AUDIT AND ASSURANCE

Unit : 1 - INTRODUCTION

ORIGIN OF AUDITING

The word “audit” originates from the Latin word audire, which means “to hear.”
In medieval times, when bookkeeping was done manually, business owners would take the
books to a knowledgeable, experienced and impartial person and read out the accounts to
them. That person would listen to the accounts and check whether there were any mistakes,
fraud, or negligence, and then give an opinion about the correctness of the accounts.
Such persons came to be known as auditors.
Thus, the term auditor literally means a hearer — one who hears.
But obviously, modern auditing is much more than simply hearing accounts.

Modern auditing in India started with the Companies Act of 1913, which made yearly audits
compulsory for companies covered by the legislation.
As the economy grew and businesses became more complex, there was a need for a standard
professional framework for accountancy and auditing.
To provide this professional framework, the Chartered Accountants Act, 1949 was passed,
which established the Institute of Chartered Accountants of India, or ICAI.
This created the statutory framework for the Chartered Accountancy profession and the
professional audit of companies.

DEFINITION AND MEANING OF AUDITING

Expert Definitions

Spicer and Pegler :

"An audit is such an examination of the books, accounts, and vouchers of a business as will
enable the auditor to satisfy himself whether the balance sheet is properly drawn up, so as to
give a true and fair view of the state of the affairs of the business.”

R. B. Bose :
“Audit is the verification of the accuracy and correctness of the books of account by an
independent person qualified for the job and not in any way connected with the preparation of
such accounts.”

Professor Lawrence R. Dicksee :

"Auditing is an examination of accounting records undertaken with a view to establishing
whether they correctly and completely reflect the transactions to which they relate.”
International Auditing and Assurance Standards Board (IAASB) :
“An audit is an independent examination of financial information of any entity,
whether profit 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”.

General Meaning

An audit is an independent examination of an organization's financial records. The purpose is to

obtain reasonable assurance and enable the auditor to form an opinion on whether the financial
statements are prepared in accordance with the applicable financial reporting framework and
present a True And fair view of the company's financial position and performance. The audit
also involves considering compliance with relevant accounting standards, laws and regulations
as applicable.

Breakdown of Key Terms

Independent Examination

The auditor should be independent of entity whose financial statements are subject to audit so
that he can form an opinion without being affected by any influence. Independence increases
the auditor's ability to act objectively without falling for any biases.

For example : A person who requests his brother, a Chartered Accountant, to audit accounts of
his proprietary concern and issue a report. Can CA audit accounts of concern in which his
brother is sole proprietor? No, he cannot. It is due to the fact that there would be no
independence in such a case due to the relationship by birth between CA and his brother. He
would be subject to influence from his brother. His affection for his brother may influence his
judgement. He will not be able to give an unbiased report.

True And fair view

True means the financial information is factually correct, properly recorded, and supported by
appropriate evidence. In other words, the accounts should reflect what actually happened in the
business.
Example:
Suppose a company claims that it purchased a machine worth ₹5 lakh. There should be
supporting evidence, such as the invoice, payment records, or other relevant documents, to
prove that the purchase actually took place. If the records match the evidence, the information is
considered true.

Fair means the financial information is presented honestly, impartially, and without any bias or
misleading omissions. The company should not hide important information or present it in a way
that gives a false impression.
Example:
Suppose a company has suffered a huge loss during the year. If it tries to hide that loss or
highlights only the profits to make the business appear more successful, the financial
statements are not fairly presented. A fair presentation means both the good and the bad
information are disclosed appropriately.

Entity

The entity whose financial information is examined need not necessarily be profit oriented like in
case of a business. It can be a non-profit organization like an NGO or a charitable trust. Audit
can be undertaken in respect of any organization be it a small, medium or large. Further, it can
be conducted for any entity irrespective of its legal structure i.e. such an entity may be a
proprietary concern, a partnership firm, a LLP, a private company, a public company, a society
or a trust.

NATURE OF AUDIT

The nature of auditing is defined by the following core aspects :

1. Independent Examination
One of the key aspects of auditing is that it is an independent process. An auditor provides an
unbiased and objective assessment of the financial statements. Independence ensures that the
auditor’s opinion is free from influence by the management or stakeholders, which is essential
for maintaining transparency and credibility in reporting.

2. Systematic and Methodical Process

Auditing follows a planned and structured procedure. Auditors use well-defined steps and
techniques to examine accounts, verify transactions, and gather evidence. This systematic
approach helps in minimizing errors and ensures consistency in the evaluation process.

3. Evidence-Based Verification
Auditing relies heavily on audit evidence, which can include vouchers, invoices, bank
statements, contracts, and other supporting documents. The collection and verification of
authentic evidence is critical to forming an accurate opinion on financial statements.

4. Review of Financial and Non-Financial Aspects

While auditing primarily deals with financial records, its nature also includes reviewing internal
controls, operational efficiency, and compliance mechanisms. This ensures that the organization
functions effectively and adheres to relevant laws and policies.

5. Professional Skill and Judgment

Auditing requires a combination of accounting knowledge, analytical skills, and professional
judgment. Auditors must evaluate complex transactions, assess risk, and identify anomalies to
provide an informed opinion.
INTERDISCIPLINARY NATURE OF AUDITING - RELATIONSHIP WITH DIVERSE SUBJECTS

Auditing is interdisciplinary in nature. It draws from diverse subjects including accountancy, law,
behavioural science, statistics, economics and financial management and makes use of these
subjects. Since audit of financial statements is concerned with financial information, a sound
knowledge of accounting principles is a fundamental requirement for an auditor of financial
statements to conduct audit and express an opinion. Similarly, good knowledge of business laws
and various taxation laws helps auditor to understand financial statements in a better way in
accordance with applicable laws.

During the course of the audit, the auditor has to interact with a lot of people to seek information
and make inquiries. This can be done only if one has knowledge of human behaviour. Auditors
use statistical methods to draw samples in a scientific manner. It is not possible for an auditor to
check each and every transaction. So, use of statistical methods to draw samples for
conducting audit is made.

Knowledge of subjects like economics helps auditor to be familiar with the overall economic
environment in which a specific business is operating. Financial management deals with issues
such as funds flow, working capital management, ratio analysis etc. and an auditor is expected
to be knowledgeable about these for applying some of audit procedures and carrying out audit
effectively.

SCOPE OF AN AUDIT

The following points are included in scope of audit of financial statements: -

(1) Coverage of all aspects of entity

Audit of financial statements should be organized adequately to cover all aspects of the entity
relevant to the financial statements being audited.

(2) Reliability and sufficiency of financial information

The auditor should be reasonably satisfied that information contained in underlying accounting
records and other source data (like bills, vouchers, documents etc.) is reliable and sufficient
basis for preparation of financial statements.
The auditor makes a judgment of reliability and sufficiency of financial information by making a
study and assessment of accounting systems and internal controls and by carrying out
appropriate tests, enquiries and procedures.

(3) Proper disclosure of financial information

The auditor should also decide whether relevant information is properly disclosed in the financial
statements. He should also keep in mind applicable statutory requirements in this [Link] is
done by ensuring that financial statements properly summarize transactions and events
recorded therein and by considering the judgments made by management in preparation of
financial statements. The management responsible for preparation and presentation of financial
statements makes many judgments in this process of preparing and presenting financial
statements.
For example, choosing of appropriate accounting policies in relation to various accounting
issues like choosing method of charging depreciation on fixed assets or choosing appropriate
method for valuation of inventories.
The auditor evaluates selection and consistent application of accounting policies by
management; whether such a selection is proper and whether chosen policy has been applied
consistently on a period-to-period basis.

OBJECTIVES OF AUDITING

In conducting audit of financial statements, objectives of auditor in accordance with SA-200

“Overall Objectives of the Independent auditor and the conduct of an audit in accordance with
Standards on Auditing” are: -
(a) To obtain reasonable assurance about whether the financial statements as a whole are free
from material misstatement, whether due to fraud or error, thereby enabling the auditor to
express an opinion on whether the financial statements are prepared, in all material respects, in
accordance with an applicable financial reporting framework; and
(b) To report on the financial statements, and communicate as required by the SAs, in
accordance with the auditor’s findings.

To achieve the overall objectives mentioned above, the auditor focuses on several practical
goals to ensure the financial information presents a true and fair view.
These key objectives are:

Verification of Accuracy
Auditing ensures that all financial transactions are properly recorded in the books of accounts
and supported by valid documents such as bills and vouchers. This helps confirm that the
records are correct, complete, and free from major errors or misstatements.

True and Fair View

The auditor checks whether the financial statements reflect the actual financial position and
performance of the business. A true and fair view means that the accounts are neither
exaggerated nor misleading and present an honest picture of the organization’s affairs.

Detection and Prevention of Errors and Frauds

Auditing is done to identify mistakes or irregularities, whether accidental or intentional. By
examining records and procedures, the auditor can detect frauds or errors and suggest
measures to prevent them in the future.

Evaluation of Internal Controls

Auditors also review the internal control systems of the organization to see how effectively
assets are safeguarded and financial transactions are monitored. Strong internal controls
reduce the chances of fraud and help maintain accuracy in accounting.
Compliance with Legal Requirements
Auditing ensures that the business follows all relevant accounting standards, auditing principles,
and legal regulations such as those under the Companies Act and tax laws. This helps maintain
transparency and builds trust among stakeholders.

ADVANTAGES OF AUDIT ( refer to the book pdf)

SOCIAL OBJECTIVES OF AUDIT

As a branch of social science, auditing is expected to fulfill certain social objectives to justify its
role in society. These key objectives include:

i. Protection of shareholders interest: Because shareholders do not directly manage the

company, an agency problem can arise where management misuses funds out of greed. The
foremost social objective of an audit is to safeguard shareholder money from such management
malpractices.

ii. Stopping tax evasion: Businesses sometimes manipulate their profit determinations to
evade taxes, which deprives the nation of funds needed for infrastructure and security. Audits
ensure accurate profit calculations so that businesses pay their rightful share of taxes to the
government.

iii. Prevention of capital erosion: Capital erosion occurs through the misutilization of resources
or by distributing inflated "paper" profits as dividends, which harms both the business and
society. Auditors must go beyond superficial voucher checks to ensure resources are utilized
efficiently and accounts are not falsified.

iv. Fair treatment with labourers: Workers are frequently deprived of legitimate dues and
benefits like fair wages, medical facilities, and provident funds. Because worker productivity
directly influences business survival, auditors have a duty to examine whether management is
treating labourers fairly and providing their rightful facilities.

v. Reasonable price for consumers: Businesses should charge consumers a fair price based
on actual costs plus a reasonable margin. Cost audits specifically help verify that prices are
determined fairly, which ensures justice for consumers and builds the firm's goodwill.

vi. Fair return to investors: Investors rely on a firm's profitability and solvency to yield a fair
return on their investment. Audits help ensure this by examining whether the business is
optimally utilizing its resources and maintaining a proper debt-equity mix.

vii. Compliance with CSR policies: Under Section 135 of the Companies Act, 2013, specific
categories of companies must spend at least 2% of their average net profits on Corporate Social
Responsibility (CSR) initiatives like education and poverty eradication. The auditor is
responsible for verifying that the company is complying with these statutory CSR obligations.

ERRORS AND FRAUDS IN ACCOUNTING

ERRORS

Errors refer to innocent, unintentional mistakes made during the preparation of financial
statements. These mistakes can arise from clerical oversight, misinterpretation of facts, or the
misapplication of accounting principles. Although unintentional, they cause misstatements in the
accounts.

Types of Errors
Errors are broadly classified into the following categories:

I. Clerical Errors
These are mistakes that occur during the routine tasks of recording, posting, totalling, and
balancing. They are subdivided into two types:

A.​ Errors of Omission:

Occurs when a transaction is partially or completely left out of the accounting records.
●​ Complete Omission: The transaction is entirely ignored. The Trial Balance will still
agree, making it difficult to detect.
●​ Partial Omission: Only one aspect of the transaction is recorded.
Example: A collection from a customer is debited in the Cash Book but is left out and not
credited to the customer’s Personal Account.

B.​ Errors of Commission:

Occurs when a transaction is erroneously recorded due to carelessness. Common types
include:

Recording with the wrong amount: Entering Rs. 8,590 instead of the actual purchase amount
of Rs. 7,890. (Also includes transpositional errors, like writing 2,657 instead of 2,567).

Posting on the wrong side: A cash collection from a debtor is correctly recorded on the debit
side of the Cash Book, but erroneously recorded on the debit side of the debtor's account as
well.
Posting in the wrong account: A collection from "Ram" is wrongly credited to "Shyam's"
account.

C.​ Errors of Principle

These occur when a transaction is recorded in a way that fundamentally violates established
accounting principles or standards. This type of error does not disrupt the Trial Balance, as the
debit and credit amounts remain equal, but it drastically alters the financial position.
Example: Wages paid for the installation of a new machine are debited to the general "Wages
Account" (a revenue expenditure) instead of being capitalized in the "Machine Account" (a
capital expenditure).

D.​ Compensating Errors

These occur when the financial effect of one error is completely nullified or counterbalanced by
the effect of one or more other errors. Since they offset each other, the Trial Balance remains
balanced.
Example: Ram’s account is mistakenly debited by Rs. 1,000 instead of Rs. 100 (an overcast of
Rs. 900), and simultaneously, Rahim’s account is mistakenly credited by Rs. 1,000 instead of
Rs. 100 (an overcast of Rs. 900). The two errors cancel each other out.

E.​ Errors of Duplication

This happens when the exact same transaction is recorded twice in the books of original entry
and subsequently posted twice to the ledger accounts.
Example: A single purchase invoice is entered into the Purchase Day Book two times.

FRAUD

Fraud is an intentional, deliberate, and mischievous act committed with an ulterior motive. It
involves the misrepresentation of facts to mislead others, deceive investors, or misappropriate
assets. Most frauds materially affect financial statements, requiring the auditor to remain highly
alert.

Types of Fraud (per Standard SA 240)

Misappropriation of Assets:
This involves the physical theft of entity assets for personal gain. It is generally committed by
ordinary staff.
Examples: Embezzling cash receipts, stealing physical inventory, or processing fictitious
payments to dummy vendors for goods or services that were never actually received.

Fraudulent Financial Reporting:

This involves intentional manipulation of accounts or results of operations. It is usually executed
by management to evade taxes, artificially inflate profits for higher remuneration, or mislead
investors.
Examples: Manipulating accounting records (e.g., charging lower depreciation or overvaluing
closing stock to inflate profits), intentionally omitting significant events (e.g., leaving goods sold
out of the sales record but keeping them in inventory), or misapplying accounting principles
(e.g., deferring a current year's revenue expenditure to the next year).
Factors Indicating Increased Risk of Fraud

Certain conditions in a business environment create vulnerabilities that increase the likelihood of
fraud:

Weak Internal Control System:

Human nature can sometimes be driven by personal gain. If a business has weak internal
controls in highly vulnerable areas—such as purchasing, sales, wage payments, and petty cash
disbursements—it creates an environment where errors and frauds can easily occur.

Weak Internal Audit Department:

An internal audit department is considered weak when it is not staffed by efficient personnel or
when its work lacks proper planning, supervision, review, and documentation. If this department
is unsound, the likelihood of fraud and error increases significantly.

Lack of Management Integrity or Competence:

Specific management behaviors and events should immediately arouse suspicion regarding
potential fraud if the management is dominated by a small group, ignoring internal audit reports,
high turnover among key financial personnel, and frequently changing auditors.

Unusual Pressure Within the Business:

Declining business trends, hasty modernization, frequent accounting policy changes, or unusual
pressure to finalize accounts quickly can create strong motives for fraud.

Unusual transactions:
Unusual transactions at the end of the year, transactions with parties with no reputation, or
sudden increase in discretionary overhead like traveling expenses, entertainment, etc.

Problems Obtaining Audit Evidence:

Excessive adjustment entries, missing authorizations, altered documents, or an indifferent
management attitude toward audit queries often point to underlying cover-ups.

Distinction between Error and Fraud ( refer to the book pdf)

Auditor’s Duty Regarding Frauds and Errors

An auditor's legal and professional duties regarding the detection and prevention of frauds and
errors have evolved through landmark rulings and standards:
Key Legal Decisions:
London and General Bank Case (1895): Established that an auditor must exercise
"reasonable care and skill." However, the auditor is not an insurer and does not guarantee that
the books are absolutely correct.
Kingston Cotton Mills Co. Case (1896): Established the famous precedent that an auditor is a
"watchdog, not a bloodhound." This means they should look after the stakeholders' interests but
are justified in trusting the company's tested employees unless there is a specific reason for
suspicion.
Professional Pronouncement (SA 240):
The auditor's objective is to obtain reasonable assurance that financial statements are free from
material misstatement, whether caused by fraud or error.
They must maintain an attitude of professional skepticism throughout the audit, remaining alert
to signals of manipulation.
For those entities having an internal audit function, the auditor shall make enquiries of internal
audit to determine whether it has knowledge of any actual, suspected or alleged fraud affecting
the entity.
When the auditor identifies a misstatement, he will evaluate whether such a misstatement is
indicative of fraud and whether management representation in this respect is reliable.
If fraud is identified, the auditor must communicate this on a timely basis to the appropriate level
of management or regulatory authorities, and consider whether it is necessary to withdraw from
the engagement.
Companies Act, 2013: Under Section 143(12), if an auditor comes across any fraud involving a
material amount during the course of their audit, they have a strict statutory obligation to report
the matter directly to the Central Government or Audit Committee.

THEORY OF AUDIT

AGENCY THEORY

The Agency Theory of Auditing provides the economic rationale for why independent
audits are necessary in modern business. It is rooted in the "agency problem" that
arises from the separation of ownership and control, where the owners of a company
(the principals) delegate daily operations to corporate management (the agents).
Because both parties are driven by self-interest, their goals often conflict; management
might prioritize their own compensation or perquisites over the shareholders' desire for
maximum profit. This conflict is worsened by information asymmetry, as management
has intimate knowledge of the firm’s true financial health, while absentee shareholders
must rely entirely on the financial statements prepared by that same management team.

To mitigate this risk, shareholders demand an independent verification mechanism. The

auditor serves as an objective third party hired to examine management's financial
statements and verify that they fairly and accurately represent the company's economic
reality. By providing a professional audit opinion, the auditor reduces information
asymmetry, acts as a crucial monitoring control to deter management fraud, and bridges
the trust gap between the principals who supply the capital and the agents who manage
it.

EXAMPLE:
A group of investors (the principals) fund a successful mid-sized logistics company and
appoint a Chief Executive Officer (the agent) to manage it. The investors expect the
CEO to generate steady, moderate growth and distribute the remaining profits as
dividends.
Driven by a desire for a higher salary and industry prestige, the CEO decides to use the
company’s cash reserves to acquire a failing technology startup. This acquisition does
not make strategic sense for the logistics company, but it significantly increases the total
size of the corporation, allowing the CEO to justify a massive compensation increase.
When preparing the year-end financial statements, the CEO aggressively accounts for
the acquisition to make it appear highly profitable, hiding the underlying losses from the
shareholders.
In this scenario, the independent auditor acts as the necessary safeguard. During the
annual audit, the auditor reviews the valuation of the acquired startup and the
corresponding accounting treatments. The auditor identifies the aggressive accounting,
requires management to adjust the financial statements to reflect the true economic
reality, and ensures the shareholders receive an accurate picture of the CEO's capital
allocation decisions.

QUALITIES OF AN AUDITOR ( refer to the book pdf)