PRINCIPLES OF AUDITING

Semester – III

Student Workbook

2023

1
All rights reserved. No part of this work may be reproduced in any form, by any means, without
written permission from JAIN UNIVERSITY

The workbook is developed for the students of JAIN UNIVERSITY

For Internal Circulation Only

Edition: 2018
Revised : 2023
NOTE:

THE WORKBOOK IS ONLY A DIRECTIVE FOR STUDENTS AND NOT EXHAUSTIVE

TOWARDS THE COURSE. THE STUDENTS MUST REFER TO THE REFERENCE
BOOKS AND READING LISTS MENTIONED.

Developed by:

School of Commerce Studies,

JAIN UNIVERISTY

Published Printed by:

Center for Virtual Learning & Innovation,

JAIN UNIVERSITY

For Private circulation only

Page 2
SYLLABUS INDEX

Sl.No. Modules Pages

1 Introduction to Auditing 7-44

2 Internal Audit, Internal 45-62

Control, And Internal
Check
3 Vouching 63-81

4 Verification And Valuation Of 82-102

Assets And Liabilities

5 Company Audit- Appointment, 103-127

Rotation and Removal of
Auditors

Course Objectives
Introduce various investment and savings options available for people. Equip to analyze the factors affecting
investment. Familiarize conceptual knowledge of constructing and evaluating portfolio. Provide knowledge of
various technical charts used by traders in the stock market. Equip to understand the different investment
horizon and introduce the various Portfolio theories developed and used in Investment.

Course Outcome (CO)

CO1 Describe various investment alternatives and the various investment schemes.
CO2 Interpret the factors of Economic, Industry & Company Analysis
CO3 Distinguish the various technical tools & different forms of charts used forTechnical Analysis
CO4 Examine the CAPM model & use different formulas to calculate return & risk.
CO5 Assess the portfolio management process & formulation of portfolio strategy.

For Private circulation only

Page 3
Program: B.Com Semester: III

Subject: PRINCIPLES OF AUDITING

Total Lecture Hours: 45 Credits: 03

Course Objectives
1. Familiarize the students with the knowledge about Audit and its types, objectives and
procedures.
2. Introduce basic elements of internal control.
3. Develop an understanding on procedures for valuation of Assets and Liabilities performed by
an auditor.
4. Outline the importance of vouching in auditing.
5. Explain the roles and responsibilities of an Auditor.

Module-1: Introduction to Auditing 10 Hours

Introduction-Meaning, Definition - Difference Between Accountancy and Auditing - Difference
Between Auditing and Investigation - Types of Audit-Objectives of Audit and Advantages of
Audit -Preparation Before Commencement of New Audit - Procedure of Audit -Audit Plan, Audit
Programme – Audit Files – Audit Note Book – Working Papers -Overview of Auditing
Committee- Auditing Standards and Forensic Audit
Module-2: Internal Audit, Internal Control, And Internal Check 12 Hours
Internal Control- Objectives, Characteristics and Limitations-Internal Control in Computerised
Environment - Internal Auditing Standards - Internal Check as a Part of Internal Control- Objects-
Advantages and Disadvantages -Internal Check with Regards to Wages - Maintenance of Wage
Records -Time Records - Piece Work Records - Overtime Records - Pass Out Records -
Preparation of Wage Sheets - Payment of Wages -Internal Check With Regard to Cash Sales-Sales
at the Counter -Sales By Travelling Salesmen - Postal Sales -Internal Check With Regard of
Expenditures – Purchases, Accounts Payable & Cash Disbursements -Internal Check with Regard
to Inventory -Internal Check With Regard to Payroll -Internal Control With Regard to All Revenue
Cycles – Sales, Accounts Receivables & Cash Receipts -Internal Audit- Meaning-Importance-
Advantages and Disadvantages -Difference between Internal Control and Check
For Private circulation only
Page 4
Module-3: Vouching 13 Hours
Meaning- Definition- Importance - Routine Checking and Vouching -Types of Vouchers -
Vouching of Receipts- Cash Sales, Receipt from Debtors, Bills Receivable, Proceeds of the Sale
of Investments and Buildings.- Vouching of Payments-Vouching of Cash Purchases, Payment of
Creditors, Bills Payable and Purchase of Fixed Assets -Vouching of Deferred Revenue
Expenditure- Preliminary Expenses, Cost of Issue of Shares and Debentures, Underwriting
Commission General and Specific Duty of Auditor with Regards to Vouching.

Module-4: Verification And Valuation Of Assets And Liabilities 13 Hours

Meaning and Objectives - Difference between Vouching and Verification -Position of an Auditor
as Regards to The Valuation of Assets -Verification and Valuation of Assets-Plant and Machinery,
Land and Building, Furniture, Fixtures, Fittings and Office Equipment-Good Will, Patents,
Copyrights, Stock, Investments, Debtors, Bills Receivable, Cash in Hand -Cash at Bank -
Verification And Valuation of Liabilities-Capital, Debentures, Creditors, Bills Payable,
Outstanding Expenses, Tax Liability and Contingent Liability - Differentiate between Verification
and Valuation
Module-5:Company Audit- Appointment, Rotation and Removal of Auditors 12 Hours
Company Auditor- Appointment, Rotation and Removal, Powers, Duties -Liabilities of an
Auditor-Civil Liability - Liability for Negligence- London Oil Storage Co. Vs. Seears Hasluck and
Co.-Liability for Misfeasance- in London and General Bank Ltd - Criminal Liability -in Re
Dumbell’s Banking Co. Ltd -Rex Vs Lord Kylsant (1931) or Royal Mail Steam Packet Company
-Auditors Report- Meaning, Types- Unqualified/Unmodified Report, Modified Report (Qualified
Opinion, Adverse Opinion & Disclaimer of Opinion)
Course Outcomes
1. Define the basic concepts of audit, audit programme and audit committee.
2. Plot the differences between internal audit, internal control and internal check and its
importance in the real business world.
3. Explain vouching and its process related to various items.
4. Examine the role played by an auditor in the verification and valuation of assets and
liabilities.
5. Elaborate the legal provisions and obligations associated with auditor.

For Private circulation only

Page 5
REFERENCES
Books for reference:
 Auditing Theory and Practice- Kalyani publications- Pardeep Kumar, Baldev
Sachdeva, Jagwant singh
 Principles of Auditing- Himalaya Publications- R.G. Saxena
 Practical Auditing- B.N Tandon – S.Chand & Company Pvt ltd
 Practice of Auditing- Dinkar Pagare
 Auditing- PN Reddy and Appannaiah, Himalaya Publications.
 Auditing- TR sharma, Sahitya Bhavan

Online reference

 http://archive.mu.ac.in/myweb_test/study%20TYBCom%20Accountancy%20
Au diting-II.pdf
 http://bcomauditing.blogspot.in/2015/02/principles-of-auditing-notes.html
 https://www.slideshare.net/vishwacrv/auditing-notes-27123132

COURSE MAPPING:

POs CO1 CO2 CO3 CO4 CO5

PO1 3 1 2 2 3
PO2 3 3 3 3 3
PO3 3 3 2 3 3
PO4 2 2 1 1 1
PO5 1 1 1 1 2
PO6 1 1 1 1 1
PO7 1 2 1 2 1
PO8 3 3 3 3 3

For Private circulation only

Page 6
Module 1
Introduction to Auditing
Structure:

1.1 Introduction and meaning of auditing

1.2 Definition of Auditing
1.3 Difference between Accounting, Auditing and Investigation
1.4 Objectives of Audit
1.5 Types of Audit
1.6 Advantages of audit
1.7 Preparation before commencement of new Audit
1.8 Procedure of Audit
1.9 Audit Plan, Audit Programme
1.10 Audit Files – Audit Note Book – Working Papers
1.11 Overview of Auditing Committee
1.12 Auditing Standards and Forensic Audit
1.13 Summary
1.14 Case Studies
1.15 Unit End Exercises

1.1 Introduction and origin of auditing

Introduction
In the ancient times, the methods of accounting were so simple and crude and number of
transactions was so small, that each businessman was able to check all the transactions himself,
at that time no one felt the necessity of auditing.

Origin of auditing
In ancient days auditing was confined to public accounts only. The historical records show that
ancient Egyptians, the Greeks and the Romans used to get their public accounts audited. With the
development of trade and commerce the need for recording transactions was felt by businessmen.
He started taking the services of others for recording those transactions.

For Private circulation only

Page 7
Luca Paciolo, an Italian, had published his treatise as double entry system of book keeping for
the first time in 1494. This system of double entry was capable of recording all kinds of
mercantile transactions. He also described the duties and responsibilities of an auditor. This system
had its effect on auditing also; thereby the scope of duties of an auditor was enhanced.

Auditing in India
The system of accounting and auditing is believed to have existed in our country under the
Mauryas, Chandragupta and other Hindu Kings. Kautilyas, in his Arthashastra had mentioned
about the accounting and auditing of state finances. He stated that “all undertakings depend on
finance. Hence, foremost attention should be paid to the treasury.” He also listed various
kinds of frauds and embezzlements and prescribed punishments to deal with them.

Auditing as it exists today can be associated with the introduction of large scale production
following the Industrial Revolution during the 18th century. This revolution led to a great
increase in the volume of trading operations which also required substantial capital investment.
Individual business houses were not in a position to provide necessary finance because of their
limited financial and credit resources. Further, the discovery of steam power, development in the
means of transport and communications, the expansion of banking facilities and mechanical
inventions also made it inevitable for businessmen to adopt some other forms of business
organizations and management. This led to the formation of numerous joint stock companies and
other corporate bodies.

The introduction of the joint stock forms of organization also widened the scope of investment
and business activities. The business community started raising money from public and also
borrowed capital from various private and state financial institutions. Today many independent
firms of professional accountants have come into existence to audit the accounts of mercantile
firms, but still the government accounts and audit are with separate government departments.
Audit now implies a written report about the accuracy and reliability of accounts by a qualified
auditor. The Indian Companies Act 1956 had made it compulsory for all corporate bodies to get
their accounts audited by qualified professional accountants.

For Private circulation only

Page 8
Meaning
The word ‘Audit’ takes its origin from Latin ‘audire’ which means ‘to hear’. In middle ages, the
auditor was a person appointed by the owners whenever they suspected fraud, to check accounts
and to hear explanation given by persons responsible for financial transactions. Auditing at that
time was carried out to locate frauds and errors.
In 1464, an Italian named Luca Pacialo, published his treatise and also described the double entry
system of book-keeping for the first time and also described the duties and responsibilities of an
auditor.

1.2.Definition of Auditing
"Auditing is a systematic and independent examination of data, statement, records, operations
and performances (financial or otherwise) of an enterprise for a stated purpose.in any auditing
situation, the auditor perceives and recognizes the propositions before him for examinations,
collets evidence, evaluates the same and on this basis, formulations his judgment which is
communicated through his audit report".
- Institute of chartered accountants of India.

"An audit is independent examination of financial information of any entity, whether project
oriented or not, and irrespective of its size or legal form, when such an examination is conducted
with a view to expressing an opinion thereon."
- Standard Audit Practices –I

“Such an examination of the books, accounts and vouchers of a business, as shall enable the
auditor to satisfy himself whether or not the balance sheet is properly drawn up, so as to exhibit a
true and correct view of the state of affairs of the business, according to the best of his
information and explanation given to him and as shown by the books; and if not, in what respect it
is untrue or incorrect”.
- Spicer and Pegler
“Audit is an intelligent and critical scrutiny of books of accounts of a business with the
documents and vouchers from which they have been written up, for the purpose of ascertaining
whether the working results of a particular period as shown by profit and loss account and also
the financial position as reflected in the balance sheet are truly and rarely determined and

For Private circulation only

Page 9
presented by those responsible for their compilation.”
- J. R. Batliboi
“An audit is an examination of such records to establish their reliability and reliability of
statements drawn from them.”
- A.W. Hanson
“The independent examination of financial information of any entity, whether profit oriented or not,
and irrespective of size, or legal form, when such an examination is conducted with a view to
expressing an opinion thereon.”
-The International Auditing Practices Committee
“Concerned with the verification of accounting data, with determining the accuracy and reliability
of accounting statements and reports”.
- Mautz
The above definitions provide some information about the meaning of auditing. Auditing may
be defined as follows:
1. It is a thorough, intelligent, systematic and critical examination of accounting data.
2. The accounts have to be prepared by the accountant and audit is done by an
independent person with requisite qualification.
3. The examination of accounts may be made throughout the year or periodically
4. It is done with the help of relevant records, vouchers, documents, information and
explanations from the authorities.
5. The auditor has to satisfy himself and report whether or not:
a.) The profit and loss account reveals true and fair view of profit or loss of the period
B.)The balance sheet exhibits a true and fair view of financial position of the concern
C.) Books of accounts have been maintained and accounts have been prepared as per the
provisions of law.
1.3 Difference between Accounting and Auditing

The points of difference between Accountancy and Auditing can be as follows:

1. Nature

Accountancy is constructive in nature as it is concerned with compilation of accounting

information for preparing profit and loss account and balance sheet. Auditing is analytical in

For Private circulation only

Page 10
nature and is concerned with checking and verification of financial statements.

2. Scope
The scope of Accountancy is restricted to preparation of financial statements and their
interpretation. Auditing determined by the agreement between auditor and his client.

3. Qualification
No formal qualification has been recommended. An auditor must be a qualified Chartered
Accountant.

4. Objective
In accountancy the main objective is to find out operating results and financial position of the
business. The main objective if auditing is to ascertain truth and fairness of financial statements
and comment there on.

5. Commencement
Accounts start where book-keeping ends. Auditing starts where accountancy ends.

6. Reporting
The accountant is not required to submit a report on the accounts and statements prepared by him.
The auditor has to submit report about correctness and presentation of accounts audited by him.

7. Basis of Remuneration
The accountant is paid monthly salary.The auditor gets a fixed amount as per agreement with his
client.

8. Appointment
The accountant is an employee of the business. The auditor is an independent outsider appointed
on contractual basis for a year.

For Private circulation only

Page 11
9. Level of knowledge
An accountant is not required to have knowledge of audit techniques and procedures. An auditor
must have knowledge of accounting as well as audit techniques and procedures.

10. Duration
The accounting work is conducted throughout the year. The audit may be conducted at the end of
the year or throughout the year.

Difference between Auditing and Investigation

1. The process of inspecting the financial statement of an entity and then giving an
independent opinion on it is known as Auditing. A careful and detailed study of the books of
accounts to discover truth is known as Investigation.
2. Auditing is a general examination while Investigation is critical in nature.
3. The evidence obtained from audit process are persuasive. Conversely, the nature of
evidence obtained from Investigation process is conclusive.
4. Auditing is conducted every year, but Investigation is conducted as per the needs of the
organisation.
5. Auditing is performed by the auditor whereas an expert team does the performance of an
investigation.
6. Auditing is compulsory for every company. On the other hand, the investigation is
discretionary.
7. Auditing verifies the true and fair view of the financial statement while Investigation is
performed to establish a fact.
8. the appointment of an auditor is made by the shareholders of the company. As against
this, an investigator is appointed by the owners/management or one-third party.
9. The scope of auditing is general, which attempts to give an opinion on the financial
statement of the company. On the contrary, the scope of the investigation is limited as it
attempts to answer only those questions that are asked in the engagement letter.

For Private circulation only

Page 12
1.4 Objectives of audit

The objectives of audit can be categorized into

a) Main objectives
b) Secondary objectives and
c) Specific objectives

I. Main objectives

Expression of expert opinion:

An entity prepares balance sheet to portray its financial position. It also prepares P&L account to
disclose the operating results of the period covered in the statement. These finical statements are
submitted to the auditor for his checking and comment. He verifies that the accounts are prepared
within the framework of recognized accounting policies and practices and relevant statutory
requirements. Based on his checking in these respects, the auditor expresses his opinion about the
quality of the financial statements concerning proper disclosure of facts in the financial
statements and the truth and fairness of the financial position and operating results of the
For Private circulation only
Page 13
enterprise, as disclosed in the balance sheet and profit and loss account respectively.

II. Secondary objectives

A) Detection and prevention of errors:

Errors are generally innocent but sometimes errors which might appear, at first sight, as innocent
are ultimately found to be due to fraudulent manipulation and therefore an auditor must pay
particular attention to every error, however, innocent it may appear to be at first sight. The
following are the various types of errors

1. Clerical errors. These errors are committed in posting, totalling and balancing. Such
errors may again be subdivided into-
a) Errors of omission and
b) Errors of commission.

2. Errors of Principle.
3. Compensating errors or off-setting errors.
4. Errors of duplication.

It may be noted here that all errors except errors of principle are known as technical clerical errors.
Let us discuss these errors in detail.

1. Clerical errors

(a) Error of omission:

As the name indicates, the error of omission is one where a transaction has not been recorded in
the books of accounts either wholly or partially. In the former case it will not be easy to detect the
error and it will not affect the trail balance. But sometimes it is apparent from the balance of an
account that an entry has been omitted. There are many other cases where it may not be possible
to detect the omission.
E.g. the rent may show that the rent for the 12th month has not been paid, purchases or sales have
entirely been omitted and therefore there is neither a debit entry nor a credit entry.
For Private circulation only
Page 14
(b) Errors of Commission:
When a transaction has been recorded but has been wrongly entered the books of original entry
or posted in the ledger, error of commission is said to have been made, e.g., a purchase invoice for
Rs. 2250 was entered in the purchase book as Rs. 2520. Such an error may be intentional or un-
intentional. Therefore vouching should be done very carefully, in order to detect such an error or
fraud. Other error of commission are, wrong castings, calculations, postings, extensions, carry
forwards, etc. some of such errors will be detected by the non- agreement of the trial balance.

2. Errors of Principle
Such errors arise when the entries are not recorded according to the fundamental principles of
accountancy, e.g., wrong allocation of expenditure between capital and revenue, ignoring the
outstanding assets and liabilities, valuation of assents against the principles of book- keeping.

3. Compensating errors or off-setting errors

Sometimes, by accident, error on the debit side and error on the credit side of accounts may be of
equal amounts. Consequently the effect of the errors is compensated against each other and trial
balance agrees. Such error is called a compensating error.

For example, the total of purchases book is overcast by Rs. 1000 due to an error. While posting
the amount to purchase account, Rs. 1000 more will be debited. Suppose Rs. 1000 is received
from Gupta and is credited with Rs. 2000 through an error. Here two errors have been
committed. Rs. 1000 more is debited to purchases account, while Rs. 1000 more is credited to
Gupta account. Both these errors affect the trail balance in different ways but since the errors on
both sides are of an equal amount, the trail balance will agree.

4. Errors of duplication
Such errors arise when an entry in a book of original entry has been made twice and has also been
posted twice.

B) Detection and prevention of fraud:

Having dealt with the detection and prevention of errors, let us now proceed to discuss the

For Private circulation only

Page 15
detection and prevention of fraud.

Fraud means false representation or entry made intentionally or without belief in its truth with a
view to defraud somebody.

Detection of fraud is considered to be one of the important duties of an auditor. As a matter of

fact, originally audit was conducted mainly with a view to detect fraud whenever it was
suspected. The system of internal check aims at the prevention of fraud.

The following are the chief ways in which fraud may be perpetrated:
1. Embezzlement of cash;
2. Misappropriation of goods; and
3. Fraudulent manipulation of accounts.

1. Embezzlement of cash:
There is a grater possibility of defalcation of money in big business house than in the case of a
small proprietary business where the proprietor has a direct control over the receipts and payments
of cash. In a big business house the system of receipt and payment of cash should be such that the
work of one clerk is automatically checked by another clerk. Such a system is known in auditing
as “Internal Check” system which will be dealt with in detail later on. It is easier to
misappropriate cash, and therefore, the auditor has to pay a particular attention towards cash
transactions.
Cash may be misappropriated by
(a) Omitting to enter any cash which has been received; or
(b) Entering less amount than what has been actually received; or
(c) Making fictitious entries on the payment side of the cash book; or
(d) Entering more amounts on the payment side of the cash book than what has been actuallypaid.

2. Misappropriation of goods:
Again, fraud may be respect of goods, i.e., misappropriation of goods. This type of fraud is very
difficult to detect especially when the goods are less bulky and are of higher value. Proper

For Private circulation only

Page 16
methods of keeping accounts in regard to purchases and sales, stock taking, periodical checking
of stocks, comparing the percentage of gross profit to sales of two periods, necessity for collusion
will help to avoid misappropriation of goods.

3. Fraudulent manipulation of accounts:

This type of fraud is more difficult to discover as it is usually committed by directors or
managers or other responsible officials with the object of
(a) Showing more profit than what actually they are

i. so that if they get commission on profits, they may get more commissions;
ii. If they hold shares, they may sell them at high price by declaring higher dividend;
iii. To obtain further credit by showing the financial position of the business better than what
actually it is;
iv. To attract more subscribers for the sale of the share of the company etc;

(b) Showing less profit than what actually they are

(i) In order to purchase share in the market at a lower prices; or
(ii) To reduce or avoid the payment of income tax; or
(iii) To give a wrong impression about the success of the business to competitors, etc.

III. Specific objectives

We have emphasized that the term audit should not be taken to imply financial audit alone, in the
definition topic. The audit may encompass such other areas like review of operations,
performance management policy, cost records and so on.

For example, in operational audit, the aim of audit is to evaluate the existing operations of the
entity in order to give expert advice to improve their efficiency. The cost audit is to check the cost
records of the entity in order to make a report on the proper ascertainment of cost of production
of goods or services.

Depending upon the nature of specific audit engagement and terms of engagement, terms of

For Private circulation only

Page 17
engagement, there may be different objective in respect of each specific audit

1.5 Types of Audit

The Audit may be classified into

a) On the basis of Legislative Control – Statutory Audit, Government Audit, Private Audit.
b) On the basis of relation of auditor viz management –External Audit, Internal Audit.
c) On the basis of periodicity of audit – Continuous Audit, Interim Audit, Periodical Audit,
Occasional Audit.
d) On the basis of subject matter of audit – Financial Audit, Operational Audit, Cost Audit,
Management Audit and Tax Audit.
e) On the basis of coverage of audit – Complete Audit, Partial Audit.
f) On the basis of manner of checking – Standard Audit, Balance sheet Audit, and Voucher
audit.
g) On the basis of audit from the point of view of specific objective – Cash Audit, Special
Audit, Efficiency Audit, Audit in depth, Human Resource Audit, and Social Audit.

For Private circulation only

Page 18
(a) On the basis of Legislative Control

Statutory audit: statutory audit refers to the audit of accounts of a business enterprise
carried out compulsorily under the provisions of statute or law.

Government audit: Government audit refers to the audit of government department and
offices, government companies and statutory or public corporations.

Private audit: Where audit is not compulsory under any statute, but is undertaken by the owners
voluntarily to get the benefits of audit, such audit is called private audit or general audit. Private
audit refers to the audit of accounts of private enterprises, such as sole trading cancers, partnership
firms and other individuals.

(b) On the basis of relation of auditor vis a vis management

External audit: External audit refers to the audit of an organization undertaken independently
by a qualified auditor. It is the audit of an organization undertaken by a professionally qualified
auditor, who is independent of the organization hiring his services for the purpose of audit.

Internal audit: Internal audit is a continuous and systematic review of the accounting, financial
and other operations of a concern by the staff specially appointed for the purposes.

(c) On the basis of periodicity of audit

Continuous audit: in the words of Spicer and Pegler, “a continuous audit is one where the
auditor’s staff is occupied continuously on the accounts the whole year round, or where the

auditor attends at intervals, fixed or otherwise, during the current financial year and
performs an interim audit.”

It is an audit which involves a detailed checking of all the books of accounts of the business
continuously throughout the year or at regular or irregular intervals during the year, and the profit

For Private circulation only

Page 19
and loss accounts and the balance sheet of the business at the end of the year.

Interim audit: Interim audit is an audit which is conducted in between two annual audits. It is an
audit conducted in the middle of the financial year. It is an audit conducted for a part of the
accounting year, say, for a quarter or for half year.

Periodical audit: According to Spicer and Pegler, “A final or completed audit is commonly
understood to be an audit which is not commenced until after the end of the financial period and is
then carried on until completed.”

It is clear that periodical audit is carried out after the close of the financial or accounting year when
the books of accounts have been closed and the financial accounts have been drawn up.

Occasional audit: An occasional audit is an audit which is conducted once a while, whenever the
need arises. For instance, if an audit is ordered to discover any error or fraud, it is called an
occasional audit. Similarly, if an audit is ordered, when an incoming partner or a creditor desires
for the audit.

(d) On the basis of subject matter of audit

Financial audit: Financial audit is examination of financial statements to express opinion on the
truth and fairness of financial conditions and operating results of the entity.

Operational audit: In operational audit, the auditor goes beyond the financial records. That is, he
examines financial as well as non-financial records.

Operational audit is, usually, conducted by internal auditors. However, it can be entrusted to
external auditors also. Where it is entrusted to external auditors, it is known as management
consulting services.

Cost Audit: The costing terminology issued by the I.C.W.A of London defines cost audit as “the

For Private circulation only

Page 20
verification of the correctness of cost accounts and of the adherence to the cost accounting plan.”

Cost audit is a thorough examination of the cost accounting records of company records of a
company by a cost auditor to ensure that they are accurate and they also adhere to the cost
accounting principles, procedures and plans.

Management Audit: The term “Management Audit” is a new concept in the sphere of auditing.
As its name signifies, management audit means the audit of management processes

and functions. According to W.P. Leonard, “The management audit may be defined as a
comprehensive and constructive examination of an organizational structure of a company,
institution or branch of government, or of any component thereof, such as a division or
department, and its plan and objectives, its means of operation and use of human and physical
facilities.”

Thus the auditor examines the policies and actions of the management to ensure that there is
proper and maximum utilization of the available resources. It facilitates to ascertain whether
sound management prevails from the highest level to downwards or not and helps in creating
most effective relationship with the outside world and smooth running of the internal
organization.

Tax Audit: Tax Audit can be defined as an examination of records of financial information to
assess the correctness of the calculation to ensure compliances of the various provisions of the
Income Tax Act, 1961. The Income Tax Act has made it compulsory under Section 44AB.

(e) On the basis of coverage of audit

Complete audit: According to Spicer and Pegler, “A final or completed audit is commonly
understood to be an audit which is not commenced until after the end of the financial period and is
then carried on until completed.”

It is an audit which is carried out after the close of the financial or accounting year when the books
of accounts have closed and the financial accounts have been drawn up.

For Private circulation only

Page 21
Partial audit: A partial audit is a kind of audit the scope of which is limited. To be specific,
when an audit is carried out in respect of only a part of the books of accounts of a business, it is
called a partial audit.
For instance, if an auditor is asked to check only the books and records pertaining to purchases
and sales of goods to detect misappropriation of goods, it is a case of partial audit. Similarly, if an
auditor is asked to check only the book to detect misappropriation of cash, it is a case of partial
audit.

(f) On the basis of manner of checking

Standard audit: standard audit is a type of audit certain items in the accounts are thoroughly
checked and analyzed and appropriate test checks are applied to other items provided there is
good and effective internal check in operation.

Balance sheet audit: balance sheet audit is a type of audit which concentrates mainly on the
verification or examination of the items in the balance sheet, such as capital, reserves, profit and
loss account balances, liabilities and provisions and all the assets of the business.

Voucher and post audit: voucher and post audit is that where the auditor checks each and every
transaction right from its origin in the books of prime entries till they are posted. This system of
audit has become obsolete in the case of large firms where the number of

transactions run into millions and where a good internal check system is prevalent or where the
mechanized system of accounting has been introduced. The auditor relies on the examination of
some of the transactions scientifically selected at random.

(g) On the basis of audit from the point of view of specific objective

Cash audit: it is type ofaudit under which only the cash receipts and cash payments are audited
in detail by the auditor. But it does not involve the checking of all the records of the business. The
auditor checks all the items of cash receipts and cash payments with the counterfoils of receipt,
vouchers, documents, correspondence, etc.

For Private circulation only

Page 22
Special audit: a special audit is a kind of audit with some special object in view. It is a fact
finding enquires.

Efficiency audit: efficiency audit is a type of audit which is undertaken with the aim of
improving the efficiency and maximum exploitation of the business. Efficiency audit covers the
examination of every transaction of the business and its usefulness to the business. It may be
noted that examination of the books of accounts is not expected under efficiency audit.

Audit in depth: the audit in depth is another type of sample checking. In this type of audit
selected transactions are subjected to a detailed stepwise verification. For example, in case of a
purchase transaction the auditor will examine all the stages through which a purchase transaction
is completed and the documents that arise in the process. The focus will be on the requisition
slip, clearance of authorizing officer, quotations or tenders submitted by suppliers, purchase
order, books received note, goods inspection note, entries in the bin card and stores ledger.
Such an audit gives the understanding of the procedures being adopted to carry out any
transaction.

Human resource audit: the personnel or human resource audit refers to checking the
organization’s performance in its management of human resources. It reveals how the
management is doing in getting things done through people.

Social audit: it is an audit which is undertaken by an organization to review, at what extent an

organization is able to pursue the social objectives of an organization.

1.6 Advantages of auditing

Importance of auditing can be judged from the fact that even those organizations which are not
covered by Companies Act 1956 get their financial statements audited. It has become a necessity
for every commercial and even non- commercial organization.

For Private circulation only

Page 23
1. For the owners of the business and shareholders

 In case of sole trader, he can depend on the audited accounts. He can value his business
on the basis of audited accounts for the purpose of sale of business or for admitting a new
partner.
 Dispute over the correctness of profit can be avoided. In case of partnership firm, audited
accounts will be useful in valuing goodwill, business on admission and retirement of a partner.
 Shareholders, who do not know about day-to-day administration of the company, can judge
the performance of management from audited accounts.
 Shareholders can value their shares on the basis of audited financial statements.

2. For the management

 It helps the management in detecting and preventing errors and frauds.
 It keeps the accountants and staff vigilant while preparing books and record as they know
in advance that all the accounts are to be audited.
 Claims due to fire, theft and accident can be estimated from audited accounts.
 Management gets advice on financial affair from the auditors who gave expert’s
knowledge.
 Because the audited accounts are uniformly prepared over the year, comparison of such
statements becomes easier.
 Money can be easily borrowed from the financial institutions and banks, if the accounts
of the business are audited.
 It helps in reviewing the system of internal control.

3. For the creditors

 Long-term and short-term creditors can depend on audited financial statements while taking
decision to grant credit to business houses.

4. For the government bodies

 Taxation authorities depend on audited statements in assessing the income-tax, sales-tax,
and wealth-tax liability of the business.
 Audited accounts can be produced in the court to provide evidence.
For Private circulation only
Page 24
 Audited accounts are useful for the government while granting subsidies etc.

5. For others
 It can be used by insurance companies to settle the claims arising on account of loss by fire.
 In case of amalgamation and absorption, the purchasing company can calculate purchase
consideration on the basis of audited accounts.
 It safeguards the interests of the workers because audited accounts are useful for
settling trade disputes for higher wages or bonus.

1.7 Preparation before commencement of new audit

Proper execution of any work requires appropriate planning and programme of action.
Before commencing a new audit an auditor should take the following steps:

1. Ascertain the scope of duties

First of all an auditor should ascertain the precise nature and scope of his duties. In the case of a
statutory audit the scope of duties can be ascertained by referring to the statute. E.g. to ascertain
the scope of duty under Companies Act 1956 and auditor should understand what is expected
from him. In other cases, how he should discuss the things with the person who is going to hire
his services.

2. Procure Engagement letter

When auditor decides to accept an audit engagement, he should procure an Engagement Letter
from the client. The letter is for all purposes of an audit contract. It should lay down terms of the
audit contract and the understanding reached between the auditor and the client.

3. Knowledge about business

An auditor should clearly understand the nature of business. He can make a beginning by going
through the document available. E.g. Memorandum of Association, in case of a company and
partnership deed in case of partnership firm. It will be desirable for an auditor to visit the factory
site to appreciate the nature of transaction which is recorded in the books of accounts. Such a visit
will enable him to understand the nature of men, material and machinery involved in the process
For Private circulation only
Page 25
of production.

4. Knowledge of the Accounting system

The auditor should obtain a list of all books maintained by the client along with information
related to internal control system. The extent of his work will be greatly influenced by the
reliability of internal control and accounting system.

5. List of principal officers

The auditor should also obtain list of the principal officers of the organization. He should also
acquire knowledge about reliability of internal control and accounting system.

6. Knowledge of technical details

He should also acquire some knowledge about the technical details, if any of the business. This
enables him to grasp the nature of transactions which will be subject matter of the audit.

7. Enquiry into special circumstances, if any

An auditor should also enquire into special circumstances, surrounding his appointment. He is
required to be careful about the implication of special circumstances. In case, he is being
appointed in place of another auditor, it becomes his professional duty to communicate with the
auditor, in whose place he is being appointed.

8. Instructions to the client

After completing the aforementioned steps he should issue clear instructions to his client on the
following lines:
a) Accounts should be finalized and kept ready for audit.

b) The necessary schedules be prepared and made available. The schedules required are
schedule of debtors and creditors, including bad and doubtful debts, schedule of fixed assets,
schedule of outstanding expenses, prepaid expenses and incomes, stock sheet, along with value
and method of valuation of stock, a statement indicating the capital expenditure incurred during
the year, a statement of deferred revenue expenditure, if any.

For Private circulation only

Page 26
1.8. Procedure of Audit
Audit procedure refers to the way in which the audit work should be conducted. It is the
procedure followed by an auditor for the actual conduct of his audit work. There are certain
aspects of audit procedure which are common in all audit works. They are:

1) Routine checking:- The checking of castings and postings of the common books of the
organization is called routine checking. In other words it is the checking of subsidiary books and
ledger accounts by an auditor.
Routine checking involve the following operations,
a) Checking of the castings, sub castings, carry forward and other calculations in the books of
original entry
b) Checking of the postings into the ledgers
c) Checking of the casting and balances in the ledgers
d) Checking of the transfer of the balances from the ledgers to the trial balance.

2) Test checking or sample checking or selective verification:- Test checking means

checking by an auditor, a few transactions selected at random here and there so as to form his
final judgement on the whole set of transactions. It means to select and examine representative
sample from a large number of similar items. Test checking involves sampling. One objective of
test checking is to arrive at characteristics present in the mass transactions from the checking of
representative sample.

Conditions or essentials or precautions of test checking:-

1) The success of test checking largely depends upon the system of internal check in
operations the business.
2) The sample selected for test checking should be at random.
3) It should be applied only to homogeneous transactions.
4) The sample of test checking should be selected without bias.
5) One selection of sample should be made in such a way that it covers the work of each of the
staff of the client.

For Private circulation only

Page 27
3) Adoption of distinctive ticks ,tick ,marks or check marks:- In the cause of audit work, an
auditor uses variety of marks or symbols to indicate the work that has been done. These marks or
symbols are known as ticks or check marks or check signs.
Ticks are much significant to an auditor. They are useful to the auditor in the following respects;

a) Ticks help the auditor to know the checking that has been done by the earlier.
b) By means of ticks made earlier, an auditor can easily find out the alterations in the books
account made subsequent to the audit.

c) Ticks facilitates tracing of processes and documents connected with the transactions and
thereby increase the efficiency of audit.

Points to be noted or precautions to be taken while using ticks:-

1) Different types of ticks should be used for different audit works.
2) Ticks should be small.
3) It should be clear.
4) It is advisable to use only pens or ball pens.
5) It is advisable to use ticks of different colours for different purposes.
6) Tick should not get mixed up with the figures shown in the books of account.
7) Ticks used by the client staff are not used by the audit staff.
8) Special ticks must be used for items which require special attention

4) Vouching:- Vouching is the act of checking or examining the entries made in the books of
account with the supporting the documentary evidences or vouchers.

5) Verification of assets and liabilities:- Verification means ‘proving the truth’ or

‘confirmation of the truth’. Verification of assets and liabilities means proving the truth about the
existence and the correctness of the money value of the assets and liabilities appearing in the
balance sheet of the business. In other words, it means establishing the actual existence of the
assets and liabilities appearing the balance sheet, ownership and possession of the assets and
proper classification and valuation of assets and liabilities.
For Private circulation only
Page 28
1.9. Audit programme

Proper implementation of any plan depends upon a good programme. Even a computer gives a
good solution, if it is provided with correct and sound programme. Therefore, auditor should
chalk out a programme according to the requirement of each case as to what work is to be done by
senior or junior staff and the time by which the work is to be finished. While preparing audit
programme, the auditor must keep in mind size and composition of the organization and nature
and extent of internal control.

According to Megis, “An audit programme is a detailed plan of the auditing work to be
performed, specifying the procedure to be followed in verification of each item in the financial
statements and giving the estimated time required.”

According to Metz “An audit programme is a detailed plan with well determined procedures for
audit work”.

In words of Holmas” An audit programme is a flexible, planned procedure of examination”.

From these definitions, it is clear that an audit programme is a programme or scheme of work,
prepared by an auditor, before the commencement of an audit, to conduct the audit.

1.9.1. Advantages of Audit Programme

1. The auditor can be certain that the audit staff will cover the whole of the ground and if, in
future, different members of the staff are engaged upon the audit, they can see the reference to
the programme exactly what work they are required to perform.
2. Audit assistants know their clear cut duties.
3. Efficiency of the audit assistants increases.
4. It enables the auditor to keep in touch with the work done and general progress of the
work
5. Fixing of the responsibility to audit assistants becomes easier.

For Private circulation only

Page 29
6. It serves as evidence, if at any time an action is taken against the auditor alleging
negligence in the performance of his duties.
7. The routine gets systematic.
8. It provides a check against the possibility of certain important items requiring
verification which are being omitted.
9. Continuity is not lost even if the person on duty is changed.
10. The chief auditor is saved from botheration of issuing instructions to the staff repeatedly.

1.9.2 Disadvantages of Audit Programme

1. The task becomes mechanical; as a result initiative and efficiency are adversely affected.
2. The task may be finished hurriedly to complete it within the scheduled time.
3. It does not serve any purpose in the audit of a small organization.
4. Uniformity of the audit programs cannot be applied extensively as the nature of work in the
audit of different organizations cannot be exactly the same.
5. It tends to introduce rigidity.
6. Inefficient audit assistants may also take shelter behind the programme.

Execution of audit programme should not become an objective in itself; surprise checking
outside the predetermined audit programme will also help in minimizing the impact of
disadvantages. The auditor should not depend entirely on one standard audit programme; he
should receive suggestions from the audit staff and review the audit programme from time to
time in the light of variation of nature of business or management.

For Private circulation only

Page 30
1.9.3 Specimen of Audit Programme

SPECIMEN OF AUDIT PROGRAMME

Name of the client …...
Date of Commencement of Audit
Any special information from previous audit …..
Nature of organisation …….

For Private circulation only

Page 31
r
r
r
r
J

a
a
e
a
a

y
u
b
y
u
n

F
T
E

H
N
O
A
Y

M
M
Cash Book
Bank Book Balanced

Cash Book Vouched

Petty Cash Vouched

For Private circulation only

Bought Ledger Vouchers

Bought Ledger Cash Postings

Sales Books Additions &

Posting
Returns Book Postings

Journal
Stock sheet

Bought Ledger

Sales Ledger

Trail Balance

General Ledger Checked

Profit & Loss A/c Checked

Balance Sheet Checked

Page 32
Remarks
c
h

A
p
r
i
l

M
a
y
J
u
n
e

J
u
l
y

A
u
g
u
s
t

S
e

For Private circulation only

Page 33
p
t
e
m
b

e
r

O
c
t
o
b
e
r
N
o
v
e
m
b
e

D
e
c
e
m

For Private circulation only

Page 34
b
e

1.10 Audit files

As an auditor is often engaged in a number of audits simultaneously, he usually keeps the records
of each audit in a separate file for ready reference. Such a file is called audit file.

The working papers are filed for future reference. Certain matters may be of permanent
importance and certain other matters may relate to a single period of audit. Matters of permanent
interest are filed in permanent file. A permanent file, for instance may include information
concerning organizational forms like memorandum of association / article of association in case
of company client, partnership deeds in case of firm client, important minutes of meetings,
review points of internal control system, accounting policies, audit and accounts reports of every
preceding year.

In current file matters concerning the audit of current are filed. For instance, the current file may
include matters documented in regard to acceptance of reappointment, audit programme of the
year, important extracts of audit notes concerning checking of transactions, balances, events,
matters arising from communications of management on accounting matters, copy of financial
statement and audit report of the relevant period under file.

For Private circulation only

Page 35
Audit note book

Audit note book is a diary or register maintained by audit staff to note errors, doubtful queries
and difficulties. The purpose is to note down various points which need to be either clarified with
the client or the chief auditor. The audit note book is also used for recording important points to
be included in the auditor’s Report. It is a complete record of doubts and their clarification.

In other words, it is a book maintained by the audit clerk for the purpose of making notes during
the course of audit of all the important matters affecting the audit.

Contents of an Audit Note Book

An audit note book usually contains the following information about the audit work performed
by the audit staff.

1. A list of books of accounts maintained.

2. The names, duties and responsibilities of principal officers.
3. The particulars of missing receipts and vouchers.
4. Mistakes and errors detected.
5. The points calling for clarifications and explanations.
6. The points deserving the attention of the auditor.
7. Various totals and balances.
8. Extracts from the minutes and contracts.
9. The points to be part of the Auditor’s report.
10. Date of commencement and completion of the audit.

Audit Working Papers

The term audit working papers designated the files of analyses, summaries comments and
correspondence built up by an auditor during the course of the field work of an audit
engagement. These papers contain essential facts about accounts which are under audit.

According to Arnold. W. Johnson, “Audit working papers are the written, private materials,

For Private circulation only

Page 36
which an auditor prepares for each audit. They describe the accounting information which he
received from his client, the methods of examination used, his conclusions (and reasons thereof)
and the financial statements.”

According to Jack. C. Robertson, “working papers are the auditor’s own evidence of compliance
with generally accepted auditing standards and the decisions respecting all procedures necessary
in the circumstances unique to the audit engagement.”

They consist of draft copies of trial balances, adjusting entries, accounts analysis, schedule of
debtors and creditors, summaries of data correspondence between auditor and debtors, creditors
and bank, detailed schedules of item like depreciation, inventories, previous audit reports,
important queries with explanation, audit programme and other important materials.
1.11. Overview of Auditing Committee

The audit committee is a crucial element of the governance structure and operates under the
delegated authority of the board. The committee’s roles and responsibilities will be documented
within its terms of reference which it should review annually and propose to the board for
approval.

The chief audit executive (CAE) should have direct, unrestricted access to the audit committee
and chief executive as and when required. The audit committee’s remit will typically include the
following:

 Internal controls and risk management systems

 The internal audit process including appointment and resourcing

 Financial statements including governance statements

 The external audit process

 Compliance reports

 Regulatory inspection reports

 Key performance data

 Whistle blowing
For Private circulation only
Page 37
 Communications with shareholders regarding its activities

1.12. Auditing Standards

In order to facilitate understanding of the scope and authority of the pronouncements of the
Auditing and Assurance Standards Board ('AASB'), the ICAI has issued revised preface viz.,
Preface to Standards on Quality Control for Auditing, Review, Other Assurance and Related
Services, which has come into effect from 1st April, 2008. Standards of the following nature
issued by the AASB shall be collectively known as 'the Engagement Standards':

Standards on Quality Control (SQC) are applicable to the auditing firms which performs Audits
and Reviews of Historical Financial information and other Assurance and related services
engagements.

Standards on Auditing (SAs), to be applied in the audit of historical financial information.

Standards on Review Engagements (SREs), to be applied in the review of historical financial

information.

Standards on Assurance Engagements (SAEs), to be applied in assurance engagements, dealing

with subject matters other than historical financial information.

Standards on Related Services (SRSs), to be applied to engagements involving application of

agreed upon procedures to information, compilation engagements, and other related services
engagements, as may be specified by the ICAI.

Auditing and Assurance Standard ('AAS') have been re-numbered and classified in the above five
categories as Standards on Auditing.

For Private circulation only

Page 38
Forensic Audit:

A forensic audit is an examination and evaluation of a firm’s or individual’s financial records to

derive evidence that can be used in a court of law or legal proceeding. Forensic auditing is a
specialization within the field of accounting, and most large accounting firms have a forensic
auditing department. Forensic audits require the expertise of accounting and auditing procedures
as well as expert knowledge about the legal framework of such an audit.

1.13. Summary

 The word audit takes its origin from Latin word “Audire” which means to hear.

 The audit may be classified

a) On the basis of legislative control
b) On the basis of relation of auditor vis a vis Management.
c) On the basis of periodicity of the audit
d) On the basis of subject matter of audit
e) On the coverage of audit
f) On the basis of manner of checking
g) On the basis of, audit from the point of view of specific objective.

 The objectives of audit can be categorized into

a) Main Objectives
b) Secondary Objectives
c) Specific Objectives

 Audit Programme is a programme or scheme of work prepared by an auditor, before the

commencement of an audit, for the conduct of audit.

 An auditor is often engaged in a number of audits simultaneously, he usually keeps the

records of each audit in a separate file for ready reference. Such a file is called audit file.

For Private circulation only

Page 39
 Audit working papers are the papers and documents which come into the possession of an
auditor and the information recorded or developed by the accounts of his client’s business.

1.14. Case Study

Satyam scandal (2009)

'Satyam Computer Services, scandal was a corporate scandal affecting India-based company
Satyam Computer Services in 2009, in which chairman Ramalinga Raju confessed that the
company's accounts had been falsified. It is about corporate governance and fraudulent auditing
practices allegedly in connivance with auditors and chartered accountants. The company
misrepresented its accounts both to its board, stock exchanges, regulators, investors and all other
stakeholders. It is a fraud, which misled the market and other stakeholders by lying about the
company’s financial health. Even basic facts such as revenues, operating profits, interest
liabilities and cash balances were grossly inflated to show the company in good health.

Price water house Coopers affiliates served as independent auditors of Satyam Computer
Services when the report of scandal in the account books of Satyam Computer Services broke.
The Indian arm of PwC was fined $6 million by the SEC (US Securities and Exchange
Commission) for not following the code of conduct and auditing standards in the performance of
its duties related to the auditing of the accounts of Satyam Computer Services. In 2018, SEBI
(Securities and Exchange Board of India) barred Price Waterhouse from auditing any listed
company in India for 2 years, saying that the firm was complicit with the main perpetrators of the
Satyam fraud and did not comply with auditing standards. SEBI also ordered disgorgement of over
Rs 13 crore wrongful gains from the firm and 2 partners(S Gopala Krishnan and Srinivas Talluri).

Kingston Cotton Mills Co. Ltd. Case (1896)

In this case, the company paid dividends in excess by showing overstated value of stocks. The
valuation of stock was done by the manger and was certified. The auditors relied on the manager’s
certificate and did not check its authenticity. It led to payment of dividend out of capital. Had the
auditor examined the books carefully, this fraud could have been detected.

For Private circulation only

Page 40
But it was held that, ‘An auditor is a watchdog not a bloodhound’.
An auditor is an expert person and he is expected to apply reasonable skill and care while
expressing his opinion regarding the accounts of the company. He need not carry out his work
with a suspicious mind, as he is not a bloodhound. As a watchdog, he is merely required to watch
that the interests of stakeholders are protected and financial information has been drawn with care
and compliance to required standards and laws. He is justified in relying on the certification made
by the employees of the organization or the experts hired for matters like valuation of stock and
other things. He may not probe into the authenticity of such documents and need not distrust the
integrity of people involved in its preparation. He was absolved of any liability in this case, and it
was established that he is justified to accept any document or certificate on its primafacie
evidence. He may not look into its conclusive evidence.

1.15. Unit End Exercises

1. An Italian, who had published his treatise as double entry system of book keeping for the first
time in 1494
2. The word Audit takes its origin from Latin Word which means .
3. On the basis of legislative control audit may be classified into ,

CASE STUDY -2

M/s JK & Associates have been appointed as auditors of Venus Ltd. for the financial year 2019-20. The team
consist of Mr. J & Mr. K both Chartered Accountants as also the engagement partners and the audit staff
consisting of 2 article assistants. While starting the audit work of Venus Ltd., the engagement partners briefed
the audit staff about the audit work, areas to be covered and the various auditing concepts and their application
in the audit of Venus Ltd. along with applicable Standard on Auditing.
Various topics like audit planning, overall audit strategy, audit programme were discussed in detail. The team
was told about the purpose and implication of various statements and guidance notes issued by the Institute of
Chartered Accountants of India (ICAI) from time to time. Mr. K also briefed the team about the concept of
materiality to be applied while planning and performing audit. The team was also explained in detail about the
area where benchmark materiality can be applied in case of Venus Ltd.
Based on the above facts, answer the following:
For Private circulation only
Page 41
1. ______________ sets the scope, timing & direction of the audit and guides the development of the more
detailed plan.
a) Audit Programme
b) Overall Audit Strategy
c) Completion Memorandum
d) Audit Plan

2. Statement 1: The establishment of the overall audit strategy and the detailed audit plan are not necessarily
discrete or sequential process but are closely inter-related.Statement 2: The auditor shall establish an overall
audit strategy that guides the development of audit plan.
a) Only Statement 1 is correct
b) Only Statement 2 is correct
c) Both Statements 1 & 2 are correct
d) Both Statements 1 & 2 are incorrect

3. __________________ means the amount set by the auditor at less than materiality for the financial state-
ments as a whole to reduce to an appropriately low level the probability that the aggregate of un- corrected and
undetected misstatement exceeds materiality for the financial statements as a whole:

(a) Benchmark Materiality

(b) Materiality in Planning

(c) Performance Materiality

(d) Materiality

4. Which of the following is not an example of benchmark that can be used in determining the materiality

For Private circulation only

Page 42
in the case of financial statements:

(a) Total Revenue

(b) Profit before tax

(c) Net Asset Value

(d) None of the above

5. Statements are mandatory in nature.

I. Guidance notes issued by ICAI provide guidance to members on matters which may arise in the course of
their professional work.

II. Statements are issued by ICAI with a view to secure compliance by members on some matters.

III. Guidance notes are recommendatory in nature.

(a) All the above statements are correct

(b) Statements 1 & 2 are correct

(c) Statements 1, 2 & 3 are correct

(d) Statements1,2 & 4 are correct

Section A (2 mark questions)

1. Explain “auditing”.
2. Explain audit programme?
3. Define audit programme.
4. Explain audit working papers?
5. Explain audit files?
6. Explain forensic Audit?
7. Write a note on Audit committee.

Section B (4 mark questions)

For Private circulation only
Page 43
1. Distinguish between accountancy and auditing.
2. Distinguish between Auditing and investigation.
3. Distinguish between errors and frauds.
4. Explain the advantages of auditing
5. Write short notes on:
a) Cash audit
b) Balance sheet audit
c) Periodical audit
d) Partial audit
e) Occasional audit
f) Cost audit
g) Management audit
h) Special audit
i) Efficiency audit
6. Draw an audit programme for cash transaction.
7. Write a note on audit procedure.
8. write a note on audit committee

Section C (10 mark questions)

1. Discuss the objectives of an audit.
2. You have been appointed as an auditor. How will you proceed to detect errors and
frauds?
3. “Accounting is a necessity, while auditing is a luxury for a business”. Explain.
4. Write a short note on the various classes of audits and their relative advantages and
disadvantages.
5. Discuss the types of an audit.

For Private circulation only

Page 44
Module 2
INTERNAL AUDIT, INTERNAL CONTROL, AND INTERNAL CHECK

Structure:

2.1 Internal Control:

2.2 Objectives of Internal control:
2.3 Characteristics or Principles of internal control:
2.4 Limitations or Disadvantages:
2.5 Internal Control in Computerised Environment:
2.6 Internal Auditing Standards:
2.7 Internal check:
2.8 Advantages and Disadvantage of Internal check:
2.9 Internal Check with Regards to Wages
2.10 Internal Check With Regard to Cash Sales
2.11 Internal Check With Regard of Expenditures
2.12 Internal Check with Regard to Inventory
2.13 Internal Check With Regard to Payroll
2.14 Internal Control With Regard to All Revenue Cycles
2.15 Internal Audit
2.16 Advantage and disadvantage of Internal Audit
2.17 Difference between Internal Control and Check
2.18 Summary
2.19 Case Study
2.20 Unit End Exercises
2.1 Internal control
2.2 Introduction and meaning:
Control is a wider term and will include all types of management. It is a means of assisting
modern business management to perform their functions effectively.

Meaning of internal control:

“The whole system of controls, financial or otherwise, established by the management in the

For Private circulation only

Page 45
conduct of a business, including internal check, internal audit and other forms of control.”

From the auditor’s point of view; an internal control includes Accounting controls and
Administrative controls:

i. Accounting control: it includes budgetary control, standard costing, bank reconciliation, self
balancing ledgers etc. it ensures accuracy and reliability of financial records.

ii. Administrative control: it comprises of plan of an organization which is mainly concerned

with the operational efficiency. It includes time and motion study, quality control through
inspection, performance reports and statistical analysis.

Definitions:
According to the institute of chartered Accounts of England & Wales, “It means not only
internal check and internal audit but the whole system of controls, financial and otherwise,

established by the management, in order to carry of the business for the company in an orderly
manner, to safeguard its assets and to secure as far as possible the accuracy and reliability of its
records.”

According to The American Institute of Certified Public Accountants, "Internal control

comprises of the plan of organisation 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."

According to SAP-6 internal control can be defined as “a plan of organization and all the
methods and procedures adapted by the management of an entity to assist in achieving
management objectives of ensuring as far as practicable orderly and efficient conduct of its
business, including:

1) Adherence to management policies

2) Safeguarding of assets

For Private circulation only

Page 46
3) Preventing and detecting of fraud and error.
4) Accuracy and completeness of accounting records.
5) Timely preparation of reliable information.

2.3 Objectives of internal control:

1. To direct, monitor and measure the organization’s resources.
2. To prevent and detect the fraud.
3. To ensure the reliability on the financial reports.
4. To achieve operational or strategic goals.
5. To provide reasonable assurance that a particular objective is achieved.

2.4 Characteristics or Principles of internal control:

1. Competent and trustworthy personnel: One of the most important elements of any system
of internal control is the employees of the organization. If they are trustworthy and competent a
reliable financial statement can be prepared.

2. Records: Documents perform the function of transmitting the information through out the
organization. The documents must be adequate to provide reasonable assurance that all assets are
properly controlled and recorded.

3. Segregation of duties: To prevent both intentional and unintentional errors the following types
of segregation of duties should be taken care of:
(i) Separation of operational responsibility from record keeping responsibility- If each
department or division in an organization is responsible for preparing its own record, there would
be a tendency of miss recording.

(ii) Separation of the custody of assets from accounting-To protect the firm against frauds it is
required that the custody of assets and there accounting should be done by separate persons. If
not there will be a risk of disposing the assets for personal gain.

4. Supervision: Directors should review the company’s financial operations and the positions at

For Private circulation only

Page 47
regular intervals. He should compare the previous period’s results which indicates the
inconsistency and also helps for further examination.

5. Arithmetic and accounting controls: balance sheet and income statements is an important
control because it provides the frame work for determining the information presented to
management. These financial statements should be prepared in accordance with generally
accepted accounting principles.

2.5 Advantages and disadvantages

Advantages
1. It provides accurate and reliable data.
2. It ensures that the policies and procedures prescribed by the management are followed by the
employees
3. It promotes operational efficiency.
4. It helps the organization to attain its goal effectively.
5. It safeguards the assets and the records of the business.

Limitations or Disadvantages
1. Operation of the internal control system involves more expenditure of time and money.
2. Internal controls are concerned more with transactions of routine nature, hence unusual and
irregular transactions may be overlooked.
3. Possibility of human error may weaken the internal control system.
4. There is a possibility that a person responsible for exercising control could abuse his
authority.
5. Manipulation by the management may defeat the objectives of internal control.

2.6 Internal Control in Computerised Environment

Information technology (IT) is integral to modern accounting and management information

systems. It is, therefore, imperative that auditors should be fully aware of the impact of IT on the
audit of a client’s financial statements, both in the context of how it is used by a client to gather,
process and report financial information in its financial statements, and how the auditor can use

For Private circulation only

Page 48
IT in the process of auditing the financial statements.

Application controls, comprising input, processing, output and master file controls established
by an audit client, over its computer-based accounting system and Computer- assisted audit
techniques (CAATs) that may be employed by auditors to test and conclude on the integrity of
a client’s computer-based accounting system

2.7 Internal Auditing Standards:

The standards are based on the core principles and provide a framework for performing and
promoting internal auditing. The standards are mandatory requirements consisting of statements
of basic requirements consisting of statements of basic requirements for the professional practice
of internal auditing and for evaluating the effectiveness of its performance.

2.7 Internal check:

Meaning and definitions:

It is the organization of the system of accounts of an office or factory and arrangement by which
the duties of the various members of the staff of a business are allocated in such a way that the
work done by one is automatically checked by another, so that the errors and frauds are quickly
discovered.

Definitions:
According to L.R.Dicksee internal check is “Such an arrangement of book keeping routine that
errors and frauds are likely to be prevented or discovered by the very operation of the book
keeping itself”

According to F.R.M. De Paula, “Internal check means practically a continuous internal audit
carried on by the staff itself, by means of which the work of each individual is independently
checked by other members of the staff.”

For Private circulation only

Page 49
Objectives:
1. To detect and eliminate the acts of fraud and error.
2. To prevent the misappropriation of cash or goods.
3. To allocate the work of a worker judiciously.
4. To implement moral pressure over the staff members.
5. To ensure that the accounting system produces reliable information.

2.8 Advantages and Disadvantages:

Advantages of Internal check:
For the business:
1. Proper division of work: It helps in proper and rational distribution of work among the
members of the enterprise.
2. Detection of errors and frauds: No individual worker is allowed to handle a job
completely from the beginning till the end and hence the work gets checked automatically.

For the auditor:

1. Quick preparation of final accounts: The profit and loss account and the balance sheet can
be easily prepared.
2. Convenience to the auditor: when the organization is operating a system of internal
check, the statutory auditor may conveniently avoid detailed check of transactions.

For the owner:

1. Accuracy of the accounts: if there is a good system of internal check, the owner can rely
upon the genuineness and the accuracy of the accounts.
2. Increase in profits: overall efficiency and the economy in operations results in more
profits which ensures larger dividends for the owners.

Disadvantages of internal check:

1. Costly for small business.
2. Quality is sacrificed just for the sake of promptness of the work.
3. More risk for the auditor.

For Private circulation only

Page 50
4. Higher officials may be careless believing internal check.
5. Disorder in the working of a business.

2.9 Internal check as regards to wages:

In big manufacturing concerns, the work associated with the maintenance of various types of
wage records, computing the amount of wages is very important. There are greater possibility of
irregularities and frauds and hence to reduce the fraudulent manipulations of records the
following measures can be taken:

1. Maintenance of wage records:

Workers are normally paid on the basis of time spent by each worker. Therefore the time spent
by each worker should be correctly recorded. If the workers are paid on the basis of piece rate
system a proper book for recording the actual work should be maintained. If the workers are
requested to work overtime then a separate overtime slip should be issued by a properly
authorized official.

2. Preparation of wage sheets:

The procedure for preparing the wage sheets or pay roll should be clearly established to minimize
the chances of over or under payments. The work of preparation of wage sheet should be done by
a separate department. It should be done by at least two to four clerks so that it helps in
minimizing the irregularities. For time and piece rate workers a separate wage sheet should be used.

3. Payment of wages:
The payment must be made by a person who is in no way concerned with the preparation of wage
sheets. Generally the cashier is assigned the job of disbursement as he is not associated with the
preparation of wage sheet.

2.10 Internal check as regards to cash sales:

In a big trading house the transactions of cash sales are large. The following measures should be
taken:
1. Each salesman should be given a separate sales memo book.

For Private circulation only

Page 51
2. The salesman should prepare four copies of the cash memo when he sells goods to the
customer.
3. These copies should be checked by another official before they are handed over to the
customers. One copy should be given for preparing the sales summary at the end of everyday.
4. Payment should be made at the cash counter and the cashier after receiving the cash should
give one copy to the customer by duly stamping it as cash paid. Two copies must be retained by
the cashier.
5. The cashier should record the day’s total sales in the cash sales register to know the total
cash received at the end of the day.
6. Every salesman should also prepare a summary sheet to know the total sales of the
counter.
7. If the sales takes place through post, then a separate register should be maintained in which
all the details are recorded.
8. The total receipts on this account should be entered in the postal sales ledger.
9. Any advance received by the customer or any goods returned by the customer should also be
entered in the postal sales ledger.
10. The postal sales ledger should be thoroughly verified by a senior officer. The goods returned
and the reasons for the same should be carefully examined. Any payment not yet received should
be carefully verified.
2.11 Internal check with Regard to Expenditures
Internal check with regards to Purchase
A business concern has to maintain a separate purchase department to have a proper and
effective control over purchases. The efforts of this department should be to buy the best product
at the most competitive price. The activities of this department should be divided into:
a. Requisition
b. Purchase order
c. Receipt of goods
d. Invoice

Requisition: The department requiring supplies or assets must send requisition to the purchase
department. Requisition books must be kept by each section of the organization. The details
about the quantity, quality and the time by which the goods must be supplied should be clearly
For Private circulation only
Page 52
stated.

Purchase order: The purchase department should invite tenders from the approved suppliers. It
must be approved by authorized senior officials. It will be prepared in four copies. One for the
vendor, second to the stores, third to the accounting department, fourth will be retained by the
purchase department.

Receipt of goods: On receipt of goods the purchase department should properly inspect them
regarding the quality, quantity and condition and it should be compared with the purchase order.
Goods received should also be entered in the goods inward books.

Invoice: The purchase department should thoroughly check the supplier’s invoices and later it
should be sent to the accounting department for payment. The accounting department should
compare the invoices with the authorized purchase order, examine the inspection of the purchase
department and then make the payment.

Internal check with regards to Cash Disbursements

There should be an effective system of internal check with regard to all payments made by the
concern in the form of cash or cheque or bank transfers. Cash payments can be misappropriated
in the following ways:

· Payments may be made against fictitious vouchers.

· Payments may be made against inflated vouchers.

· Payments may be made without receipt of goods.

· Revenue expenses maybe treated as capital expenditure.

Hence, a proper system of internal check is necessary. The following system of internal check
should be adopted as regards cash payments.

1. The person in charge of making cash payments should not have any connection with the
person responsible for receiving cash.
For Private circulation only
Page 53
2. The person responsible for making cash payments should not have access to the books of
accounts.

3. All the payments should be paid by way of crossed cheque.

4. After making payment against a particular bill or invoice, the voucher and the supporting bill
or invoices should be stamped as ‘paid’ so that the same voucher is not again passed for payment.

5. Unused and cancelled vouchers and cheque books should be kept under the custody of a
responsible person.

6. Person who is responsible for preparing the cheque should be clearly specified.

Before passing a bill for payment, it should be ensured that the goods have been received.

7. The bill for which payment is to be made should be sanctioned by the responsible official.

8. Confirmation balances from the creditors should be made through direct correspondence.

9. Proper sanction should be obtained by Directors from higher officials to make payment of
transactions of special nature.

10. Bank reconciliation statement should be prepared to reconcile cash and bank balances from
time to time.

2.12 Internal Check for Stores (Inventory)

A store has to preserve finished goods, semi finished goods and raw materials in big business
houses. Therefore proper control of stores to prevent pilferage, theft and misuse is also necessary.
Chances of misappropriation are more in the case of inventory and therefore require strict control
and vigilance.

The following points may be of great help for the effective control of stores:
(i) Store should be located at a convenient place. It should have proper storage facilities so
that the goods may not be wasted, misplaced and misused.
(ii) Goods received in the store should be entered into “Goods Received Sheets”. These
sheets should be prepared in triplicate- one for the purchase section, second for the accounts
section and the third copy to be retained in the store.
(iii) Goods received should be stored at their allotted racks.
For Private circulation only
Page 54
(iv) The system of bin cards should be used to show the receipts, issues and balances of
stores.
(v) Stock taking should be carried out at regular intervals. Bin cards must be compared with
the storage ledger.
(vi) Store keeper should issue the goods only against proper authorized requisition.
(vii) A gate pass should be given to those authorized persons who will take out goods from
the store.
(viii) When materials are returned from the job or by some department, a “Material Returned
Note” (Or stores returned note) should be prepared. Proper entry for the material returned should
be made in the bin card.

2.13. Internal check with regard to payroll

1. Scan your employee list, pay rates, andhours worked

2. Confirm pay rates andhoursworked

3. Verify variable payments

4. Scrutinize off-cycle payroll

5. Do a payroll reconciliation

6. Reconcile internal payroll records with tax forms

7. Search foroutstandingtax liabilities

8. Identify areas for improvement in the payroll process

9. Ensure compliance with labor andrecordkeeping laws

2.14 Internalcontrol withregards to Revenue Cycles

The revenue cycle includes all activities directly associated with selling products or services.
For Private circulation only
Page 55
Typically, it encompasses order processing, credit checking, sales contracts, warranties or
guarantees and cash receipts.

Revenue cycle policies are designed to ensure that there are effective internal controls over all
aspects of the cycle. The common objectives of these internal controls are to:

 Ensure that all sales are billed and that all billings are recorded
 Control the risks associated with extending credit
 Prevent loss or theft of assets, particularly cash or cheques
 Report accurate financial information

These objectives can be achieved by establishing basic internal controls, including:

 Comparing business activity to billings

 Processes to control and grant credit
 Controlling processes over mail opening and receiving cheques by using more than one
person and by independently comparing a list of cheques received to bank deposits
 Separating handling of cash receipts from accounting record-keeping
 Following up customer complaints independently of the invoicing function
 Approval processes and support for credit notes, write-offs of bad debt, and other items
that reduce revenue or accounts receivable
 Analyzing results by comparing to budget and prior years and investigating unusual
trends


2.15 Internal Audit:

Meaning
It is a review of operations and records undertaken within a business by specially assigned staff.
It is a past transaction review to evaluate the correctness of records and the effectiveness of the
operations on a continuous basis in an organization by the salaried staff.

For Private circulation only

Page 56
Objectives and importance:
1. To verify the correctness, accuracy and authenticity of the financial accounting and the
statistical records presented to the management.
2. To confirm that the liabilities have been incurred by the organization in respect of its valid
and legitimate activities.
3. To comment on the effectiveness of the internal control system and the internal check
system in force and to suggest ways and means to improve these systems.
4. To facilitate the early detection and prevention of frauds.
5. To examine the protection afforded to the company assets and the uses to which they are
put.
6. To identify the authorities responsible for purchasing assets and other items as well as
disposal of assets.
7. To assist management in achieving the most efficient administration of the operation by
establishing procedures.
8. To ensure that standard accounting practices which should be followed by the
organization are strictly followed.

2.16 Advantages and Disadvantages:

Advantages:
1. It will have a continuous check on the accounting records and the accounting staff will be
alert.
2. Errors and frauds will be detected quickly and the books of accounts will be free from any
error.
3. It facilitates in finalization of accounts easily at the end of the financial year.
4. Every business activity will be continuously reviewed.
5. It facilitates in the adoption of standard accounting practices in the firm.

Disadvantages:
1. Every time checking might affect the accounting staff as they feel their work is been
doubted.
2. It adds the cost of the organization because the additional expenditure will be incurred to

For Private circulation only

Page 57
maintain a separate audit wing.
3. Even if the internal auditor examines the books, there is a possibility of altering the
figures later.

2.17 Distinguish Between Internal Control and Internal Check

1. Internal check is a part of internal Control.
2. Internal Control is a means of exercising control of the entire working of the business.
Internal check is a method of organizing the accounting work of a business.

2.18 Summary

 Internal control is a whole system of control which includes internal check, internal audit
and other forms of control.

 It prevents and detects fraud.

 Internal check is a part of internal control which helps in checking frauds and errors.
 It helps in proper and rational distribution of work among the workers.
 Internal check helps in checking the irregularly and frauds with regard to
maintenance of wage records, cash sales and purchases.
 Internal audit is a review of operations and records undertaken within a business by
specially assigned staff

2.19 Case Study

TOSHIBA - A CASE OF INTERNAL AUDIT FAILURE

In July 2015, Toshiba Corporate president Hisao Tanaka and his two predecessors quit after
investigators found that the company inflated earnings by at least $1.2 billion during the period
2009-2014.

The investigators committee found out, the corporate audit division of Toshiba in reality is
provided consultation services for the management being carried out at each of the companies,
and it rarely conducted any services from the perspective of an accounting audit into whether or
not an accounting treatment was appropriate.

For Private circulation only

Page 58
In Toshiba, the compensation of executive officers comprises a base compensation based on title
and role compensation based on work content. Besides, the top management used to set targets that
are unachievable. There was excessive pressure from the top management to achieve those
targets. The challenges to achieve the unachievable targets and performance- based pay provide
enough motivation for employees to commit fraud. Therefore, internal audit should focus on this
area.

Apart from that, they are three external audit committees had no knowledge of finance and
accounting. Therefore, the internal audit was not independent of the management. According to
Generally Accepted Auditing Standards, the role of internal audit is to provide independent
assurance that an organization’s risk management, governance and internal control processes are
operating effectively and not providing consultant service for the management. Besides, variable
pay and pressure from top management to achieve those targets cause employees to being fraud.
Internal audit should pay attention on this and change the internal management system.
According to GAAS, auditors should be independence, adequate technical training and
proficiency. But in Toshiba, there are three external audit committees had no knowledge about
finance and accounting, they should be punished for their responsibility.

2.20 Unit End Exercises

Fill in the Blanks

1. Internal control includes ………….. and ................ control.
2. Internal control achieves .................. goals.
3 ..................... is a process of internal audit carried on by the staff itself.

Anvisha Ltd. is a company engaged in the business of software development. It is one of the largest companies
in this sector with a turnover of ` 25,000 crores. The operations of the company are increasing constantly,
however, the focus of the management is more on cost cutting in the coming years to improve its profitability.
Shares of Anvisha Ltd. are listed on Bombay Stock Exchange. Company in its AGM held on 26.08.2018,
For Private circulation only
Page 59
appointed M/s ABC and Associates, Chartered Accountants, as their auditors for five years.
In respect of the financial statements of the company for the year 2018-19, which are used by various
stakeholders, some fraud was observed in respect of assets reported therein due to which those stakeholders
suffered damages. As a result, those stakeholders applied to Tribunal for change of auditor on the basis that
auditor is colluded in the fraud. In the meanwhile, ABC and Associates, resigned from the company without
assigning any reason. As per the requirements of Sec. 140(2) of Companies Act, 2013, the auditor who has
resigned from the company shall file within a period of 30 days from the date of resignation, a statement in the
Form ADT-3 with the company and the Registrar. However, no such statement is filed by ABC and
Associates.
Based on the above facts, answer the following:

Q1. In case of an listed entity, for the purpose of appointment of a person as auditor of the company,
qualifications and experience of the individual or the firm proposed to be considered for appointment as
auditor and whether such qualifications and experience are commensurate with the size and requirements of
the company, is to be considered by:

(a) Audit Committee

(b) (b) Board of Directors
(c) Audit Committee and SEBI
(d) (d) Board of Directors and SEBI

Q2. After appointment of the auditor in AGM, Anvisha Ltd. shall inform ABC and Associates of their
appointment, and also file a notice in Form ________________ of such appointment with ____________
within _________ of the meeting in which the auditor is appointed.

(a) Form ADT - 1, SEBI, 15 Days

(b) Form ADT - 1, Registrar, 15 days.
(c) Form ADT - 2, SEBI, 30 days
(d) Form ADT - 2, Registrar, 30 days.

Q3. Which of the following stands true in respect of application made by shareholders to Tribunal for change of

For Private circulation only

Page 60
auditor on the basis that auditor is colluded in the fraud?

(a) Application will be rejected by Tribunal as application for change of auditor can be made only by Central
Government.
(b) Application will be rejected by Tribunal as Only Tribunal may suo motu take action for change of auditor.
(c) If Tribunal is satisfied that the auditor of a company has, whether directly or indirectly, acted in a fraudulent
manner or abetted or colluded in any fraud by, or in relation to, the company or its directors or officers, it may, by
order, direct the company to change its auditors.
(d) Approval of Central Government is required before making application to Tribunal for change of auditors.

Q4. An auditor, whether individual or firm, against whom final order has been passed by the Tribunal u/s
140(5) of Companies Act, 2013 shall not be eligible to be appointed as an auditor of any company for a period of
___________________ from the date of passing of the order and the auditor shall also be liable for action
under section _________________.

(a) 5 years; Sec. 147

(b) 10 Years; Sec. 147
(c) 5 Years; Sec. 447
(d) 10 years; Sec. 447

Q5.If the auditor does not comply with the provisions of Sec. 140(2) of Companies Act, 2013, he or it shall be
liable to a penalty of:
(a) ` 50,000 or an amount equal to the remuneration of the auditor, whichever is less, and in case of continuing
failure, with further penalty of ` 100 for each day after the first during which such failure continues, subject to a
maximum of ` 1 lakh.
(b) ` 50,000 or an amount equal to the remuneration of the auditor, whichever is higher, and in case of
continuing failure, with further penalty of ` 100 for each day after the first during which such failure continues,
subject to a maximum of ` 1 lakh.
(c) ` 50,000 or an amount equal to the remuneration of the auditor, whichever is less, and in case of continuing
failure, with further penalty of ` 100 for each day after the first during which such failure continues, subject to a

For Private circulation only

Page 61
maximum of ` 5 lakh.
(d) ` 50,000 or an amount equal to the remuneration of the auditor, whichever is less, and in case of continuing
failure, with further penalty of ` 500 for each day after the first during which such failure continues, subject to a
maximum of ` 5 lakh.

Section A (2 Marks Questions)

1. Define internal check.
2. Explain internal control?
3. Mention the two importance of having an internal control system.
4. Comment on the internal control system with regard to wages.
5. Distinguish between internal check and internal control.

Section B (4 Marks Questions)

1. Explain the elements of a good internal control system.
2. Explain the advantages of internal check?
3. Explain the main objectives of internal control?
4. Explain the advantages of internal control system?

Section C (10 marks Questions)

1. How will you satisfy yourself that there is a suitable system of internal check in a large manufacturing concern
with regard to cash sales and wages?

For Private circulation only

Page 62
Module 3

Vouching

Structure
3.1 Introduction
3.2 Meaning and Definition
3.2.1 Importance of vouching:
3.2.2 Routine checking and vouching:
3.3 Vouchers
3.3.1 Types of vouchers:
3.4 Vouching of receipts:
3.4.1 Vouching of cash sales
3.4.2 Vouching of receipts from debtors
3.4.3 Teeming and lading or lapping
3.4.4 Vouching of receipts from bills receivables
3.4.5 Receipts from sale of investments and buildings
3.5 Vouching of cash payments
3.5.1 Vouching of cash purchases
3.5.2 Payments to creditors:
3.5.3 Vouching of bills payable:
3.5.4 Vouching of payment for purchase of fixed assets:
3.6 Vouching of Deferred revenue expenditure:
3.6.1 Auditor’s duty with regard to deferred revenue expenditure:
3.6.2 Vouching of preliminary expenses:
3.6.3 Vouching of cost of issue of shares and debentures:
3.6.4 Vouching of underwriting commission:
3.7 General and Specific Duty of Auditor with Regards to Vouching
3.8 Summary
3.9 Case Study
3.10 Unit End Exercises

For Private circulation only

Page 63
3.1 Introduction

An auditor is required to certify the transactions which are recorded in the books of accounts as
correct. Auditor will certify only after checking the transactions recorded, entries made and after
he gets satisfied himself that they are accurate.

3.2 Meaning and Definition

It is a potential tool in the hands of an auditor to check the accuracy of the various transactions
recorded in the books of accounts. It does not just mean the mere inspection of receipts with the
cash book but also includes the examination of receipts with the transactions of a business along
with documentary and other evidence of sufficient validity.

Definition:

According to Taylor and Perry vouching is “The examination of the evidences offered in
substantiation of the entries in the books, including in such examination the proof, so far as
possible that no entries have been omitted from the books.”

According to F.R.M. De Paula, “Vouching does not merely mean the inspection of receipts with
the cash book, but includes the examination of receipts with the transactions of a business,
together with documentary and other evidence of sufficient validity to satisfy an auditor that such
transactions are in order, have been properly authorised and are correctlyrecorded in the books.”

3.2.1 Importance of vouching:

1. The success of an audit largely depends upon the care and the attention with which
vouching is accomplished.
2. It is one of the most effective tools in the hands of an auditor to ascertain the accuracy of
the transactions recorded in the books of accounts.
3. It is only after vouching that an auditor definitely says that the books of accounts, the
balance sheet and profit and loss account exhibit a true and correct state of the financial affairs of
For Private circulation only
Page 64
the business.
4. It ensures the arithmetical accuracy by ensuring the appropriateness of the postings, carry
forwards, balancing etc.
5. It is an indispensible and a preliminary requirement to carry on the further scrutiny with
ease.

3.2.2 Routine checking and vouching:

Routine checking or simple checking is the checking the arithmetical accuracy of the entry in the
books of original entry and in the ledger and the subsidiary books. The carry forwards and
balancing of accounts and the transfer of ledger balances to trial balance will be checked.

Differences between routine checking and vouching:

Routine checking Vouching
1. It is checking of postings, carry 1) It is checking of the validity,
forwards, balancing etc. authenticity and accuracy of the
entries in the books of accounts.
2. It reveals only minor frauds. 2) It reveals not only minor frauds
but also clever and well defined
frauds.
3. It just reveals only clerical
errors, not errors of principles.
3) It reveals clerical as well as
4. It just checks
errors ofprinciples.
the arithmetical
4) It checks the
accuracy of entries.
real accuracy and
genuineness of the entries.

For Private circulation only

Page 65
5. Routine checking does not 5) Vouching includes routine checking
include vouching; hence it has a hence it has a broader scope.
narrow
scope.

3.3 Vouchers:

Meaning:
It is a document which evidences a transaction or an entry in a book of account.

Definition:
Joseph Lancaster defines a voucher as “any documentary evidence by which the accuracy of the
book entry may be substantiated”.

3.3.1 Types of vouchers:

1) Primary vouchers:
It is written evidence in original. It means it acts as an original evidence of a transaction or an
entry. Examples: purchase invoices, cash memos for goods purchased, statement prepared by the
bank etc.

2) Collateral or secondary vouchers:

If the original evidences are not available, the copies of the original evidences are also produced
for the purpose of audit. Carbon copies of sales invoices, copies of receipts, copies passed in the
resolution passed at the meetings of the board or shareholders etc.

3.4 Vouching of receipts:

Meaning
Vouching of receipts means, vouching of receipt side or debit side of the cash book. Vouching of
cash receipt is more difficult than vouching of cash payments because there are greater chances

For Private circulation only

Page 66
of manipulation in regard to cash receipts. An auditor gets in support of cash receipt entries only
the indirect evidences, such as counterfoils or carbon copies of receipts issued which are less
reliable.

3.4.1 Vouching of cash sales

The vouching procedure in regard to cash sales should be on the following lines:

1) An auditor should examine the system of internal check in operation in regard to cash sales
and satisfy himself that the system is effective and efficient.

2) After ascertaining the efficiency of internal check sales, the auditor should vouch the cash sales
as follows:
i) Cash memos written by the salesman should be checked with the summary of daily sales
prepared by each salesman at the end of the day.

ii) He should compare the abstracts of the sales with the cash analysis of the receiving
cashier.
iii) He should examine the rough cash book, if any.
iv) He should check the rough cash book with the main cash book.
v) If there is an automatic cash register in use, the daily totals entered in the cash book
should be checked.
vi) The summaries of daily sales should be checked with the entries in the stock register.
viii) He should verify the daily deposit of cash received in the bank. Pay-in slips should also be
verified.

3.4.2 Vouching of receipts from debtors:

Cash received from the debtor can be vouched with reference to the counterfoils of the receipts
issued to them. But the counterfoils of receipts issued to them are not reliable documentary
evidence as they are subjected to number of frauds. Hence while vouching the receipts from the
debtor; an auditor should remember the following points:

For Private circulation only

Page 67
1) An auditor should enquire into the system of internal check in operation in regard to the
receipt from debtors, and satisfy himself about the efficiency of the internal check in operation in
regard to the receipt from debtors. He should know the essentials of an effective internal check
like:
i. People who are maintaining the debtors’ ledger should not be allowed to collect
money from the customers.
ii. The customers should be asked to remit cash or cheque through post and not to hand
over directly to the cashier.
2) After satisfying himself about the efficiency of the internal check in operation in regard to
the receipts of cash from the debtors, the auditor should conduct the vouching of receipts from
the debtors on the following basis:
a. He should check the total cash received from the debtors by verifying the rough cash
book with the counterfoils of the receipts issued to the customers.
b. He should check the cash book with rough cash book and the counterfoils of the
bank pay-in slips.
c. He should test check the details of cash and cheque paid into the bank.
d. He should enquire into the method of granting discounts and find out the general rate
of discount and check that the discount allowed does not exceed the general rate.
e. He should be alert to the possibility of “teeming and lading” or lapping.
f. He should see that people who handle remittance received do not take part in the
preparation and sending out of statements of accounts to debtors.

3.4.3 Teeming and lading or lapping

In the context of vouching of receipts from debtors, it is important to know the meaning of
teeming and lading method of committing frauds. Teeming and lading is a fraudulent practice

For Private circulation only

Page 68
on the part of the cashier to misappropriate or misuse cash. It is a method of covering up of
shortage of cash.

According to Meigs, “Lapping may be defined as the concealment of a shortage by delaying the
recording of cash receipts.”

Teeming and lading method of fraud can be detected by an auditor by taking the following
steps:
a) An auditor should ascertain whether the name, amount and dates as shown on the carbon
copies are in complete agreement with relevant entries in the cash book.
b) He should compare the counterfoils with the counterfoils of the pay in slips to see
whether the full amount had been deposited into the bank or not.
c) He should ascertain whether the details of receipts, as recorded in the rough cash book,
main cash book and the receipts issued to individual customers, agree with the amounts shown in
the counterfoils of the pay in slips.
d) He should ascertain whether cash receipts are deposited into the bank on the date on which
cash was received or not.
e) He should carefully examine the debtor’s account especially those accounts which show
part payments from time to time to satisfy himself that the debtors concerned have made only
part payments and not full payments.

3.4.4 Vouching of receipts from bills receivables

The receipts from bills receivable can be in two ways:

a) Receipts from bills discounted
b) Receipts from bills matured

Receipts from bills discounted

i) The vouching of receipts from bills discounted should be as follows:
ii) The amount of cash received from bills discounted should be checked by comparing the
bills discounted book with the cash book, pass book and the bills receivable book.

For Private circulation only

Page 69
iii) The auditor should see that proper records have been made in the books for discount on
bills discounted.
iv) The auditor must determine the contingent liability in respect of bills discounted.

Receipts from bills matured

i) The auditor should check the cash received from bill matured by comparing the bills
receivable book with the cash book and pass book.
ii) Special attention should be given to bills which are matured but remains unpaid. It might
have been dishonored or it is also possible that such bills might have been paid and the amount
received might have been misappropriated.

3.4.5 Receipts from sale of investments and buildings:

The vouching of receipts from the sale of investments should be on the following lines:

a) Investments are usually sold through brokers. Hence the contract notes which contain the
details about the actual amounts received from sale of investments and the commission paid to
the brokers should be examined to vouch the amounts received from the sale of investment.
b) The sale proceeds of the investments should also be checked with the related investment
accounts and also with the stock market quotation.
c) If the investment has been sold along with the dividend, the auditor should see that the
sale proceeds thereof are properly apportioned between capital receipt and revenue receipt (i.e the
dividend or interest which is included in the sale proceeds are separated and credited to the
dividend or interest account and the remaining sale proceeds are credited to investment account.)
d) If the investment has been sold ex-dividend, the auditor should see that the dividend is
received and recorded subsequently.
e) He should see that the profit or loss on the sale investment is properly adjusted.
f) The auditor should see that the sale of fixed assets has been properly sanctioned. Usually,
fixed assets are sold through a broker or an auctioneer. If the fixed assets are sold through brokers
the proceeds should be vouched with the help of sold notes. If it is sold through auctioneer, it
should be vouched with the help of auctioneers note.
g) He should also see that the proper fixed asset account has been credited with sale

For Private circulation only

Page 70
proceeds.
h) If there is any capital profit on the sale of fixed assets, he should see that it is credited to
the capital reserve account and not to P/L account.
i) In case certain prepaid expenses in respect of the fixed assets say prepaid insurance
premium are partly unutilized the auditor should check whether suitable adjustments are made in
the expenses accounts.

3.5 Vouching of cash payments

3.5.1 Vouching of cash purchases:

The vouching of cash purchases should be on the following lines:

1) The auditor should examine the entries in the cash book with the help of cash memos,
invoices issued by the supplier and also the goods inward book. This helps in examining the
genuineness of the cash purchases.
2) Special attention should be paid to trade discount which should be deducted from the
purchases. He should see that only net amount is recorded in the books of accounts.
3) If any voucher is missing he should insist upon getting a duplicate copy of it. He should
vouch such an item also with any other possible documentary evidence.
4) He should see that the goods paid for have actually been received.
5) He should see that the purchases are duly authorized.
6) He should see that the amount paid is debited in the appropriate account.

3.5.2 Payments to creditors:

The vouching of payments to creditors should be on the following lines:

1) Payments to creditors may be vouched with the receipts issued by the creditors.

For Private circulation only

Page 71
2) He should check the amounts due to the creditors with the accounts of the creditors and
the goods received with the voices.
3) Entries in the goods inward book or stock ledger should also be verified to see whether
the goods have actually been received.
4) To ascertain whether the payments made to the suppliers relates to the business, the
auditor should examine the original invoices to find out whether the goods were purchased for
business or for personal use.
5) He should see that vouchers have references of bills against which payments are made.
6) He should verify the periodical statements of accounts.
7) If the creditors are paid in advance for supplies made in future, it should be differentiated
from the payments for actual purchases.
8) Care should be taken to ensure that there is no double payment against the same supply.

3.5.3 Vouching of bills payable:

Bills payable honored on maturity should be vouched on the following lines:

The payments of bills payable as recorded in the cash book should be vouched with the bills
payable book and also with the bills payable returned by the payees.
If it is paid through bank, he should examine the bank pass book for the payment. He
should see that the bills payable paid and returned by the payees are cancelled.

3.5.4 Vouching of payment for purchase of fixed assets:

1. The auditor should see that the payment of capital expenditure is properly authorized.
2. He should examine the documents pertaining to the purchases and the ownership of the
fixed assets.
3. He should also get the documents examined by the solicitor.
4. He should examine the invoices and the receipts obtained from the suppliers of the fixed
assets to ensure that the payments have been made.
5. He should vouch the payment of these expenses with the help of the receipts given by the
payees.

For Private circulation only

Page 72
3.6 Vouching of Deferred revenue expenditure:

According to Arnold Thomson deferred revenue expenditure is a “Non-recurring expenditures

which are expected to be of financial benefit to several accounting period of indeterminate total
length.”

Example: preliminary expenses incurred at the time of the formation, research expenditure, cost of
issue of shares and debentures, underwriting commission, brokerage on the issue of shares and
debentures etc.

3.6.1 Auditor’s duty with regard to deferred revenue expenditure:

1. He should understand himself with the nature of the business so that he can take right
decision regarding the treatment of revenue expenditure.
2. He should see that only exceptional revenue expenditures are treated as deferred revenue
expenditures and normal revenue expenditures are not treated as deferred revenue expenditures
to inflate the profits of the business.
3. He should discuss with the clients and understand clearly the policies of the client in
respect of writing off (amortization) of the deferred revenue expenditure.
4. He should verify whether the amount of deferred revenue expenditure written off and
charged to the profit and loss account is reasonable.
5. He should verify that the amount unwritten off portion of the deferred revenue
expenditure is correct. It should be shown on the asset side of the balance sheet until it is
completely written off.

3.6.2 Vouching of preliminary expenses:

Preliminary expenses are also called as promotional expenses, floatation expenses. They are the
expenses which are incidental to the creation or floatation of a company.

Example: cost of printing memorandum of association, articles of association, legal expenses

For Private circulation only

Page 73
incurred in drafting the memorandum, stamp duty, registration fee, cost of company’s seal etc.

Duties of an auditor with regard to preliminary expenses:

1. The auditor should see that only the expenses connected with the creation or floatation of
the company have been included in preliminary expenses.
2. When the prospectus is issued, the auditor should see that the amount of preliminary
expenses has not exceeded the amount stated in the prospectus.
3. The auditor should see that the preliminary expenses are not entirely debited to profit and
loss account of the first year, but are spread over a period of three, five or seven years.

3.6.3 Vouching of cost of issue of shares and debentures:

Cost of issue of shares and debentures refers to the expenses incurred on the issue of shares and
debentures and the discount allowed on the issue of shares and debentures.

Auditor’s duty in regard to audit of cost of issue of shares and debentures:

1. He should see that the provisions of the Companies Act of 1956 in regard to cost of issue
of shares and debentures are fulfilled.
2. The auditor should advise the management of the company to write off the cost of issue
shares and debentures as early as possible.
3. He should see that the cost of issue of shares and debentures written off is debited to profit
and loss account and the amount not written off is shown separately on the assets side of the
balance sheet under the head miscellaneous expenditures and losses.

3.6.4 Vouching of underwriting commission:

Underwriting commission is the commission payable to a person called an underwriter who agrees
to take up all or certain number of shares issued by the company.

Auditor’s duty in regard to underwriting commission:

1. The auditor should examine the articles of association of the company and ascertain
whether the payment of underwriting commission is authorized or not.

For Private circulation only

Page 74
2. He should ascertain whether the provision of section 76 of the Companies Act, 1956 has
been fulfilled.
3. He should see that the rate of underwriting commission does not exceed the prescribed
limit.
4. He should ensure that the underwriting commission has been separately shown in
the balance sheet under the head “miscellaneous expenditure” until it is written off.
5. If the shares are issued to the underwriters in their commission, the auditor should see
that such a contract has been filed with the registrar of the companies.

3.7 General and Specific Duty of Auditor with Regards to Vouching

1. Check whether the vouchers are printed, numbered and arranged in the order of the date of
occurrence of transactions.

2. The entries in the books of accounts should also be numbered and the number and date
should correlate with the concerned voucher.

3. The name of the person with whom the transaction is carried out, the details of the
transaction and the amount involved should be clearly stated in the voucher.

4. All payments should be supported by a stamped voucher.

5. The transactions should be clearly classified into revenue or capital transactions and
accordingly entered in the books of accounts.

6. The vouchers should bear the signature of the authorizing officer.

7. The transaction should relate only to the business aspects of the organization and
transactions of personal nature should not be recorded.

For Private circulation only

Page 75
8. Some transactions may be entered twice or some voucher may be used as an evidence for two
different transactions entered in the books of accounts. So, the auditor should stamp the vouchers
already verified by him to avoid such frauds.
9. Wherever necessary, the supporting documents are to be attached with the vouchers, so that
the transaction can be verified in depth. If the supporting evidences are not available, the auditors
may ask for more information and explanation concerning such transactions.

10. The auditor should verify that the prepaid and outstanding amounts are duly accounted for
the period to which such transactions relate.

11. After completing the vouching, the auditor may make a separate note of explanation
sought in support of the transactions. He shall also make out a list of missing vouchers.

12. An auditor should ensure that the alterations made in the vouchers are duly authorized.

13. While vouching, the auditors should use different types of “tick marks” which may be
helpful for them for their future reference. Each mark made by them conveys different meanings
which could be useful to them for future reference.

14. Vouching should be continuous and vouching for a specified period and for a specified
nature of transactions should be done at a stretch and completed at one go which may reduce the
chances of errors and frauds.

3.8 Summary

 Hence it can be summarized that an auditor is required to certify the transactions

recorded. Vouching is not just routine checking it checks the validity, authenticity and accuracy of
the entries.

 For vouching the transaction, vouchers are very much essential because it acts as
documentary evidence. There are 2 types of vouchers:- Primary and Secondary.

For Private circulation only

Page 76
 Vouching is carried on for the receipts or the debit side of the cash book regarding cash
sales, receipts, from debtors, sale of investments and buildings etc.

 It is carried on even for the cash payments regarding cash purchases, bills payable,
purchases of fixed assets, deferred revenue expenditure etc.

3.9 Case Study

ARMITAGE VERSUS BREWER AND KNOTT (1932)

Facts of the Case: The Company had only one chief clerk Miss. Harwood, who was in charge of
all books, vouchers, wages and other documents. By misusing her position, she had embezzled
large sums of money by misappropriating petty cash and manipulating wage sheets. Company
had appointed auditors to conduct continuous and detailed audit of the books. They were charged
of negligence by the company because they had failed to exercise reasonable care and skill in
examining wages sheets. They did not conduct detailed audit. Auditors tried to defend themselves
by pleading that the frauds could not have been detected by the exercise of reasonable care and
skill. But the court rejected the defense of the auditors and held them liable for the damages
caused to the company due to the embezzlement of money by Miss Harwood because it was
thought that had the auditors carried a detailed checking of the accounts and books, the work
for which they were employed, they would have surely detected the fraud. There was an
undertaking on the part of the auditors to audit the books fairly, completely and the circumstances
of the fraud were such that the auditor should have been put upon enquiry.

In the course of his judgment, the judge observed: “The documents at the beginning set out that
the defendants would vouch all payments with receipts in petty cash, check calculations of all
wage sheets, check totals of wage sheets into wages book and check weekly totals with other
detailed provisions, and accountants undertaking duties of that kind could not be heard to excuse
themselves on the ground that this or that was a small matter, the undertook rigorous check, and
they did so because that was what the client wanted.

For Private circulation only

Page 77
Case Study 2

You are an audit manager at RMT & Co. and you are considering a number of ethical issues
which have arisen on some of the firm’s long-standing audit clients. ABC Ltd. RMT & Co. is
planning its external audit of ABC Ltd. Yesterday, the audit engagement partner, Ramesh,
discovered that a significant fee for information security services, which were provided to ABC
Ltd. by RMT & Co., is overdue. Mr. Ramesh hopes to be able to resolve the dispute amicably
and has confirmed that he will discuss the matter with the finance director, Mr. Keshav, at the
weekend, as they are both attending a party to celebrate the engagement of Ramesh’s daughter
and Keshav’s son. XYZ (P) Ltd. RMT & Co. is the external auditor of XYZ (P) Ltd. and also
provides other non-audit services to the company. While performing the audit for the current
year, the audit engagement partner was taken ill and took an indefinite leave of absence from the
firm. The ethics partner has identified the following potential replacements and is keen that
independence is maintained to the highest level: u Mr. Pankaj Garg who is also the partner in
charge of the tax services provided to XYZ (P) Ltd. u Mr. Mohit Taneja who was the audit
engagement partner for the preceding five years. u Mr. Chetanya Garg who introduced XYZ (P)
Ltd. as a client when he joined the firm as an audit partner five years ago. u Mr. Nikunj Garg who
is also the partner in charge of the payroll services provided to XYZ (P) Ltd. MN Ltd. MN Ltd. is
a large public company, and has been an audit client of RMT & Co. for several years. Aadish
Jain, a partner of RMT & Co., has acted as the engagement quality control reviewer (EQCR) on
the last two audits. At a recent meeting, he advised that he can no longer be EQCR on the
engagement as he is considering accepting appointment as a non-executive director and will sit
on the audit committee of MN Ltd. The board of directors has also asked RMT & Co. if they
would be able to provide internal audit services to the company. PQR Ltd. PQR Ltd., a listed
company, is one of RMT & Co.’s largest clients. Last year the fee for audit and other services
was ` 1.2 Cr. and this year it is expected to be ` 1.5 Cr. which represents 18% and 19.6% of RMT
& Co.’s total income respectively.

Q1. Which of the following statements correctly explains the possible threats to RMT & Co.’s
independence and recommends an appropriate safeguard in relation to their audit of ABC Ltd.?
(1) An intimidation threat exists due to the overdue fee and ABC Ltd. should be advised that all
For Private circulation only
Page 78
fees must be paid prior to the auditor’s report being signed. (2) A self-review threat exists due to
the nature of the non-audit work which has been performed and an engagement quality control
review should be carried out. (3) A self-interest threat exists due to the relationship between
Ramesh and Keshav and Ramesh should be removed as audit partner.
(a) 1, 2 and 3
(b) 1 and 2 only
(c) 2 only
(d) 3 only

Q2. Taking into account the concern of the ethics partner, which of the partners identified as
potential replacements should take over the audit of XYZ (P) Ltd. for the current year?
(a) Mr. Pankaj Garg
(b) Mr. Mohit Taneja
(c) Mr. Chetanya Garg
(d) Mr. Nikunj Garg
Q3. Which of the following correctly identifies the threats to RMT & Co.’s independence and
proposes an appropriate course of action for the firm if Aadish Jain accepts appointment as a
non-executive director of MN Ltd.?
Threats Course of action
(a) Self-interest and familiarity Can continue with
appropriate safeguards
(b) Self-interest and self-review Must resign as auditor
© Self-review and familiarity Must resign as auditor
(d) Familiarity only Can continue with
appropriate safeguards
Q4. You are separately considering MN Ltd.’s request to provide internal audit services and
the remit of these services if they are accepted. Which of the following would result in RMT & Co.
assuming a management responsibility in relation to the internal audit services? (1) Taking
responsibility for designing and maintaining internal control systems. (2) Determining which
recommendations should take priority and be implemented. (3) Determining the reliance which can
be placed on the work of internal audit for the external audit. (4) Setting the scope of the
internal audit work to be carried out.
For Private circulation only
Page 79
(a) 1 and 3
(b) 2, 3 and 4
(c) 1, 2 and 4
(d) 3 and 4 only

Q5. Which of the following actions should RMT & Co. take to maintain their objectivity in relation
to the level of fee income from PQR Ltd.? (1) The level of fee income should be communicated to
those charged with governance (2) Separate teams should be used for the audit and non-audit work
(3) Request payment of the current year’s audit fee in advance of any work being performed (4)
Request a pre-issuance review be conducted by an external accountant
(a) 1 and 4 only
(b) 3 and 4 only
(c) 2 and 3 only
(d) 1, 2, 3 and 4

3.10 Unit End Exercises

Fill in the Blanks:
1. Routine checking is the checking of arithmetical accuracy of the entries in .................. ,
………. and ……….. .
2. is the documentary evidence of transaction.
3. Vouching of.......... is more difficult than vouching of cash payments.

Section A (2 Marks Questions)

1. Explain a voucher?
2. Define vouching.
3. Explain deferred revenue expenditure?
4. Explain the types of entries the auditor should check while vouching a journal
proper?

Section B (5 Marks Questions)

1. Briefly explain the duties of an auditor while vouching the transactions of sales book?
2. Write a note on vouching bought ledger.

For Private circulation only

Page 80
3. Explain the duties of an auditor while vouching the deferred revenue expenditure?
4. Discuss measures can an auditor take while detecting the fraud occurred due to teeming
and lading?

Section C (15 Marks Questions)

1. Vouching has been described as ‘the essence of auditing’. Amplify this statement.
2. As an auditor how would you vouch the receipts on sale of investment and buildings?

For Private circulation only

Page 81
Module 4

VERIFICATION AND VALUATION OF ASSETS AND LIABLITIES

Structure:

4.1 Meaning
4.2 Objectives of verification of assets and liabilities
4.3 Position of an auditor as regards to the valuation of assets
4.4 Verification and valuation of assets
4.5 Verification and valuation of liabilities
4.6 Outstanding Expenses
4.7 Differentiate between Verification and Valuation
4.8 Summary
4.9 Case study
4.10 Unit End Exercise

4.1 Meaning of Verification of Assets and Liabilities:

Verification means the procedures normally carried out at the year end, to confirm the
ownership, valuation and existence of items as per the balance sheet on that date. It also involves
confirming that the presentation in the financial statements is in accordance with legislations.

It means establishing the actual existence of the assets and liabilities appearing in the balance
sheet, ownership and possession of the assets, and proper classification and valuation of the
assets and liabilities. In simple words verification means ‘proving the truth’ or ‘confirmation’.

4.2 Objectives of verification of assets and liabilities:

The important objectives of verification of assets and liabilities are:
i) To find out whether the assets and liabilities shown in the balance sheet actually exist.
ii) To ascertain whether the assets and liabilities appearing in the balance sheet are
shown at their correct values.
iii) To ascertain whether the balance sheet gives a true and fair view of the financial
For Private circulation only
Page 82
position of the business.
iv) To confirm the possession and ownership of the assets appearing in the balance sheet.
v) To find out whether there is proper classification of assets and liabilities.
vi) To check the arithmetical accuracy of the books of accounts.
vii) To detect errors and frauds, if any, in the books of accounts.

4.3 Position of an auditor as regards to the valuation of assets.

As mentioned earlier, it is not part of the auditor’s duty to determine the values of various assets.
He is not liable, if in the absence of suspicious circumstances, he relies on the certificates issued
from trusted officials of the company or the partners. He is not a valuer and cannot be expected
to act as such. It has been judicially held that he is not a valuer or a technical man to estimate the
value of an asset. But the question arises – does it imply that he will be free from his liability if
assets are incorrectly valued by the senior officials of the management or partners as it suits
them, in view of the fact that the correctness of the balance sheet depends very largely upon a
proper valuation of assets.

The answer is obviously ‘no’. He is definitely concerned with values set against the assets. He has
to certify that the profit and loss account for the year shows a clear picture of the profit and loss
and the balance sheet shows a similar view of the state of affairs of the company as at the close of
the year. He should, therefore, exercise reasonable care and skill, analyze all the figures critically,
enquire into the basis of valuation from the technical experts. He should satisfy himself that the
different classes of assets have been valued in accordance with the generally accepted
conventions and bases of accounting which are determined by law and professional
pronouncements made from time to time. He will have to take all the necessary precautions while
accepting valuation where several assets have been purchased for a consolidated price, and
examine the method by which the consideration has been purchased appropriated among the
method by which the consideration has been appropriated among the various assets.

In case the expert and technical opinion has been obtained for this purpose, the same should be
examined whether expert advice is reasonable and based on factual position. If there is any
change in the mode of the valuation of an asset, he should seek proper explanation for it. He
should, therefore, take all the necessary steps to find out the proper valuation and not rely on the
For Private circulation only
Page 83
values even though they have been certified by trusted officers.

4.4 Verification and Valuation of Assets

Assets – Meaning:
Verification of assets is a process by which the auditor satisfies himself, by actual inspection or by
examination of documentary evidences, as to the existence, ownership and valuation of the
various assets appearing in the balance sheet.

For the purpose of convenience we may divide the assets into the following four categories:
i) Fixed assets, viz., land and building, plant and machinery, furniture and fixtures, motor
vehicles etc.
ii) Intangible assets, viz., goodwill, patents, trademarks, copyright, etc.
iii) Floating assets, viz., and cash in hand, and at bank, bills receivable, stock in trade,
sundry debtors, investment, etc.
iv) Fictitious assets, viz., preliminary expenses, discount on issue of shares or
debentures, etc.

4.4.1 Plant and Machinery

The valuer should obtain a schedule of plant and machinery certified by responsible official. It
gives details about each machinery. He should compare the schedule with the plant register. If
machinery is acquired under hire purchase he should verify the hire purchase agreement. If the
machinery is imported he should verify the export license copy of invoice, permission of RBI
from foreign exchange payment.

Plant and Machinery is valued at cost less depreciation. Depreciation rate is decided by the
management. The only duty of the auditor here is to see whether depreciation is charged as per
the provision of the IT Act.

4.4.2 Land and Building

For verifying land and building the auditor should differentiate between free hold and lease hold
For Private circulation only
Page 84
properties.
a) Free hold land and building: In this case, the auditor should verify with the title deeds to
ensure that the property is in the name of the client.
He should check the other documents like the life encumbrance certificate etc to see whether the
property is free of any charge. If it is mortgaged he should verify the mortgage deed. As long as
the title deeds are in order the auditor can’t be held liable for frauds. However, the auditor should
obtain a certificate from the client’s legal advisor confirming the validity of ownership.

Land is valued at cost price which includes purchase, price, commission pay registration and legal
charges, etc. it should be remembered that the land is not depreciable assets.
On the other hand building is always valued at cost less depreciation. It should be remembered
that is to be charged even if the building is not used during the year.

In case of building under construction valuation is made based upon the architect certificate.

b) Lease Hold Property: In case if the property is held in lease he should verify the lease
agreement and see whether it is registered or not it is valued at cost less depreciation.

4.4.3 Furniture and Fixtures

Furniture is a movable asset whereas fixtures become a part of another asset. It any addition is
made during the year, he should verify the invoice and pass book. He should also verify the
schedule of furniture and see whether they are properly numbered and proper accounts are
maintained.

Repairs to furniture should be treated as revenue expenditure and hence debited to P&L a/c.
furniture is always valued at cost less depreciation at a reasonable rate. He should verify the
method of depreciation. The amount of depreciation varies with the usage.
Example: Furniture used in Canteen requires more depreciation than furniture used in office.
Hence the auditor must verify carefully to satisfy himself about the adequacy of depreciation.

4.4.4 Goodwill
Goodwill is the value of reputation of the firm. It enables the firm to earn more than the normal
For Private circulation only
Page 85
rate of profit. It is the reputation of a business valued in terms of money. Goodwill is an
intangible asset. That is, it has no physical existence or form. The value of goodwill depends
upon the earning capacity of the business. It increases with rise in profit and decrease with fall in
profit. That means, goodwill cannot have a permanent value.

Goodwill should appear as an asset in the balance sheet only when:

(a) It has been purchased. Where the price of goodwill has not been specifically fixed, it is
determined as the difference between the total purchase price paid less than the assets acquired at
their valuation, or
(b) The company has revalued whole of its assets and raised a goodwill account in the books,
or
(c) In the case of partnership, when a new partner is admitted or an old partner retires or dies,
it becomes necessary to bring goodwill or revalue it (if it is existing) in the books of accounts, or
(d) When the company has succeeded in establishing a special reputation in the market
because of its increasing sales and profits.

Verification:Where goodwill has been purchased along with a running business, the same should
be verified from the agreement with the vendor showing the price paid for it. But when the
amount is not specially fixed, goodwill is the amount paid for the purchase of the business over
the net assets taken over.

In the case of partnership firm, the partnership deed should be duly verified by the auditor. He
may also verify the changes made in the goodwill account from time to time on the basis of
provisions made in the partnership deed.

Valuation: Goodwill should be valued at cost less amount written off. It is no part of an auditor’s
duty to comment upon the price paid for goodwill even though he considers it to be excessive.
The auditor must satisfy himself that the future benefits associated with goodwill do exist to
justify the continuation of goodwill account. An auditor cannot insist on writing off the goodwill
account, but if it appears to him that the future benefit is non- existent, he should insist on the
account being written off.

4.4.5 Patents
For Private circulation only
Page 86
Patents refer to the sole right vested with a party over a designer or production formula. A patent
right has 20 years of life unless the term is extended

Patent can also be defined as an official document, which secures to an investor exclusive right
for a year to make, use or sell his invention.

Patents rights can be acquired in two ways, viz.,

i) By research and development., and
ii) By purchase from somebody else.

Verification:If the number of patent is large, auditor can ask his client to prepare a list with full
details mentioning therein dates of acquiring such patents, registered number and the unexpired
period. Auditor should be careful in checking that none of the patent right has lapsed. Lapsed
patents should be written off. Auditor should also examine the last renewal fee payment
certificate to satisfy himself that patents have been renewed at the prescribed time. The original
fee paid to purchase the patent right should be capitalized and should be

debited to patent account while the subsequent renewal fee should be treated as a revenue
expenditure.

Valuation: Patents must be valued at cost less depreciation. There may be three causes of
depreciation, viz., (a) laps of time, (b) obsolescence and (c) the patented article going off fashion.

The patents should be written off in a period of sixteen years after which the right automatically
lapses unless the terms extended. Where patents have been obtained in the name of some
employee of the firm, auditor must see that it is properly assigned in favor of firm.

4.4.6 Copyrights
Copyright is a legal right created by the law of a country, which grants the creator of original work
exclusive rights to its use and distribution, usually for a limited time, with the intention of enabling
the creator to receive compensation for their intellectual effort.

For Private circulation only

Page 87
Copyright is a form of intellectual property (as patents, trademarks and trade secrets are),
applicable to any expressible form of an idea or information that is substantive and discrete. It is
often shared, then percentage holders are commonly called rights holders: legally, contractually
and in associated "rights" business function. Generally rights holders have "the right to copy", but
also the right to be credited for the work, to determine who may adapt the work to other forms,
who may perform the work, who may financially benefit from it, and other related rights.

Verification:In verifying the copyright, the auditor should inspect the agreement between the
author and the publisher. If there are many copyrights with the business of the client, the auditor
should ask for a schedule thereof from the client and verify them from the schedules.

Valuation: Copyright valuation requires an in-depth understanding of the particular industry in

which the copyright operates. Copyright valuation is something Intangible Business has carried
out for a number of different properties including books, films, plays, TV, music, characters,
images and musicals.

copyright. This future copyright value is then discounted using the discounted cash flow
methodology (DCF) to arrive at the present value of those cash flows. Each type of copyright
has key sensitivities to consider such as the duration of the copyright and the expected
lifetime of its creator. Another key consideration during copyright valuation is what drives
the value of the copyright. For instance, a living musician generally supports their back
catalogue of recordings through personal appearances and new releases, buoying their
copyright valuation. After their death, or after the musician stops recording, their
copyright value may diminish more rapidly than expected as the support is no longer there.

Steps in Valuation

1. The auditor should see the value of copyright is determined on proper basisincluding the
period of copyrights.
2. It should be ensured that if any copyright does not command sale of any books, the same
should be written off in that year.
3. It should be confirmed that the legal life of copyright has not expired.
For Private circulation only
Page 88
4. The auditor should see that the copyright having no commercial value has been
completely written off.

4.4.7 Stocks
Examination of the values assigned to stock is of considerable importance and this should be
cautiously done by the auditor. He should enquire into the basis of its valuation and see that a
particular mode of valuation has been uniformly followed from year to year to arrive at correct
amount of net profit or loss every year. Any change in the basis of valuation adopted should be
duly enquired into and should be indicated in the balance sheets. He should apply all the
reasonable tests to check the stock sheets. What is reasonable would depend upon the nature of
business and records maintained in the concern.

The recognized and accepted slogan with regard to the valuation of the stock is “cost or market
price, whichever is lower.” The term cost or market values have been used differently in different
concerns.

The generally accepted principles of valuation of stock have, however, to be modified in case of
the following kinds of goods in stock according to their nature. With whatever implication we use
the terms, there are two methods of its valuation, namely, pick and choose method, and the
global method.
a) The pick and choose method: it is also known as the individual method. This method
implies that we deal with each item of stock separately and find out the cost or market price,
whichever is lower, of each item. Some writers feel that it results into ultra conservation.
b) Global method: under this method, each item of the stock is not taken onto account
separately. The aggregate cost price of all the articles and their aggregate market price is
calculated. Then the entire inventory is valued at the price which is lesser of the two.

Raw materials:The raw materials constitute the original materials purchased with a view to
manufacture the goods. They should be valued at the price ignoring the market price. The cost
would, for this purpose, mean the invoice price plus freights, duty etc., incurred in bringing the
material to the factory. In case there is expectation of heavy fall in the market price of the raw
materials, their net realizable value in the form of finished product should be taken into account
For Private circulation only
Page 89
for their valuation.

Process or semi-finished goods:Those goods which are in the process of being converted into
finished goods or partly manufactured goods are valued at cost. Market value should not be taken
into account in this case also. To verify the cost, the auditor should be familiar with the cost
system in operation. In case there is no cost system in use, it will be difficult to obtain
approximately correct costs. The auditor must verify the standard cost of process goods and be
certain that the items constituting factory overheads do not include selling,

administrative and financial costs, but include all factory cost in addition to direct material and
direct labour. The repair jobs and manufacture of fixed assets should also not be included. It will
be advisable not to take any profit into account in this case.

Finished goods: If finished goods are purchased, they are valued at cost price as in the case of
raw material. But if they are manufactured by concern, they should be valued at cost or market
price whichever is lower. Of course, anticipated profits not are taken into account. They may be
valued at contract rates in case the goods have been sold under forward contracts but not
delivered till the date of the balance sheet.

4.4.8 Investment
Investments include government securities, shares, and debenture. Etc. where the number of
investment is considerable, the auditor should ask for a schedule of investments held by the
client. Such a schedule of investments should include information about
(a) Name of the securities;
(b) Date of their purchase;
(c) Nominal value;
(d) Cost price;
(e) Market price at the date of the balance sheet etc.

Verification: The auditor should verify the details of the schedule of investments by applying for
checking tests, e.g., financial journals and newspapers should be consulted for checking market
rates. The securities themselves may be consulted or the broker’s notes may be examined for

For Private circulation only

Page 90
checking the cost etc.

The auditor should verify the amount of interest or dividend accrued on investments. The auditor
should verify the existence of investments by his personal inspection. If the securities have been
entrusted to the bank for safe custody, the auditor should obtain a certificate from the bank giving
details about all such securities so kept.

Valuation:If investments are to be held as a fixed asset for the purpose of earning
interest/dividend, these are to be valued at a cost which includes brokerage and stamp duty paid in
regard thereto.
But if the investments are to be held as current assets, these should be valued at cost or
market price whichever, is lesser.

4.4.9 Debtors
Verification of book debts is conducted with certain objectives. They are:
(a) To establish their accuracy
(b) To establish their validity as claims.
(c) To establish their collectability and to determine their realizable value.
(d) To ensure their fair disclosure in the financial statements in accordance with legal
provisions.

While conducting the verification of sundry debtors or book debts, an auditor should undertake
the following steps:

1) He should obtain and examine the schedule of debtors, duly signed by some responsible
official of the business, containing the names and the amounts due from the debtors.
2) The schedule of balances of debtors should be checked with the sales ledger or debtors’
ledger balances by test checking.
3) The sales ledger balances should be checked with the sales book, sales returns book, cash book,
etc.
4) He should see that the book debts balance do not include the amounts due in respect of goods
out on sale or return basis, or goods sent on consignment basis.

For Private circulation only

Page 91
5) He should see that the book debts shown in the balance sheet are and at their realizable
values.
6) He should obtain from a responsible official of the business a certified statement of book
debts, clearly distinguishing between good debts, secured debts, unsecured debts, current debts,
bad and doubtful debts, outstanding for a period exceeding six months and other debts.
7) If there are doubtful debts, the auditor should see that adequate provision is made against them.
In case the provision made for doubtful debts is inadequate, the auditor should bring the
inadequacy of the provision to the knowledge of the owners of the business.

4.4.10 Bills Receivable

Bills receivable denote a broad category of formal documents of indebtedness including
promissory notes and acceptance receivable.

Verification:
To verify the bills receivable, an auditor should undertake the following steps:
1) He should examine each bill in hand to ensure that it is properly drawn, sufficiently
stamped and duly accepted (i.e., signed) by the acceptor.
2) He should verify the bills receivable given in the balance sheet by obtaining a certified
schedule of bills in hand.
3) The schedule of bills in hand should be compared with the bills receivable book and the bills
receivable account.
4) He should see that overdue bills are not included in the bills in hand.
5) Bills discounted after the date of balance sheet should be examined by referring to the cash
book and pass book.
6) He should see that bills dishonored before the date of the balance sheet, and not renewed, are
not included in the bills in hand.
7) He should see that bills discounted or endorsed, but not yet met are treated as contingent
liability and are indicated by way of foot note in the balance sheet.
8) He should see whether provisions are made for contingent liability on bills discounted or
endorsed. He should also see that proper provision is made for doubtful bills in hand.
9) If any bills have been retired before the date of the balance sheet, the proceeds of such bills

For Private circulation only

Page 92
should be checked by reference to the cash book.
10) In case of renewal of any bill, the auditor should check the new bill with the old bill, where
a part of the original bill has been received; the auditor should check the cash received and
ensure that a new bill for the balance amount has been obtained.

4.4.11 Cash in Hand and Cash at Bank

Verification: the auditor should verify the cash-in-hand by actually counting it on the date of the
balance sheet. A fundamental aspect of the verification of cash-in-hand is the time, i.e., when it
should be verified. The verification should be made at the close of the business or on the date of
the balance sheet. The auditor should insist upon the presence of a cashier to witness the
counting. It is quite necessary so that the auditor may not be blamed for the shortage of the cash,
if any.

In case there is unusually heavy cash balance at the end of the year, the auditor must draw the
attention of the management to the dangers which may arise there from such heavy balance. He
should also check the system of making payments and safety arrangements provided for the
protection of cash-in-hand.

As far as the cash-in-transit is concerned, the auditor should verify this with the help of proper
documentary evidences and correspondence.

Cash at Bank
In verifying the bank-balance, the auditor should take the following steps:
a) Comparison of the balances as shown in the cash book and the pass book.
b) Preparation of bank reconciliation statement.
c) Obtaining a letter of confirmation from the bank.
d) Separate certificates for different accounts should be obtained.
e) In case there are accounts with more than one bank, the auditor should verify them
individually.

4.5 Verification and valuation of Liabilities

Liabilities - Meaning:
Verification of liabilities is the process by which the auditor satisfies himself that all the

For Private circulation only

Page 93
liabilities of the business are included in the balance sheet, that there are no fictitious liabilities
included in the balance sheet, that the amounts of the liabilities are correctly determined in
accordance with the principles of accountancy and that they are properly classified and disclosed.

4.5.1 Capital:
It is not a liability in the strict sense of the word. Nevertheless, it is a liability popularly known as
internal liability. The auditor is required to verify it so as to certify the correctness of the balance
sheet.

In case of a firm, the auditor should verify the liability on account of capital with the help of
partnership deed, cash book and pass book. He should see that it has been properly recorded in the
books of account.

If it is the first audit of the company, the auditor should examine Memorandum of Association and
the Article of Association of the Company. He should examine the Cash book, pass book,

and minute book of the board of directors to find out the number and different classes of shares
issued, the amount received on each share and the balance due from the memorandum and
articles of association, and minute’s book of the board of directors should be examined. The
auditor should see that the issue of capital is according to the memorandum and articles of
association. If any shares have been issued to the vendors the contract between the vendors and
the company should be examined.

If it is not the first year of the life of a company, there will be no difficulty as the figures
regarding capital will be the same as they were during the previous year unless more capital has
been issued during the course of the current year. He should see that the provisions in Schedule
VI of part I of the Companies Act 1956 are complied with in disclosing the share capital.

4.5.2 Debentures
For the verification of debentures issued by a company, an auditor should take the following steps:
1) He should examine the memorandum of association and the article of association of the
company to ascertain the powers of the company to issue debentures and to see that the

For Private circulation only

Page 94
borrowing limit is not exceeded.
2) He should examine the debentures trust deed to verify the amount of debentures issued
and the securities offered.
3) He should also examine the debentures account to verify the debentures issued.
4) If necessary, he can obtain a certificate from the debenture holders to verify the amount of
debentures issued.
5) He should also examine the debenture bonds, register of charges and the register of
debenture holders to see that the debentures shown in the balance sheet agree with the debentures
recorded in the books of account.
6) In case the debentures are issued at a premium, or at a discount, the auditor should see that
the debenture premium and the discount on issued of debentures are properly dealt with in the
books of account.
7) He should see that the discount on issue of debentures or the loss on the issue of
debentures, if any, is written off as early as possible.
8) Since debentures are required to be redeemed after some time, the auditor should verify
the arrangements made by the company for the redemption of the debentures.
9) If any profit is made on the redemption of debentures, the auditor should verify whether it
is treated as capital profit.

4.5.3 Sundry Creditors or Trade Creditors:

While verifying the sundry creditors or trade creditors, an auditor should bear in mind the
following points:
1. The first task of the auditor is to ask for a schedule of the creditors. The schedule should be
checked with the balances of ledger accounts and statements of account received fromcreditors.
2. The purchase ledger should be checked with books of original entry, invoices, credit notes etc.

3. If the client maintains provision in respect of discount on creditors he should check the
same with reference to the creditor’s accounts.
4. He should see that all purchases during the year have been taken account of. Special care
should be exercised with regard to the purchases made at the close of the year.
5. Where goods have been purchased on hire-purchase basis he should see that the
conditions of the agreement are properly complied with.

For Private circulation only

Page 95
6. He should pay special attention to the entries made either in the beginning or at the end of the
year to check fictitious entries in this respect being passed by the employees of the undertaking.
7. If any debt is found unpaid for a long time, an enquiry should be made since it is possible that
instead of paying to the creditor, the amount might have been misappropriated.

4.5.4 Bills Payable:

These are acknowledgements of debts payable. Auditor should take following steps to verify this
liability:
1. The auditor should obtain a list of outstanding obligations on account of bills payable. This
should be checked with the bills payable book and bills payable account and any variation between
the two should be properly reconciled.
2. With the permission of his client, the auditor should obtain confirmatory statements from the
drawers directly.
3. The bills paid after the balance sheet date should be verified with the entries passed in the
cash book.
4. He should ensure that the bills which have been paid are not recorded as outstanding
expenses.

4.6 Outstanding Expenses:

While verifying the liabilities for outstanding expenses, the auditor should bear in mind the
following points:
1. He should verify whether all the outstanding expenses are brought into account by obtaining
a statement of outstanding expenses certified by a responsible official.
2. He can also verify the items of expenses, such as salaries, wages, rent etc., which, usually,
remain outstanding.
3. He should also compare the outstanding expenses of the current year with those of the
previous year to see whether there is any material difference.
4. He should see that all the outstanding expenses have been subsequently paid.
5. He should see that the outstanding liabilities for expenses are clearly shown in the balance sheet.

For Private circulation only

Page 96
4.6.1 Tax Liability:
Determination of the client’s tax liability and its properdisclosure in the balance sheet is an
important duty of an auditor. To discharge this duty efficiently, an auditor is required to
familiarize himself with relevant tax laws. In case of any doubt, he can seek expert opinion.

The auditor’s duties in regard to the verification of tax liability are:

1. He should determine the estimated tax liability of the client.

2. He should see that the provision made for taxation is sufficient to meet the estimated tax
liability.
3. He should also see that the provision made for tax liability is shown in the balance sheet.

4.6.2 Contingent Liabilities:

Contingent liabilities are a liability is a liability which may or may not arise.

Auditor’s duty:The auditor should inspect the various contracts entered into by the company and
assess the likelihood of contingent liability arising there from. His duty is to ensure that all such
likely liabilities have been accounted for and show in the balance sheet. He should also obtain a
certificate from the management to the effect that all contingent liabilities, which are
apprehended to materialize at a future date, have been duly disclosed.

4.7 Differentiate between Verification and Valuation

Verification
Meaning: It means ascertaining the accuracy of the assets and liabilities appearing in the
Balance Sheet by documentary evidence and physical examination.
Objects: It is done with the object of proving the existence, ownership, possession,
freedom from charge and proper valuation.
Scope: It is wider in scope. It also includes valuation.
Responsibility: Verification is done by the auditor or his staff.
Nature: Verification is objective. It is based on the documentary evidence and physical

For Private circulation only

Page 97
examination.
Liability: The-auditor himself does the work of verification. It does not rely on the
certificates provided by others.

Valuation.
Meaning: It means testing the accuracy of the valuation of the assets and the liabilities
according to the accepted accounting principles.
Objects: It is done to ensure that the balance sheet shows a true and fair view of the
financial position of the organization.
Scope: Its scope is limited.
Responsibility: Valuation is done by the clients staff but it is tested by the auditor or his staff.
Nature: Valuation is subjective. It is based on documentary evidence and certificates
given by the valuers.
Liability: The auditor is not liable for in correct valuation as he is not the valuer. He can
depend or rely on the certificates given by the valuers or official of the client.

4.8 Summary
 Verification means proving the truth or confirmation.
 Verification of assets is a process by which the auditor satisfies himself, by physical
inspection or by examination of documents, the existence of ownership and valuation of the
various items appearing in the balance sheet.
 Good will is the reputation of a business valued is terms of money.

 Debtors: Debtors is a person who owes money to the business.

 Bills receivable: Means a bill on which amount is receivable, A drawer calls it bills
Receivable.
 Stock: Stock in trade refers to stock of goods which have to be ultimately converted into
cash.In case of manufacturing concerns, stock in trade includes:-
a) Stock of raw materials
b) Stock of semi-finished goods or work-in-progress
c) Stock of finished goods.
d) Scrap or by product
e) Stores and spare parts.
For Private circulation only
Page 98
 Capital: Capital is a net investment of the business. It means excess of assets over
liabilities of an organisation.
 Sundry creditors: Creditors is a person to whom the business owes money.
 Bills payable: Bills payable means a bill on which amount is payable. Acceptor calls it
as Bills payable.
 Outstanding expenses: There are certain expenses which relate to a particular
accounting period but they are not paid in that accounting period due to certain reasons.
 Contingent liabilities: are liabilities which may or may not arise.

4.9 Case Studies

WESTMINSTER ROAD CONSTRUCTION ENGINEERING CO. LTD. (1932)
It has been held, in the case that the auditor must take care to satisfy himself that all the expenses
and liabilities which the company could be expected to have incurred have been brought into
accounts. In the course of his judgment in this case, the learned judges observed:“If the auditor
found that a company in the course of its business was incurring liabilities of a particular kind
and that the trade payables sent in their invoices after an interval and that liabilities of the kind in
question must have been incurred during the accountancy period under audit when he was
making his audit, sufficient time has not elapsed for the invoices relating to such liabilities to
have been received and recorded in the company’s books, it becomes his duty to make specific
inquiries as to the existence of such liabilities and also before he signed a certificate as to the
accuracy of the Balance Sheet to go through the invoice files of the company in order to see that
no invoice relating to liabilities has been omitted. The evidence has established to my satisfaction
that no experienced auditor would have failed to ascertain the existence of the liabilities omitted
from this Balance Sheet.

AUTHOR E. GREEN AND CO. VERSUS THE CENTRAL ADVANCE AND DISCOUNT
CORPORATION LTD (1920) UNITED KINGDOM
The defendant company had been carrying on the business of money – lending. The plaintiff
(auditors) had been conducting audit of the accounts of the company for many years in the past.
Auditor had accepted the figures of bad debts as supplied by the Board of Directors, who had

For Private circulation only

Page 99
considerably under-estimated the amount. Out of a total of about £19,000 of the irrecoverable
debts many of them had become statue barred but even then, they were not written off as bad.
The suit was filed by the auditors in order to claim the fees due to them.

But the defendant company made a counter-claim for damages caused to it as a result of the
negligence of the auditors in not pointing out the time barred debts contained in the schedule of
debtors. This resulted in inflating the profits and consequent overpayment of commission to the
Managing Director, calculated on the basis of net profits. The defence of the plaintiff to the
counter-claim of the defendant was that although some of the debts had become time barred, they
did not point out this fact as from past experience they had found that the customers had been
paying even the time barred debts. The defence of the auditors was not considered to be
satisfactory by the court and damages were awarded to the company. It was pointed out that on no
occasion did the auditor refer to the state of the book debts in his report to the members. Auditors
are liable for negligence in performing their duties in not pointing out to the shareholders
regarding the insufficient provision for bad and doubtful debts.

CASE STUDY – 2
M/s NSG & Associates have been appointed as auditors of Viaan Ltd. for the financial year 2019-
20. The processes, operations, accounting and decisions are carried out by using computers in Viaan
Ltd. The auditors understand that there are several aspects that they should consider to determine
the level of automation and complexity in the business environment of Viaan Ltd. While planning
the audit work, the engagement partners discussed with the audit staff about the various types of
controls in the automated environment.
The different types of audit tests that can be used in audit of an automated business environment
were also discussed within the engagement team. The responsibility regarding the Internal Financial
Controls was also discussed in detail. Further the tools and techniques that can be used to deal with
the enormous data and information of Viaan Ltd. were briefed to the audit staff by the engagement
partners.
From the above facts, answer the following questions by choosing the correct answer:

1. ____________________________ are the manual controls that make use of some form of data or
For Private circulation only
Page 100
information or report produced from the IT systems and applications
a) Application Controls

b) IT dependent Controls

c) Automated Controls

d) General IT Controls

2. Statement 1: Application controls include both manual and automated controls that operate at a
business process level.
Statement 2: General IT Controls apply to mainframe, miniframe as well as end user environment

a) Only Statement 1 is correct

b) Only Statement 2 is correct

c) Both Statements 1 & 2 are correct

d) Both Statements 1 & 2 are incorrect

3. ________________________ are also known as pervasive or indirect controls:

a) General IT Controls

b) Application Controls

c) IT dependent Controls

d) None of the above

4. Which of the following are not the types of audit tests that can be used in the audit in
an automated environment?
a) Observation

b) Inspection

c) Re performance

d) None of the above

For Private circulation only

Page 101
5. ______________________ is the combination of processes, tools and techniques that
are used to tap vast amounts of electronic data to obtain meaningful information:
a) Computer Assisted Audit Techniques

b) Automated Controls

c) Data Analytics

d) None of the above

4.10 Unit End Exercises Section
A - 2 Marks Questions:
a. Explain verification?
b. Explain valuation and tits objectives?
c. Explain contingent liabilities?

Section B - 4 Marks Questions:

1. “An auditor is not a valuer. But he is intimately connected with values comment.
2. Explain the objectives of verification of assets?
3. How would you verify the following:
a. Goodwill
b. Cash-in-hand
c. Patents
d. Book-debts
e. Creditors
f. Bills payable
g. Tax Liability
h. Investments.
4. Point out the difference between verification and valuation of assets.

Section C - 10 Marks Questions:

1. Write as essay on the valuation of stock and examine the auditor’s position in this respect.
2. Explain the duties of an auditor regarding the valuation of goodwill and investments?
3. Write a note on verification of any five liabilities.

For Private circulation only

Page 102
Module 5
Company Audit- Appointment, Rotation and Removal of Auditors Strucutre

5.1 Company Auditor

5.2 Appointment of an Auditor
5.3 Rights of the Company Auditor
5.4 Duties of the Company Auditor
5.5 Liabilities or Responsibilities of a Company Auditor
5.6 Qualifications of an auditor
5.7 Rotation and removal of an auditor
5.8 Auditor’s report
5.8.1 Meaning
5.8.2 Kinds of Auditors Reports
5.8.3 The Enron scandal
5.9 Summary
5.10 Case Study
5.11 Unit End Exercises

5.1 Company Auditor

The accounts of Joint Stock Co, are required to be audited compulsorily and an effort has been
made to explain the basic principles of audit which have been universally recognized for
conducting audit of institution of different nature and character. There are certain special rules and
legal provisions to conduct audit of companies like banking, insurance company, public
company, private company, etc., a study of which is very essential for an auditor to conduct the
audit of companies. The company auditor is expected to be familiar with all companies
provisions, rules and regulations.

The company law has separately defined the rights, powers and duties of an auditor and he
cannot be relieved from his legal responsibility. The company has a separate legal entity and the
shareholders are the members of the company. The shareholders do not have any rules and
regulations which come under the Companies Act 1956. Therefore the study of audit of accounts
of the company is made compulsory by law. An auditor has to study the company law by himself

For Private circulation only

Page 103
with his rights and duties and with his responsibility. There are several provisions in the law
regarding the issue of share capital preparation of Memorandum of Association, Article of
Association, appointment of directors, managing-directors, issue of prospectus, under writing
contract, issue of debentures, allotment of shares, issue of share certificates, transfer of shares,
transmission of shares and other important matters which an auditor has to study for the successful
conduct of Companies Act 1956.

5.2 Appointment of an Auditor

Under section 224 of the Companies Act deals with the provisions regarding the appointment of
auditors of a company, the provisions regarding appointment of auditor are as follows: -

(i) Appointment of first auditor under sec 224(5):-

The board of directors must appoint the first auditor within one month from the date of
registration of the company. The appointed auditor must hold the office until the conclusion of the
first annual general body meeting. The board of directors must pass a resolution regarding the
appointment of first auditor. But the board of directors does not exercise the auditors powers and
rights of the company. The first auditor of the company shall also be appointed by the company
in its general body meeting. But the auditor is appointed by the board of directors by the
company. The information regarding the appointment of first auditor must be informed to the
company registrar. The first auditor is not required to inform to the company registrar about his
acceptance or refusal of the social appointment.

(ii) Appointment of auditors by the company under section 224(1) (shareholders): Except
in the case of first auditor, every company must appoint auditors in each annual general body
meeting. The company has to appoint an auditor to hold the office from the conclusion of that
meeting, until the conclusion of the next annual general body meeting and within 7 days of the
appointment, and give intimation to the appointed auditor and to the company registrar. Such
auditor must be within 30 days of receiving the intimation from the company regarding his
appointment , inform the company registrar in writing, that he has accepted or his refusal to
accept the appointment.

(iii) Re-appointment of auditor under section 224(2):

For Private circulation only
Page 104
Generally at any general body meeting, the retiring auditor shall be automatically re- appointed.
The re-appointment of retiring auditor can be refused either by the board of directors or by the
shareholders. But in the following cases the retiring auditor shall not be re-appointed:
(a) If he is not qualified for re-appointment.
(b) If he has given to the company a notice in writing regarding his unwillingness for re-
appointment.
(c) If the resolution has been passed in the meeting to appoint somebody other than the
retiring auditor.
(d) If the resolution has been passed that retiring auditor shall not be re-appointed.
(e) If a notice has been given of an intended resolution proposing the appointment of some
other person in the place of retiring auditor, etc.

(iv) Appointment of auditor by Central government under sec 224(3):

Where the company cannot appoint or re-appoint an auditor in annual general body meeting the
central government may appoint a person to fill the vacancy. In this case the company must give
the information within 7days of its failure to appoint or re-appoint to the Central Government.
The said application must disclose sufficient information in detail with actual reasons where the
company could not appoint an auditor in its general body meeting. In case of default the company
and every concerned officer of the company shall be punished with a pine of Rs. 500 under section
224(4).

(v) Appointment in case of casual vacancy under sec 224(6):

The board of directors may fill any casual vacancy in the office of the auditor, where any casual
vacancy is caused by the resignation of an auditor during the term of his appointment, that casual
vacancy shall be filled by the company only at its general body meeting. Sometimes the boards
of directors also have the power to fill the casual vacancy.

The term casual vacancy has not been defined anywhere under the Companies Act 1956. But the
casual vacancy means vacancy in the office of auditor resulting from accidental circumstances
such as death, insolvent, lunacy, incapacity, and disqualification etc. of the auditor. But the
refusal of the person to, accept his appointment or re-appointment as auditor will not be
considered as casual vacancy. The board has no power to fill such vacancy even if the

For Private circulation only

Page 105
shareholders give permission regarding the appointment or re-appointment of a person as an
auditor. The board can fill such vacancy with the special permission from the Central
Government.

(vi) Appointment by special resolution under sec 224(A):

It has been introduced by the Amendment Act of 1974, which states that in the case of company
in which not less than 25% of the subscribed share capital is held individually or jointly by:

(a) A public financial institution or a Government Company or Central Government or any

State Government.
(b) Any financial institution established by any Provincial or State Act in which the state
government holds not less than 51% of the subscribed share capital.
(c) Any nationalized banks or an insurance company carrying on general insurance business etc.

Under the above circumstances the appointment of auditor or re-appointment of retiring auditor
must be appointed by conducting annual general body meeting and by passing a special
resolution under the Companies Act. The said appointment must be informed by the company to
the company registrar.

(viii) Appointment of auditor of government co under sec 619:

The appointment of auditors in the case of government company which subject to the provisions
of sec-619 under the companies act. Sec – 224 to 223 dealing with the appointment of auditor in
case of non-government companies.

The auditor of Government Company shall be appointed or re-appointed by the central

government on the advice of the Comptroller and the Auditor General of India. But while
rendering advice or making appointments; the effect shall be given to the relating provisions of
sec-224 regarding the appointment of auditors.

(ix) Appointment of auditors of other companies under sec-619(E):

Section 619, will also apply in the case of the company in which not less than 51% of the paid up
share capital is held jointly, individually by any companies by central government, by state

For Private circulation only

Page 106
government, by corporations etc. The appointment of an auditor of such a company shall be
made by the Central Government on the advice of the Comptroller and Auditor General of India.

5.3 Rights of the Company Auditor:

The rights are important for auditor to make a report to the members of the company on accounts
examined by him & to state the true and fair picture of the company and the results of his
operations. The important rights of a company auditor are:

(i) Rights to access the books of accounts, vouchers under sec –227(1):
The auditor of a company has the right to access at all times to the books, a/c’s and vouchers of the
company whether kept at the head office of the company or elsewhere. The right of access to
books is an absolute right and it is not subject to any restrictions and exceptions.

The term book includes not only financial books of the company but also the statutory and
statistical books. The term voucher includes all documents correspondence agreements etc which
contains the data disclosed in the financial statements whether directly or indirectly. The right of
access means the auditor can undertake the examination of the books at any time during the
normal working hours and need not wait till the accounts are closed.

ii) Right to obtain information and explanation under sec – 227 (1):
The auditor has the right to collect the information and explanation from the officers of the
company. It is left to the auditor to decide what information and explanation would be necessary
to enable him to perform his duties. Where information is not available from the a/c’s of the
company. The officers are under obligation to provide that information. If any information or
explanation is refused on the ground that it is not necessary for the performance of his duties, the
auditor may report to the company registrar and to the members of the company.

iii) Right to receive notices under sec – 231:

The company has a right to receive all notices and other communications relating to any general
body meeting of the company. If he fails to receive the notices, the same must be informed by the
auditor to the company registrar and to the members of the company.
For Private circulation only
Page 107
iv) Right to attend the meeting:
The company auditor also has the right to attend any general meeting of the company and it is not
his duty to take part in discussion. Such right is restricted to general meetings but not

extended to meetings of board of directors. He should also exercise the right when any
information having a material bearing on the financial statement has come into his notice earlier;
the same must be included in his report.

v) Right to report to the members under sec – 227 (2):

The auditor has the right to write a report to the member on the accounts examined by him & to
state whether in his opinion to the best of his information according to the explanation given to
him. The said accounts give information required by the Companies Act 1956 in the correct
manner and whether the financial statements give a true and fair picture of the state of affairs of
the business of the company.

vi) Right to sign the audit report under – 229:

Only the persons appointed as auditor of the company has the right to sign the audit report or
authenticate any other documents of the company.

vii) Right to visit branches:

The company auditor has the right to visit different branches of the company in different places.
He is entitled to visit the branch office and verify the accounts books and other affairs of the
company. In case a banking company has a branch office outside India, it is sufficient if the
auditor is allowed to access such copies extracted from the books and accounts of the branch
office supplied to the company.

viii) Right to have legal and technical advice:

Where the auditor needs experts advice in respect of any legal or technical matters for the proper
discharge of his duties, the auditor may appoint some legal persons and technical persons for the
purpose of performing his duties effectively and efficiently.

For Private circulation only

Page 108
ix) Right to receive remuneration under sec – 224(8):
The auditor has the right to receive remuneration for auditing the a/cs of the company. The
remuneration is secured by the auditor from the appointing authority etc.

5.4 Duties of the Company Auditor

The duties of the company auditor can be discussed under 2 heads namely:-
A. Statutory Duties
B. Duties under Common Law.

A. Statutory Duties:

The important statutory duties performed by the auditor are:-

(i) Report to members under sec – 227(2):

The company auditor is required to make a report to the members of the company on the
accounts examined by him on the profit and loss account and balance sheet and every other
document listed in the Companies Act. This report must state whether in his opinion and the best
of his information and according to the explanation given to him, the said accounts give

the information required by the companies act in the manner so required and give true and fair
information. The company auditor must follow certain procedures at the time of reporting to the
members.

a) Report to all the members: The company auditor should report to all the members of the
company by sending the auditor’s report. The auditor sends his report to the secretary with a
view to submit to the company’s annual general meeting. The company auditor has right to attend
the meeting and read out the same report in the annual general body meeting.

b) Examination of accounts: The examination of accounts regarding verifications is also one of

the important statutory duties because it requires the auditor to be fully alert and to satisfy
himself by examining such basic materials and documents.

For Private circulation only

Page 109
c) Annexed documents: The auditor’s report has to be not only with the accounts like profit and
loss a/c and balance sheet, but also with every other document which are declared by the
companies act.

d) True and fair view: The first duty of the auditor is to express his opinion whether the
balance sheet shows a true and fair view of the state of the company affairs at the end of the
financial year and whether the profit and loss account shows the true and fair view of the results
of operations by the company for that year etc.

(ii) Duty as to enquiry under sec 227(1):-

According to this section the company auditor must enquire the following matters:-

a) Regarding loans and advances:The company auditor has to see whether the loans and
advances made by the company on has been property secured.

b) The transactions represented by book entries:The auditor must see that the transactions
which are not supported by any evidence though recorded in the books are not prejudicial harmful
to the interest of the company.

c) Sale of investment less than the purchase price: The auditor is required to see whether it has
sold any shares, debentures or other securities at a price which is lower than the price at which
they were purchased by the company.

d) Loans and advances shown as deposits:The auditor has to see whether loans and advances
taken by the company have been shown as deposits.

e) Personal expenses:The auditor should enquire any personal expenses have been charged to
revenue accounts of the company or it has been utilized for the individual benefits of persons
directly or indirectly.

For Private circulation only

Page 110
f) Allotment of shares for cash:If the company allots the shares for cash; the auditor must
enquire whether cash has been received in respect of such allotment, has been charged

correctly to the account. The auditor has to enquire and apply his mind to the information
supplied by the company for deciding the actual facts.

(iii) Duty as to additional matters:- under section 227(4)(A):

Under this section the central government has power to direct by means of general or special order
that in the case of company specified in such order. The central government issued an order to the
manufacturing and other companies in the year 1975. This order applies to the foreign companies
manufacturing mining; supplying and redesign services, trading companies, financial and
investment companies, chit funds, the branches of Indian companies etc. according to this order
the auditor’s report shall also include a statement in such order as may be specified therein.

(iv) Dutyto sign report under sec – 229:

It is the duty and also the right of auditor to sign the reports. In case of a firm, only a partner of the
firm practicing in India, may sign the auditor report.

(v) Duty as to statutory report – under section 165(4):

The statutory report which has been certified as correct by the required number of directors, the
auditor of company must be satisfied in relation to:-
a) Shares allotted by the company.
b) Cash received in respect of such shares.
c) The receipts and payments of the company.

(vi) Duty as to prospectus: under section – 56(1):

The prospectus of the company share includes a report by its auditor as per the Second Schedule
of the Companies Act. As regards to profit and loss account, issue of shares and of capital, assets
and liabilities, the rates of dividend paid if any in the financial year etc should be certified as
correct.

For Private circulation only

Page 111
(vii) Duty as to report under voluntary winding up – under section – 488 (2):
When a company has been wound up voluntarily with required number of its members and
directors, the auditor’s duty is to prepare report. Such report depends upon the circumstances in
accordance with the provisions of the Companies Act of 1956. At the time of preparing the
report, the auditor must obtain the declaration from its members regarding voluntary winding-up
of the company.

(viii) Duty to assist investigation under section 240:

Where an inspector is appointed under section 235, 236, 237 to investigate into the affairs of the
company, it is the duty of the auditor produce to the inspector all books and papers which are in
his custody and to give all assistance to inspector in connection with the investigation.

B. Duties under Common law:

Important duties that come under common law are:-

(i) Duties to perform contract:

The auditor has the duty to the party who has appointed him and the duty is discharged when he
perform the terms of the contract between him and the particular party. Regarding that the
company must pass the resolution in the annual general body meeting.
(ii) Duty of care and caution:
The company auditor holds himself as an expert and he must act honestly and exercise with due
care and caution in the performance of his managements.

5.5 Liabilities or Responsibilities of a Company Auditor

The company auditor is appointed under the Companies Act of 1956. The position of public
company audition is different from private company auditors. The public company auditors
appointment, remuneration, rights, duties, liabilities and responsibilities are defined under the
Companies Act 1956 only. The liabilities of the company. Auditors are mainly classified into two
types namely:

For Private circulation only

Page 112
A) Civil Liability
B) Criminal Liability.

A. Civil Liability: The important civil liabilities are:

(i) Liability for Negligence:

An auditor is appointed by the company and he is expected to safeguard the interest of the
shareholders because the auditor must work as an agent of the shareholders. If he fails to do so and
as a consequence if any loss arises, the auditor is held liable to pay the actual amount of loss to his
client under the Companies Act. Thus the auditor can be compelled to compensate the loss
caused to the company resulting from his negligence. He is also liable for damage, if the
company has suffered any amount of loss due to his negligence in the performance of his duties.

London Oil Storage Co. Vs. SeearsHasluck and Co.

In this case, the auditor failed to verify the existence of petty cash. As a result, the company
suffered loss. It was held that, if the auditor of the company fails to verify the existence of assets
as shown in the balance sheet, he is liable to pay damages to the company.

(ii) Liability for misfeasance:

As an auditor is held liable for damages caused to a company on account of negligence, in the
performance of his duties, then he commits a breach of trust. If an auditor does something wrong
in the performance of his duties, resulting in a financial loss to the company then, the directors,
managing agents and other concerned officers of the company may also be held responsible for
the amount of loss or damages.

In London and General Bank Ltd

In this case, the assets of the company were over-valued. As a result, dividend was paid out of
capital. The auditor was aware of the over-valuation of the assets. But he did not report

the matter to the shareholders in clear terms. It was held that an auditor is liable for misfeasance,
if he fails to bring to the notice of the shareholders in clear terms about the unsatisfactory state of
affairs of the company when he himself was not satisfied.

For Private circulation only

Page 113
B. Criminal Liability:
An auditor is an officer of the company and in that capacity he is liable for his acts of omission or
commission which can be constructed as an offence under the provisions of the Companies Act.
The penalties for such offence may be imprisonment or fine or both. The important criminal
liabilities of the company auditor are:-

In re Dumbell’s Banking Co. Ltd:

In this case, the directors of the Dumbell Banking Co. Ltd issued a false balance sheet to deceive
and defraud the shareholders of the company. Accounts were proved to have been materially
false, in the sense that overdrafts which were known to be bad were taken to be good. The
auditors of the company drew the attention of the management regarding the overdrafts, but did
not mention anything about it in their report to the shareholders. The directors and the auditors of
the company were criminally prosecuted and were sentenced to various terms of imprisonment.

(i) Mis-statement in prospectus:

Where a prospectus issued by a company includes any untrue statements. Every person including
the auditor who authorizes the issue of prospectus shall be punishable with imprisonment for a
term which may extend to 2 years with a fine of Rs. 5,000 or both.

In Royal Mail Case or R v Kylsant&Otrs

In this case the director of the Royal Mail Steam Packet Company, Lord Kylsant, had falsified a
trading prospectus with the aid of the company accountant to make it look as if the company was
profitable and to entice potential investors. Following an independent audit instigated by HM
Treasury, Kylsant and John Moreland, the company auditor, were arrested and charged with
falsifying both the trading prospectus and company records and accounts. Although they were
acquitted of falsifying records and accounts, Kylsant was found guilty of falsifying the trading
prospectus and sentenced to twelve months in prison. The company was then liquidated, and
reconstituted as The Royal Mail Lines Ltd with the backing of the British government.

For Private circulation only

Page 114
(ii) Non-compliance by an auditor – under 227, 228 & 229:
If the auditor does not comply with the requirements of sec-227,228 and 229 to making of his
report or signing or authentication of any document, he shall be punishable with a fine ofRs. 1000.

(iii) Failure to assist investigation – under section 240:

The auditor of the company is required to give assistance to the inspector appointed by the
central government to investigate the affairs of the company. If he does not do so, the auditor will
be punishable with imprisonment up to 6 months or with the fine up to Rs. 2,000 or both.

(iv) Failure to assist prosecution of guilty officers of section 242:

When on the basis of the report submitted by an inspector, Central Government may take action
and prosecute any person connected with the affairs of the company. The auditor is required to
assist the prosecution. If the auditor fails to do so, then it will be considered as the contempt of
court and is punishable under the Companies Act.

(v) Failure to return property, books or papers – under section 477:

In the course of winding up of the company, the auditor is subjected to a private examination of the
court and he is required to return the books, papers or documents etc to the court. If he fails to
appear before the court, the auditor can be arrested.

(vi) Public Examination by court – under section 478:

The auditor of a company on the application of the official liquidator can be examined in the high
court. The notes shall be taken and signed by the auditor; such notes may be used as evidence
against him in any civil or criminal proceedings.

(vii) Penalty for falsification of books and accounts – under section – 539:
If an auditor destroys or mutilates (cut-off), alters the secrets of any books, papers or securities
etc, he shall be punishable with an imprisonment for a term which may be extended to 7 years
and shall also be liable for fine and penalties.

For Private circulation only

Page 115
(viii) Prosecution of auditor under section – 545:
The court may direct the liquidation of the company and in winding-up to prosecute the auditor if
he found guilty of any criminal offence in relation to the company.

(ix) Penalty for deliberate act of omission or commission – under section – 628:
If the auditor of the company makes a statement in any written report, certificates, balance sheet,
prospectus etc which is false in any material facts, he shall be punishable with an imprisonment
for a term which may be extended to 2 years and shall also be liable for fine and penalties.

(x) Liabilities under Indian Penal court (IPC):

Under the Indian Pinal court the company auditor shall be punishable in the same manner as if he
gives false evidence.

(xi) Liabilities under Income Tax Act – under section – 278:

If any person induces another person to make or delivery of any amount statement or
declaration relating to any income chargeable to tax which is false, the auditor shall be
punishable for an imprisonment or fine or both.

5.6 Qualifications of an auditor:

According to Section 226 of the Companies Act, a person will not be qualified for appointment
as an auditor of a company unless he is a chartered accountant within the meaning of the
Chartered Accountants Act, 1949. It is further provided that a firm , whereof all the partners
practicing in India are qualified for appointment as the auditor, he may be appointed by its firm
name to be the auditor of a company. In such a case, any partner so

practicing may act in the name of the firm. In this regard, it may be noted that under the
Chartered Accountants Act 1949, only a chartered accountant holding a certificate of practice can
be engaged in India in the pubic practice of accountancy.

For Private circulation only

Page 116
Apart from practicing chartered accountants as mentioned above, a holder of certificates in an
erstwhile part B state, which entitles him to act as an auditor in the territories of the state, is also
qualified to act as an auditor of companies registered anywhere in India(section226(2)).
However, the Central government may by notification in the Official Fazette, make rules
providing for the grant, renewal, suspension or cancellation of such certificates to persons and
may prescribe conditions and restrictions for such purposes. (section226(2)). Besides, he cannot
hold any audits in excess of the limits specified in section 224(1B).

Disqualifications of an auditor
According to section 226(3) of the Companies Act, none of the following persons shall be
qualified for appointment as auditor of a company:
(a) A body corporate
(b) An officer or employee of the company
(c) A person who is a partner or who is in the employment under an officer or employee f the
company.
(d) A person who is indebted to the company for an amount exceeding one thousand rupees
or, who has given any guarantee or provided any security in connection with the indebtedness of
any third person to the company for an amount exceeding one thousand rupees.
(e) Person also shall not be qualified for appointment as auditor of a company, if he is by
virtue of the above listed provisions disqualified for appointment as auditor of an other corporate
body which is that company’s subsidiary, holding company or a subsidiary of that company’s
holding company, or would be so disqualified if the corporate body were a company. (section
226(4)).
if an auditor, after his appointment, becomes subject to any of the disqualifications specified
above, he shall be deemed to have vacated his office as such. Section 8 of Chartered Accountants
Act 1949, is also relevant since the chartered accountant is also subject to the disabilities stated
in this section.

For Private circulation only

Page 117
5.7 Removal of an auditor

An appointed auditor may be removed from his office either in accordance with the provisions of
the companies Act, or as per restrictions imposed by Chartered Accountants Act.The procedure
contains many safeguards to ensure the independence of auditors.

1. Removal as per the Companies Act

The removal of an auditor may be in accordance with the provisions of the companies act,
depends upon the option of the concerned company. He may be removed before the expiry of his
term or after the expiry of the term.

2. Removal before Expiry of the term

An auditor may be removed, at any time before the expiry of his term in the following manner:
a. First auditor: First auditor, appointed by the board of directors may be removed by
merely passing an ordinary resolution.
b. Subsequent auditors: for removal of subsequent auditors, besides passing an ordinary
resolution, prior permission of the central government must be obtained. Thus it is difficult to
remove an auditor before the expiry of his term since adequate grounds must exist to prove to the
government that the person or the firm sought to be removed is unsuitable for continuing as the
auditor.

3. Removal as per the chartered Accountants Act

An auditor may also be removed from his office due to his professional misconduct. Following
are some of the important clauses of the Chartered Accountants Act 1949, which mention the
professional misconduct for which; a chartered accountant may be removed from his office:
a. If a Chartered Accountant accepts the position as an auditor previously held by
another chartered accountant without communicating to him in writing.
b. If a Chartered Accountant is engaged in any business or occupation other than the
profession of accountancy, unless permitted by the council of the institute.
c. If a Chartered Accountant is grossly negligent in the conduct of his professional
duties.

For Private circulation only

Page 118
d. If a Chartered Accountant contravenes any of the provisions of the act an regulation
made there under etc.
Rotation of an Auditor

The principle of Audit Rotation implies the periodic breaks to audit engagements and is imposed
to avoid long term relationships between an auditor and the client. Audit breaks/rotation is a
major provision to enhance the Audit quality and maintain the trust of various stakeholders in the
company.

Section 139(2) of the Companies Act, 2013 deals with the mandatory auditor/audit firm rotation
principle and provides for the rules and regulations in this regard.

5.8 Auditor’s report

An auditor is appointed by the client to check the accounts of his business and submit to him a
report on his findings. Thus, a report is the medium through which an auditor expresses his
opinion on the state of affairs of the client’s business.

An auditor's report is considered an essential tool when reporting financial information to users,
particularly in business. It is an important part of the audit process, since it summarizes the
results of the audit work conducted by the auditor.

5.8.1 Meaning

An auditor’s report is an important document in which the auditor sets forth the scope and nature
of the audit and also gives his impartial opinion regarding the client’s financial statement. It is
the end product of every audit.

5.8.2 Kinds of Auditors Reports

An auditor may submit to the shareholders:
(1) A clear or unqualified report or
(2) A qualified report

For Private circulation only

Page 119
(1) Clear or unqualified report
When the auditor is satisfied as to the fairness of the balance sheet and profit and loss account,
He will give a clear report. In other words, If the auditor makes the various statutory affirmations
without reservations he is said to have given an unqualified report on the financial statements of
the company. An Unqualified report indicates the following –
(i) The Financial Statements have been prepared using the Generally Accepted Accounting
Principles which have been consistently applied;
(ii) The Financial Statements comply with relevant statutory requirements and regulations;
(iii) There is adequate disclosure of all material matters relevant to the proper presentation of the
financial information subject to statutory requirements, where applicable;
(iv) Any changes in the accounting principles or in the method of their application and the
effects thereof have been properly determined and disclosed in the Financial Statements.

A specimen of a clean or unqualified report:

FORM OF AUDIT REPORT

(For a Company Having a Branch)
To,
The shareholders of XYZ limited.

We have audited the attached balance sheet of XYZ limited as at 31stmarch 1989 and also the
profit and loss account of the company annexed thereto for the years ended on that date and we
report that :
1. We have obtained all the information and explanation which to the best of our knowledge
and belief were necessary for the purpose of our audit.
2. Proper books of accounts as required by law have been kept by the company as far as
appears from our examinations of the books and proper returns adequate for the purpose of our
audit have been received from branches not visited by us
3. The accounts of .............branch office have been audited under section 228 of the Act
by .......................The report on the said accounts which has been forwarded to us has been
dealt by us in the manner we have considered necessary while preparing the report.

For Private circulation only

Page 120
4. The balance sheet and profit and loss account dealt with by this report are in agreement
with the books of accounts and returns.
5. In our opinion and to the best of our information and according to the explanation given
to us, the said balance sheet together with the notes thereon give the

information required by the Act 1956, in the manner so required and give a true and fair view.

A&B
(CHARTERED ACCOUNTANT)
DATED……….
BANGALORE……..

(2) Qualified Report

When the auditor is not satisfied with the accounts presented to him or if he finds some
discrepancy in the treatment of some items or if he is not satisfied with any explanation or
information given to him or if he thinks that the profit and loss account and the balance sheet do not
exhibit ‘a true and fair view’ of the state of company’s affairs and the management is not
prepared to make the desired changes, he will qualify his report. It means when an auditor gives
an opinion subject to certain reservations he is said to have given a qualified opinion. In that case
an auditor may include his objection in the audit report and state ‘subject to the above we report
that the balance sheet shows a true and fair view’ According to section 227 (4) of the Companies
Act, where the auditors answer any of the statutory affirmation in the negative or with a
qualification, their report must state the reasons for such answers.

An qualified report may be in respect of the following matters

1. The stock in trade has been valued at the market price which is more than cost price.
2. The provision for depreciation of fixed assets is inadequate.
3. Proper books of accounts have not been kept in accordance with the provisions of the
Companies Act.
4. Accounting principles adopted are not appropriate to the circumstances and nature of the
business.

For Private circulation only

Page 121
A qualification in the report also becomes necessary when an item regarding specific disclosure
under the companies Act, is not disclosed. Thus, the director’s remuneration whether material or
not must be disclosed in the annual accounts of a company. If it is not disclosed the auditor has to
qualify his report.

5.8.3 The Enron scandal:

The Enron scandal, revealed in October 2001, eventually led to the bankruptcy of the Enron
Corporation, an American energy company based in Houston, Texas, and the de facto dissolution
of Arthur Andersen, which was one of the five
largest audit and accountancy partnerships in the world. In addition to being the largest
bankruptcy reorganization in American history at that time, Enron was attributed as the biggest
audit failure.

Enron's auditor firm, Arthur Andersen, was accused of applying reckless standards in its audits
because of a conflict of interest over the significant consulting fees generated by Enron. The
auditor's methods were questioned as either being completed solely to receive

its annual fees or for its lack of expertise in properly reviewing Enron's revenue recognition,
special entities, derivatives, and other accounting practices.

Arthur Andersen was charged with and found guilty of obstruction of justice for shredding the
thousands of documents and deleting e-mails and company files that tied the firm to its audit of
Enron.

Although only a small number of Arthur Andersen's employees were involved with the scandal,
the firm was effectively put out of business. The company surrendered its CPA license on August
31, 2002, and 85,000 employees lost their jobs

5.9 Summary

For Private circulation only

Page 122
 The Accounts of Joint Stock Co. are required to be audited compulsorily.
 Appointment of an auditor [Sec – 224]
1. Appointment of first auditor under Sec 224 (5)
2. Appointment of auditors by the company under Sec 224(1) share holders.
3. Re- appointment of auditor under Sec.224 (2).
4. Appointment of auditor by central government under sec.224 (3).
5. Appointment in case of casual vacancy under Sec 224 (6)
6. Appointment by special resolution under Sec 224 (A)
7. Appointment of auditor of government company under Sec 619
8. Appointment of auditors of other companies under Sec 619 (CE)

 Rights of the company Auditor

1. Right to access books of accounts and vouchers under Sec 227(1)
2. Right to obtain information and explanation under Sec 227 (1)
3. Right to receive notices under Sec 231
4. Right to attend the meeting
5. Right to report to the members under Sec 227 (2)
6. Right is sign audit report under Sec 229
7. Right to visit branches.
8. Right to have legal and technical advice.
9. Right to receive remuneration under Sec 224 (8)

 Duties of the company Auditor.

a) Statutory Duties.
i. Report to members under Sec 227(2)
ii. Duty as to enquiry under Sec 227 (1)
iii. Duty as to additional matters under Sec (A)
iv. Duty to sign report under Sec 229
v. Duty as to statutory report under Sec 56(1)
vi. Duty as to report under voluntary winding up under Sec 488 (2)
vii. Duty to assist investigation under Sec 240.

For Private circulation only

Page 123
b) Duties under common law.
i. Duties to perform contract

ii. Duty of care and caution.

 Liabilities or Responsibilities of a company Auditor.

a) Civil Liability
i) Liability for negligence.
ii) Liability for misfeasance.
b) Criminal Liability.
i. Mis-statements in prospectus.
ii. Non-compliance by an auditor.
iii. Failure to assist investigation
iv. Failure to assist prosecution of guilty officers.
v. Failure to returns properly books or papers.
vi. Public examination by court.
vii. Penalty for falsification of books and accounts.
viii. Prosecution of auditor.
ix. Penalty for deliberate act of omission or commission
x. Liabilities under Indian Penal Court
xi. Liabilities under Income Tax Act.

 An auditor’s report is an important document in which the auditor sets forth the scope
and nature of the audit and also gives his impartial opinion regarding the client’s financial
statement. It is the end product of every audit.

 An auditor may submit to the shareholders:

(1) A clear or unqualified report or
(2) A qualified report

 The Enron scandal, revealed in October 2001, eventually led to the bankruptcy of the
Enron Corporation, an American energy company based in Houston, Texas, and the de facto

For Private circulation only

Page 124
dissolution of Arthur Andersen, which was one of the five largest audit and accountancy
partnerships in the world. In addition to being the largest bankruptcy reorganization in American
history at that time, Enron was attributed as the biggest audit failure.

5.10 Case Study

REX VS KYLSANT AND MORLAND (1931)
The company had suffered actually trading losses whereas the accounts presented showed
considerable amount of profit available for dividend. These profits were brought by utilizing
provision for taxation and other reserves which were no longer required for the purpose. There
were the secret reserves as they were not disclosed in accounts. The effect of the adjustment was
that shareholders were made to believe that company was doing business (profitably) but in fact
it was making losses.
It was alleged that false annual report had been issued by the chairman to the shareholders with
the intention to deceive and the auditor of company was guilty of aiding in issue of false report.

The criminal proceedings against the chairman and the auditor under larceny act 1861 both were
acquitted of charge. But for civil liability the remedy for damages will be appropriate.

CASE STUDY 2

ABC Ltd., is one of the leading companies in the pharmaceuticals manufacturing industry. 75%
Equity shares of ABC Ltd. was acquired by XYZ Ltd. five years ago and is being retained by XYZ
Ltd. till date. Total shareholding of XYZ Ltd. includes the following:

 The Government of Punjab and Government of Haryana each hold 18% of the paid -up share
capital,

 The Government of Rajasthan’s share is 15.5%.

On 29th Oct. 2019, Mr. Shyam, the auditor of ABC Ltd. had resigned from his post, citing medical
reasons. However, he had forgotten to inform about his resignation to the concerned authorities.
Casual vacancy so created was filled up with the appointment of RMT & Co. Chartered
Accountants as statutory auditors of ABC Ltd.

For Private circulation only

Page 125
As far as RMT & Co. Chartered Accountants are concerned, Mr. R, who is one of the partners of
the firm had borrowed a sum of ` 3.00 lakhs from XYZ Ltd. He had also purchased goods worth `
1.89 lakhs from the company. Both the sum borrowed and the cost of the goods bought are not yet
paid by Mr. R does not sign the financials of ABC Ltd.

During the course of audit for the financial year 2019-20, the following observations with respect
to the
company were made by the auditors:

1. The company was not maintaining proper records with respect to the fixed assets maintained

by it. The value of fixed assets of the company amounts to `1.50 crores approximately.

2. Physical verification for the same was not carried out at regular intervals. The last physical

verification
was conducted on 31st July 2018.

5.11 Unit End Exercises Section

A (2 Marks Questions)
1. Explain company audit?
2. Discuss appointment of auditor?
3. Explain voluntary winding up?
4. Write a note on liability for negligence
5. Write a note on appointment of an auditor under special resolution:
6. Explain an auditors report?

Section B (5 Marks Questions)

1. Discuss any 5 Rights of the company Auditor.
2. Discuss any 5 statutory duties of the company auditor.
3. Explain criminal liabilities of a company auditor?
4. Write a note on the qualifications and disqualifications of an auditor.
5. Write a note on the removal of an auditor.

For Private circulation only

Page 126
Section C (15 Marks Questions)
1. Discuss the various rights of company Auditor
2. Explain the various duties of a company auditor
3. Explain the liabilities of a company auditor.
4. Explain the kinds of auditor's report.

********************

For Private circulation only

Page 127
THIRD SEMESTER UNIVERSITY EXAMINATION, NOVEMEBER-2022

PRINCIPLES OF AUDITING

TIME: 3 HOURS MAX MARKS :50

SECTION-A

Answer any FOUR of the following questions. 4X5=20

a. Briefly explain the origin of auditing

b. Classify the 5 disadvantages of internal check.

c. Discuss the duties of an auditor while vouching the transactions of Sales BookS.

d. Explain the procedure for verification of patents.

e. Explain the duties of the company auditor.

SECTION - B

Answer any TWO of the following questions. 2x9=18

a. "Accounting is a necessity, while auditing is a luxury for business" explain.

b. No entry in the books without a voucher and no voucher without its entry. Explain.

c. Explain in detail valuation and verification of debenture.

SECTION -C

Answer the following questions. (COMPULSORY) 1x12 =12

a. Discuss the qualification and disqualification of an auditor.

For Private circulation only

Page 128