERNAL AUDIT
1. To v erify the accuracy and authen ticity of the financial accounting
and statistical records presented to the management.
2. To ascertain that the org anization is following the standard
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84 3. To establish that there is a pro per authority for every acquisition,
retiremen t and disposal of assets.
4. To confirm that liabilities have been incurred only for the legitimate
activities of th e organization.
5. To analyse and improve the system of internal check; in particular to
see (a) tha t it is working;( b) that it is sound; and (c) that it is
economical.
6. To facilitate the prevention and detection of frauds.
7. To examine the protection afforded t o assets and the uses to which
they are put.
8. To make special investigation for management.
9. To pro vide a channel wh ereby new ideas can be brough t to the
attention of management.
10. To review the operation of the overall internal control system and to
bring mat erial departures and non -compliances to the notice of the
appropriate level of management; the re view also general ly aims at
locating unnecessa ry and weak controls for making the entire control
system effective and economical.
5.4 EVALUATION OF INTERNAL AUDIT BY
STATUTORY AUDITOR
Both o f them apply similar techniques for examining the books of
account s. However Internal Auditor is a representative of the
management. He is a regular employee of the concern. He reports to the
managements. Statutory auditor in the case of the company is app ointed
by the share holders and reports to them about the truth an d fairness about
the account statements. Scope of work and functions of the internal auditor
are decided by the management. In the case of statutory auditor, they are
decided by law.
If an a uditor finds that internal audit is adequate and satisfactory or
effective, he may apply audit procedure to a limited extent. Thus, presence
of internal auditor reduces the physical labour of the auditor. However, it
in no way reduces his responsibility. He cannot say that he did not verify a
particular item because it was already verified by the internal auditor. The
ultimate responsibility for reporting on financial statements is that of the
statutory auditor only. Intern al auditor w ill verify the reliabili ty and
integrity of the information. He will confirm that the m anagement’s
policies are being strictly followed and the accounts are maintained taking
in to account the different laws applicable to the business. Resource s are
used e conomically and the asse ts are being properly safeguarded.
Finally, it is the past exp erience and discretion of the outside auditor
which decides to what extent he can rely on the work done by the internal
auditor. Internal auditor, being a re gular emplo yee, cannot act effective ly
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85 5.5 USEFULNESS OF INTERNAL AUDIT
1] More Effective Management: Internal auditing facilitates effective
organisational management. The internal auditor will be able to identify
any weaknesse s in the organization's operations or internal controls.
2] Continuous Review: The internal audit p rocess provides the
organisation with a unique opportunity to conduct a performance review
during the current fiscal year. They don't have to wait until the end of the
year to evaluate the company's performance; they can change course and
correct their err ors right away.
3] Employee Performance Improves: The company's employees remain
alert and active, and they avoid engaging in any fraudulent activities for
fear of their mistakes being discovered by the internal audit or, resulting in
improved employee perf ormance.
4] Ensures Optimal Resource Use: Another advantage of the internal
control process is that it can be used as a tool to promote resource
optimization . It will aid in identifying areas where resources are being
underutilised or wasted. These can the n be corrected. It will aid in the
management of the company's costs and expenses.
5] Labor Division: Internal auditing promotes labour division. It is criti cal
to monitor and observe the activities of all departments and their
employees. The division of l abour will aid in this endeavour.

5.6 INTERNAL CHECK VS INTERNAL AUDIT
Both internal check and internal audit are parts of the whole system of
internal c ontrol. Both are com plementary to each other and go together.
Still there is lot of difference betwee n the two.
Internal Check Internal Audit
1) It is arrangement of duties in
such a way that the work done
by one is automatically
checked by the other 1) It is independent appraisal of
the records
2) Object is to prevent errors and
frauds 2) Object is to detect errors and
frauds
3) No additional staff is necessary 3) Additional staff is to be
appointed
4) It starts before the transaction 4) It starts after the recording of
the transaction



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86 5.7 INTERNAL AUDIT V/S EXTERNAL AUDIT
Internal Audit External Audit
1) It is arrangement of duties in
such a way that the work done
by one is automatically
checked by the other 1) It is independent check of the
books of accounts done by an
qualified person .
2) The role of internal audit is
determined by manage ment 2) The role of external audit is
determined by Companies
Act.
3) Internal auditor report s to the
management of the company. 3) External auditor repor ts to
the shareholders o f the
company.
4) The internal audit cannot be
expected to have same degree
of independence as external
auditor 4) External auditor are
independent of the
management and it is one of
the basic condition o f the
appointm ent.
5) They are appointed by the
Management of the company. 5) They are appointed by the
Shareholders of the
company.

5.8 SUMMARY
In big concerns in addition to audit of accounts by an independent outside
Auditors, they have their own Audit staff. Before presentin g the books of
accounts to the external auditor, they are audited by the internal auditor.
The purpos e behind this additional system of audit is to d etect and prevent
errors and frauds at an early date. Suitable penal action can be taken at an
early date a gainst the guilty persons and the concern may be saved from
the further such loss in the future.
5.9 QUESTIONS
1. How internal check is different from internal audit?
2. Write short notes on :
a) Internal audit
b) Principles o f Internal audit
3. Explain the ter ms “Internal control” an “Internal Audit”.
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87 5. Disti nguish between Internal Checks Vs Internal Audit
6. Select the approp riate option and rewrite the following statements :
a. Internal auditor’s appointment is mad e by --------------------
a) Institute of internal auditors of India.
b) Members at the Annual General m eeting.
c) The management
d) The statutory auditor

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