Financial Accounting and Auditing-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 tements 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 company.
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 becomes 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, bonus 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 the
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 OBJECTIVES 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 voucher 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 erformance.”
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 periodically.
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 is 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 verify 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 entries 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 received
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 statements. 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 accuracy 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 and 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 Audit :
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) Expression 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 reasons 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 statements; 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
3) Errors of commission
4) Errors of duplication
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7 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 depreciation 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 accounts.
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 balance 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
carefully 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 one 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 refers 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 accounting policies etc.
Frauds are intentionally committed by people in the higher authority. So, it
is more difficult to detect them than errors. Detection of frauds is one of
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8 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 purchases
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 false
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
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 munotes.in

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9 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 such 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 premises 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 type 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 valued.
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 shares 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 funds 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 done 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
adjustment for them may not be made in the accounts. Assets may be over
or under depreciated, capital expenditure may be treated as revenue or vice
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10 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, heavy 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.
1.4.6 Auditor 's Duties and Responsibilities 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 munotes.in

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11 required to consider the risk of material misstatements in the f inancial
statements resulting 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 mi sstatement,
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 Au ditor:
1. In planning and performing 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 fina ncial 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 manage ment 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 th e effect of fraud is properly
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 and
errors, and frame his report 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.
Check your progress:
1. Enlist the objecti ves of Auditing.
2. Define the following terms:
a. Auditing
b. Error
c. Frauds munotes.in

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12 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 prope r record of purchases and 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 information.
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. Compensating 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-operati ve societies only. Auditing 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. These days even cost
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 Audited b ecause 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 in tim e and immediately rectified.
Remedial action can be taken in time to avoid or prevent them in
future. Quick action can be taken against inefficient or negligent staff
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13 3) Employers will write the accounts in time or im mediately 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 punished.
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 there ar e 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 will c ome to their rescue.
5) Shareholders of joint stock companies are laymen and scattered all over the country and in the case of cer tain 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 a udited 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 Partner ship Firm, when any partner retires or dies, his
account can be easily and quickly settled.
9) Banks and other financial institutions sanction loans quickly on
the basis of accounts audited by a duly qualified auditor.
10) Trade unions will demand bonus and ris e in salary for a
reasonable 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 prof its 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 audi ted 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 munotes.in

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14 certain mistakes and frauds . After the entire Auditor is a watchdog and
not a blood 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 acco unts 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 adverse ly if the explanation and information prove to
be false.
3) Dependence on opinions of others : - Auditor has to rely on the views
or opinions given by different experts viz Lawyers, Solicitors,
Engineers, Architects etc. he cannot be an expert in all the fiel ds Such
opinion given by 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 person to person.
5) Audit is a post 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 shareholders.
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 displeasin g the Directors to continue 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
not bold enough to express their frank opinion and displease the
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 assurance: - Auditor cannot give any 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 perso nal judgement of the owners. 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 d o test checking. munotes.in

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Introduction to Auditing
15 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 complet ing his Audit work, Auditor finally expresses his Frank
opinion on the quality of the accounts maintained. He suggests ways and
means to further improve their quality.
9.6 DISTINCTION
9.6.1 Accounting v/s Auditing
Points of
difference Accounting Auditi ng
1. Meaning
It is recording 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 concern ed with
finalization of accounts. 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. Commencement Accounting commences
when book keeping ends. Auditing begins when
accounting ends.
5. Scope
It involves various
financial statements. It
involves maintenance of
books of accounts. It does
not go beyond books of
accounts. It depends upon the
agreement of upon the
provisions of law. It
goes beyond books of
accounts.





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16 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 f air
view of business. It is undertaken 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 i s conducted for proprietors only. 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 r eport 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 auditor s
must possess proper
qualifications.
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 th e important 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
transaction. 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. Audito r should 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 unimportant 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 the 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 m ore 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 statem ents give a true and fair view. Balance 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 we re substituted by True and Fair. Many 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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Financial Accounting and
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18 The phrase True and Fair has not been define d by the companies Act.
However, the 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 d eep 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. Intang ible assets like goodwill, patents, preliminary expenses or
other deferred revenue expenses are written off properly.
5. Proper provision is made for bad and doubtful debts.
6. Capital expenses is not treated as revenue expenses and vice versa.
7. Capital receipts are not treated as revenue receipts.
8. Effect of changes in rate of foreign exchange on value of assets and
liabilities is recorded in the books properly.
9. Contingent liabilities are not treated as actual liabilities and vice
versa.
10. Provision is made for all known losses and liabilities
11. A reserve is not shown as a provision and vice versa
12. Cut off transactions are recorded properly, so that all sales invoices
are matched with goods delivered and all purchase invoices are
matched with goods received.
13. Transaction s are recorded on accrual basis, i.e., outstanding
expenses, prepaid expenses, income accrued and advance income are
recorded properly.
14. Expected or anticipated gains are not credited to the profit and loss
account.
15. Effect of events after the balance sheet date on the value of an asset
and liability is disclosed in the accounts properly
16. The exceptional or non -recurring transactions are disclosed
separately in the accounts.
17. If there is any charge on the assets, that should be disclosed clearly. .
18. In the case of assets, the auditor should see that they are neither over
valued nor undervalued.
19. The auditor should ensure that no important asset is omitted.
20. Similarly, liabilities should not be under or overstated and no
liability should be omitted. Accounting poli cies should be
consistently followed, and all legal requirements should be complied
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Introduction to Auditing
19 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 requiremen ts should 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 used
to hear or listen to different concerned 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 accounting ends.
Trial balance, profit 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, financ ial institutions etc. They will readily 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 wor ds.
The auditor has to check the accounts 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 check 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
limitations 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 t he science of keeping books of
accounts 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 business secrets to outsiders or competitors.
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
must concentrate on material matters. He must proceed with an
assumption that the business is going to be continued for a considerable
future period.
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Financial Accounting and
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20 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 A uditing
iii. Window dressing
iv. Secret reserves 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 frauds?
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 m ain object 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
b) To mislead investors
c) To understate profits
d) To avoid payment of bonus to workers
iii) Auditing commences after ------------------------ .
a) Investigation is over b) Accounting work is over
c) The General Meeting is over d) None of the above

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Introduction to Auditing
21 iv) --------------------- is not an error of commission.
a) Arithmetical error b) Compensating error
c) Posting error d) None of the above
v) Misappropriation of goods is generally done 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 a udit
d) Principle of audit
2. State whether 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 rev enue expenditure 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 the 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 Annua l 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 organ ization. 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 at 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. Auditing commences with a selection of areas to observe
and assess. Principally, the area with the greatest risk for errors and
inaccuracies should be reviewed most intensively. As each firm is unique,
the audit needs to be adapted to be applicable to each firm’s s pecial
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 o rganization to ascertain how far munotes.in

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Types of Audit
23 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 assu rance
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
Audit 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 undert akings, 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 b usiness 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. Con tinuous 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.
2.2 INTERIM AUDIT
2.2.1 Meaning and Definition
Interim aud it is 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 large -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 munotes.in

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24 examination or a review of the accounts and records 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 acc ounts, 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 interim period.
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 decisions 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 client 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
mistakes 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 Audit : The interim audit is helpful for the early
completion of the final audit.

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 Figure s: 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. munotes.in

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Types of Audit
25 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 management : Interim 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 purchas es and sells 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 accounts is not
possible.

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 aud it. 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. I t 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 b e 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 may 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 p rovide a guideline to third parties. The interim accounts are
not final so the figures may not be reliable for making decisions.

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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
continuous 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 declara tion of dividend 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 option 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 continuou s audit is one 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 a udit is one member 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 c onducted through 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 advantage 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 easily
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 pre sentation of accounts: 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 audit is beneficial for the
prompt filing of returns as the accounts are prepared as well as audited
at the end of the year.
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Types of Audit
27 5. Interim dividend: Here it is easy to prepare the accounts for six
months. Hence Continuous audit is helpful to decla re interim dividend.

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 audito r can surprisingly 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 functi ons can be removed
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 th eir 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 bec ome 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. Alterat ion 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 client'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 for the whole year. 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 answe red on the same day. The audit clerk may lose
the thread of work and the queries may remain outstanding as there
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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 P eriodical audit. This 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
prepared. Therefore, there is no clash among the duties of accounting and
audit staff. Here the 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 is 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 tim e. There is continuity 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 ha ve 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 le ast 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 conti nuous session.
3. Auditor 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. Economical:
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 v arious 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 wor k. There
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
provi des 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 benef icial 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 o ne session
and the queries 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 les s chance 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 ge t undue benefit from audit 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 acc ounts 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 books 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
managemen t. So, such frauds are committed 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 after the end Of the
year. The 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 staffs 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 used 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. Concur rent Audit means doing the examination 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 Objective s of Concurrent Audit
1. Concurrent 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 chec king but on
substantial checking 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 effe ctive 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 substantive
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 fo r a vigilance 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 decisions 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 balanc e sheet,
working back to the books 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. T his type of audit can be successful 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 check ed. For 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 sheet
audit means checking the accuracy of information found in a company's
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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 entirely computerized. In such cases, 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 c onducts 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 the 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 example, in
the case of companies, the issue of share capital is correctly recorded
in the books.
7. All the adjustmen t entries and journal entries relating 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 basically an audit of the final
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 recommended by Companies Act. In 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 observ ance of the
financial statements according 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 o f the law, as pertinent to the organization.
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 company. The management of the
company 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 finan cial records of the company and publish 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 authentic.

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 appropri ate regulations 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 audi t improves the reliability of the published 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 inte rnal 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 statement s.
2.7.4 Disadvantages/Limitations of 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
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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 rep orts 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
bloodhounds. 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 option
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
nowhere assures for its future viability. 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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35 3

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 Summary
3.10 Questions
3.0 OBJECTIVES
After studying this chapter, the students will be able to:
 Understand the meaning and importance of audit planning and 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 other 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
permanent audit file, temporary audit file. munotes.in

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36  Understand the Meaning, structure, conte nts, General information,
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 that
job successfully and in time. Audit of 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 issued detailed instru ctions in this regard
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 planning of his work by the auditor. It will help 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 different operations
etc.
Audit plan should inter -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 nature timing and extent of the audit procedure 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. Planning should be
continuou s throughout the engagement. 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 significant 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 auditor to complete the
work successfully and in 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 conducting 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 as sistants and
properly 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 his liking, he will alwa ys 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 work can be supervised easily. Suitable directions 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 present.
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
suggestions and amendments in t his connection. The auditor 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 -
storming exercise. 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
once prepared, should be altered as an d when there are changes in the
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38 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 step s.
1) Ascertain the scope 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 technical details.
6) Inqui ry into special circumstances.
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 duties are enumerated in 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 not legally mandatory, a ppoints an
auditor, auditor 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 servic es.
2) Procure engagement letter :
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 other
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 promised.
3) Knowledge abo ut business :
Every type of 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 should study the special problems
of the business unit and the system of account followed by it. If necessary,
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39 production procedure followed by the factory. He must acquir e knowledge
about the raw material 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 payable 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 not check each and every transaction. He may 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 through the 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 scope
of authority of each one of them.
5) Knowledge 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) Enquiry into special circums tances 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 auditor,
it is his profess ional duty to communicate with 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 prepared and made availab le to him. E.g.,
schedules of 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 of deferred revenue expenditure
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 the 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 :
Examples :
a. Annual reports sent to the shareholders.
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. Exter nal sources:
Examples :
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 information is actual disc ussion with the management. 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 managemen t, organisational structure 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 financial difficulties or accounting problems.
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 manageme nt letters.
h. Changes in accounting 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 firsthand
information a bout the plant layout, process 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 th e accounts in the ledger and 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 client or his staff to prepare the
following statements 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 returned from banks.
e) A schedule of Debtors and creditors.
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 the 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 dividend received
and recei vable.
h) List of inventories 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 ou tstanding and the income received 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 FACTO RS TO BE CONSIDERED 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
contained in the concerned Act 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 preparing 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 gi ven and the auditor has to submit 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 Stock Company is require d to be submitted to
the stock 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 Polici es :
Every concern 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 the se existing policies and changes 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 Accounting standards :
The Institute of Chartered Accountants 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 according to these standard s. So, the auditor should take 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 t he possible areas where frauds 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 end of the year, every concern has
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 checked by another.
E.g., in a departmental 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 sold. 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 system, the auditor 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 natur e and volume of work, the auditor 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 Exter nal 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 audit objectives. Detai led
instructions should be included 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 he 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 and 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 procedures to be followed. H e must also take into account the
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 closing
stock, he has t o do it on the last working day only.
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 accounts of the
firm and t he time he allots to each operation.
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 programme the auditor should study the
internal 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 test 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 evidence in support of s uch entries.
E.g., If there is proper 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 auditor should study the s pecial features of the client’s business 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 auditor 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 :
Auditor cannot neglect the cost factor. He must take in to account 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 errors.
5. Different proce dures adopted should 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 auditor 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. There is absolutely no p ossibility of any book being left out
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 assistants. While dividing th e work amongst
different persons, the 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 carefully 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 may be taken immediately 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 persons 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 duty
etc. it an be produ ced in the court as an evidence to prove 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 get 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 Programme :
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. There are continuous
chang es in the business world. If Cognisance 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 necessary 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 affected.
6. A uniform audit 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 not verify anything more than what is given 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 necessary.
Secondly if w e take an overall view, the advantages 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 systematic and efficient
manner , the following steps should be taken:
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 made in the
audit note bo ok.
2) Definite portion of the work should 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 cancelled 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 enable 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 classified and mentioned.
8) Details of mortgaged 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 papers 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 performed,
evidence obtained and the conclusions reached by the auditor.
 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 contain information on the following points:
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 o f audit of different 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 the audit of a Trust.
2) Extracts from minute books of meetings 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 outsiders like banks,
Insura nce companies, debtors, 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 of investments.
12) Conti ngent liabilities.
13) Audit time budget. munotes.in

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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 assistants.
2. They are usef ul to the auditor 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 papers provide training to the 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 accusing him of
negligence i n 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 re sponsibility 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 period 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 these papers should
also b e 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 about 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 wh en necessary. It includes the following
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 accounts maintained and names of concerned officers.
d. Information 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 administrative Papers:
These papers a re concerned only 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 contains the following pape rs :
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 bankers, creditors,
debtors e tc. and replies received.
As working 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 should be
complete and there should be clarity and accuracy. A good 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 important and relevant que stion 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 prepared by the auditor. So,
he has a right over 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 secon d category argue that their ownership 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 the 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 Accountant for the sole purpose o f producing a balance
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 belong to
the client and not to the accountant.
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 rightfully 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 views of the institute of Ch artered Accountants, the
working papers 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 copies
of some papers if de manded by the client.
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 report to the shareholders of the company. Audit evidenc e is not only
useful to form an opinion but also 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 r eports.

Characteristics 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 adequacy of the
data i.e . whether or not the documents and evidences provided is of an
adequate quantity for arriving at the judgement. If an auditor was
given details of only three branch out of the twenty branches, it would
be considered as insufficient for the financial standi ng of that
company.

2. Reliability: Reliability answers to the query that whether or not the
material can be trusted and can counted on for forming 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 information that is receiv ed. For
example, the information can be provided through legal documents,
presentations, orally from employees, or through a physical
confirmation.

5. Relevance: Depending on the type of audit being conducted, how
pertinent the information received in its re lation 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 business processes for the 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
sufficient audit evidence to reduce 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
processes and operatio ns in order to identify any lag or deficiencies
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53 4. External confirmation. It is the process whereby the a uditors attempt
to seek the information from the third parties by various means like
telephonic confirmation, mail confirmation , letter confirmation etc. , to
verify the financial information and accounting records provided by
the client. Ecxternal confirmation can be negative confirmation or
positive confirmation. In negative confirmation , the third party will
reply only if he doesnot

5. Recalculation. The auditors perform their own calculations to verify
that the final accounting balances match those reported by the client.

6. Reperformance. Auditors may reperform certain tasks or processes to
identify deficiencies and discover opportunities for further
optimization.

7. Analytical procedures. Auditors analyze the client’s financial records
to find discrepancies.


3.9 SUMMARY
This chapter deals with Audit Planning procedures and documentation.
Any important task to be completed successfully needs proper planning.
Similarly Audit of a firm needs proper pre planning before it is actually
performed. All the information of the client’s business is first collected.
His accounting system is studied. A li st 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 close the books of
accounts and prepare a Trial Balance and Trading and Profit and Loss
Account and Balance sheet. Auditor then studies the internal control
system prevalent in the organisation and decides to what extent he can rely
on the same. If the system is satisfactory, he may adopt test checking. In
such cases he need not waste much time on ro utine checking of each and
every item.
Auditor collects information about the client’s business from various
sources – internal as well as external. He discusses relevant issues with the
client. If necessary, he visits the client’s premises and his facto ry.
Accounting policies adopted by the client are noted down.
Auditor decides the number of persons to be spared for the particular
Audit assignment taking into account the volume of work involved. The
task is divided amongst different assistants taking i nto account their past
experience, qualifications, degree of efficiency and likes and dislikes.
Time schedule is to be prepared. Dates of commencement and completion
are decided. These dates are decided in consultation with the client taking
in to account his convenience. Thus, an Audit programme is developed.
Audit programme has number of advantages. It ensures that each and
every book of account and register is checked. Auditor can see the
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54 instructions given in the programme and complete the work in time, work
is done systematically. Possible problems are properly dealt with Co -
ordination between the work done by different assistants can be easily
done.
There are also some disadvan tages for Audit Programme. Work becomes
rigid inflexible and mechanical. It may kill the initiative of the efficient
and enterprising assistants. However, by imaginative supervision, the
disadvantages may be overcome. There is no alternative to planning an d
programming specially for the efficient, systematic and timely completion
of audit of large concerns.
Audit Working Papers :
There are two files of working papers – 1) Permanent file 2) Current file.
Permanent file consists of documents like Memoran dum of Association,
Articles of Association, Partnership Deed, Trust Deed etc. Current files
contain Bank Reconciliation statement prepared, contingent liabilities,
Adjustment entries passed etc.
Working papers are very useful to the Auditor while prepari ng his final
report. They can also be used as evidence in the court of Law if
subsequently 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 pr epared and preserved for a reasonable
period of time.
There is a controversy amongst the experts about their ownership.
However, courts have held that they belong to the Auditor and not the
client. However, the Auditor should not misuse the secret informa tion
contained in them about the business of the client. He may at his discretion
give copies of the same to the client.
3.10 QUESTIONS
1. Explain the importance of Audit Working papers.
2. What are the contents of Working Papers?
3. What are the contents of Audi t Programme?
4. Write a short note on :
a) Audit Note Book
b) Audit Planning
5. Explain current file. Give examples of its contents.
6. Elaborate the factors considered by an auditor while preparing an
Audit plan.
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55 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 type questions:
A. Select most appropriate option and rewrite the followin g 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 and Auditor
iv) Equity Share holder
c) Audit programme must be prepar ed –
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 Audit file includes Trust Deed.
c) Audit working papers constitute the link between the auditor’s report
and client’s records.


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56 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 Internal Audit
4.9 Summary
4.10 Questions
4.0 OBJECTIVES
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.
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 carry 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 different 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 cl ass of transaction checked. Like posting, casting, carry forward,
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57 be used for the same transaction in all the firms to maintain secrecy of
these ticks. While auditing each section, wo rk 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 Book. Vouching work should be done by two
audit assistants together. T he 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 Che cking 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 f ew
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 h as 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.
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58 In a large organisation 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
internal check and internal control system the auditor can adopt test check
system. He need not check each an d 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
proceed further.
Thus, test checking can be defined as “in depth checkin g 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 of test checking system, representative number of
entries of each cl ass 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 also involve lot of
unnecessary expenditure. Test checking is based on 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 th e 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 population.
The statistical theory of sampling is based on a scientific 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
complete reliability; it cannot give accurate results. It is a process o f
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 large 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 unchecked.
4. Full Coverage over a time period : Test Check is normally plan ned
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.
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59 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
one year and will be carefu l regarding the same.
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 test 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 efficacy of Internal Control System.
Anyway, the auditor has to veri fy 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 t he 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 may even be overseas transactions. Bank loans, letters of
credit, ove rdrafts, 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 remembered 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 negli gence 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:
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60 2. He should thoroughly study the system in the concern from
authorisation, documentati on, recording and evidencing the same. The
system should be found perfectly O.K.
3. The auditor should carefully study the internal check system followed
by the concern. As we have seen earlier, internal check system means
a system where the work of one is a utomatically 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 system, he should adopt test check. Not otherwise.
4. There should be abso lutely 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 may
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 should be
properly and thoroughly investigated.
3.2.5 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 di sposal.
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 precautions while adopting this system:
1. For the success of the system of t est 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. Client’s staff should not be
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61 predict the areas and periods to be covered for audit and will be careful
only about those transactions and neglect the others.
3. There should be flexibility. Auditor should change his method of
selecting transactions for test check from year to year. In selecting
appropriate transactions for test check, the auditor should use his past
experience and discretion current developments and changes made in
the internal chec k system, should also be taken in to account.
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 form or assist in forming a
conclusion concerning the population.
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 samplin g. Likewise, applying audit
procedures to all items within a population which have a particular
characteristic (for example, all items over a certain amount) does not
qualify as audit sampling with respect to the population examined, nor
with regard to the population as a whole, since the items were not selected
from the total population on a basis that was expected to be representative.
Such items might imply some characteristic of the remaining portion of
the population but would not necessarily be the ba sis for a valid
conclusion about the remaining portion of the population.
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
selecting 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 th e
whole population. It should be large enough to provide statistically
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 includ ed 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 y ears.
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62 purchase or sales ledger to be checked. E.g., January, April, July and
October months may be selected for verification in one year and February,
May, August and November months maybe selected next year. However
usually a large number of items at the 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 compl etely
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 sampl es. Hence definitely better
than the earlier discussed judgment sampling 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 circum stances. This method is widely used especially where the
population 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 ar e available. So, the
auditor need not have knowledge of statistics 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 types of random sampling.
i. Simple random sampling:
Under simple 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 me thod
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 ite ms 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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63 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 sampl ing: Block 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 auditing :
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 risk 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 compu lsions.
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 arr iving at his final
conclusion no doubt takes risk. Because, if subsequently 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 differ ent conclusion 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 s ubstantive procedures. There may be risk of
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64 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 hi gher
risk, he will select a smaller sample and if he is not and prepared 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 expe cts 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. Efficiency of internal control :
If the internal control system 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.
5. Evaluation of Sample Result s :
After selecting the sample items for detailed investigation, the auditor
should audit all these sample entries in detail. Then the y should analyse
the errors in the sample. First the auditor should confirm that it is really an
error. For that he should take in to account the objective he has decided
while auditing. If expected evidence is not available to audit a particular
item, he should look for alternate evidence. The auditor should consider
the qualitative aspect of the error. i.e., nature and cour se of the error and
the possible effect of the error on other phases of the audit. The auditor
may come across some common factors like type of the transaction,
location, period of time etc. Then the auditor should check all items of his
type of transactio ns and not restrict himself only to the scrutiny of the
sample transactions selected. The auditor should project the error results
of the sample to the population. He should keep in mind the qualitative
aspects of the errors found. If the population is div ided in to sub
population, the projection of errors is done to each sub – population and
the results are combined.
Then the auditor should decide whether the error in the population exceeds
the tolerable error limit. If so, he must reassess the sampling r isk. If that
risk is unacceptable, he should adopt alternative audit procedure.
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 be fore him in support
of the entry. Auditor should select the sample in a scientific manner. He
must use statistical rules of sampling. He should exercise his best
judgment so that he may not be held responsible subsequently for the
opinion he has expressed. As far as possible the auditor should use test
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65 extra careful in using test check method 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 transaction.
Check Your Progress
1. Define the following terms:
a. Routine Checking
b. Test checking
c. Judgment Sampl ing
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 DEFIITION
Internal control is a broad term with wide coverage. It covers the control
of the whole management s ystem. It may be financial as well as non
financial. It involves number of checks and controls in order to ensure that
the business is carried on efficiently. Only with the help of control,
efficient and effective management of business becomes possible. I nternal
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 incl uding internal check,
internal audit and other form of control.” This definition explains internal
control from the auditor’s point of view.
According to American Institute of Certified Public Accountants,
“Internal control comprises of the plan of organi sation and all the 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 definition both accounting and administrative
control are emphasized.
Internal control includes financial and administrative controls. It is
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66 control system is very important fr om 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 data 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 m ay be stolen, misused or accidentally
destroyed. Same is the case of other important documents in the
business. Confidential records may be properly maintained. Now a
days lot of such documents are fed to the computers. If proper care is
not taken magnetic tapes can be destroyed.
c. Internal control system promotes operational efficiency. Business
resources are properly used. Business policies are strictly followed.
2. From the Auditor’s point of view :
The business will have competent and trust worthy personne l. 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 different
members of the staff. Every transaction is authorised by the competent
authority. Duties and r esponsibilities of each member of the staff are
clearly stated. The internal audit is part of the whole system of internal
control.
4.4.4 Inherent limitations of Internal Control:
Standard auditing practice SA –6 issued by the Institute of Chartered
Accoun tant of India mentions 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 i s adversely affected.
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 of the control system.
4) Persons implementing the system may abuse the authority given to
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67 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 sys tem may lose its effectiveness.
6) Management may manipulate the system.
4.4.5 Scope of internal control :
Internal control is a broad term having wide coverage. It may normally
cover the following areas :
1) Financial control : It includes proper system of accounting and proper
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 sales 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 wor ker is kept and used while
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 authorised 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.
4.4.6 Internal Control and Auditor:
The management 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 e xtent. So, if he 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 bin ding on
the client. He can only help and guide the client.
AUDITORS DUTIES
Following are the duties of an Auditor considering the internal control
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68 1. Auditor will carefully study the existing system of internal control and
then decide to what extent he can rely on 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 the
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 h is normal
duties as usual. If he performs his duties carelessly or negligently, he
will be held liable subsequently if any errors or frauds are detected.
3. Necessity for Evaluation: The Auditor is interested in ascertaining
that transactions are executed in accordance with 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 Programme.
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 fa r the weaknesses 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 matter 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 duti es of the members 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 irreg ularities are thus
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 duti es where
by no one person is allowed to carry through and record every aspect of
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69 is prevented and at the same time, the possibilities of errors are reduced to
the minimum.”
F.R.M. P aula “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 organis ation of office
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 one employee is automatically checked by the other and
the possibility of error or fraud is reduced to the minimum.
4.5.2 Features of internal check system:
1) The work is divided amongst different assistants.
2) Work is divided amongst different persons, ta king in to account 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 case 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 Internal 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 erro rs 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 mor e alert and efficient.
7. The firm can get all the advantages of division of labour.

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70 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 dist ributed 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 ti me.
Whenever a different 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 checked by
another.
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 und er
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
authorities 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 Sys tem :
The advantages 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 them are :
i) Proper division 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
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71 ii) Detection of errors 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 a nd capable of doing, 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 autom atically checked by another. Members of
the staff will not be easily tempted to commit frauds.
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 enumerated 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 a nd 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 Owne r :
i) The owner can 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 Disadv antages of Internal 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.

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72 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 time
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 syste m is sometimes likely to be proved risky for
the auditor. If there is any laxity in the implementation of the system,
errors and frauds can not be ruled out.
In short, the system should be carefully and continuously implemented.
Auditor should use his tac t and judgement while 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 wh at extent he can adopt 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 his physical 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 transactio ns in the sample selected 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 hi s contractual
responsibilities. 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 Sales 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.
Examp le of Internal check System for cash sales of the goods
The salesman will only complete the transaction of sale by showing the
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73 He prepares 3 -4 copies of the invoice and sends the g oods to the packing
department. 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 entr y. He also sends the goods 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 start with, different forms 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 trac e them and causes for
their loss should be investigated. If not found even after all efforts,
duplicate may be obtained and this fact may be mentioned by the
auditor in his final report.
2. Credit control : No businessman can insist on cash sales only. To
increase his sales and to meet 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 b asis 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 s hould be conducted about the 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 custom er. It should always be remembered 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 goo ds,
recording the sales 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 a nd kept in a separate 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 w ith the goods, invoice 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
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74 7. If there is any transfer of goods from the Head Office to Branch or
from one department to another it should be distinctly recorded.
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 same should 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 cre dit note should be sent
to the customer.
11. Debtors’ balances should be tallied with the balances in the control
accounts if a self balancing system is in vogue.
12. Reminders should be regularly sent to the customers whose
accounts are overdue. All possible ef forts should be done to recover
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 e ach stage. Purchases are also 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 t hen prepares purchase 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 depart ment to keep space ready for 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 e xperts
and then 2 -3 suppliers 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, becau se sometimes if the goods are
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 respective shelves or bins. If munotes.in

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75 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 b e sent to
them at regular intervals 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 su ppliers is prepared
by every 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.
4.6.3 Internal check system for Salaries and 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 ke pt of Number of days or hours 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 . From the gross 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 different deductions net amount 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 manually 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 wo rker is absent
on the 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 wor kers were shown and their salary 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 no more prevalent as the
amount of salary or wages is directly credited to their bank accounts. So,
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76 Under the law wages are to be paid before 10th of every month. So, care
should be taken to see that the whole proce dure 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.
4.7 DISTINGUISH
4.7.1 Test Check v/s Internal Check
Test Check Internal Check
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 the
management
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 CHECK INTERNAL 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 controls, 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 continuo us process 2) Internal control 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 cheaper. 4) Relatively setting up of internal
control system is costly and time
consuming.
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77 CHECK YOUR PROGRESS:
1. Enlist the advantages and disadvantages of Internal check system.
2. “Internal control is a broad term having wide coverage”, Explain.
3. Define the terms Internal Control and Internal Check.
4. Explain the examples of Internal Check System.
4.8 INTERNAL AUDIT
4.8.1 MEANING AND DEFINITION
The normal concept about audit is checking the books of accounts by an
outside expert to detect and prevent errors and frauds. In other words, the
auditor is an outsider and an independent expert. However, some concerns
get their accounts audited by its own staff and then presents the same to
the outside expert. This is internal audit. Internal audit is the review of its
records by its specially appointed staff.
Definition :
Watter B. Meigs defines Internal Audit as “Internal Audit 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
firm should be properly accounted for and adequately safeguarded.
Acquisition and dispos al of assets should be done only with the
permission of the proper authority. Internal Auditor will ensure that the
accounting policies laid down by the management are being meticulously
followed :
4.8.2 Basic Principles of Establishing Internal Audit
The basic principles of establishing 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 directors.
2. Objectives: the o bjectives of the internal audit 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 intern al audit department must be
specified in a comprehensive manner. The department must at all
times, have authority to investigate every phase of organizational
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78 4. Definition of Duties: The internal au dit Department's duty is to
review operations as part of the internal control system. It should not
be involved in performance of executive actions.
5. Internal Audit Department: The size and qualification of staff of the
internal audit department should be e qual with the size of the business.
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 for periodic reporting on v arious
operational and other aspects.
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 compliance with
actions points raised in the report.
8. Relationship with statutory auditor: The copy of the internal audit
report should be made available to the statutory Auditor, who can deal
with the same in the manner as he deems fit.
Objectives or Usefulness of the Internal Audit
1. To verify the accuracy and authenticity of the financial accounting
and statistical records presented to the management.
2. To ascertain that the organization is following the standard
accounting practices or not.
3. To establish that there is a proper authority fo r every acquisition,
retirement and disposal of assets.
4. To confirm that liabilities have been incurred only for the legitimate
activities of the organization.
5. To analyse and improve the system of internal check; in particular to
see (a) that 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 to assets and the uses to which
they are put.
8. To make special investigation for management.
9. To provide a channel w hereby new ideas can be brought to the
attention of management.
10. To review the operation of the overall internal control system and to
bring material departures and non -compliances to the notice of the
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79 locating unnecessary and weak controls for making the entire control
system effective and economical.
4.8.2 Internal Check Vs Internal Audit :
Both internal check and internal audit are parts of the whole system of
internal control. Both are co mplementary to each other and go together.
Still there is lot of difference between 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 recordin g of
the transaction

4.8.3 Internal Audit V/S External Audit
1) The role of internal audit function within an entity is determined by
management and its prime objective differs from that of the external
auditor who is appointed to report independently on fi nancial
information. Nevertheless, some of the means of achieving their
respective objectives are often similar and, thus , much of the work of
the internal auditor may be useful to the external auditor in
determining the nature, timing and extent of his p rocedures.
2) The external auditor should, as part of his audit, evaluate the internal
audit function to the extent considers that it will be relevant in
determining in nature, timing and extent of his compliance and
substantive procedures. Depending upon suc h evaluate, the external
auditor may adopt less extensive procedure than would otherwise be
required.
3) By its very nature, the internal audit function cannot be expected to
have some degree of independence as is essential when the external
auditor expresses his opinion on the financial information. The report
of the external auditor is his sole responsibility, and that responsibility
is not by any means reduced because of the reliance he places on the
internal work.
4.8.3 Evaluation of Internal Audit by Stat utory Auditor :
Both of them apply similar techniques for examining the books of
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80 management. He is a regular employee of the concern. He reports to the
managements. Statutory auditor in the case of the company is appointed
by the share holders and reports to them about the truth and 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 auditor 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 reduce s 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. Internal auditor will verify the reliability and
integrity of the information. He will confirm that the management’s
policies are being strictly followed and the accounts are maintained taking
in to account the different laws applicable to the business. Resources are
used economically and the assets are being properly safeguarded.
Finally, it is the past experience 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 regular emplo yee, cannot act effectively
as an independent auditor
4.9 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 items, he will conclude that other tran sactions are also recorded
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 sampling, the auditor relies more on his p ast
experience and selects 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 always 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 checked.
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.
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81 In big concerns in addition to audit of accounts by an independent outside
Auditors, they have their own Audit staff. Before presenting the books of
accounts to the external auditor, they are audited by the internal auditor.
The purpose 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 against the guilty persons and the concern may be saved from
the further such loss in the future.
4.10 QUESTIONS
1. What is test checking? What are the advantages and disadvantages 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. How internal check is different from internal audit?
5. What are the duties of an auditor in respe ct of internal check?
6. What are the principal aim s of audit by Test – checking?
7. Write short notes on :
a) Internal audit
b) Objectives of Internal control
c) Test Checking
d) Technique of audit
8. What is internal control? How is the auditor concerned a bout it?
9. Explain the terms Internal control, internal audit and internal check.
10. What is internal control? Suggest internal control system for credit
purchases.
11. Explain the terms “Internal control” an “Internal Audit”.
12. What are the various techniques of au diting?
13. Select the appropriate option and rewrite the following statements :
a. Internal auditor’s appointment is made by --------------------
a) Institute of internal auditors of India.
b) Members at the Annual General meeting.
c) The management
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82 ii. Internal check is meant for ------------------ .
a) Prevention of fraud
b) Increase in the profits
c) Detection of fraud
d) Helping audit in depth
iii. ----------------- deals with audit sampling.
a) SA 530
b) SA 400
c) SA 610
d) SA 510



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83 5
AUDITING TECHNIQUE
VOUCHING
Unit Structure :
5.0 Objectives
5.1 Introduction
5.2 Meaning and Definition of Vouching
5.3 Vouching of Income / Revenue
5.4 Audit of Expenditure
5.5 Summary
5.6 Questions
5.0 OBJECTIVES
After studying this unit, the st udents will be able to:
 Understand about vouching.
 Vouch different types of receipt of Income and different types of
expenditure.
5.1 INTRODUCTION
The act of examining vouchers is called vouching. In auditing vouching is
done to establish the authentici ty of the transaction recorded in the books
of accounts. It is to find out the documentary evidence for the entry.
Vouching plays a very important part in the process of audit. The auditor
will verify whether the amount in the voucher is posted to the corr ect
account while examining the voucher. Auditor should pay special attention
to the following points: -
i) The date of the voucher. The date should be relevant to the period of
audit.
ii) Voucher is in the name of the client.
iii) Voucher is duly authori sed.
iv) The voucher is complete in all respects.
After examining the voucher, the auditor should either cancel it by putting
a cross or put a stamp on the same so that the same voucher could not be
produced once again.
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84 5.2 MEANING AND DEFINITION OF V OUCHING
5.2.1 Meaning and Definition
Vouching is an inspection by the auditor of the evidences supporting the
transaction entered in the books. It is a technique used by the auditor to
judge the truth of entries appearing in the books of accounts.
Account ing entries are made in the books of accounts. All such entries
must be supported by some document. An accountant is not supposed to
make any accounting entry unless he is having a documentary evidence to
support. If a proper supporting evidence is not ava ilable or such evidence
is not fully supporting accounting entries made, Auditor has every reason
to doubt about the existence of error, fraud or manipulation of accounts,
goods or cash. Every transaction must be invariably supported by a
suitable voucher. Success of an audit depends upon the efficiency with
which the devices of vouching have been used. Without vouching
auditing is incomplete.
Definition :
J. R. Batliboi : “Vouching means testing the truth of items appearing in
the books of original entry. ”
Lawrence Dicksee : “Vouching is an act of comparing entries in the books
of accounts with documentary evidence in support there of.”
Thus, vouching is a device used to prove that the various transactions for
the period are fairly, truly and sincerely refl ected in the books. Vouching
is checking the accuracy of entries made in the books of accounts with the
help of available documentary evidences. No transaction has been omitted
and all the transactions have been recorded properly. So, vouching is
called as an essence of auditing.
5.2.2 Objectives or Importance of Vouching :
Objectives of vouching are:
1. To confirm that all the transactions have been recorded and every
transaction recorded has supporting documentary evidence.
2. Vouchers produced are legally v alid, authentic and are in the name of
the client.
3. Proper distinction has been made between capital and revenue items.
5.3 VOUCHING OF INCOME / REVENUE
Now let us consider vouching procedure of some transactions. Books of
accounts mainly contain two type s of transactions viz transactions
regarding revenue and those of different types of expenses. Let us first
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85 Income of any business unit depends upon the nature of its activities. If
it’s a trading concern it ear ns its income by selling goods. If it is a service
organisation, it earns its revenue by rendering services.
5.3.1 Revenue from Sales :
A trading concern earns its revenue by selling goods. Sales again are of
three types.
i) Cash Sales
ii) Credit Sales
iii) Sale on approval or sale or return
All the three types of sales involve different procedure and hence naturally
their vouching will involve adoption of different procedures.
1. Cash Sales :
a. To study the internal check system: The auditor should study t he
internal check system of the organisation for cash sales. He should find
out whether there is any loophole in the same so that cash received
from sales could be misappropriated. Then he should see whether there
is a system of issuing a cash memo for ev ery cash sale. In some
business units, a cash memo is issued not only for cash sales but also
for the amount collected from the debtors for previous credit sales.
Such practice should be discouraged. Because if such system is in
place, then auditor cannot be sure that all the debts have been collected
before the end of the year. Amount received on some of the sales may
not be accounted for and misappropriated.
b. Cash sales are usually verified with the carbon copies of cash
memos. If the number of sales is v ery large, it becomes very difficult
to check every sale. Here a cash sales summary book is maintained. A
total of such a book is than tallied with the cash memos.
c. While checking cash sales, the auditor should particularly pay
attention to the date on the cash memo and whether the amount
received is accounted for in the books on the same day. All cash sales
are entered on the debit side of cash book.
d. Then the auditor should verity whether the price of the goods sold
is properly calculated . If any cash mem o is cancelled, the auditor
should insist on the production of original of such receipt. It should be
kept with the carbon copy. Production of both the copies is essential.
Otherwise, there is a possibility of showing cancellation of the receipt
and misapp ropriating the sale proceeds.
e. In some business concerns, there is a system of giving discount on the
price. If so, the auditor should insist that there should be clear
rules regarding rate of discount to be granted to their customers.
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86 given, verify whether discount granted is according to these rules only.
If any extra rate of discount is to be granted that should be granted by
an official at the highest level only. This is necessary because there is a
possibility of showing higher discount and misappropriating the
difference.
f. Auditor should verify that the date on the cash memo and date of
the entry in the cash book is the same . Otherwise, there is a
possibility of temporary misappropriatio n of the cash. That is cash
received on sale of goods is used for personal purposes and then later
returned to the business and accounted for.
g. Auditor should also check the balance of stock in hand and the
quantity of goods sold. Transfer or posting of th e entry from the cash
book to the ledger should also be checked.
h. Sale of fixed assets should not be included in the sale of goods. If
there is any sale of scrap, it should be recorded separately. If the
business uses automatic cash register, the daily tot als entered in the
cash book should be checked with the till rolls.
i. There are chances of cash misappropriation of cash sales.
Salesman may sell the goods but may not account for the cash
received. To avoid such possibility internal control system in the
concern regarding cash sales should be effective. In big stores like
Malls the salesman is not allowed to receive cash from the customers.
Goods are also not delivered by him to the customer. This is done by
some other person. He is only expected to prepare four copies of
memo of the goods sold. Of these two copies are handed over to the
customer. The salesman will send one copy with the goods to the
delivery clerk and retain one copy for his record. In the meantime, the
customer will make payment to the cas hier. Who stamps the bill as
“cash received”? The customer can get the goods from the delivery
clerk who is always at the exit point by showing the copy of the memo
with the stamp cash received. At the end of the day the salesman,
cashier and delivery cler k will prepare summaries all of which must
tally. The auditor should check these summaries and cash book to
detect mistake or fraud if any.
2. Goods sent on consignment :
a. Goods sent on consignment are not actual sales. So, the auditor should
verify that thei r accounting is properly done.
b. Proforma invoices are sent for such goods and auditor should
verify them with the duplicate copies of the proforma invoice sent.
c. Auditor should also see that the stock with the consignee on the last
working day is properly valued at cost plus proportionate non
recurring expenses incurred by the consignor or and consignee on the
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87 3. Sales Returns :
a. Returns are verified with the copies of the credit notes sent to the
customers.
b. Sales returns of the first and last month sh ould be particularly verified
as they are likely to be bogus.
c. To inflate or deflate profits, bogus sales may be shown and then shown
as returns in these months.
d. Auditor should also verify whether the returned goods are in good
condition.
4. Sales on approv al or sale on return basis :
a. Auditor should see that a separate register is maintained for such sales.
b. Entries in such Register should be checked with the carbon copies of
the proforma invoices sent with the goods.
c. When the customer informs that he has a pproved the goods, then such
goods should be transferred from goods on approval register to
regular sales book and further entries are passed.
d. Goods not approved but returned, should be entered in the goods sent
on approval and stock register, Incidental expenses incurred, if any
should be properly accounted for.
5. Rental Receipts:
a. Rent is received from the tenants and the landlord issues them receipts.
The auditor should verify the amount received with the carbon copies
or counter foils of the receipts give n to the tenant.
b. Then the auditor should look in to the agreements entered in to with
the tenants. This will help him to see whether a correct amount is
received from the tenant or not.
c. On the house property, there are certain charges to be paid like
Mun icipal Taxes, Electricity charges, water charges etc. They may be
paid either by the tenant or by the owner on behalf of the tenant. Who
has to pay these charges is decided by the mutual agreement between
the two? So, the auditor should verify whether such charges are paid
by the concerned person as per the agreement
d. Landlords usually maintain a Rent Register and entries for rent
received are subsequently entered in this register. He should look in to
the total accommodation available for letting out and w hether all of it
is let out or not. If any part is shown as vacant, he should obtain a
certificate to that effect from a responsible officer of the client.
e. Auditor should carefully study the rent agreement or lease deed. If the
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88 should be verified. In case of heavy arrears of rent auditor should
confirm the arrears from tenants with the consent of the client and
enquire into the causes for the same.
f. Many landlords collect rent for some peri od in advance as a security
deposit. So, the auditor should see that proper adjustment is made for
rent received in advance, rent deposit and regular rent received and
receivable.
6. Interest and Dividends received :
a. If the investments are in number of compan ies, investments register is
maintained. In such a case dividend income is first vouched by
reference to the counterfoils of dividend warrants and the interests on
securities by reference to the tax deduction certificate issued by the
bank.
b. Afterwards the amounts collected are traced into the investment
register. The Register is carefully checked to ascertain whether any
dividend has remained unrealised. If so, the auditor should enquire in
to the reasons for the same.
c. Profit and loss account should show the gross amount of interest as
income. So, when a tax is deducted at source a certificate is received,
the tax deducted is debited to Income Tax account and credited to
interest account. The auditor should verify that this has been done
properly.
d. The aud itor should compare the income of interest and dividend of this
year with the one received last year. If there is significant change, he
should enquire in to the reasons for the same.
e. The auditor should obtain a list of the securities and check whether
income is received on all of them. He should physically check their
existence.
f. If any securities are pledged with the bank, he should obtain a
certificate from the bank about their existence with them.
g. If there are any fixed deposits with the banks, he shou ld check interest
received on them from the bank pass book and also inspect Fixed
Deposit Receipts issued by the bank.
h. These days interest and dividend is directly credited to the investor’s
bank account through electronic transfer. Then the auditor can ch eck
their receipt with the entries in the bank pass book directly.
7. Royalties Received:
a. Royalty is paid when ore or oil is extracted from the earth or oil well.
Royalty is also paid to the author of the book or singer etc. To check
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89 conditions of the agreement between the parties for the payment of
Royalty.
b. He should go through the correspondence with the lessee.
c. Calculation of the Royalty should be checked and the auditor should
see the count er foil or carbon copy of the receipt issued to the lessee
on the receipt of the Royalty.
d. Royalties due but not yet received should have been properly
accounted for.
e. If any income tax is deducted at source (T.D.S.) the auditor should see
that certificate of such deduction is duly received from the lessee.
Further, he should verify that entries in the Royalty Account and
Income Tax Account are correctly done.
8. Recovery of bad debts written off
a. Ascertain from the trail balance, the amount under considerati on, and
it should be taken to Profit and Loss Account.
b. Check the journey entry passed for the same and its authorization.
c. If the amount is received from a party under liquidation through his
liquidator/ official receiver, check the letter from the person a nd check
the amount which is received along with the year in which the original
depth written off.
d. Trace the amount in the bank statement.
e. Check the correspondence with the party and with the official
receiver/liquidator.
5.4 AUDIT OF EXPENDITURE
1. Purchase s
One of the major items of expenditure in a trading concern is purchase of
goods for sale. Purchases can also be of two types namely cash purchases
and credit purchases.
a. Cash purchases should be verified with the cash memos or the
receipted invoices rece ived from the suppliers.
b. All credit purchases of goods are entered in the purchase book.
Along with the goods, the supplier sends invoices containing
particulars of the goods like their weight, packing price, discount
allowed or freight, Sales tax etc. pai d on behalf of the client. These
invoices are serially numbered and kept in a separate file. Entries in
the purchase book are done on the basis of these invoices. Auditor
should see that all the invoices received have been properly entered in
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90 c. Secondly, he should confirm that all the goods purchased are
actually received by the client. This is necessary because many a
times, the invoices are sent by post and the goods are dispatched
through a carrier like truck, railway etc.
d. There may be some time gap between the receipt of the two. Client
should pay only for the goods which are actually received by him. So,
there should be a suitable internal control over the purchases.
e. Goods are received by the store and the store keeper will verify th at
the goods received are as per the order placed and as per the invoice
received. He must count, weigh and check the quality of the goods and
if found satisfactory, then only the invoice should be forwarded to the
accounts department for entry in the book s and making of payment
subsequently.
f. Auditor should study the internal check system prevalent in the
organisation for purchases and then decide to what extent he should
verify the purchases. If test check is to be adopted, how many items
are to be select ed for verification? Each organisation develops internal
control for purchases according to its needs. It will usually depend on
the number of purchase and the size of the organisation and the staff
employed. If the existing internal control system is not found to be
satisfactory, the auditor should, exercise greater care in vouching the
purchase transactions. He should suggest suitable changes in the
internal check system.
g. In a large concern, to start with the stores department sends purchase
requisitions to the purchase department whenever certain goods are
required. These purchase requisitions are to be sanctioned by the Head
of the Department. He decides whether to purchase and how much to
purchase. Purchase requisition contains details about the goods to be
purchased, their quality quantity etc. After a decision to purchase is
made, the purchase department invites tenders or quotations from
different suppliers. Purchases manager studies these quotations and
selects the best supplier and places order wit h him. Usually there are
printed order forms which contain the terms and conditions. Copies of
this order are sent to the stores department, accounts department and
goods receiving from the supplier. The goods receiving department
will verify the goods wit h the order placed – Quantity, quality packing
etc. If everything is found satisfactory a goods received note is
prepared and sent along with the goods to the stores department. One
copy of this note is sent to purchase department and another to
accounts d epartment for payment.
h. On receiving the bill from the supplier, the accounts department
verifies the amount from the purchase order and quantity with the
goods received note and then the bill of the supplier is passed for
payment.
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91 i. The bill is first ente red in the purchase book and the account of the
supplier is credited. When payment is done to the supplier either in
cash or through a cheque, entry is made in the cash book and in the
supplier’s account.
j. Thus, a large number of persons are engaged in the purchase
department. So, an effective internal control system alone will prevent
frauds in the department. However, the possibility of frauds cannot be
completely ruled out. E.g., Payment may be made for fraudulent
invoices without delivery of goods. Sele cted suppliers only may be
favoured by orders and Kickbacks or gifts are received from them. So,
the auditor should thoroughly study the internal control system and see
that purchases are duly authorised by some responsible officer and a
proper procedure o f purchase is strictly followed.
k. The auditor should ensure that payment is done only after the goods
are received in proper condition. The invoice received should be in the
name of the client only. The date of the invoice is within the period
under audit.
l. Goods purchased should be used by the business and not by the
officers of the company.
m. Each invoice should be ticked or stamped after checking so that the
same may not be produced once again.
n. He should also see that trade discount is allowed at usual r ate and as
per the terms agreed upon while placing the order.
o. The auditor should not accept duplicate invoices under the pretext that
some invoices are misplaced or lost. Under such circumstances, he
must obtain a statement from the supplier.
p. The auditor should be more careful while vouching the purchases at
the end of the year and at the beginning of the year. Because there is a
possibility of showing bogus purchases at the end of the year to reduce
profits and then to show them as returned at the beginn ing of the year.
Current years purchases may be shown in the next year to increase
profits. In both the cases, the accounts will not present true and fair
operating results.
2. Purchase Returns :
a. If the goods are not of the ordered quality or quantity, they may be
entered in a purchases return book or return outward book and along
with the goods a debit note is sent to the supplier. Auditor will see
that the client follows a proper procedure for the return of the goods.
b. Purchase return book entries are verif ied with the carbon copies of the
debit notes sent to the supplier.
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92 c. As we have seen earlier, in large organisation, Purchase manager
inspects the goods received and confirms that they are of the quality
ordered. If they are not found to be as per the ord er, the goods are
rejected. Rejection report is prepared and a copy of the same is sent to
the accounts department. The suppliers account in the ledger is then
debited. No such adjustment is necessary, if the supplier immediately
replaces the defective goo ds by goods of satisfactory quality.
d. He should see that the client sends a debit note or the supplier sends a
credit note and the same is properly accounted for in the books of
accounts.
e. Quantity returned must be tallied with the store keeper’s records. For
manipulation of the year’s profits, bogus purchase returns are shown
in the beginning of the year or at the end of the year. Or this year’s
returns are shown in the next year or last year’s returns are shown in
this year. So, the auditor should verify returns in the beginning and
the end of the year more carefully.
3. Salaries and Wages :
a. Payment of salaries and wages is usually a major item of expenditure
in any organisation. So, the auditor should pay a special attention for
the verification of this ite m.
b. There should be a proper system of internal control on this item. There
are possibilities of payment of amount which were not due or excess of
the amount due. There should be a strict control on the preparation of
paysheets.
c. Calculations of the salari es or wages due should be done correctly by a
responsible officer and then checked and rechecked by 2 or 3 other
high-level officers.
d. There are two systems of wage payment. Time rate system and piece
rate system. If the time rate system is sued, a fixed a mount is paid as
salary or wages for each month. Here the preparation of wage sheets is
comparatively easy. Every month the same amount is paid to an
employee unless he is on leave without pay. His pay increases either
when he completes his year of service or on a fixed date every year as
per the terms of the contract.
e. If piece rate system is followed, we have to keep a record of not only
his attendance but the work he has actually done during the month.
Wages are calculated on the basis of the work actual ly done by him or
goods produced by him. Besides salary, a worker may be paid
dearness allowance, incentive bonus etc and a total gross salary is
arrived at. From this there are deductions for Employee State
Insurance Scheme, Professional Tax, Employees’ P rovident Fund,
Income Tax, recovery of home loan vehicle loan fines and penalties
etc. and a net amount payable to each employee is calculated. In
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93 f. A copy at the paysheet or wages sheet after the calculat ions are
checked is now a days sent to the banker who directly credits the net
amount to the personal accounts of each employee in the bank.
g. As per Payment of Wages Act, employer has to pay dues to the
employee every month before 10th of next month. Audit or should test
check the calculations made in the wages sheets and get himself
satisfied that the amount payable is calculated on proper lines.
h. Then various deductions made for Provident Fund, Income tax etc.
should be credited to the respective accounts and paid to the concerned
authorities in time as per provisions of concerned legislation.
i. There are possibilities of showing bogus names in the pay sheets and
misappropriating the amount drawn in their names. So, the auditor
should see that such fraud is not committed.
j. If wages are paid on Time basis, an accurate record of attendance of
the employees should be maintained. These days there are machines to
record attendance of the employees, time of arrival and departure etc.
Wherever possible, such machine s should be used to correctly record
their attendance. If piece rate system is in vogue, an accurate record of
the work done by each worker should be maintained.
k. Wages sheets should be prepared by the staff which is in no way
connected with the recording of attendance etc. If any employee is
promoted during the month and his salary is increased, the auditor
should personally verify the correspondence in this connection and re -
fixation of his salary in the higher grade should be checked.
l. If there is overti me payment, which is usually drop 1½ or double the
normal rate, the auditor should see that it is sanctioned by a competent
authority and is justified. Auditor should compare the names in the
wage’s sheets with the worker’s register to detect inclusion of dummy
workers and the workers who have left the company.
m. Auditor should compare the total amount paid as wages in this month
with the amount paid as wages last month or any other month. If there
is a great difference between the two, the auditor should en quire in to
the causes.
n. If the client has a system of employing casual workers, the auditor
should verify payment of wages to these workers more carefully as
possibility of frauds here are more.
o. If the client has a Standard Costing system in his factory, the auditor
should compare the actual amount paid as wages with the standard
wages or budgeted wages calculated earlier and if the difference
between the two is more, causes for the difference should be enquired
in to.
p. If the salary sheet contains any pa yment of wages of a partner, it
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94 the Income Tax Act. Every year business firms send an annual return
of salaries and wages paid to the employees to the Income Tax
Department.
q. Auditor shoul d cross check the amount in the wages sheets with the
statement sent to the Income Tax department.
r. Salaries and wages paid can be revenue or capital. Salary paid on
installation of plant and machinery or on construction of a building is a
capital expendit ure whereas wages and salaries aid for the production
of goods and administration of office are revenue expenses. Auditor
should verify whether this classification of expenses in to revenue and
capital is correctly done.
4. Payment of Rent :
We have studied earlier the vouching of receipt of rent. Almost a similar
procedure is to be adopted to vouch payment of rent.
a. To begin with the auditor should go through the terms and conditions
of the rental agreement entered with the land –lord.
b. He should pay special attention to the period of the lease, rent to be
paid, manner of payment, amenities to be provided by the landlord
etc.
c. These days, many landlords insist on payment of rent for a certain
period like 3 or 6 months in advance. Some amount is also to be pai d
as a security deposit. If required Income tax (T.D.S.) and Service Tax
is required to be deducted from the rent payable. Auditor should
verify that the amount paid is properly accounted for in the books of
account.
d. When we pay rent to the landlord, he issues a receipt. Such receipts
should be serially numbered and neatly kept in a separate file. Auditor
will check payment of rent on the basis of such receipts.
e. Auditor should verify the correctness of the payment of rent as per the
rent agreement. Income tax wherever deducted should be paid in to
Government Account in time and a statement or a Return is filed with
the Income Tax Authority in the prescribed form.
f. Rent paid as advance or as a deposit should not be charged to revenue.
g. If the security depos it with the landlord carries any interest, such
interest received should be properly taken to profit and loss account.
h. Auditor should ensure that suitable adjustment entries have been
passed for prepaid and outstanding rent, in the books of accounts.
5. Payment of Insurance Premium :
Business is generally concerned with General Insurance i.e., Fire, Marine,
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95 insurance etc. These policies are usually for one year and they are to be
renewe d every year. Insurance premium depends upon the amount of the
policy. Business these days is full of uncertainties and the business
management has to decide what risks it wants to insure. As noted above
now a days there are innumerable insurance policies covering different
types of risks. Manager will consider the different risks it has to face in
business like fire, riots etc. and the premium payable for insurance.
Studying both the aspects, the management decides to insure certain risks
and the amount fo r which the risk is to be covered.
a. Premium depends upon the amount of the policy. Auditor should
verify the payment of insurance premium with the receipt received
from the insurance company.
b. Auditor should verify that the Insurance premium is paid and th e
policy is renewed every year in time.
c. He should also consider whether the amount for which the policy is
taken, adequately covers the risk involved in the particular business.
d. Now a day, there are number of Government and Private Insurance
companies an d their rate of premium and risks covered are different.
So, the management should study these different terms contained in
the policies and then select the company and the policy most suitable
to meet its needs.
e. Insurance premium paid is for one year. So , at the end of the year,
suitable adjustment should be made in the books of accounts for
prepaid insurance if any.
f. Sometimes the staff takes life insurance policies on their own lives or
lives of their members of their family drop and pay premium through
their employer. Employer deducts the premium from the salary
payable to the member of the staff and directly pays the amount to the
insurance Company. LIC calls such policies, salary saving scheme
policies. This is convenient both to the staff member conc erned and
also to the Insurance Company. Staff member need not bother to pay
the premium every month to the company and the company gets the
amount regularly from the employer. Under these circumstances, the
auditor should see that the premium amount is co rrectly recovered
from the member of the staff and paid to the Insurance Company in
time. Auditor should scrutinize the ledger and see that the transactions
are accounted properly.
g. If no claim of loss is made during the year, Insurance Companies give
some bonus or discount in the premium paid the next year. e.g., If you
take an accident insurance policy for the vehicle and do not have any
accident during the year. Insurance Company charges lower premium
next year. Auditor should verify whether such bonus or discount has
been allowed by the Insurance Company as per its rules or not.
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96 6. Telephone Expenses :
a. To start with the auditor should obtain a list of telephones land line
and mobile in the organisation.
b. Telephone charges are paid usually after the recei pt of the bill from the
telephone company. Auditor should verify whether the bill is in the
name of the client only.
c. Telephone companies may require the customer to keep some amount
with the company as security deposit. Auditor should verify the
payment o f deposit and payment of regular telephone charges are
properly accounted for in the books of accounts.
d. Deposit with the company will be treated as an asset and shown in the
Balance sheet whereas telephone charges paid are revenue expenses
and taken to pr ofit and loss account.
e. Personal Telephone bills of Directors and other executives should not
be charged to the profit and loss account even though they are paid by
the business on their behalf.
f. In good many companies, utility bills of the staff like tele phone,
electricity, water tax etc. of the staff are paid by the peons of the
company to save the botheration of the members of the staff. However,
amount thus paid on behalf of the members of the staff is subsequently
recovered from their salary. Auditor s hould see that such recovery has
been done. Auditor should also see that at the end of the year
adjustment entries are passed for outstanding telephone and other
expenses.
g. Auditor should study the internal control system specially over the use
of I.S.D. c alls. Profit and Loss account should contain the telephone
expenses of the full year. If the telephone bill is paid through the bank,
auditor should verify the same in the bank statement. If any new
instrument of telephone is purchased, the bill for the sa me should be
preferably capitalized.
7. Petty Cash Expenses
a. Identify the persons who handle Petty Cash.
b. Verify the ceiling limit of disbursement through Petty Cash.
c. Note the limit of Imp rest System.
d. See whether petty cash payments are regularly checked by a
responsible official.
e. Examine Reconciliation Statements prepared regularly for Petty Cash,
based on vouchers.
f. Verify the Cashbook for the transfer of Cash under Imp rest system to
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97 g. Scrutinise the Petty Cash Vouchers along with Invoices, Bills,
Receipts signed by the recipients.
h. Trace the postage expenses along with entries in Mail Outward
Register. Compare with previous periods and obtain satisfactory
explanations for abnormal movements.
i. Check the castings of columns, totals and main totals.
j. Trace the postings from the Petty Cash Book into the Nominal
Ledger Head of Account.
k. Verify the petty cash physically available on a certain date, by
way of surprise check.
l. Examine the Suspense Vouchers I lOU's and ensure that they
are reversed within a reas onable time.
m. Conduct a Surprise Check of Petty Cash balance and compare the
same with the Petty Cash Book.
8. Advertisement Expenses
a. These days, business houses spend crores of rupees on advertisement.
It’s a necessary business expenditure and the auditor sh ould see that
the amount is properly spent Expenditure on advertisement should be
sanctioned by the competent authority of the organisation.
b. Today there are innumerable types of advertisement and there are
number of companies providing advertisement facil ity. A proper type
of advertisement should be selected and a competent agency should be
asked to conduct the advertisement campaign for the company. If the
advertisement is done on right lines, it will immensely benefit the
business unit. If not, advertise ment is a waste.
c. Auditor should verify the amount spent with the receipt received from
the advertising agency.
d. He should see that the date of the receipt falls within the period of
audit. It should be in the name of the client. Amount should be spent
on the advertisement of the client’s products only. First the advertising
agency sends its bill for services and on receipt of the same, agencies
account should be credited. Bill received should be kept securely in a
file. When the amount is actually paid to the agency, its account
should be debited and cash or bank account should be credited. If the
firm has advertised its products in a New Paper, a cutting of the same
should be obtained as a proof of the publication of the advertisement.
e. If the Advertiseme nt. is done through signboards the business unit has
to pay rent for the place of display of the board. Auditor should see
that payment of rent is properly accounted for.
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98 f. Usually, commission is paid to the Advertising agencies at an agreed
rate. Auditor should vouch payment of such commission. If there is a
regular contract with the agency, auditor should go through the
agreement and note down the terms and conditions agreed in the same.
g. If any advance is paid, it should be suitably adjusted when the fin al bill
is paid. If the payment is done through a bank, auditor should verify
the same with the bank statement.
h. If a large amount is spent on advertisement on a new product
introduced in the market, some part of it may be treated as deferred
revenue expen diture as the advertisement is likely to benefit the
business for 2 -3 years to come. In such cases, the auditor should verify
whether the classification or division of expenditure in to capital and
revenue is done on some sound principles.
i. Advertisements a re usually issued through advertising agencies. These
agencies not only arrange for the publication of the advertisement as
per your instructions but also prepare the draft of the advertisement in
an attractive language in a minimum number of words. They h ave
number of experts in this field on their staff. They also prepare
advertising films, arrange for booking advertisement time on radio or
television etc. After the publication of the advertisement, they prepare
and send their bill. The auditor should ver ify the payment of this bill
and the receipt received from the agency.
9. Travelling
Demanded for all items of expenses incurred, except those which are
capable of independent verification. As regards traveling expenses
claimed by directors:
a. The auditor shou ld satisfy himself that these were incurred by them in
the interest of the business and that the directors were entitled to
receive the amount from the business.
b. The voucher for travelling expenses should normally contain the under
mentioned information: Name and designation of the person claiming
the amount, Particulars of the journey, Amount of railway or air fare,
Amount of boarding or lodging expenses or daily allowance along
with the dates and times of arrival and departure from each station,
Other expenses claimed, e.g., porter age, tips, conveyance, etc.
c. If the journey was undertaken by air, the counterfoil of the air ticket
should be attached to the voucher; this should be inspected.
d. For travel by rail or road, the amount of the fare claimed shou ld be
checked from some independent source.
e. Particulars of boarding and lodging expenses and in the case of halting
allowance the rates thereof should be verified. The evidence in regard
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99 long as the amount appears to be reasonable it is usually not
questioned.
f. All vouchers for travelling expenses should be authorised by some
responsible official.
g. In the case of foreign travel or any extraordinary travel, the expenses,
before being paid , should be sanctioned by the Board.
h. Unless the articles specifically provide or their payment has been
authorised by a resolution of shareholders, directors are not entitled to
charge travelling expenses for attending Board Meetings.
5.5 SUMMARY
This c hapter deals with an important function or technique vouching of
audit viz. Vouching of five items of revenue and five items of expenditure
are discussed in greater details as illustrations.
Vouching is an act of examining vouchers. It is done to establis h the
authenticity of the transaction recorded in the books of accounts. It is to
trace documentary evidence. Voucher is a supporting document. Success
of audit largely depends upon the efficiency with which the vouching
function is carried out. It is the testing of the truth of the item in the books
of accounts. Entries in the books are compared with the details in the
voucher produced. Vouching confirms that all the transactions have been
recorded and every transaction recorded has a supporting documentar y
evidence. Proper distinction has been made between capital and revenue
items.
5.6 QUESTIONS
1) State the purpose of vouching.
2) How will you investigate misappropriation of cash sales?
3) How would you vouch cash purchases?
4) What do you understand by the term vouching?
5) “Vouching is the essence of Audit”. Explain.
6) How would you vouch purchase ledger and sales ledger or credit
purchases and credit sales?
7) What do you mean by vouching? How would you vouch cash sales?
8) How would you vouch the following?
a) Interest received on investments.
b) Cash purchases of stationary
c) Cash Sales
d) Advertisement expenses
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100 9) Select the appropriate option and rewrite the sentence.
a) Which of the following document is not relevant for vouch ing of
sales?
i) Daily cash sales summary
ii) Credit memos
iii) Delivery Challans
iv) Sales department attendance record.
b) ---------------- document is not relevant for vouching cash
purchases.
i) Purchase invoice
ii) Goods inward register
iii) Attendance record of cashier
iv) Purchase order
c) Telephone charges should be examined on the basis of ------
i) Cash memo
ii) Agreement with telephone department
iii) Telephone bill
iv) All of the above
10) State whether the following st atement is true or False.
While checking dividend received the auditor should check dividend
warrant.


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101 6
AUDITING TECHNIQUE
VERIFICATION
Unit Structure :
6.0 Objective
6.1 Introduction
6.2 Verification
6.3 Auditors general duties
6.4 Audit of Assets
6.5 Audit of Liabilities
6.6 Summary
6.7 Questions
6.0 OBJECTIVE
After studying the unit , the students will be able to:
 Understand another technique of auditing viz. verification
 Explain the Difference between vouching and verification
 Explain how to verify assets viz. Plant and Machinery, Account
receivables, investments and inventory and
 Know how to v erify liabilities like outstanding expenses, Accounts
payable, secured loans and unsecured loans.
6.1 INTRODUCTION
Verification is the technique used for auditing the assets and liabilities.
Verification means the procedure normally carried out at the ye ar end to
confirm the ownership, valuation and existence of items at the balance
sheet date. It also involves confirming that presentation in the financial
statements is in accordance with laws governing the particular unit. Just
examinations of the books of accounts with a view to ascertain their
arithmetical accuracy is not enough. The auditor must verify that the
various items appearing in the balance sheet are actually in the possession
of the concern. In short, verification means proving the truth or
confirmation.

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102 6.2 VERIFICATION
6.2.1 Meaning and Definition
Verification is a broader term and includes valuation of the assets and
liabilities. The auditor has to report that the Balance – sheet exhibits a true
and fair view of the state of affairs . So, he has to ascertain the correctness
of value of assets and liabilities in the Balance sheet. Such examination is
called verification of assets and liabilities.
Spicer and Pegler ,
“The verification of assets implies an enquiry in to the value owners hip
and title, existence and possession and the presence of any charge on the
assets!
J.R. Batlib oi,
“the auditor must satisfy himself that assets really existed at the date of the
Balance sheet and were free from any charge and they have been properly
valued. In verifying the liability, he has to see that all liabilities have been
inserted at their proper figures and that no liability has been omitted.”
Institute of Chartered Accountants opines that verification of assets
should establish their:
a) Existe nce
b) Ownership
c) Possession
d) Freedom from encumbrances
e) Proper recording and
f) Proper valuation
6.2.2 Verification V/S Vouching:
Vouching and verification appear to be similar or same but they are not.
Vouching proves the accuracy of the books of accounts but the worth of
the assets and liabilities is confirmed by verification. Thus, there is a clear
line of demarcation between the two. Vouching is to examine the
correctness of the transaction in the books and verification confirms
correctness o f their valuation as shown in the balance sheet. Thus, the
auditor has not only to see that a particular asset has been actually
acquired but to see that it physically exists and is owned by the client. It is
to be shown in the balance sheet at a right pri ce.
Difference between the two will be clearer it we look at an example
Building. If the auditor only vouches the purchase of a building, he may
not know whether the building is mortgaged for any loan or not. Vouching
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103 shown in the Balance – sheet may not be the same on the date of the
balance sheet. So, to verify the existence and proper valuation, verification
is necessary.
Thus, we can conclude that vouching and verification are different but
equally important for proper audit.
6.2.3 Technique of verification:
1. Inspection :
The auditor may visit the premises of the client and physically verify the
existence of the assets, second method is observation. E.g., closing stock
or cash i n hand on the last working day is counted by the staff of the
client. The auditor may be present there at that time and observe that they
are doing their job on proper lines. In the case of assets like shares and
securities, mortgaged with the Bank for a l oan, he may ask the concerned
Bank manager to issue a certificate about their existence in his possession.
2. Observation :
The auditor may observe or witness the inspection of assets done by
others.
3. Confirmation :
It means obtaining written evidence from o utside parties regarding
existence of assets.
6.3 AUDITORS GENERAL DUTIES
6.3.1 Auditors General Duties
Here the position of the Auditor is a little different because he is not
supposed to be an expert in this field. He has no technical knowledge. He
has to depend upon the valuation made by the Directors, expert valuers,
surveyors etc. to a large extent. In this concern auditor’s general duty is as
below:
1. He has to see that the assets are valued by valuer on reasonable
ground. Auditor cannot guarantee the correctness of the valuation. But
he must get himself satisfied that valuation done is fairly satisfactory.
2. Auditor should see that the valuation is done according to certain
accepted principles of accountancy.
3. Auditor should carefully inspect the av ailable documents to arrive at
the correct value of assets. If there is any room for suspicion, the
auditor should probe deep in to the matter.
4. The auditor is required to report about the valuation of the assets on
the date of the balance sheet. However, if before the completion of
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104 should take cognizance of such an event and take note of the same in
his report.
5. Many a times a foot note is added to the financial statements. Suppose
the balance sheet shows the existence of a building of Rs. 10 lakhs but
after the date of the balance sheet there is a fire in the premises and the
same is completely destroyed. This fact should be shown as a foot note
in the financial statement and included i n the auditor’s report.
6. Whatever is the policy of the management regarding valuation of
different assets, there should be consistency in the same. This policy
should not be changed from year to year. Policy should be changed
only when it is absolutely nec essary and when such change is made, it
should be either mentioned in the financial statements or included in
the auditor’s report. Auditor should mention the effect of such policy
change on the profits of the concern. Auditor is expected to test check
the calculation of valuation of assets.
6.4 AUDIT OF ASSETS
1. Plant and Machinery:
Business units which use number of machines in their business usually
maintain a Plant Register. To begin with the auditor should ask any
responsible officer of the business uni t to supply him a list of plant and
machinery used in the business. This list should be complete in all
respects.
Auditor’s duty
a) The auditor should verify the asset by comparing the schedule with the
details in the plant register. The machinery purchased d uring the year
should be vouched by reference to the invoices and other relevant
vouchers. If any machinery is sold during the year, auditor should
verify that the sale has been properly accounted for in the books of
accounts. Profit or loss on sale of the Machinery should be duly
recorded.
b) If any plant is located or installed in a foreign country, the auditor
should require that the engineer concerned should furnish a certificate
reporting whether the plant is working efficiently or not. Such report
shoul d be compared with the details in the Plant Register or schedule
of plant.
c) At the end of the year a statement is prepared from the Plant Register
showing opening balance, sale and addition there to during the year in
respect of various items of machinery and plant. Its total is then
reconciled with the balance in the General Ledger.
d) It any new machinery is purchased it is as usual vouched with the
invoice and receipt of money issued by the supplier. However, it any
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105 auditor should verify whether correct amount spent on material,
Labour etc. is allocated to the machinery account. In addition, drop the
auditor may ask any senior engineer of the client to certify the
correctness of the val ue of the machinery. If any machinery or part of
it is sold, scrapped or destroyed, the auditor should ascertain the
correctness of profit or loss arising therefrom.
e) Though it is the duty of the management to ensure that the fixed assets
are in existence, the auditor should periodically physically examine the
different machines in the premises. Such verification may be done
every three years or five years depending upon the size of the
organisation .
f) Plant and machinery are fixed asset s and is valued in th e Balance
Sheet at cost less depreciation. There are different methods of
depreciation in use and a business concern can choose any method that
is found suitable to it. However, Income Tax department adopts
written down value method only for calculating ta xable income. So,
using the same method will be more convenient as adjustment in the
books of accounts are not necessary. Any method adopted, should be
consistently used because the amount of depreciation under different
methods is different and find profi t will also be different. If the method
of depreciation is changed in any year, this fact should be clearly
mentioned on the financial statements and the report of the Auditor. If
any year the plant and Machinery is revalued the depreciation should
be cal culated on the revised value and not on the historical value.
g) Large concerns maintain a special Plant Register which contains full
information about each machinery like its cost date of purchase,
amount spent on repairs, name and address of the supplier e tc. Thus,
the Register contains full history of each plant. As and when any plant
is to be replaced, this information helps the management to select the
supplier for the new machine.
h) Under Indian Companies Act it is mandatory for the limited companies
to maintain a Register of Fixed Assets.
i) Auditor should get himself satisfied that adequate amount of
depreciation is provided on plant and machinery. He may take here the
help of a technical expert to estimate the number of years for which
the machinery is l ikely to work satisfactorily.
j) Sale and acquisition of plant and machinery should be done only by a
duly authorised person. Auditor should verify from the available
documents that the plant and machinery is owned by the client and is
not mortgaged with any financial institution for a loan. If it is found to
be mortgaged, auditor should verify the relevant documents and see
that the fact of this charge created is clearly disclosed in the financial
statements. Present market value of the machine should not be taken in
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106 k) Machinery under Hire Purchase Scheme : If the client has acquired
plant and machinery on Hire Purchase Scheme the auditor should
inspect the Hire Purchase Agreement and terms of payment. He should
further confirm that the instalments are being paid regularly as per the
agreement. Usually, the title of the machinery is passed on to the
purchaser only after the last instalments is paid. However, it depends
upon the agreement between the concerned parties. So, the auditor
should look part icularly for this clause in the agreement. Hire purchase
instalments paid include interest. Auditor should see that only part of
the cash value of the machine paid is capitalised. Interest paid is taken
to profit and loss account. However, deprecation shou ld be calculated
on the entire cost price of the asset and not merely o the part of the
cash price paid. If any machinery is taken on hire it should no be
shown in the balance sheet.
l) Imported Machinery: If the machinery is imported, the auditor
should see the agreement with the foreign supplier. He should also see
whether the client has received import licence and permission of the
Reserve Bank for the remittance of the price of the machine.
2. Fixtures and Fittings :
Fixture is an asset fixed to land or bui lding and forms part of the machine.
Fittings are fitted on the wall like electric fittings. Cost of fixtures and
fittings are added to the cost of the machine.
3. Investments :
Investments may be in Share certificate, Government Bond certificate,
Government Loan certificate, Debenture Certificate, Mutual Fund
Certificate or statement etc. Extra or idle funds with the concern may be
invested in shares, bonds, debentures etc.
 Auditors Duty
a. If a large amount is found invested in different types of securities, the
auditor may ask any responsible officer of the client to provide him an
exhaustive list of such investments. Just like a Plant Register many
concern maintain an Investment Register giving full details of each
title like its face value, purchase price, rate of interest date on which
interest is due, date of their maturity name and address of the
company, the date on which the interest is actually received and so on.
b. The auditor should physically inspect the investment certificate as per
this register. T hese days usually the investments are not maintained in
physical form because all transactions on the stock exchange are done
usually through Demat accounts. If the investments are in demat form,
the auditor should ask the depository participant (popularly known as
D.P.) to supply a copy of the demat account of the client with him and
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107 c. If the investments are in a physical form, the auditor should complete
their verification at one stretch so that the same certificates may not be
produced twice.
d. If the number of such certificate is very large, if may not be possible to
complete verification in one sitting. In such a case, the auditor should
keep the verified certificates separately under his control or custody.
e. Sometim es such certificates are with the trustees. Then the auditor
should inspect the trust deed and see whether such an action is
permitted by the trust deed. Securities may also be kept with the
bankers for safe custody. Then the auditor should get a list of
investments with them from the trustees or bankers.
f. Client may have taken a loan from the bank on the security of such
certificates. In that case also the certificates are with the bankers. So,
the auditor should enquire whether the certificate s are deposi ted with
the bankers for safe custody or as a security against any loan. If any
loan is taken, the auditor should further enquire whether the loan is
taken for the purpose of the business and properly accounted for in the
books of account. Here there is a possibility that top executives of the
client, might have used the certificates to obtain a loan for their
personal purpose. When any loan is taken against the security of
investments, this fact should be clearly disclosed in the financial
statements.
g. If the investments are of non -trading investments or investments of a
permanent nature, they are to be shown in the Balance Sheet as fixed
assets and valued at their historical cost. However, here also their
market price on the date of the balance sheet is sh own in the inner
column in a bracket for the information of those who read these
financial statements.
h. The auditor should also ask the client to supply a list of securities
bought and sold during the year under audit. Decision about the
purchase or sale o f investments should only be taken by top
authorities. Auditor should verify whether their consent has been duly
obtained. Acquisition and disposal of shares and other securities are
done through the brokers on the stock exchange. The auditor should
verify these transactions with the contract note, bill of cost etc sent by
the brokers. Investments can be purchased or sold cum interest /
dividend or ex -interest / dividend. Auditor should verify that such
transactions are properly accounted for in the books o f account. If the
amount of the purchases and sales is substantial, the auditor should
check the price paid and received with the stock exchange quotations
of those respective days. Expenditure incurred on account of transfer
fees stamp duty etc. are inclu ded in the cost of the investments.
i. Dividend declared during the year under audit or before completion of
the audit but for the period covered by the audit is treated as the
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108 j. Auditor should be satisfie d that there is a valid evidence of their
ownership and custody of the investments and they should be properly
classified in the Balance Sheet as current and long-term investments.
k. If there is any right issue, auditor should verify whether the client has
subscribed for them fully or sold the right.
l. If the client holds any partly paid shares, the auditor should see that the
uncalled amount on these shares is shown in the balance sheet as a
contingent liability. If any investments are held in the name of pe rsons
other than the client, the auditor should confirm their ownership.
4. Patent and Trademarks:
a. The ownership of patent rights is verified by inspection of certificate
issued for grant of patent, by the prescribed authority.
b. If it has been purchased, the agreement surrendering it in favour of the
client should be examined.
c. If there are a number of patents held by the client, obtain a schedule
giving the full details thereof or verify with reference to the register
maintained by the client.
d. It must be veri fied that patent rights are alive and legally enforceable
and renewal fees have been paid on due dates and charged to Revenue
Account. The last renewal receipt should be examined to ascertain that
the patent has not lapsed.
e. See that the patents are properl y registered in the name of the client
only.
f. See that the cost of patent is being written off over its useful period of
life.
g. In case the patent is acquired, cost paid for the same and all relevant
expenses are to be capitalized.
h. If the patent is created b y the client by the research experiments and
laboratory work, only the actual expenses incurred for it in the process
are to be capitalised.
5. Copyrights
a. The auditor has to examine the written agreement of assignment
along with the royalty paid to the autho rs etc., for such copyrights.
b. He has to see that such assignments are properly registered.
c. If the client is the owner of many copyrights, the auditor should ask
the client to prepare a schedule of copyrights and get the detailed
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109 d. Regarding the value of copyrights, it should be remembered that this
asset has no value in the long run. Hence, value is determined on
revaluation basis and period of copyrights.
e. If any copyright does not command th e sale of any books, then the
same should be written off in such year. The auditor has to verify the
same in detail.
6. Know how
a. Know how is recorded in the books only if it has been paid for. If it is
developed in house, it cannot be capitalised. The audito r should keep
his in mind while verifying know -how.
b. Know -how can be of two types:
i) Relating to manufacturing process - The auditor should ensure
that the expenditure is written off in the year of payment itself.
ii) Relating to design plans of plants, building etc. - The auditor
should ensure that the expenditure is capitalized and depreciation
is charged on the capitalized figure. In case lumpsum payment is
made for both types of know -how, both the types should be
segregated on a reasonable basis.
c. Under the In come -Tax Act, cost of Know -how can be deducted
subject to the rules laid down.
d. The auditor should keep this fact in mind while computing the tax
liability for the year under audit.
7. Free hold Property (Land & Buildings):
a. The auditor has to examine the titl e deeds of the property owned by
the client and confirm that the same is freehold.
b. If the property has been purchased during the year, the auditor has to
examine the correspondence with the broker, or solicitor in details.
c. When a building has been construc ted on the freehold property, the
same is to be verified from builder's bill or architect's certificate.
d. Where the title deeds are deposited with the mortgagee on a
mortgage, then a certificate from him to that effect is to be obtained
for verification.
e. If the title deeds are deposited with the bankers or solicitors for safe
custody, the auditor should get a certificate from them to confirm the
fact.
f. If required, the auditor should ask the solicitor of the client to
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110 g. The auditor has to see that the conveyance of the property is in the
name of the client and the same is properly registered.
h. The auditor has to ensure that the property is properly insured.
i. The auditor should see that separate acco unt for land and building is
maintained. Because on land, usually no depreciation is provided.
j. In case there is appreciation of land and buildings value by
revaluation, the auditor has to see the basis of revaluation and
confirm that the same is properly d isclosed in the Balance Sheet, to
comply with the generally accepted accountancy principles and also
the provision of Companies Act, 1956.
8. Loose Tools, Patterns, Dies, etc.
a. Since the duration of the usefulness of such assets is very low, there is
no need of maintaining separate accounts for each of them. The auditor
in this case should see whether proper supervision has been exercised
over these assets, as there is every possibility of pilferage of such
small assets.
b. The auditor should collect a list of sm all tools, dies, moulds, rigs, etc.
from a responsible officer and examine the same very carefully. He
should also see that such a list has been certified by a responsible
officer.
c. As regards the valuation of small tools, the auditor should see that in
the case of the concern which manufactured its own tools, the tools are
not to be valued in excess of the cost.
d. Generally, these types of assets appear to be either lost or consumed
very rapidly. So, the conventional method of depreciation should not
be appli ed in their cases. The suggestion as given by Montgomery in
this connection may be stated. "Charging the cost of replacement of
such items to maintenance in lieu of depreciating them is usually a
satisfactory alterative". The auditor should see whether the above -
mentioned suggestion has been accepted or not.
e. The auditor should also see whether such an asset has been
properly shown in the Balance Sheet.
9. Stores and Spare Parts
Auditor's duties with regard to the verification and valuation of such assets
may b e stated as follows:
a. The asset known as stores and spare parts consists of materials which
are means for consumption in the business and not for resale.
Lubricants, dyes, fuel, etc., are examples of stores, while spare parts of
machinery are preserved to m aintain it in proper order.
b. The asset as such should be clearly shown in the Balance
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111 c. The auditor should obtain an inventory of stores and spare parts duly
certified by a responsible officer. He should count the stock himself
and thus verify the exis tence by personal inspection, if possible.
d. It is to be remembered that the stores consumed are debited to the
Manufacturing Account and spare parts used are debited to the
Machinery Account.
e. The asset is to be shown at cost price in the Balance Sheet It is not a
depreciable asset by use and provision for depreciation is not
necessary.
f. However, the loss on account of breakage or waste on being
worn out should be duly written off.
g. The asset should be revalued annually.
6.5 AUDIT OF LIABILITIES
Liabilities are the financial obligations of an enterprise. Like loans, trade
creditors, installments payable under Hire purchase agreements etc. An
important feature of the liabilities is that they are represented by
documentary evidence. Liabilities originate from third parties which deal
with the client.
Verification of liabilities is as important as the verification of assets. If any
liability is omitted or under or over stated, the balance sheet would not
show a true and fair view of the state of affairs of the concern. E.g., If
liability for payment of any expenditure is omitted, the profit and loss
account will not show the correct profit earned by the concern. Moreover,
as the outstanding expense is not shown in the balance sheet and it will not
show the corre ct financial position of the concern. On the other hand, it
any fictitious liability is included, profits shown will be lower and the
financial position revealed by the Balance sheet will be found to be
misleading. So, the Auditor should carefully verify t hat the liabilities
stated in the Balance sheet on the last working day are in fact payable and
all liabilities payable have been accounted for. The auditor may ask any
responsible officer to certify that all liabilities have been included in the
books of account and all contingent liabilities are also shown as a foot
note in the Balance Sheet.
 Audit of some liabilities by the Auditor.
1. Outstanding Expenses and Auditor’s Duty
a. To begin with the auditor should ask the Chief Accountant or any
other responsibl e officer dealing with the accounts of the client to
supply him a list of outstanding expenses classified by nature of
expenses.
b. Further, he should be asked to certify that all the outstanding expenses
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112 c. The amount paid on various accounts should be verified from the
entries in the cash book. All unpaid expenses on the date of the
Balance sheet should be included in such a list.
d. Auditor should compare this year’s outstanding expenses with those of
the last year. If there is a major difference between the two, he should
enquire in to the reasons for the same.
e. He should examine the documentary evidence supporting the
outstanding expenses. Usual outstanding expenses are last month’s
salary and wages, rent, leg al expenses, audit fees etc.
2. Secured Loans and Unsecured Loans :
Loans and borrowings form an important part in any business. No
businessman carries on his business using only his own funds. Even in the
Tata group of companies, Tata family hardly owns 5% of the capital.
Thus, almost all business units have to take loans for running their
business. Loans are of two types – secured loans and unsecured loans.
Both the types of loans have many things in common. So, let us consider
them together.
a. To start wi th, the auditor should examine the partnership deed or
Memorandum of Association to find out the powers of the client to
borrow money.
b. There are no restrictions on the sole proprietor regarding the amount to
be borrowed. He can borrow as much as he needs. However, as his
assets and repaying capacity is limited, he cannot borrow on a very
large scale. His capacity to repay, puts a limit on the amount he can
borrow.
c. Amount borrowed should be within the permissible limit. The auditor
should examine the loan agreement and note down the terms on which
the money is borrowed, like rate of interest to be paid, security to be
offered, period of the loan, method of repayment etc.
d. He should verify the cash received from the entry in the cash book and
a duplicate of receipt passed on to the lender.
e. In case of bank overdraft, he should scrutinize the agreement with the
bank.
f. If any security is offered against the loan, he should enquire into the
details of the security given. This fact should be clearly disclosed in
the balance sheet.
g. The auditor should find out whether there was a real need for such
loan and the terms of the loan are reasonable and not against the
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113 h. He should also see that the loan taken is used for the very purpose for
which i t was taken. If any property is mortgaged, the mortgage deed
should be registered with the Government Authorities.
i. Interest and installments paid on the loan should be verified with the
receipt issued by the lender. Such payment should be according to the
time schedule agreed in the agreement. If such installments are not
paid in time as agreed to, it will affect the goodwill and credit
worthiness of the client in the market.
j. With the permission of his client, he should confirm the balance of the
unpaid lo ans directly from the lenders.
k. In the case of a bank overdraft, a certificate of balance may be
obtained from the bank. If any interest is outstanding on the date of the
balance sheet, the auditor should see that the same is shown in the
Balance Sheet. Th e rate of interest agreed to be paid on the loan should
be reasonable taking in to account the prevailing market rate.
l. Loans in business are for large amounts. So, they are normally
secured. If any loans are unsecured, there will be no charge on any
asset s of the concern.
3. Contingent Liabilities
Contingent liabilities are those liabilities which may or may not arise in
the future for payment. The auditor's duty is to see that all known and
unknown liabilities have been brought into the accounts at the dat e of the
Balance Sheet and have been shown in the Balance Sheet separately as
such.
a. Liabilities on Bills Receivable discounted and not matured : If the
bills receivables are discounted with a bank and the money so received
from it is made use of, the entir e money will be refunded to the bank if
the acceptor does not make payment on the date of its maturity. This is
why such a contingent liability is distinctly shown in the Balance
Sheet by way of a footnote.
b. Liabilities for calls on partly paid shares: The amount called on
shares held and paid should be verified from the cash book and the
liability for the amount uncalled should be ascertained.
c. Liability under a guarantee: The auditor should ascertain the
liability for a guarantee given by the client for a l oan or overdraft to
his friend or partner. In case of nonpayment of such a loan, the
possible liability should be ascertained.
d. Liability for cases against the company not acknowledged as
debts: It is a liability in a disputed case where damages may have to
be paid. A contingent liability should be ascertained and a note should
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114 e. Liability in respect of arrears of Dividend on Cumulative
preference Shares: The auditor should examine the Articles of
Association which sho uld lay down rules in this regard and due
provision should be made for such a liability.
Auditor's duty: The auditor should very carefully check the various
contingent liabilities named above. There may be some such liabilities for
which no provision has b een made in the books but merely a note has been
made at the foot of the Balance Sheet, e.g., Bills Receivables which have
been discounted and which have not matured at the date of the Balance
Sheet, arrears of fixed cumulative dividends, etc. For liabilit ies in respect
of which provision has to be made in the Balance Sheet, viz a suit, etc., the
auditor should examine such cases and ascertain the amount to be
specifically reserved for the purpose. The auditor should examine the
Director's Minute Book, corr espondence made with the legal advisers and
the information obtained from the officials of the business. He has to
ensure that proper provision has been made for all such liabilities and if he
is not satisfied, he should mention the fact in his report. It is to be
remembered that the requirements of the Companies Act regarding the
contingent liability should be complied with in the Balance Sheet on the
liabilities side.
4. Bills Payable:
The auditor should verify the Bills Payable in the following ways:
a. The B ills Payable Book should be checked with the Bills Payable
Account.
b. The Bills Payable already paid should be checked from the Cash Book
and the returned Bills Payables should be examined.
c. To verify the Bills Payables which have not yet matured at the year
end, the auditor should examine the Bills Payable book and should
check the Cash Book of the succeeding years to see whether any
payment has been made in respect of such bills. In case of any doubt,
the auditor may ask the drawers for the confirmation of t he bill.
d. The auditor should see if any charge has been created on the assets of
the concern by accepting the bill and he should see that the facts are
disclosed in the Balance Sheet.
We have discussed above verification of some assets and liabilities as
illustrations. All other assets and liabilities are also to be verified almost
on the same lines.
6.6 SUMMARY
The procedure of verification is carried on at the end of the year. The
purpose of verification is to verify ownership, valuation and existence o f
different assets and liabilities, at the end of the year. Merely checking the
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115 that these assets and liabilities do really exist on the date of the balance
sheet.
Verification is an enquiry in to the valuation, ownership, title and
existence and possession of assets and liabilities. It also checks whether
there is any charge on the assets.
As per the instructions of the institute of Chartered Accountants CARO
(Company Auditor’s Re port Order) it is the duty of the management to
verify the existence of fixed assets from time to time. Auditor has to state
in his report whether the management has done this or not.
There is a lot of difference between vouching and verification. In
vouc hing entries in the books are checked. This process can be carried out
throughout the year. Documentary evidences are verified. Verification
examines assets and liabilities shown in the balance sheet at the end of the
year. It includes valuation. However, vouching and verification are equally
important for audit.
6.7 QUESTIONS
1. Write a short note on objectives of verification.
2. “Vouching and verification appear to be similar or same but they are
not.” Explain.
3. State the importance of verification and valua tion of stock from the
point of view of an auditor.
4. What are the steps to be taken by the auditor in verification of stock?
5. How would you audit the following?
i) Plant and Machinery
ii) Patterns, Dies and Loose Tools
iii) Investments
iv) Contingent Liabilities
v) Outstan ding expenses
vi) Secured loans
vii) Unsecured loans
6. Select most appropriate option and rewrite the following sentences.
i) Debtors are valued at
a. Book value
b. Decided by the customer
c. Realisable value
d. As per articles of Association

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116 ii) Stock of goods on consignment should be valued at -----------
a. Invoice price
b. Cost plus proportionate expenses
c. Cost or realisable value whichever is less
d. None of the above
iii) ---------------- asset which is not subject to physical verification.
a. Cash
b. Debtors
c. Stock
d. Furniture
2. True or fa lse
i) Verification protects against misuse of assets.
ii) Mortgage means a charge on the immovable property to secure a
debt.
iii) A method of valuation of assets should not be consistent.
3. Filling in the blanks;
i) As long as the business is in existence, the assets are valued under
the------------------------- .
ii) When the business is closed and winding up process starts, the
assets are valued under the ------------------------- .
iii) Intangible Assets like goodwill, patent rights, know – how etc. are
valued on cost basis.
iv) Floating assets like stock in trade. Bills receivable, sundry debtors
etc. are shown at --------------- value.
v) Investments are of two types ------------------ investments and -----
-------------- investments.
vi) Current investments are valued as ---------- assets and long-term
investments are valued like ----------- assets.
vii) The price at which the asset is being transacted in the market
means ----------------------- .

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