Meaning and Definition of Auditing

The word Audit is derived from Latin word “Audire” which means ‘to hear’. Auditing is the
verification of financial position as disclosed by the financial statements. It is an examination
of accounts to ascertain whether the financial statements give a true and fair view financial
position and profit or loss of the business. Auditing is the intelligent and critical test of
accuracy, adequacy and dependability of accounting data and accounting statements.
Different authors have defined auditing differently, some of the definition are:

“Auditing is an examination of accounting records undertaken with a view to establishment

whether they correctly and completely reflect the transactions to which they purport to
relate.”-L.R.Dicksee

“Auditing is concerned with the verification of accounting data determining the accuracy
and reliability of accounting statements and reports.” - R.K. Mautz

“Auditing is the systematic examination of financial statements, records and related

operations to determine adherence to generally accepted accounting principles, management
policies and stated requirement.” -R.E.Schlosser

FUNCTIONS OF AUDIT
1. Study The Accounting System :-
It is the basic function of auditing. In order to determine the nature, timing and extent of the
audit procedures auditor should study the accounting system.
2. Internal Control System :-
It is a process which determines that management policies are carried out according the
accounting principles. This system is very useful to safeguard the interest of the enterprise.
The auditor determines the effectiveness of this system.
3. Vouching :-
This function is essential to determine the accuracy of accounting record. Through audit
those documents can be checked which support and prove the business transactions. All
entries in books of accounts are made on the basis of relevant vouchers.
4. Verification Of Assets :-
It is the function of auditing that it should verify the assets of the business. It is concerned
with the determination of value, ownership and possession of business asset. The auditor can
check the existence of asset.
5. Legal Requirement :-
It is the function of auditing to verify that statements are prepared under the legal
requirements or not. There are various laws like company and income tax ordinance which
are introduced by the govt.
6. Liabilities Verification :-
The liabilities of the business can be verified from the books of accounts. The auditor can
write a letter to the creditors for the verification of liabilities. The auditor must receive the
certificate from the management in this regard.
7. Capital And Revenue :-
Auditing should make difference between capital and revenue items. The capital items are
compared to note the financial position of the business. The revenue items are compared to
determine the income. The income and expenses related to many years can be divided in
current and coming year.
8. Valuation Of Liabilities :-
Through auditing value of liabilities can be checked from the books of accounts and other
papers. The auditor can also confirm the value from outside sources. The value of liabilities
is given in the balance sheet by the management but it is the function of auditing which
confirms this value.
9. Valuation Of Assets :-
The management gives the value of assets and auditor can apply the accounting principles to
assess the value of assets. The auditor critically examines and takes help from the expert.
10. Reporting :-
Auditing important function is reporting. Auditor is an independent person and it is his duty
to submit his report in writing. If he is satisfied he can present clean report otherwise he can
give qualified report.
Importance of Auditing

Importance of auditing can be judged from the fact that even those organizations which are
not covered by companies Act get their financial statements audited. It has become a
necessity for every commercial and even non- commercial organization. The importance of
auditing can be summed in following points:

a. Audited accounts help a sole trader in knowing the value of the business for the purpose of
sale.

b. Dispute over correctness of profits can be avoided.

c. Shareholders, who do not know about day-to-day administration of the company , can
judge the performance of management from audited accounts.

d. It helps management in detecting and preventing errors and frauds.

e. Management gets advice on financial affairs from the auditors.

f. Long and short term creditors depend on audited financial statements while taking decision
to grant credit to business houses.

g. Taxation authorities depend on audited statements in assessing the income tax, sales tax
and wealth tax liability of the business.
h. Audited accounts are useful for the government while granting subsidies etc

. i. It can be used by insurance companies to settle the claims arising on account of loss by
fire.

j. Audited accounts serve as a basis for calculating purchase consideration in case of

amalgamation and absorption.

k. It safe guards the interests of the workers because audited accounts are useful for settling
trade disputes for higher wages or bonus

 Objectives of Auditing
 The objectives of auditing are changing with the advancement of business techniques.
Earlier it was only to check the correctness of receipts and payments. The objectives
of the auditing have been classified under two heads:
 1) Main objective
 2) Subsidiary objectives
 Main Objective: The main objective of the auditing is to find reliability of financial
position and profit and loss statements. The objective is to ensure that the accounts
reveal a true and fair view of the business and its transactions. The objective is to
verify and establish that at a given date balance sheet presents true and fair view of
financial position of the business and the profit and loss account gives the true and fair
view of profit or loss for the accounting period. It is to be established that accounting
statements satisfy certain degree of reliability. Thus the main objective of auditing is
to form an independent judgement and opinion about the reliability of accounts and
truth and fairness of financial state of affairs and working results.
 2) Subsidiary objectives:

1. Detection and prevention of errors: errors are mistakes committed unintentionally

because of ignorance, carelessness. Errors are of many types:
a. Errors of Omission: These are the errors which arise on account of transaction into
being recorded in the books of accounts either wholly partially. If a transaction has
been totally omitted it will not affect trial balance and hence it is more difficult to
detect. On the other hand if a transaction is partially recorded, the trial balance will
not agree and hence it can be easily detected.
b. Errors of Commission: When incorrect entries are made in the books of accounts
either wholly, partially such errors are known as errors of commission. Eg: wrong
entries, wrong Calculations, postings, carry forwards etc such errors can be located
while verifying.
c. Compensating Errors: when two/more mistakes are committed which counter
balances each other. Such an error is know an Compensating Error. Eg: if the amount
is wrongly debited by Rs 100 less and Wrongly Credited by Rs 100 such a mistake is
known as compensating error.
 d. Error of Principle: These are the errors committed by not properly following the
accounting principles. These arise mainly due to the lack of knowledge of accounting.
Eg: Revenue expenditure may be treated as Capital Expenditure.

2. Deduction and Prevention of Fraud: A fraud is an Error committed intentionally to

deceive/ to mislead/ to conceal the truth/ the material fact. Frauds may be of 3 types.
A Misappropriation of Cash: This is one of the majored frauds in any organisation it
normally occurs in the cash department. This kind of fraud is either by showing more
payments/ less receipt.
The cashier may show more expenses than what is actually incurred and misuse the
extra cash. Eg: showing wages to dummy workers. Cash can also be misappropriated
by showing less receipts
Eg: not recording cash sales. Not allowing discounts to customers. The cashier may
also misappropriate the cash when it is received. Cash received from 1st customer is
misused when the 2nd customer pays it is transferred to the 1st customer’s account.
When the 3rd customer pays it goes forever. Such a fraud is known as “Teaming and
Lading”. To prevent such frauds the auditor must check in detail all books and
documents, vouchers, invoices etc.
B Misappropriation of Goods: here records may be made for the goods not purchase not
issued to production department, goods may be used for personal purpose. Such a fraud
can be deducted by checking stock records and physical verification of goods.
C Manipulation of Accounts: this is finalizing accounts with the intention of misleading
others. This is also known as “WINDOWS DRESSING”. It is very difficult to locate
because its usually committed by higher level management such as directors. The
objective of WD may be to evade tax, to borrow money from bank, to increase the share
price etc.
to conclude it cab be said that, it is not the main objective of the auditor to discover
frauds and irregularities. He is not an insurance against frauds and errors. But if he
finds anything of a suspicious nature, he should probel it to the full.

Various classes of audit

1. Statutory Audit: any audit carried on as per the requirement of law is called as a
statutory audit. eg: all companies have to get their accounts audited as per the provision of
the company’s Act of 1956.
2. Periodical/ Annual Audit: it is a kind of audit where the auditor verifies the account at
the end of the financial year. He starts the audit work after the closure of financial year.
This is a common audit and is mostly used by small organizations.
3. Interium audit: its an audit conducted in the middle of the accounting year before the
accounts are closed. In other words any audit conducted between two financial audit is
known s interium audit. The objective is to get periodical results, to declare interium
dividend.
4. Partial Audit: when an auditor is asked to audit only a part of the account system. Its
called partial audit. Eg: he may be asked to audit only the payment side of cash book.
5. Balance sheet audit: it’s a kind of partial audit and is concerned with the verification of
only those items appearing in the Balance Sheet. It is more popular in the USA. Infact
while verifying BS items the auditor verifies/ checks all related items/accounts.
6. Cost audit: cost audit is defined as the verification of cost accounting records. Data and
techniques for its accuracy and authenticity. It gets as effective managerial tool for the
 detection of errors and frauds in cost accounting records. The companies act implies the
central government to order cost audit incase of specifies companies.
7. Management audit: Management audit may be defined as a comprehensive examination
of an organizational structure of a company, institution/government and its plans and
objectives it means of operations and use of human and physical facilities. The main
objective of mgt audit is to see how far the objectives of mgt are fulfilled. It aims to
ascertain whether sound mgt prevails throughout the organisation and evaluates its
efficiency in the system of its operation.
8. Continuous audit: a continuous audit is one in which the auditor visits his clients office
at regular intervals through out the year to verify the account. The objective of CA may
be-
a. To get final account audited immediately after the closure of accounting year.
b. When the business is very large.
c. When interval control system is into effective.
d. When regular final accounts are required.

Limitations of auditing

1. Non-detection of errors/frauds:- Auditor may not be able to detect certain frauds which
are committed with mollified intentions.

2. Dependence on explanation by others:- Auditor has to depend on the explanation and

information given by the responsible officers of the company. Audit report is affected
adversely if the explanation and information prove to be false.

3. Dependence on opinions of others:- Auditor has to rely on the views or opinions given by
different experts viz Lawyers, Solicitors, Engineers, Architects etc. he can not be an expert in
all the fields

4. Conflict with others: - Auditor may have differences of opinion with the accountants,
management, engineers etc. In such a case personal judgement plays an important role. It
differs from person to person.

5. Effect of inflation : - Financial statements may not disclose true picture even after audit
due to inflationary trends.

6. Corrupt practices to influence the auditors :- The management may use corrupt
practices to influence the auditors and get a favourable report about the state of affairs of the
organisation.

7. No assurance :- Auditor cannot give any assurance about future profitability and
prospects of the company.

8. Inherent limitations of the financial statements :- Financial statements do not reflect

current values of the assets and liabilities. Many items are based on personal judgement of
the owners. Certain non-monetary facts can not be measured. Audited statements due to these
limitations can not exhibit true position.