1.

1 Meaning And Definition Of Auditing

From ancient times on through industrial revolution, the term 'audit' was associated with 'hearing of
accounts'. With the emergence of limited liability corporates in the eighteenth century and as a
result of subsequent legislations, auditing started getting closely linked with examination of
accounts, books and relevant documentary evidence. Various developments in the twentieth century
such as increase in size and complexity of business, acceptance of the idea of social responsibility of
business, increase in the level of consumer awareness and other such factors have led to further
enlargement in the scope of the term 'audit'. A few of the important definitions have been taken up
for discussion below.

Narrow Definition Of Auditing 1.1-1 Montgomery Has Defined Auditing As

"A systematic examination of the books and records of a business or other organisations in order to
ascertain or verify and to report upon the facts regarding the financial operations and the results
thereof." Spicer and Pegler have a similar opinion to that of Montgomery, but they have elaborated
the concept of audit. They have asserted that, "An audit may be said to be such an examination of
the books, accounts and vouchers of a business as will enable the auditor to satisfy that the balance
sheet is properly drawn up, so as to give a true and fair view of the state of affairs of the business
and whether profit and loss account gives a true and fair view of the profit or loss for the financial
period according to the best of his information and explanations given to him and as shown by the
books and, if not, in what respect he is not satisfied."

1.1-2 Auditing In A Broad Sense

The definitions given above limit themselves to independent financial audit.

However, in today's context, auditing should be defined, broadly enough, to

Meaning And Definition Of Auditing

Parcompass the various types and purposes of audit. The Institute of Charlesely encompass the
various types and parpor and Guidelines on Internal Accountants of Chartered Au Accountants of
India in its publication. According to it Accommitten one such definition. According to it ing, gives
one such and independent examination of data, statements "Auditing is a systematic and
independent or otherwise) of any this situation, 'propositions' before an auditor are (i) whether
assets and liabilities shown in the balance sheet actually exist with the business (ii) whether entity
has a legal title to its assets (iii) whether liabilities are incurred for the purposes of business (iv)
whether recognised accounting principles and statutory requirements, if any, have been followed for
valuation of assets and so on.

(vi) collects evidence, evaluates the same: Evidence consists of books of account, tax returns, direct
confirmations, departmental budgets, human resource records, etc. In any audit situation, the
auditor should collect relevant evidence depending upon the proposition he needs to examine.

After collecting the evidence, the auditor should evaluate it on the basis of his professional
knowledge and skill.

(vii) formulates his judgment which is communicated through his audit report: The last stage in audit
examination is formulation of opinion by the auditor which is communicated to the users of
information through an audit report. The format and contents of audit report depend upon many
factors including the type of audit, statutory requirements and purpose of audit.

Another similar and comprehensive definition is given by the American Accounting Association's
(AAA) Committee on Basic Auditing Concept - According to this definition.

"Auditing is a systematic process of objectively obtaining and evaluating evidence regarding

assertions about economic actions and events to ascertain the degree of correspondence between
those assertions and established criteria and communicating the results to interested users." From
the above discussion, it is clear that the scope of auditing has now been enlarged to include any
evaluation process carried out systematically for a defined purpose and resulting in opinion which is
communicated to the interested parties through a report.

1.1-3 Nature Of Financial Auditing

The nature of financial auditing can be explained as follows: (i) Systematic and Independent: It is a
systematic and independent examination by qualified persons. The auditor should arrange the audit
procedures to be adopted by him during such examination in a logical sequence. He should complete
the audit work in an unbiased manner.

(ii) For a Stated Purpose: The stated purpose of such an audit is to express an opinion as to the
truthfulness and fairness of the financial statements.

(iii) Evaluation of the Assertions/Propositions: The auditor should have clear idea of the propositions
to be examined to achieve the audit objective(s).

(iv) Based on Evidence: The auditor collects and evaluates the evidence to examine propositions
before him. Besides books, accounts and vouchers, "Auditing is a systemance (financial or otherwis
wise wise wis wise) of an eneprises records, operations and performance (financial or otherwise) of
an energive records, operations and perporitime situation, the auditor perceival enterprive for a
stated purpose. In any auditing situation, collects evidence sucheres.

for a stated purpose. In any want for examination, collects evidence, evaluence, evaluates nises the
propositions of or cornulates his judgment which is communicated through his audit report. " Several
key phrases in the above definition merit attention. These are discussed (i) systematic: The word
'systematic' implies that an audit should be care.

(ii) independent: The core idea of any audit exercise is an independem evaluation of the available
evidence. In any audit situation, the auditor while forming and expressing his opinion should not be
susceptible to any influence or pressure from client or anybody else.
Example - A present director of a limited company is appointed as an auditor. In this case, the audit
of accounts prepared by co-directors and report thereon would add little to the confidence of the
shareholders Therefore, directors are not thought to be properly qualified to at as auditors of a
limited company.

(iii) data, statements, records, operations and performance: This phrase indicates the scope of audit.
It extends from examination of books accounts and vouchers to review of operations and
performance connected with non-financial area also. For example, review of the effectiveness of an
advertising programme (through operational audit) can also be included in the term 'audit'.

(iv) stated purpose: The object or 'stated purpose' of audit should be clearly defined. The audit
process and procedures should be designed according to the stated purpose. For example, the
'stated purpose' of a financial audit is to express an opinion about the truthfulness and fairness of
financial statements. To take another example, the 'stated purpose' of an environmental audit is to
examine and report on verifiable quantitative and qualitative information in the areas of
environmental concern Thus, the definition has not specified any purpose. It will vary from one
situation to another.

(v) perceives and recognises the propositions before him for examination: The auditor should have a
clear idea about propositions he is examining i.e. he must know 'what he has to prove'. It may be
noted that 'stated purpose' is a broader term than 'propositions'.

Example - 'Stated purpose' of a financial audit is to ascertain a true and fair view of the state of
affairs and working results of an enterprise. In 3

Objectives Of Financial Audit

evidence may take different forms including oral testimony of the client written communication with
outsiders and observation and physical inspection by the auditor.

(v) Communication with Stakeholders: The opinion or judgment of the Comtor on the assertions
made by the management in financial statem ture is communicated through audit report to the
client or the shareholders.

(vi) Encompasses all Entities: The scope of audit extends to all types of entities - commercial as well
as non-commercial.

(vii) Interdisciplinary in Nature: Financial auditing requires diverse ser of skills and knowledge. It
integrates with various disciplines in the following manner:

Accounting Auditors are required to verify the financial statements which are based on financial
information from accounting records. The auditor requires a deep understanding of accounting to
express an opinion on the financial statements. Law Auditing is regulated by legal and statutory
requirements. including corporate, tax, and regulatory legislation such as the Indian Companies Act,
2013. Behavioural Auditing, particularly in fraud detection and risk assessment, Sciences utilizes
insights from behavioural sciences to understand human behaviour and predict organizational risks.
Statistics As it is not feasible to review each transaction, auditors use statistical sampling to select
transactions for auditing. Economics An understanding of economic principles helps auditors better
understand their clients' business environments. Their ability to recognize possible risks related to
industry trends or eco- nomic downturns, as well as the effect of economic factors on financial
statements, is enhanced by this knowledge. Financial Auditing ensures organizational transparency,
accountability, Management and effective resource stewardship, collaborating closely with financial
managers for improved governance. Auditors work closely with financial managers to evaluate
internal controls, improve them, and reduce financial risks. Information Due to the increasing role of
IT in auditing, and need to audit Technology the information systems of the entity, an auditor should
have a strong knowledge of IT systems and tools.

1.2 Objectives Of Financial Audit 1.2-1 Overall Objectives As Per Sa 200

Standard on Auditing (SA) 200, "Overall Objectives of the Independent Auditor and the Conduct of an
Audit in accordance with Standards on Auditing" issued by the Institute of Chartered Accountants of
India (ICAI), outlines the overall objectives of an independent financial audit as below:

(I) To Obtain Reasonable Assurance

A financial audit is conducted by the auditor to obtain reasonable (not absolute) assurance that
financial statements are free from material misstatements caused by fraud and/or error. Material
misstatements are those that could influence the decisions of informed users of financial statements.
In order to obtain reasonable assurance, an auditor audits financial statements with professional
competence; applies Standards on Auditing to obtain and evaluate evidence, to draw conclusions,
and also to express his or her opinion on the same.

(Ii) To Express An Opinion

After obtaining reasonable assurance, the auditor has to express an opinion on whether the financial
statements give a true and fair view in accordance with an applicable financial reporting framework.
A framework used in the preparation and presentation of the financial statements and that is
acceptable in view of the nature of the entity and the objective of the financial statements, or that is
required by law or regulation is the applicable financial reporting framework.

(Iii) To Report On Financial Statements And Communicate The Audit Findings

The auditor communicates his findings through audit report. The format and contents of the report
are governed by the applicable laws and relevant Standards on Auditing.

1.2-2 Incidental Objective - Detection And Prevention Of Frauds And Errors Background

The detection and prevention of frauds and errors was the primary objective of auditing until well
into the twentieth century. The auditors were required to report on whether the financial statements
gave a 'true and correct' view of the state of affairs of a business.

With increase in size and complexity of the business during the last century, audits evolved into 'test
audits'. In addition to the increased use of testing methods, auditors in order to examine transactions
began to secure evidence from third AXMANN

Types Of Error And Fraud

parties such as debtors, banks in case of loan taken by the client, etc. They started paying close
attention to the valuation and disclosure of assets and liabilities paying close attention to the
vacualized to the broad to the broadening of audit objectives beyond establishing clerical accuracy
and detecting fraud to ascertaining reliability of financial statements. Thus, detection and prevention
of frauds and errors was relegated to incidental status.

Importance As Incidental Objective

The auditor cannot give reasonable assurance on the basis of accounts which The adultor caments
resulting from errors and fraudulent manipula.

tions. An incidental but, nonetheless, important objective of financial audit is detection and
prevention of frauds and errors.

Legal perspective - The perception of auditor's duty with regard to detection and prevention of
frauds and errors has undergone various changes in the last century. Initially, it was based on the
decision given in Kingston Cotton Mills Co. [1896] case. The learned Judge Lopse summed up
auditor's duty by stating, "Auditor is a watchdog, not a blood hound." This statement implies-

(a) An auditor is appointed by the shareholders in case of a limited company. He is expected to play
the role of a watchdog on their behalf and should look after their interests.

(b) Unlike a blood hound the duty of the auditor is verification and not detection. If he discovers
something suspicious, during the course of audit, he should probe the matter thoroughly and apprise
the shareholders about it. In the absence of such suspicious circumstances, he is fully justified in
believing and relying on representations made by the 'tried servants' of the company. In short, in
case of frauds and errors, the auditor has a duty of 'reasonable care' only.

Later, the decision given in Westminster Road Construction and Engineering Co. [ 1932 ] case
emphasised adoption of audit procedures to confirm the facts stated through management
representations. Thus, it widened the scope of auditor's duty with regard to frauds and errors and
laid down more strict standards of In recent years, this scope has been further extended to include
auditor's duty in such cases, besides shareholders, to third parties also provided his negligence is
proved. This is in recognition of public pressure on auditors to take more responsibility for fraud
detection in pursuance of their role of lending credibility to financial statements. The judgment in
Hedley Byrne and Co. Ltd. v. Heller and Partners Ltd. Co. [1963] recognised for the first time the
liability of professionals including company auditors towards third parties. More recently similar
decision in Caparo's [1990] case has also upheld the principle of auditor's duty towards third parties
for detection and prevention of frauds and errors in case of his negligence.

7 Professional perspective - SA 240 entitled, "The Auditor's Responsibility to Consider Fraud and
Error in an Audit of Financial Statements" provides expanded guidance on auditor's responsibility for
identifying and reporting on fraud and error. The important points are summarized below :

· The responsibility for preparation of financial statements is that of management and consequently,
the primary responsibility for the prevention and detection of fraud rests with both those charged
with governance of the entity and management.

◆ As already stated, a financial audit is conducted by the auditor to obtain reasonable (not absolute)
assurance that financial statements are free from material misstatements caused by fraud and/or
error.

· The auditor should approach audit work with a certain degree of professional skepticism i.e. be
alert to any signals of misstatement. To take an example, in Satyam's case, auditors did not exercise
sufficient professional skepticism. They accepted the financial statements at face value without
questioning discrepancies or unusual patterns that could indicate fraud.

· Communication of fraud should be to the appropriate authority: i. To the appropriate level of

management-If the auditor has identified or suspects fraud.
ii. To those charged with governance on a timely basis - If the auditor suspects fraud involving
management and he shall discuss with them the nature, timing and extent of audit procedures
necessary to complete the audit.

iii. To regulatory and enforcement authorities - If the auditor has identified or suspects a fraud and
there is a responsibility to report the occurrence or suspicion to a party outside the entity as per
legal requirements. Thus SA 240 acknowledges an auditor's duty to consider the risk of material
misstatements in the financial statements and lays down audit procedures when evidence indicates
the possibility of a fraud. It may be noted that auditor is not responsible for subsequent discovery of
frauds if he has adopted adequate audit procedures and his opinion is based on sufficient
appropriate evidence.

1.3 Types Of Error And Fraud Error

The term 'error' in context of audit refers to unintentional mistakes in the measurement or
presentation of financial information. The errors, in general, may be of the following types and are
shown in Figure 1.1.

Ypes Of Error And Fraud

(a) Clerical errors: Errors in recording, posting, totalling and balancingare Clerical errors. There are
two sub-types of clerical errors - Envors of omission and errors of commission:

· Errors of omission - Where a transaction is omitted wholly or partially in the books of account.
Some of the examples of such errors are given below :-

1. Voucher for purchase of goods on credit may have been overseen and was not entered in the
journal (full oncel sion and would not affect trial balance).

2. Goods sold to X were correctly recorded in journal but while posting to ledger X's account
was not given credit in Goods account (partial omission and would, therefore, affect trial
balance).

· Errors of commission - Where there is wrong posting of amounts, posting on the wrong side,
posting in wrong account, errors in totalling and balancing, errors in carry forward totals to trial
balance, etc. Some examples are given below :-

1. A purchase of ₹ 10,000 was entered in the purchase book as ₹ 1,000 (would not affect trial
balance).

2. Goods were sold to X for ₹ 20,000. This amount is posted to the debit of Y instead of X
(would not affect trial balance).

3. The debit balance of commission account of ₹ 550 may be carried forward to the debit
column of trial balance as ₹ 505 (would affect trial balance).

(b) Errors of principle: They occur when generally accepted accounting principles are not observed
while recording any transaction in the books of account. For example, wrong account head being
chosen or recording of capital expenditure as revenue or vice versa. These errors do not affect trial
balance. In order to detect them, the auditor should pay particular attention to those items where an
error of principle is most likely to occur.
(c) Compensating errors: Compensating errors are those errors that result in compensating the effect
of other errors. For example, if a person's account was to be debited by ? 100, he is debited instead
by ? 200 and other person who was to be debited by ₹ 200, is debited by ₹ 100. These errors do not
affect trial balance and can be located by checking the totals, postings and castings.

(d) Errors of duplication: These errors occur when the same transaction is recorded twice in the
books of original entry and, hence, also posted twice in ledger accounts. These do not affect trial
balance. In order to prevent them, clerks should distinctly mark the invoices and other vouchers after
having entered them in the books of original entry and duplicate invoices should be maintained in
separate files and should be stamped 'duplicate'.

Fraud

'Fraud' refers to intentional misstatement which is material to the financial statements.

Management, those charged with governance, employees or third parties may get involved in
committing frauds to obtain an illegal advantage or personal gain-

EMPLOYEE FRAUD It generally involves the theft of assets, mostly of cash or goods from @NNVWXVI
(i) Meaning the firm and computer hardware and software. Transactions are recorded in a manner so
as to conceal theft. (ii) Conceal- ment For example, fictitious purchases may be recorded to
misappropriate cash; actual sales may be shown as 'goods on consignment' to misappropriate goods;
good production may be classified as defective or as scrap and then may be used for personal
purposes and so on. Business relies on the system of internal control to reduce the (iii) Prevention
probability of occurrence of employee fraud. MANAGEMENT FRAUD It involves manipulation of
accounts by the upper level management (i) Meaning for the purpose of deliberately
misrepresenting the firm's financial position or results of operations to evade taxes, to receive higher
remuneration (when it is based on a percentage of profits), to show better performance of
management, etc. This process is also called window dressing. a. Manipulation, falsification or
alteration of books of account (ii) Examples b. Omission of transactions from books of account. c.
Misapplication of accounting policies

Advantages Of Auditing

10

a. Pressure to commit Fraud frequently involves b. Perceived opportunity to do so. The reasons are-
Management fraud is more a. Those charged with governance and management occupy difficult to
such positions that one trusts rather than suspect their detect than integrity. employee fraud. b.
They are in a position to override control procedures. c. Their position of authority enables them to
direct employees to do something or seek their help in carrying out a fraud.

Difference Between Error And Fraud

As indicated by definition and examples, intent is the underlying difference

TABLE 1.1: DIFFERENCE BETWEEN ERROR AND FRAUD Basis Error Fraud (i) Meaning (i) Error is an
uninten- (i) Fraud refers to intentional tional mistake in the misstatements which is ma-
measurement or pre- terial to financial statements sentation of financial TAXMANN information (ii)
Intent (ii) Error is (ii) Fraud is committed with unintentional an intention to derive some personal gain
(iii) Consequence (iii) The auditor should (iii) The auditor should consider- on the audit ensure
financial · its effect on financial work statements are ad- statements; justed for detected ◆ reliability
of manage- errors ment's representation; and · whether we should withdraw from engage- ment. (iv)
Possibility of (iv) More (iv) Less : Management makes detection deliberate attempts to conceal it.

between an error and a fraud.

1.4 Scope Of Auditing

As per SA 200, the scope of audit in India encompasses a wide range of activities aimed at providing
stakeholders with confidence in the reliability and integrity of financial information. By adhering to
established standards and procedures,

Table 1.1: Difference Between Error And Fraud Features Of Fraud

11 auditors play a crucial role in ensuring transparency, accountability, and trust in the financial
reporting process.

1.4-1 Inclusions In The Scope Of Audit

(i) Coverage of all essential aspects of the entity: The auditor's work should cover all material items
at individual level or at group level.

(ii) Reliability and sufficiency of financial information: He should satisfy himself that the information
contained in underlying accounting records and other source data is reliable and sufficient for
preparation of financial statements.

(iii) Appropriate disclosure of financial information: Auditors have to ensure that all relevant
information has been disclosed in the financial statements as per the applicable laws and financial
reporting framework applicable.

(iv) Expression of opinion: Expression of an opinion serves as a professional judgement on whether

the financial statements present a true and fair view of the company's financial position,
performance, and cash flows.

1.4-2 Exclusions From The Scope Of Audit

(i) Preparation and presentation of financial statements: The responsibility for the preparation and
presentation of the financial statement lies with the management and those charged with the
governance.

(ii) Roles outside the domain of auditor's competence: The auditors are not expected to perform the
duties which fall outside the preview of their competence. For example, auditors are not expected to
determine the physical condition of assets, such as machinery or buildings, as this falls outside their
domain of expertise.

(iii) Authentication of documents: Auditors do not authenticate the genuineness of documents, as

they are not experts in document authentication.

(iv) Investigation: Auditing is not investigation. While auditing is a regular and a systematic process of
evaluating the assertions made in the financial statements, investigations are conducted for the
purpose of gathering evidence to address specific concerns like a suspected fraud. Auditors do not
have the legal powers for conducting investigations.

1.5 Advantages Of Auditing

The advantages of audit to different user groups emanate from this, attestation function performed
by the auditor. Some of the advantages to different user groups are given below:

Inherent Limitations Of Auditing (Sa 200) 1.5-1 To Owners - Present And Potential

(i) Serves as a basis for relying on financial statements: An audit, b e a basis for relying from int
financial audit provides a basic f particular, independent financial audit provides a basis for assessing
particular, independent statements in case of all forms of business organisations. Examples of
situation where audited statements can be helpful are- (a) Determination of purchase consideration
in case running business is to be purchased.

(b) Settlement of accounts in a partnership firm in case of admission retirement or death of a partner
or any other dispute.

(c) In case of a joint stock company, to assess the reliability of the financial statements prepared by
board of directors.

(d) In case of non-trading organisations like schools, hospitals, clubs and other similar entities, to
know or to verify whether the money received in various forms such as grants, donations and
subscription fees has been utilised properly.

(ii) Serves as a check on the integrity of person at the helm of affairs: An audit besides lending
credibility has another important aspect - Control dimension. For example, in case of joint stock
companies, an independent financial audit gives the shareholders a basis for satisfying themselves
that the affairs of the company are being run smoothly and honestly by the management. In case of
trusts, co-operative societies etc., audited statements serve as an evidence for the beneficiaries or
members that their interests are being looked after properly and efficiently by board of trustees and
managing committee.

1.5-2 To Others

(i) To employees: As a basis for negotiating higher wages or bonus.

(ii) To potential creditors (e.g., bankers and suppliers): Provides a database for taking credit decisions.

(iii) To analysts (e.g., underwriters and credit rating agencies): Supplies required information to them.

(iv) To monitoring agencies (e.g., regulatory agencies such as SEBI and stock exchanges): Provides a
basis for monitoring the financial infor-

1.5-3 To Management
(i) Serves as a basis for establishment of and improvement in the control system: Managers at
various levels of management use financial data produced by firm's accounting system to make
decisions on questions such as budgeting, pricing of the products or services and so on.

(ii) Helps in dealing with lenders, insurers, Government and such other third parties: Audited
statements, on help the management in 13 establishing and settling claims against the insurers in
case of loss or damage to business property by way of fire, theft, burglary and other unforeseen
events. It can also serve as a basis for obtaining loans from banks and financial institutions, for
preparation of tax returns and various similar purposes.

(iii) Settlement of disputes: Audited financial statements are useful for settling trade disputes with
workers and settling disputes by arbitration.

From the above discussion, it is clear that an audit provides both external and internal users a basis
for making logical and informed decisions about various matters such as financial position,
management performance, establishment of controls and so on.

1.6 Inherent Limitations Of Auditing (Sa 200)

An audit can provide only reasonable assurance that the financial statements are from any material
misstatement. A reasonable assurance is a high-level assurance, but it does not reduce the risk of
material misstatement to zero. It means that an audit cannot provide an absolute assurance or
guarantee that financial statements are free from material misstatements. The audit's inherent
limitations explain this.

(i) Nature of financial statements: The preparation of financial statements involves the use of
management judgments and estimates. These judgments and estimates are based on context and
hence bring subjectivity and bias to the reporting. For example, the estimation of an asset's useful
life, the choice of a depreciation method, or the inventory valuation method involves judgment and
estimations by the management. These judgments and estimates bring a degree of uncertainty and
reduce the precision of the audit.

(ii) Nature of audit procedures: The auditor does not test all transactions; instead, they base their
opinion on evidence from testing samples. An auditor cannot force management to provide the
necessary information; he can only report if he has not received it or received a satisfactory response
from management.

(iii) Internal control limitations: Despite a well-designed internal control system, there is always a
possibility of human error. Furthermore, employees or senior management may conspire to
circumvent the internal control system and commit fraud.

(iv) Audit is not investigation: Since audit is not in the nature of investigation, they can only rely on
the information that is provided to them. Audit procedures used to gather audit evidence may be
ineffective for detecting an intentional misstatement. For example, fraud may involve sophisticated
and carefully organised schemes designed to conceal it.

Principles Of Audit

14 (v) Time and cost constraints: The relevance of some information may Time and cost constraints.
diminish over time, and time constraints may prevent the auditor from verifying all of it. They must
strike a balance between the cost of obtaining the information and its reliability.
(vi) Future events: The future is uncertain. An auditor cannot predict a future event or its impact on
an entity's business.

While the audit enhances the credibility of the financial statements, it does not completely eliminate
the risks associated with financial reporting.

1.7 Principles Of Audit

The core principles of auditing in India are established by the Institute of The Che promote of India
(ICAI) through various Standards on Auditing (SA) and Guidance Notes. The principles given by ICAI
are majorly influenced by best practices and international standards set by the International Auditing
of Assurance Standards Board (IAASB), which is an independent board for setting auditing standards
within the International Federation of Accountants (IFAC) that establishes auditing and assurance
standards at international level. The alignment of auditing standards and principles with
international bodies ensure comparability and consistency in the quality of auditing practices globally
while enhancing the credibility, reliability, proficiency, ethical conduct and relevance of auditing
practices in India.

The principles of audit as laid down by various accounting bodies serve as guidance in conducting
their audit engagements efficiently and ethically. The pivotal principles adopted globally as well as in
India are follows: (i) Integrity, objectivity and independence · Integrity: Auditors should be honest
and have strong moral principles. Auditors should adhere to the highest standards of ethical
behaviour. Auditors should not engage in any conduct which can discredit the profession.

· Objectivity: Auditors should be impartial and unbiased in their judgements and decisions. Auditors
should not be influenced by personal prejudices, or conflict of interests in expressing their opinion.

♦ Independence: Independence of auditors is of utmost importance to be free from circumstances

that could compromise the professional judgment. Auditors are expected to maintain independence
in appearance and fact to uphold impartiality and objectivity in performance of their duties.
Independence requires auditors to avoid personal relationships, financial interest or engaging in
situations that create any conflict of interests.

(ii) Professional skill and competence: Auditors are experts in accounting and should have requisite
knowledge and skills to perform their duties and responsibilities and efficiently conclude audit
engagements.

(iii) Confidentiality: In maintaining highest standards of ethical conduct, the auditors are expected to
maintain the confidentiality of any information they might have obtained during their audit
engagement. No information should be disclosed to any unauthorised parties unless it is warranted
by laws or professional standards.

(iv) Professional skepticism: Professional skepticism requires an auditor to maintain a questioning

mindset. Auditors should be critical in evaluating audit evidence and assertions made by the
management. Auditors should challenge the assumptions and judgments made by the management
to identify any potential risk or irregularities.

(v) Evidence-based approach (audit evidence): Auditors are required to express their opinion as to
whether the financial statements represent a true and fair state of affairs of the entity. The opinion
of the auditors should be based on the evidence that they gather during the course of their
engagement. The evidence should be both sufficient and reliable to provide a concrete base to the
opinion of auditors.
(vi) Work performed by others: At times, due to paucity of time or extremely high volume of
transactions, auditors may have to rely on work done by others, for example, internal auditors or
other specialists. In relying upon the work of others, auditors must evaluate the objectivity and
competence of the parties involved. Auditors must perform appropriate tests and procedures to
evaluate the work done by others.

(vii) Audit planning: Audit planning helps auditors and their teams to conduct the audit efficiently,
effectively and in a timely manner. It involves making an audit strategy, understanding the entity
being audited, determination of the nature, timing and extent of audit procedures. A good audit plan
helps to improve the quality of audit engagement.

(viii) Documentation: The importance of documentation cannot be understated while performing an

audit engagement. The auditors should document all the audit plans and programmes containing the
details about the nature, timing and extent of audit procedures. They should also maintain the audit
notebook and working papers.

(ix) Accounting system and internal control: Auditors should have a deep understanding of the
accounting systems as well as the internal control systems of the entity being audited in order to
identify the risk of material misstatements, that is, the chances of errors and frauds.

A risk assessment of this kind helps auditors in formulating the audit strategy, and determination of
the nature and extent of audit procedures.

(x) Audit conclusions and reporting: The audit report includes the opinion of the auditors and other
key matters that are identified during the 15 course of audit. The audit report serves as a means of
communicati with the shareholders and stakeholders.

Test Your Knowleinge

1. What do you understand by 'auditing'? Explain its objectives.

2. The main objective of an audit is to express an opinion on the truth and The main
beyenteents." Elacidate what is the importance of haning the accounts audited by an
independent professional auditor?

3. Write short notes on- (i) Objectives of auditing (ii) Principles of auditing (ail) Window
dressing

4. Comment on the following: (2 An auditor is a watchdog and not bloodhound.

(ii) Fraud does not necessarily involve misappropriation of cash or goods 5. Evaluate the following
statement: Every business entity should have an annual audit by a qualified auditor. To fogo an audit
because of its cost is false economy.

1. Explain the following : (i) Auditor does not guarantee that the books do correctly show the
tue position of the company's affair. Comment.

(ii) What are the different types of fraud in connection with accounts?

1. "Detection and prevention of errors and frauds are the main objects of auditing." Discuss it
fully and explain the duties of an auditor in this regard.

S. What is the importance of having the accounts audited by independent professional auditors?

1. Explain the scope of auditing.

 2. What is the auditor's duty with regard to detection of frauds? Cite legal cases in support of
your answer.

3. "Audit is persuasive in nature and not conclusive." Critically examine this statement.

4. Write a note on legal perspective of Auditor's duty with regard to detection of errors and
frauds giving reference of decision given in Kingston Cotton Mills

Co. (1896). 13. After completion of statutory audit of X Ltd. a fraud has been discovered. Can an
auditor be held responsible as per SA-240?

2.1 Introduction

Auditing, as already stated earlier, refers to any evaluation process carried. out systematically for a
defined purpose and resulting in an epinion, which is communicated to the interested parties
through a report.

This definition of auditing is sufficiently broad to encompass various types of audit. Different basis
can be adopted to classify audits to gain a better understanding of their characteristic features. The
following chart shows different types of andit:
Figure 2.1: Basis Of Classification Of Audit

IAXMANN 17

Classification On The Basis Of Organisational Structure Para 2.2 2.2 Classification On The Basis Of
Organisational Structum A. Private Audit B. Statutory Audit (V) Report (I) Statutory Requirement

of directors, or the Comptroller and Auditor General may appoint the auditor.

Private audits are carried out at the behest of the interested parties and w to fulfil statutory
requirements. The terms and conditions between the elle to fulfil statutory requires the scope of
latter's work. Sole proprietors, partnersk firms, certain individuals such as rent collectors, estate
manager, patnersh architects, etc. and non-profit organisations such as schools, hospitals, close
architects, etc. and non-provers of or various reasons. Some of these are to meetik requirements laid
down by internal rules and regulations, to ensure reliabily of financial statements and derive related
advantages.

(iv) Accounting treatment and disclosure of various items of financial statements · In the former case,
such treatment and disclosure should be in accordance with the Act.

· In the case of a firm, treatment and disclosure depends upon specific instructions of the client. But
the auditor should keep in consideration recognised accounting principles and standard auditing
practices while dealing with various items of financial statements.

An audit which is authorised, governed and made compulsory under any status is called statutory
audit. Various aspects concerning audit of accounts sucha scope of audit, qualifications of an auditor
and his rights, duties and liabilitie and other details are mentioned in the statute itself. Some such
examples are (i) The Companies Act, 2013 covering audit of limited companis ◆ A statutory auditor
has to submit his report to the shareholders of a company in accordance with the requirements of
the Companies Act, 2013.

incorporated under it.

· An auditor of a firm should report or certify in accordance with the terms of his appointment.

(ii) The Banking Regulation Act, 1949 applicable to audit of banking con panies.

c. Government audit (iii) The Insurance Act, 1938 governing audit of insurance companies.

(iv) The Electricity (Supply) Act, 1948 governing audit of electricity boards companies.

· MEANING AND SCOPE - Government audit is a control measure for public accounting of
Government funds. It covers the audit of all expenditure and receipts done by the executive and
audit of commercial accounts maintained by public enterprises. Public enterprises are classified
under three categories-departmental undertaking, statutory corporations financed by Government
and Government companies set up under the Companies Act, 2013.

(v) Co-operative Societies Act and Public and Charitable Trust Act o various states dealing with audit
of these entities.

Distinction between audit of a limited company and audit of a firm · WHO CONDUCTS IT - In India,
the Accounts and Audit Department of the Government of India, headed by the Comptroller and
Auditor General of India (CAG), carries the audit work. The CAG's duties have been specified by the
Comptroller and Auditor General's (Duties, Powers and Condition of Service) Act, 1971 and can be
classified as under - · The audit of limited companies is governed by statute i.e. the Companies Act,
2013 (hereinafter referred to as the Act).

The audit of a firm is governed by specific instructions from the client and partnership deed (if any).

(i) To audit the receipts and expenditures of the Union and State Governments alongwith
departmental undertakings.

(ii) Scope The rights and duties of statutory auditor cannot be restricted by the Articles [Newton v.
Birmingham Small Arms Co. Ltd. (1906)] or in any other manner. Auditor must conform to
requirements of the Act.
(ii) To audit the accounts of statutory bodies or corporations depending upon the nature of statute
governing them.

(iii) To audit the accounts of the Government companies in accordance with the provisions of the
Companies Act, 2013. In case of Government companies, as per the provisions of the Companies Act,
2013, the CAG appoints the statutory audit.

However, he has the power to give directions to such auditors for reporting on specific aspects of
their audit work and to conduct supplementary test audit of accounts.

· The scope of work of auditor of a firm may be varied, enlarged or restricted by proprietor or
partners.

(iii) Appointment of auditor · The auditor, in case of limited companies, is appointed by the
shareholders in general meeting. But in specific cases the board 19 XMANN Para 2.3

· Submission Of Audit Report

(i) The audit reports of the CAG on the accounts of the Union of The audit reports of inance and
Appropriation Accounts are States and certifica is dent or Governor for being laid before Submitted
to the Legislature. These audit reports include matters such as wasteful expenditure, non-observance
of rules cases of financial impropriety, etc. The Comptroller and Auditor General (CAG) presents the
audit reports to the Parliament which thereafter forwards them to the Public Accounts Committee
(PAC). It reviews the findings and recommendations of the CAG.

(ii) The reports of the CAG on public enterprises of the Central Government are presented to
Parliament and of the State Governments, to respective State Legislature.

2.3 Classification On The Basis Of Specific Objectives A. Independent Financial Audit

· Object: Independent financial audit is conducted for the purpose of ascertaining whether the
balance sheet and profit and loss account of a business give a true and fair view of the operations
and working results of a business respectively.

♦ Conducted by: It is conducted by professionally qualified auditors for clients who may be sole
proprietors, partners, various individuals, members of non-profit organisations and shareholders.

♦ Statutory status: Independent financial audit has been made compulsory for many entities
established under respective Acts.

· Reports: The auditor is required to submit his report to the client which is a useful document for
third parties as well.

b. Internal audit · Definition: Internal audit has been defined by the Preface to the Standards and
Guidance Notes on Internal Audit issued by the ICAI as, "an independent management function
which involves a continuous and critical appraisal of the function of the entity. The objective of
internal audit is to suggest improvement to the function of the entity and add value to and
strengthen the overall governance mechanism of the entity including strategic risk management and
internal control system." · Statutory status: Under section 138 of the Companies Act, 2013 internal
audit has been made mandatory for the class of limited companies required by the Central
Government to do so.

Independent audit v. Internal audit

Table 2.1 : Distinction Between

INDEPENDENT AUDIT AND INTERNAL AUDIT Internal audit Independent audit Basis (i) To review
financial (i) To ascertain the truth- (i) Object and non-financial fulness and fairness of operation as a
service state of affairs of an to management entity (ii) Owners/shareholders (ii) Management (ii)
Appointment of audi- tor (iii) Management (iii) To owners/ (iii) Submission of report shareholders (iv)
Decided by the (iv) Duties (iv) Fixed by statute or by management engagement letter (v) Auditor is
directly (v) Auditor is incidentally (v) Responsibility for de- concerned tection and prevention
concerned of frauds and errors (vi) Internal auditor (vi) May be conducted on (vi) Periodicity reviews
the operation an annual basis or on of a company contin- a continuous basis uously, i.e. through-
NVWXV out the vear

c. Cost audit · Definition: Cost audit is the verification of the correctness of cost accounts and of
adherence to the cost accounting plan.

· Statutory status: Section 148 of the Companies Act, 2013 has made cost audit mandatory for some
limited companies.

D. Management Audit

· Meaning and definition: Management audit is an audit to examine, review and appraise the various
policies and actions of the management on the basis of certain standards. It goes beyond the
conventional audit which lays emphasis on scrutiny of financial transactions and the books of
account only. Management audit is a comprehensive and critical review of all aspects of
management performance.

· Statutory status: It is not compulsory under any law. The shareholders or board of directors may
appoint the management auditor.

e. Tax audit · Definition: Tax audit can be defined as an examination of financial records to assess the
correctness of calculation of taxable profit, to ensure compliance with provisions of the Income-tax
Act, 1961 and also to ensure fulfilment of conditions for claiming deductions under the said Act.

AXMANN

22 SSIFICATION ON THE BASIS OF TIME 23 · Statutory status: The Income-tax Act has made tax audit
compulson The functions of the company secretary shall include- Statutory status. The mostion
44AB. The Assessing Officer has Functions of for specified persons in der section 142(2A) to direct
the assessee to get his To report to the Board about compliance with the Company Secretary a.
provisions of the Act, the rules made thereunder and been empowered untan 'accountant'
nominated by the Commissioner other laws applicable to the company; of Income-tax. To ensure
that the company complies with the applicable. b. f. Secretarial audit secretarial standards; and
Meaning Secretarial audit is an audit to examine compliance of various To discharge such other
duties as may be prescribed C. Secretains applicable to the entity by a practising company Duties of
Company Same as that of statutory audit secretary duly appointed by Board of Directors. Secretary
� Objectives To verify and report on compliances with applicable Secretarial audit report to be
annexed to the Board report. Report submission laws and Secretarial Standards. It should be
submitted before the preparation of Board's � To point out instances of non-compliances and
Report. inadequate Compliances. To give all assistance and facilities to the Company Secretary Duty
of the company in Practice, for auditing the secretarial and related records � To look after the
interest of various stakeholders i.e. the of the company. employees, local community, customers, etc.
Action on BOD's part Board of Directors, in their report, shall explain in full, any � To protect the
entity against any unwarranted legal qualification or observation or other remarks made by the
actions/penalties by law enforcing agencies. Company Secretary in practice in audit report.
Applicability of Sec- a. All Listed Companies. retarial audit- Section g. Forensic Audit (Discussed in
Chapter 14) ь Every public company having paid up share capital of 204 50 crore rupees or more, or
ONNVWXVI AXMANN 2.4 CLASSIFICATION ON THE BASIS OF TIME C. Every public company having a
turnover of 250 crore rupees or more a. Continuous audit d. Every company having outstanding
loans or borrowings · CONCEPT - According to R.C. Williams from banks or public financial institutions
of Rs. 100 "A continuous audit is one where the auditor or his staff is constantly crore or more
engaged in checking the accounts during the whole period or where the e. Secretarial Audit is also
applicable to a private com- auditor or his staff attends at regular or irregular intervals during the
pany which is a subsidiary of a public company, and which falls under the prescribed class of
companies as period." indicated above. The following features of continuous audit come to light on
analysis of SEBI (LODR) Regula- As per Regulation 24A of SEBI (LODR) Regulations, 2015, the above
definition- tions, 2015 Every listed entity and its material subsidiaries incorporated (a) It is carried
throughout the year. in India shall undertake secretarial audit and shall annex (b) It is conducted at
regular or irregular intervals. secretarial audit report with its annual report, given by a (c) The
accounts are subjected to scrutiny as and when prepared. practicing company secretary in form and
manner as may be prescribed. "Material Subsidiary" means a subsidiary whose (d) Full verification of
assets and liabilities is left until the balance income or net worth exceeds ten per cent of the
consolidated sheet is prepared. However, some assets like cash balances and income or net worth,
respectively, of the Company and its inventory may be verified at every visit by the auditor.
Subsidiaries in the immediately preceding accounting year. (e) Trial balance, profit and loss account
and balance sheet are Whoshould conduct it Practising Company Secretary in respect of secretarial
and audited at the end of the year. other records of the company. Disqualifications mentioned under
section 141(3) for Statutory auditor are also applicable · SUITABILITY - The nature of continuous audit
is such that it is not suited for Secretarial auditor. for all types of organisations. It is most suited in
following situations: (a) Where transactions are frequent and regulatory requirements are stringent
e.g., banks and mutual funds.

Classification On The Basis Of Time B. Annual Audit

24 (b) Where transactions are complex and operations are Where transaccead e.g., companies with
multiple subsidianes (c) Where transaction volume is high, e.g., e-commerce platforms (a) The
auditor can guard himself against tampering of figures in following ways : where transacontinuous
audits to monitor sales, inventory and compliance in real time.

· He should instruct the staff of the client to make alterations, if any, in figures that have been
audited by only passing rectification entries in journal and bringing it to the notice of auditor.

(d) Where internal controls are not very effective.

· ADVANTAGES OF CONTINUOUS AUDIT - These are as follows: The auditor should also device special
form of ticks for being placed against figures which have been altered and neither their purpose nor
significance should be disclosed to client's staff.

(a) Early detection of frauds and errors: Detailed and exhaustive checking of accounts leads to quick
detection of frauds and errors. Extent of fraud gets limited in case of continuous audit as compared
to a situation where the defrauding party has full one year in which to operate.

Totals of accounts at the end of the period under review should, if practicable, be recorded in the
audit note book and verified at the next visit.
(b) Knowledge of technical details: The auditor utilizes automated audit tools and software that can
help him to continuously monitor and analyze data. He/she may employ data analytics to identify
patterns, anomalies, and trends that indicate the presence of red flags.

(b) To prevent collusion between staff of the auditor and that of client, the auditor may rotate the
duties of his staff in such a manner that every audit clerk is allowed to check a particular account
only for a short period.

(c) Efficiency of auditors: Auditor, in case of continuous audit, can plan his audit work in a systematic
manner. The auditor's work is more evenly spread over the year.

(c) In order to ensure that the link in audit work is not lost: · The auditor should prepare detailed
audit programme.

· He should note down the queries, whose explanations are unsatisfactory, in his audit note book and
try to sort them out at subsequent visit.

(d) Moral check: The fact that the auditor is visiting frequently acts as a moral check on the staff of
the client.

· DISADVANTAGES OF CONTINUOUS AUDIT - The main disadvantages are as follows: · If possible, the
auditor should try to check the accounts of similar nature in one continuous sitting.

(a) Tampering with figures: Figures may be altered (unknowingly or fraudulently) after being checked.

(d) The dislocation in client's work may be reduced if the auditor plans his visits in consultation with
the client. But planned visits need to be supplemented by surprise checks.

(b) Likely collusion between client's staff and auditor's staff: Frequent interaction of the staff of the
client with that of the auditor may provide scope for unhealthy relationship between the two. They
might collude to perpetuate a fraud.

(c) Losing link in audit work: The auditor's staff may not be able (e) The biggest limitation of
continuous audit is that it is quite expensive. Only big organisations should go for it after undertaking
cost-benefit analysis.

to, despite caution, follow up transactions and certain queries may be left unanswered.

· CONCEPT - Annual audit is one which is carried out only at the end of an accounting period. Spicer
and Pegler have defined it as, "An audit which is not commenced until after end of the financial
period and is then carried on until completed." (d) Dislocation of client's work: Frequent visits of the
auditor disrupt the normal flow of work. The staff of the client may divert its attention from their
routine work to providing details required by the auditor.

Annual audit is also called periodical, final or completed audit.

(e) Expensive: The continuous audit involves detailed and exhaustive checking. The auditors,
therefore, charge hefty audit fees ..

· CHARACTERISTICS OF ANNUAL AUDIT - The main characteristics of annual audit are as follows: (a) It
is done at the close of the financial year after books of account have been closed and final accounts
drawn.

· SAFEGUARDS TO BE APPLIED - The effect of disadvantages listed above may be minimised by

adopting certain safeguards which are as follows: 25 TAXMANN (b) The audit work is completed in a
single continuous session 24 (c) It gives satisfactory results in case of small concerns, Continuous
audit v. Annual audit

Table 2.2 : Distinction Between Continuous Audit And Annual Audit

CONTINUOUS AUDIT AND ANNUAL AUDIT Basis Annual audit Continuous audit (i) Nature (i)
Completed in (i) Carried on at regular or ir. a single con- regular intervals during the tinuous session
year after the close of financial year (ü) Thoroughness (ii) Less thorough (ii) More thorough; the
auditor is better acquainted with ac- counting and other controls of the entity (iii) Suitability (iii)
Small business- (iii) Big organisations or medium es sized organisations (iv) Verification of assets (iv)
At the end of the (iv) Full verification of assets and and liabilities year liabilities is not undertaken till
the end of the year Cash balances and inventory may, however, be verified at every visit by the
auditor (v) Detection and pre- (v) At the end of the (v) During the year vention of frauds and year
errors (ví) Cost (vi) Less expensive (vi) Expensive (vii) Preparation of inter- (vii) It does not help (vii) It
helps im accounts c. Interim audit

An audit conducted between two annual audits is called interim audit. It is always carried out with an
interim purpose, for example, declaration of interim dividend or valuation of shares to decide swap
ratio in case of a merger. Interim audit does not enjoy statutory status. However, it is generally
carried out by professionally qualified auditors.

D. Balance Sheet Audit

The following points can be made about balance sheet audit:- (i) Origin: Balance sheet audit is of
recent origin as compared to other (ii) Limited audit: It means limited audit in which all the balance
sheet items are verified vit. assets, balances of reserves and provisions, 27

St Your Knowledge

capital, profit earned or loss suffered by the firm during the year and other liabilities.

(iii) Tests are applied on items of profit and loss account: It may be noted that balance sheet audit is
not confined to balance sheet items only, wherever appropriate, tests are applied on those profit and
loss account items which are directly related to the assets, for example, repair and maintenance
account can be scrutinised to ascertain whether any expenditure of capital nature has been classified
as revenue expense.

(iv) Ascertainment of profit: The idea of ascertainment of profits in the balance sheet audit is similar
to that of the single entry system.

(v) Suitability: Balance sheet audit is most suitable for organisations which have an efficient system of
internal control or where mechanised accounting system is in operation.

(vi) Popularity: Balance sheet audit is popular in U.S.A. But, in India, there is no distinction between
final audit and balance sheet audit.

Test Your Knowledge

1. Distinguish between- (i) Audit of accounts of a partnership firm and a company (ii) Internal
audit and statutory audit (iii) Balance sheet audit and continuous audit (iv) Continuous audit
and annual audit 2. Write short notes on- (i) Continuous audit (ii) Final or completed audit
(iii) Balance sheet audit 3. Comment-

(i) Continuous audit is a double edged weapon.

(ii) The Companies Act, 2013 has given statutory recognition to secretarial audit. 4. State the main
difference between private audits and statutory audits. Explain the advantages of statutory audit in
respect of those organisations where it is obligatory.

Dr. Praveen Kumar Loharkar has a Ph.D. in Engineering with one post-graduate degree in Industrial
Design from Maulana Azad National Institute of Technology and another in Data Science from Narsi
Monzi Institute of Management Sciences (NMIMS), Mumbai. He has more than 14 years of combined
experience in industry and academia. Dr. Praveen has been certified as a Base SAS Programming
Specialist and a Predictive Modeler with a successful track record in executing industry projects.
NPTEL has recognized him as a Discipline Star. He currently has 20 Scopus-indexed journal
publications. Dr. Praveen has been a gold medallist graduate trainee at ISMT Ltd, Pune. He has
acquired 30+ MOOC certifications. He is passionate about integrating engineering expertise with data
science for impactful solutions and using generative AI in teaching-learning.