Chapter

DEFINITION OF AUDIT -01

Auditing is the process of thoroughly inspecting and assessing something, such as financial
records, procedures, or systems, to confirm their accuracy, legality, and effectiveness. It helps
ensure that everything is in line with established rules, regulations, and standards.

OBJECTIVE OF AN AUDIT
The main objective of audit is to find out, after going through the books of accounts, whether
the balance sheet and profit and loss account are drawn up accordingly and whether they
represent a true and fair view of the state of the affairs of the concern.

For the fulfillment of the primary objects of an audit, the following

subsidiary objects are to be realized:
 Detection of errors
 Detection of frauds
 Prevention of errors
 Prevention of frauds

Again, errors, which arise out of innocence and carelessness, are of three
types:
 Clerical errors
 Compensating errors
 Errors of principles

clerical errors may be of two types:

 Errors of omission
 Errors of commission

Frauds which arise out of some intention to gain something through some
manipulating devices are of three types:
• Misappropriation or embezzlement of cash

• Misappropriation of goods

• Manipulation of accounts
ERRORS AND FRAUDS IN ACCOUNTING
Errors
Generally, errors are the result of carelessness on the part of the person preparing the
accounts. Errors can be described as unintentional mistakes.

1. Errors of omission:

When a transaction is omitted completely or partially from the books of accounts, it is

known as an error of omission. This type of error is not reflected in the trial balance and
hence is more difficult to detect.

Examples: (a) Omission of purchases from purchases daybook.

2. Errors of commission

When entries made in the books of original entry or ledger are either wholly or partially
incorrect, they are known as errors of commission.

Examples: (a) Wrong amount recorded in the books of original entry, e.g. sale of goods
of Rs. 15,000 recorded as Rs. 1,500 in sales daybook. This error will not affect trial
balance.

3. Compensating errors

When an error offsets the effect of another error, it is known as a compensating error.
These errors do not affect the agreement of the trial balance, hence cannot be located by
it.

Examples: (a) A debit balance is undercast by Rs. 100 and credit balance is undercast by
the same amount.

4. Errors of principles

When principles of book-keeping and accountancy are not followed, the error is known as
error of principles. Such errors may be committed intentionally to understate asset and to
overstate liability and to inflate and deflate profit as and when the circumstance dictates.

Examples: (a) Treatment of capital expenditure as revenue expenditure, e.g. purchase of

machinery treated as purchase of goods.
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 one of the important duties of an auditor.

1. Embezzlement of cash
2. Misappropriation of goods
3. Manipulation of accounts

ROLE OF AUDITORS IN DETECTING ERROS AND FRAUDS

Detection of errors and frauds
It is desirable that the auditor should exercise reasonable care and skill, so that he may detect
errors and frauds. If he carries routine checking and vouching more carefully and checks the
books of accounts thoroughly, he may be successful in his duty. Hence, an auditor is not an
insurer.

Prevention of errors and frauds

The auditor has no authority to introduce remedial measures for the prevention of errors and
fraud. All that he can do is to advise his client and suggest the ways and means to prevent
them.

RELATION BETWEEN BOOK-KEEPING, ACCOUNTING

AND AUDITING
Book-keeping
It is concerned with systematic recording of transactions in the books of original entry and
their posting to the concerned ledger accounts.

Accountancy
Accountancy is concerned with the checking of arithmetical accuracy of ledger accounts as
prepared by the bookkeeper and preparing the trial balance from the balance available of
different ledger accounts.
accountancy involves the following activities:

• Preparation of trial balance

• Incorporation of adjustment entries and passing entries for rectification

• Preparation of profit and loss account

• Preparation of balance sheet

Auditing
When the accountancy work is completed, an auditor is invited to check the accounts pre-
pared by the accountants. That is why, it is said that “Auditing begins where accountancy
ends”. It is the duty of the auditor to critically examine and verify the accounts.

Accountancy vs auditing
Points of Accountancy Auditing
difference

Scope The scope of accountancy is limited to In auditing, the auditor is concerned

the preparation of financial statement. with
the checking of accounts.

Objectives The objective of accountancy is to The objective of auditing is to verify

know the
the financial result and financial truth and fairness of the accounts.
position.
Status An accountant is an employee of the An auditor is an independent outsider
organization.

Qualification Accounting work requires no formal To be a company auditor, one should

qualification. be a qualified chartered accountant.

Tenure of Accountant is usually a permanent Auditor can be changed from year to

service employee of the organization. year
 Knowledge An accountant is not expected to have An auditor must have good
in other knowledge in other subjects. knowledge not only in accountancy,
subjects but also in other related subjects.

ADVANTAGES OF AUDITING
From Legal Point of View
1. Filing of income tax return
2. Borrowing of money from external sources
3. Settlement of insurance claim
4. Sales tax payments
5. Action against bankruptcy

From Internal Control Point of View

1. Quick discovery of errors and frauds
2. Moral check on the employees
3. Advice to the management
4. Uniformity in accounts.

From External Affairs Point of View

1. Settlement of accounts
2. Valuation of assets and goodwill
3. Future trend of the business

LIMITATIONS OF AUDITING
1. Want of complete picture
2. Problems of dependence
3. Post-mortem examination
4. Existence of errors in the audited accounts
5. Lack of expertise
6. Diversified situations
7. Quality of the auditor
8. Existence of defective policies
 Chapter
CLASSIFICATION OF AUDIT
-02
Classification on the Basis of Organization
1. Audit required under law.
 Company audit
 Bank audit
 Electricity company audit
 Co-operative society audit
 Trusts audit

2. Audit under voluntary category.
 Proprietary concern
 Partnership firm
 Hindu undivided family
 Association of persons
 Non-profit seeking organizations

Classification on the Basis of Function

In this group audit is classified on the basis of the auditor involved in the work of audit. It
includes the following types:

1. External audit/Independent financial audit

External audits are conducted by an independent external auditor. This type of audit is
usually conducted to fulfil the requirement of the provisions of law.

2. Internal audit

Internal audit is conducted by specially assigned staff within the organization. It is an

audit through which a thorough examination of the accounting transactions as well as
the system according to which these transactions have been recorded is conducted.
Classification on the Basis of Practical Approach
The classification of audit under this group involves a practical approach to the work. It
includes the following types:

• Continuous audit

• Occasional audit

• Periodical audit

• Standard audit

• Interim audit

• Balance sheet audit

• Partial audit

• Complete audit

Classification on the Basis of Audit Dimension

• Management audit

• Cost audit

• Tax audit

• Human resource audit

• System audit

• Propriety audit

• Performance or efficiency audit

• Environment audit

• Social audit

• Cash transactions audit

• Government audit

• Secretarial audit

• Energy audit
Differences between external audit and internal audit
Area of External audit Internal audit
difference

Nature It is conducted for reporting on the It is conducted with a view to check

reliability and fairness of the financial adherence to norms and established
statements procedures and protect the assets of
the organization.
Qualifications The auditor must possess specific No specific qualification is required
qualification as prescribed by the to be possessed by the internal
respective statute. auditor

Scope of This type of audit must be complete in The scope of work of the internal
work all respects. Its scope cannot be audit is determined by the
curtailed in any way by the management.
management.
Purpose The object of this type of audit is to The basic objective of internal audit
protect the interest of the owners and is to improve performance, efficiency
other parties related to the enterprise. and profitability of the enterprise.
CLASSIFICATION ON THE BASIS OF PRACTICAL
APPROACH
Continuous Audit
A continuous audit or a detailed audit is an audit which involves a detailed examination of the
books of accounts at regular intervals of, say, one month or three months.

Advantages

 Easy and quick discovery of errors

 Moral check on the client’s staff
 Up-to-date accounts
 Quick presentation of accounts

Disadvantages

 Expensive system of audit

 Dislocation of client’s work
 Queries may remain outstanding
 Unhealthy relationship

Periodical or Final or Complete Audit

A periodical audit is one which is taken up at the close of the financial period, when all the
accounts have been balanced and final accounts have already been prepared.

Advantages

 Inexpensive
 Quick completion of audit
 Minimum chances of alteration
 Less disturbance in client’s work
 Requirement of small establishment

Disadvantages

 Delay in presentation of accounts

 Preparation of interim accounts
 Possibility of undetected errors and frauds
 Fixation of audit program
Standard Audit
Standard audit can be defined as a “complete check and analysis of certain items and con-
tingent upon effective internal check, appropriate test checks on remaining items, the whole
of work being in accordance with general auditing standards.”

Balance Sheet Audit

Balance sheet audit means limited audit in which all the balance sheet accounts are verified
and tests imposed only on those profit and loss items which are directly related to the assets
and liabilities such as repairs and maintenance, provision for depreciation, bad debts etc.

CLASSIFICATION ON THE BASIS OF AUDIT DIMENSION

Cost Audit
Cost audit is an effective means of control in the hands of the management to have an idea
about the working of the costing department of the organization and to suggest ways and
means for its smooth running.

Tax Audit
Tax audit refers to audit of incomes or expenses or specific claims of deductions or exemp-
tions for the purpose of assessment of income tax.

Environmental Audit
Environmental audit is an excellent management tool for relating productivity to pollution.
Environmental audit is the examination of the correctness of environmental accounts.

Social Audit
Social audit is aimed at an assessment of the performance of an entity towards the fulfilment
of social obligations. The objective of social audit is to bring to light for public knowledge
how far an organization has discharged its responsibility to the society and to assess the social
performance of an organization.

Cash Transaction Audit

Cash transaction audit is the oldest concept in auditing system. In the olden times, a person
was appointed to check cash transactions only, i.e. whether the person responsible for
recording cash receipts and payments on behalf of the business owner has done his job
properly or not.
 Chapter
INTERNAL CONTROL
-04
Definition
Internal control refers to the various methods and procedures adopted for the control of
production, distribution and the whole system (financial and non-financial) of the enterprise.

Basic Elements of Internal Control

 Financial and other organizational plans
 Competent personnel
 Division of work
 Separation of operational responsibility from record keeping
 Authorization

Objectives of Internal Control

 proper authorization
 Prompt recording of transactions
 Restricted access to assets
 Actions against deviations

Evaluation of Internal Control

Evaluation of internal controls is fundamental to an audit. It is on the basis of this evaluation
the auditor will do the following:

• Determine the nature and extent of his audit procedure, i.e., draw up his audit pro- gramme.

• Draft letters of weaknesses, to draw the attention of the management to inform them about
the weaknesses of the system.

• Whether the basic principles of internal control, which is prevailing in the organization
have been properly followed
Internal Control in Specific Areas of Business
Internal control in general

Cash sales and collections

Payment into bank

Cash balances

Cheque payments

INTERNAL CHECK
Definition
Internal check is an arrangement of the duties of the staff members of the accounting
functions in such a way that the work performed by one person is automatically checked by
another.

Objectives of Internal Check

 Assigning responsibility
 Minimizing error or fraud
 Detecting errors or frauds
 Reducing clerical mistakes
 Enhancing work efficiency
 Obtaining confirmation

INTERNAL AUDIT
Definition
Internal audit refers to an independent appraisal of activity within an organization for the
review of accounting, financial and other business practices.

Scope and Objectives of Internal Audit

 Accuracy in accounts
 Adoption of standard accounting practices
 Proper authority on assets
 Confirmation of liabilities
 Prevention and detection of fraud
Distinction between Internal Audit and External Audit