Unit No: 1
Concepts And Authorities of Auditing
1.1 Basic Principles and Techniques of Auditing
1.2 Classification of Audit
1.3 Internal Control - Internal Check and Internal Audit
1.4 Role of Auditors in Corporate Governance
1.5 Peer Review and Independent Review of the Audit
1.6 Public Company Accounting Oversight Board (PCAOB)
1.7 National Financial Reporting Authority (NFRA)
Introduction of Audit
Accounting can be done manually or using computers, but human errors are common. As a result, financial statements may not always provide a true and fair view of the business. To detect and correct such errors and frauds, accounting needs to be reviewed. Auditing serves as a tool for management to uncover mistakes and fraud, allowing for corrective action. It involves a systematic examination of the client’s accounting records, including the verification of financial statements such as the Balance Sheet and Profit and Loss accounts, along with supporting documents, reports, and vouchers.
Objectives of an Audit
Primary Objective: To provide an opinion on the accuracy and fairness of the financial statements.
Secondary Objective: To detect errors, uncover fraud, and prevent future errors and fraud.
Advantages of Auditing
The audit is not nowadays luxury but it has turned into necessity, it is must. The advantages accrued from the audit can be stated in brief as under:
1. Helps in maintaining the books of accounts regular
As the accounts are subject to regular audit, it helps in maintaining the books of accounts up to date.
2. True and fair view of the state of the affairs
By conducting audit of books of accounts, the owner, partners and the shareholders come to know a true and fair view of state of affairs of the business.
3. It helps in the calculation of purchase consideration
If a business is to be sold off, purchase consideration can be easily calculated on the basis of audited statements.
4. Understanding among the partners
In case of a partnership firm audited accounts reduce the chances of future disputes among the partners in the matters of accounts.
5. Safeguard the interest of shareholders.
Directors are elected by the shareholders and the management of a company is in the hands of the directors. The shareholders have no access to the books of accounts and therefore, they are required to be assured that they are not defrauded by the directors. Hence the accounts maintained by the directors are required to be audited by an auditor, who is supposed to work as an agent of the shareholders. The auditor in the audit report mentions the frauds and error committed by the directors and thus keeps check on such malpractices.
6. Safeguard the interest of the investors.
As the audit is conducted regularly, it give up-to-date information regarding the financial position of the business. So while taking the decision about investment of investors can rely on the same.
7. Directors can get the audited statements regularly
The audited books of accounts are regularly provided to the directors of the company. From those audited reports directors can analyses increase in the expenditure or decrease in the production if any which in turn enable the management to take proper steps and decide future policy.
8. Prevention on frauds and errors.
There is every possibility of committing frauds and defalcations by the employees. An efficient audit acts as a moral check on the employees on such malpractices.
9. Helps in ascertaining the tax.
The audited statements are trustworthy and thus can be used by the sales tax and income tax authorities for calculating the tax.
10. Helps in raising funds and getting loans
As the audited books of accounts are trusted by common people and financial institutions, it is useful for the committee in raising funds and getting loans from the banks.
11. Easy to get reimbursement
On the basis of audited books of accounts insurance companies can settle the claims against loss or damage due to fire and other calamities.
Types of Audit
1. Private Audit
It is the audit of accounts or any other situation by private organizations like sole proprietorship, partnership firms and non-trading organizations. There is no statutory compulsion to get the accounts audited, for such organizations. If turnover or receipts exceed a specific limit, tax audit is required under the Income-tax Act, 1961. Sometimes the parties interested in using the financial information of these organizations get the audit done. In case of partnership firms one or more of the partners may require the audit to be done, for settling disputes or to increase the credibility of financial statements. Non-profit organizations may get the accounts audited in order to get government grants. The objective and scope of a private audit is determined by the persons, who appoint the auditor.
2. Government Audit
Government audit is the audit of accounts of Union of India, States, Government Departments, Government undertakings and local bodies. The auditors appointed for a government audit are called Government Auditors and their appointment is in accordance with the provisions contained in the Constitution of India. There is statutory compulsion to get the accounts audited.
3. Statutory / Mandatory Audit
The audit which is prescribed by law i.e. governing by statute or by regulations is called statutory audit. Where scope is defined by law, it can't be restricted by the appointing authority. Only a person possessing the prescribed qualification shall conduct the audit. The matters to be covered in the auditor’s report are generally defined by law.
Examples of Statutory Audit
When the Auditor's staff is engaged continuously in checking the accounts of the client during the whole year round or when the staff attends audit work at some intervals, it is called a Continuous Audit.
It involves the examination of books of account at regular on Monthly Basis or Quarterly Basis
5. Annual Audit
Audit that is conducted at the close, of the financial period, after the final accounts are prepared, is called the annual audit final audit or complete audit. Such an audit may commence before the final accounts are prepared and may continue even after of the financial year. Since, audit work is completed in one continuous session it is also called a complete audit The Auditor visits his client only once a year an the accounts pertaining to the whole period under review. Although, some disadvantages associated with continuous audit is absent in this case
6. Interim Audit
An audit which is conducted between two annual audits is called an interim audit. Such type of audit conducted at a specific date as per client's requirement. E.g. 30th September, 31st December. Financial statements are prepared for interim audit period. Assets and liabilities are verified for interim balance sheet purposes.
7. Occasional Audit
This type of audit is carried out occasionally as per the need (Claiming Insurance Amount, on Admission, Death or Retirement)of the business. This is applicable to the proprietary concerns such as sole trading and partnerships. It is just a need based audit. It is conducted at the desire of the owner of business.
8. Financial Audit
Financial audit means examination of financial statements to express an opinion thereon. This audit is mandatory for all enterprises. It covers all the items which form part of the financial statements (Balance Sheet & Profit & Loss Account). This audit helps to determine the true & fair view of financial statements. Here propriety aspect is not considered in detailed.
9. Management Audit
Review of decisions & actions of management. Propriety & efficiency of decisions & managerial actions are studied. It covers all aspects like organizational objectives, policies, procedures, structure, control & system.
10. Environment / Green Audit
Environment audit is also called a green audit. An audit of the impact of the activities of an organisation on the environment is called 'Environment Audit'. Its purpose is to ensure that the organisation has clear environment protection policies, that its operations comply with the stated environment policies and that its policies are subject to regular review. Environment, audit may be conducted by a technical person from within the organisation or may be done externally by environment consultants. The areas covered by a 'green audit' include energy usage, wastage recycling procedures, conservation of raw materials and adoption of cleaner technology.
11. Cost Audit
Cost Audit is audit of cost records of the company. It is checking of cost accounts and costing techniques, methods, systems followed by the entity. The cost auditor seeks to verify the truth and fairness of cost of production of goods or rendering of service by an entity. As per the amendments to the Companies Act 1956, a cost audit is compulsory in case of specified companies. The government can require/ order an audit of the cost records kept by a company. Cost audit is conducted in the manner laid down in the Cost and Works Accountants Act, 1959.
12. Tax Audit
The Income-tax audit has been made compulsory for specified persons under the provisions of Income-tax Act, 1961. Tax audit is an examination of financial records to assess, the correctness of calculation of taxable profit to ensure compliance with provisions of the Income-tax Act, 1961 and also to ensure fulfilment of conditions for claiming deductions under the Act.
13. External Audit
An audit is said to be an external audit if the auditor is appointed by persons other than those whose performance is to be evaluated. For example, a auditor for a financial audit may be appointed by shareholders to ensure that their funds have been properly utilized by the Board of Directors. An External auditor is an independent person. The scope of his audit cannot be reduced by the management. Generally, an external auditor submits his report on the truth and fairness of the financial information contained in the financial statements to the shareholders or in case of other forms of businesses, to the owners of business.
14. Internal Audit
Internal audit is conducted by an auditor who is appointed by the persons who are responsible for the performance of the entity. An internal auditor is usually appointed by the management. He becomes a regular employee of the organisation. The Directors would also like to ensure that the accounts are free of errors and frauds. They may ask the auditor to devise an effective system of internal control, so as to prevent the occurrence of errors and frauds.
Types of Errors
1. Error of Omission
They arise when a transaction is wholly or partly omitted to be recorded, If the transaction is wholly omitted it does not affect the agreement of trial balance and therefore, they cannot be detected in routine checking. If one aspect of the transaction has been entered, its affects the agreement of trial balance. If credit purchase is not recorded at all it is omitted wholly and if it is recorded in the purchases book but remained to be posted in the creditor’s accounts it is partially omitted.
Example: A company receives ₹1,200 in revenue from a client on September 15th, but the accountant forgets to record the transaction.
Impact:
- Cash Account: The cash balance remains understated by ₹1,200.
- Revenue Account: The company's income is understated by ₹1,200.
2. Error of Commission
When a transition has been recorded but has been wrongly entered in the books of original entry or in the ledger, error of commission is said to have been made,
These types of mistakes are as follows.
- Wrong side posting.
- Posting of wrong amount.
- Wrong posting in the ledger.
- Wrong calculation of closing balance.
- Incorrect entries in the subsidiary book.
3. Errors of Principle
When principles of book-keeping and accountancy are not followed such an error is error of principle. For examples. Treatment of revenue expenditure as capital expenditure or vice -versa e.g., repair of plant and machinery debited to plant and machinery account, or purchase of Plant and Machinery debited to purchase account.
4. Compensating Errors
When an error offsets the effect of another error, such errors are known as compensating errors. These errors do not affect agreement of Trial balance, hence can’t be located by the auditor easily. These errors can be located by checking the total, posting and casting. Some of these errors may affect the profits of the year.
5. Errors of Duplication
When a transaction is recorded twice and also posted twice in the ledger, such an error will not affect the Trial balance. Sometimes the supplier sends the invoice in duplicate and both the copies of the bill are recorded separately.
Example: A company makes a payment of ₹500 for office supplies on August 1st. Due to an accounting oversight, this transaction is recorded twice in the accounting system.
Impact:
- Cash Account: The company's cash balance will reflect a deduction of ₹1,000 instead of ₹500.
- Expenses Account: The office supplies expense will be overstated by ₹500.
Types of Frauds
Eg.
- Amount Received from customer is not recorded.
- Misuse of money by showing false Purchases.
- Preparing dummy salary sheet.
- Entering a less amount than what is received and Etc.
Eg.
- Goods Received but not recorded.
- Office Stationery as been theft by employee.
- Recorded Dummy Purchase or Sales
Management Fraud
- To earn the faith at partners/ Shareholders
- To raise the capital.
- For obtaining higher value for shares.
- To create goodwill in the market.
- To increase sale in the market.
- To earn more commission.
- To evade taxes.
- To mislead the Income Tax Authorities.
- To buy the shares at lower value.
- To create black money.
- To get political help.
- To mislead the workers.
Internal Control
The system of internal control is defined as the organizational plan and management's methods and procedures aimed at achieving its objectives as effectively as possible.
1. Ensuring accuracy & completeness of the accounting records
2. Timely preparation of reliable finance information
3. Prevention & detection of frauds & errors
4. Loyalty to management policies
5. Maximum use of utilization resources
Internal Check
Internal check is a part of the overall internal control system. It involves assigning tasks and authority in a way that allows routine daily transactions to be reviewed by someone else, or where one person's work complements and verifies another's.
Objects of Internal Check
1. Proper division of work:
Division of work based on each individual's ability, training & specification
leads to overall efficiency & effectiveness.
2. Fixation of Responsibility:
The total work is divided into small units & responsibility for the same
fixed on individual workers. Due to clear determination of responsibility
each member of the staff knows what is expected of him & for any
fraud error originating of going undetected at his end, he alone will be
held responsible.
3. Minimization of errors & frauds :
Work performed by each individual checked by another individual in ordinary course. There is considerable reduction in the incidence of errors
& fraud.
4. Reliability of books of accounts:
If an enterprise is operating an effective system of internal check, its
books of accounts & other records are relied upon by interested parties.
Even the statutory auditor confines his examination to selective test
checking, thus avoiding the need to undertake a detailed examination of
each & every transaction.
5. Early detection of errors & frauds:
Work performed by each individual checked by another individual so, any
errors & fraud committed by an employee is likely to be discovered in
one by another.
6. Early preparation of final accounts:
Accounting data emanating under an effective system of internal check
can safely be used to prepare final accounts of the business in time.
Internal Audit
Many large organizations have system of internal audit within the
organization as an internal part of the internal control. They have a separate audit
department. The scope & function of this department vary considerably from
organization to organization.
Internal audit is the review of the various operations of the company & of
its records by staff specially appointed for the purpose. This review may be periodical
or may be even continuous.
Objectives of Internal Audit:
1. Evaluation of accounting & administrative systems & controls:
Internal audit is concerned with ensuring effective & efficient system of
accounting control, standard cost control & other administrative controls.
2. Safeguarding of business assets:
It ascertains the accuracy, the integrity & the reliability of the financial &
other records. It assures the top management that the accounts & the
financial statements show a true view.
3. Compliance with established policies & procedures:
It is concerned with reporting to the management as to compliance with
predetermined policies, procedures & standards of performance.
4. Reliability of management data:
It assures the top management that the accounts & financial statements
show true & fair financial position.
5. Prevention & detection of fraud:
It facilitates the prevention & detection of fraud & errors.
6. Making special investigations:
It takes up special investigation at the special request of the management.
7. Review of Internal Control System:
It reviews the operation of the overall internal control system & non
compliance to the notice of the appropriate level of management.
8. Suggesting improvements:
If the internal auditor finds any inadequacy & weakness in the working
of internal control in any area, he makes appropriate recommendations to
the management for the improvement of the system.
Role of Internal Auditor
1. Internal Auditor appointed by the management generally directors.
2. The scope of work is determined by management.
3. Internal auditor is responsible to the management.
4. The scope of work of an internal auditor may extend even beyond the
financial accounting & may include cost investigation, inquiries relating
to losses & wastages, production audit, performance audit etc.
5. He has to submit the audit report to the management.
6. Format of report is not prescribed
Role of Auditors in Corporate Governance
Auditors play a critical role in corporate governance by:
1. Ensuring Accuracy of Financial Statements: Verifying the accuracy and reliability of a company's financial reports.
2. Evaluating Internal Controls: Assessing the effectiveness of internal controls to safeguard assets and ensure compliance.
3. Risk Management: Identifying and addressing financial risks.
4. Enhancing Transparency: Providing stakeholders with clear and accurate financial information.
5. Supporting Board and Audit Committees: Assisting in oversight and governance functions.
6. Fraud Detection and Prevention: Detecting and helping to prevent fraud through thorough audits.
7. Building Stakeholder Confidence: Enhancing trust in the company's financial integrity.
Peer Review of Audit
Peer review means review of work done by a professional by another professional of similar standing. The purpose of the peer review can be defined as a review of accountants by their fellow accountants in order to promote quality in the accounting and auditing services.
Objectives of Peer Review
1. Comply with the technical, Professional and Ethical Standards as applicable.
2. To identify chronic and pervasive loopholes, proper standard of operation.
3. Not to find out deficiencies but to improve the quality services rendered by members of the profession.
4. Not to change the scope & authority of technical standards specified by the council but to implement them within the parameters.
5. Not to identify isolated case of engagement failure, but to identify weaknesses that are pervasive, & chronic in nature.
Qualifications of the Reviewer
1. Be a member of the AICPA, licensed to practice as a CAP
2. Be currently active in public practice at a supervisory level in accounting
3. Have at least five years of recent experience in the practice.
4. Prosses current knowledge of professional standards for practice.
5. Obtain at least 40% of the aicpa required in cap in the subjects relating to accounting, auditing & quality control.
Collection of evidence by peer reviewer
1. Inspection: it includes scrunching of documentation and other records of the practicing unit.
2. Observation: he observes the procedures / processes followed in the production unit.
3. Enquires: he enquiries and collects required information from the responsible of practice unit.
Public Company Accounting Oversight Board (PCAOB)
PCAOB is public company accounting oversight board which is a non-profit organization established by congress to protect investors and the public interest by promoting accurate & independent audit reports and to oversee the audit of public companies using innovative & cost-effective tools, the PCAOB aims to improve audit quality, reduce the risks of auditing failures in the U.S. public securities market.
The PCAOB is board comprised of five members appointed by SEC (Securities and Exchange, Commission) Sarbanes-Oxley Act of 2002
Role of PCAOB
1. Inspections: PCAOB performs inspections of public registered companies. PCAOB inspections are designed to identify auditing problems at an early stage and focus firms on correcting them.
2. Importance of regulatory coordination to the PCAOB: the PCAOB face an interesting challenge of inspections of registered public firms who are in the trade in U.S. markets. PCAOB has to coordinate with SEC and also has to follow some rules of SEC.
3. Reliance: under PCAOB registered public companies have to follow them for Auditing of financial statements.
4. Cost & Benefit of financial reform: Policy markers have to make policy in such a way which provide security, protection & transparency to the investor.
5. The impact of regulation on U.S. market: Implementing PCAOB regulations have improved the quality of Financial reports & also reduces the risk of investing in registered public companies.
Powers of PCAOB
1. Create quality control, auditing, independence & additional standards that relate to the preparation of audit.
2. Promote professional standards among registered public accounting firms.
3. Improve the quality of audit services provided by public accounting firms.
4. Create and maintain offices and operations in any part of the U.S.
5. Hire lawyers, staff, accountants & other agents in offices.
The National Financial Reporting Authority (NFRA)
NFRA stands for The National Financial Reporting Authority on October 1st 2018 the Indian governments established NFRA with section 132 (1) of the companies Act, 2013 NFRA was established in companies' financial disclosures. It monitors level of service quality that the accounting & auditing professions offer. It has power to investigate professional misconduct by chartered accountants or CA firms, impose penalty and debar the CA of firm for up to 10 years.
The NFRA is composed of one chairperson, three full time members & one Secretary. The chairperson shall have expertise in accountancy, auditing or law to be appointed by central government.
