PRINCIPLES

OF
AUDITING

Semester – V

Student Workbook

2022
All rights reserved. No part of this work may be reproduced in any form, by anymeans,
without written permission from JAIN UNIVERSITY

The workbook is developed for the students of JAIN UNIVERSITY

For Internal Circulation Only

Edition: 2018
Revised : 2022

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:
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JAIN UNIVERISTY

Published Printed by:

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 SYLLABUS INDEX
Sl.No. Modules Pages

1 Introduction to Auditing 5-28

2 Internal Audit, Internal Control, And 29-40

Internal Check

3 Vouching 41-51

4 Verification And Valuation Of Assets And 52-66

Liabilities

5 Company Audit- Appointment, Rotation 67-83

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 chartsused 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.

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Program: B.Com Semester: V

Subject: PRINCIPLES OF AUDITING

Total Lecture Hours: 60 Credits: 04

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

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.

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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.

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 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
%20Au 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

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 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.

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

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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.

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

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“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 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

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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
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.

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 Accounting and Investigation

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 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.

1.4 Objectives of audit

The objectives of audit can be categorized into

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

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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 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.

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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.

(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.

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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
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 actually
paid.

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 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
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 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 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.

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(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

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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 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 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
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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.

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
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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.

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.

1. For the owners of the business and shareholders

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  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.
 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:

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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 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.

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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.

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.

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.
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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.

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.
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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.
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.

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 …….

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YEAR

General Ledger
Bought Ledger

Bought Ledger

Bought Ledger

Balance Sheet
Cash Postings

Returns Book

Trail Balance

Profit & Loss

Sales Ledger

A/c Checked
MONTH

Additions &
Sales Books

Stock sheet
Bank Book

Petty Cash
Cash Book

Cash Book

Vouchers
Balanced

Remarks
Vouched

Vouched

Postings

Checked

Checked
Posting

Journal
January
February
March
April
May
June
July
August
Septemb
er
October
Novembe
r
Decembe
r

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.

Audit note book

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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,
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
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 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
 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.

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

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.

 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

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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.

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 , ,
and .

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Section A (2 mark questions)
1. What is meant by “auditing”.
2. What is an audit programme?
3. Define audit programme.
4. What are audit working papers?
5. What do you understand by audit files?
6. What is forensic Audit?
7. Write a note on Audit committee.

Section B (4 mark questions)

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.

Module 2

INTERNAL AUDIT, INTERNAL CONTROL, AND INTERNAL CHECK

Structure:

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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

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
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,

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

2.2 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.

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2.3 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 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.

2.4 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.

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2.5 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 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

2.6 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.”

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.

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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.
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

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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.
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 every
day.
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

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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 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.
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.

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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.
(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 youremployee list, pay rates, andhours worked

2. Confirm pay rates andhoursworked

3. Verify variable payments

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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. 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.

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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 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.

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  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.

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.

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Section A (2 Marks Questions)
1. Define internal check.
2. What is meant by 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. Give any two differences between internal check and internal control.

Section B (4 Marks Questions)

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

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 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

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:

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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 correctly
recorded 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 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 3) It reveals clerical as well as errors of
errors of principles. principles.
4. It just checks the arithmetical 4) It checks the real accuracy and
accuracy of entries. genuineness of the entries.

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

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 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:

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

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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.
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:

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 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
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.
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 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.

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:

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 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

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.

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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.
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.

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.

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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.

 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

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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.

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

Section B (5 Marks Questions)

1. What are the duties of an auditor while vouching the transactions of sales book?
2. Write a note on vouching bought ledger.
3. What are the duties of an auditor while vouching the deferred revenue expenditure?
4. What 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?

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 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
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

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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 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.
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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 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 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.

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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
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

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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.

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 valuation generally depends on the value of future revenue attached to the
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

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 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.
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 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,
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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 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:
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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.
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 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.

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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
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,
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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 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 from
creditors.
2. The purchase ledger should be checked with books of original entry, invoices, credit notes
etc.

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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.
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.

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.

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 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
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.

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  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.
 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 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.

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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.

4.10 Unit End Exercises

Section A - 2 Marks Questions:

a. What do you understand by verification?
b. What do you mean by valuation? What are its objectives?
c. What are contingent liabilities?

Section B - 4 Marks Questions:

1. “An auditor is not a valuer. But he is intimately connected with values comment.
2. What are 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. What are the duties of an auditor regarding the valuation of goodwill and investments?
3. Write a note on verification of any five liabilities.

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

Structure

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 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

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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):

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.

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(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 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.

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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 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.

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
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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.

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
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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.

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.

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

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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.

(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:

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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:
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
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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.

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.

(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 of
Rs. 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:

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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.

(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
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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.

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.

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

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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.
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

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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

(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 31 stmarch 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.
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

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 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.
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

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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

 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.
b) Duties under common law.
i. Duties to perform contract
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 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 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.

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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.

5.11 Unit End Exercises

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

Section B (5 Marks Questions)

1. Write any 5 Rights of the company Auditor.
2. Write any 5 statutory duties of the company auditor.
3. What are 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.

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.

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 PRINCIPLES OF AUDITING
MODEL QUESTION PAPER
Time: 3 Hours SECTION-A Max Marks: 70

I. Answer any eight of the following. Each question carries 2 marks. 8x2=16
1. Define Auditing.
2. Write any two types of error in accounting.
3. Give any two differences between internal check and internal control.
4. Write the Meaning of Verification of Assets and Liabilities.
5. What is meant by contingent liabilities? Give one example. .
6. Mention the components of Inventory.
7. Define voucher.
8. What is deferred revenue expenditure?
9. What is voluntary winding up?
10 State the two types of Auditor’s Report.

SECTION-B
II. Answer any six of the following. Each question carries 4 marks. 6x4=24
1. Write the differences between Accounting and Auditing.
2. What are the advantages of Audit Programme?
3. Write the objectives of Internal Audit.
4. What are the steps to be taken by the auditor for the verification of debentures issued by
a company.
5. Give the importance of vouching.
6. What are the types of entries the auditor should check while vouching a journal proper?
7. Write a note on the qualifications and disqualifications of an auditor.
8. Under what circumstances an auditor can be removed?

SECTION-C
III. Answer any three of the following. Each question carries 10 marks. 3x10=30
1. State the types of Audit and explain.
2. Explain a suitable system of internal check that can be adopted in a large manufacturing
concern with regard to cash sales and cash purchases?
3. Write an essay on the verification and valuation of any five fixed assets and examine the
auditor’s position in this respect.
4. What are the duties of an auditor while vouching the transactions of the following?:
a) Sales book b) Purchases book c) Bills receivables book d) Bills payables book
5. Explain the various rights and duties of a company auditor.
********************

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