M.Com.

4th Semester Course: MC404 AF(C)

FORENSIC ACCOUNTING AND AUDITING

(DSE)

Lesson 1 to 20

By: Amit Kumar

INTERNATIONAL CENTRE FOR DISTANCE EDUCATION AND OPEN LEARNING

(ICDEOL)
HIMACHAL PRADESH UNIVERSITY
SUMMER HILL, SHIMLA, 171005
 MC404 AF(C ): FORENSIC ACCOUNTING AND AUDITING (DSE)
Max. Marks 80
Internal Assessment 20
Note: There will be Ten (10) questions in all spreading into Five Units consisting of two questions from each
unit. The candidate will require to attempt one question from each unit. Each question will carry Sixteen (16)
marks

Course Objectives: To enable students to meet the challenges posed by rising financial frauds and scams world
over, more so in the view of limitations of financial accounting and auditing procedures.

Course Contents:

Unit I
Forensic Accounting & Fraud Auditing Fundamentals: Meaning, nature and scope, Auditors liability for undetected
frauds, Fraud auditing (forensic audit) phases: Recognition and planning, Evidence collection and evaluation,
Communication of results
Unit II
Fraud Definition & Taxonomy: Ingredients of fraud, why is a fraud committed and who commits a fraud? , Meaning and
nature of corporate fraud, concept of fraud under Companies Act 2013, frauds for and against a company, victims of
fraud.
Unit III
Types of Corporate Frauds: Bribery and corruption, Misappropriation of assets, Manipulation of financialstatements,
Procedure-related frauds, Corporate espionage, Fraud in e-commerce. Fraud Prevention- Strategies, Fraud
prevention for consumers and businesses.
UNIT IV
Auditing: Concept Type, Principles, Internal Control- Internal Check and Internal Audit, Vouching and Verification of
Assets and Liabilities.
UNIT V
Dividend and Divisible Profits, Company Auditor: Qualifications and disqualifications, Appointment, Removal,
Remuneration, Rights, Duties and Liabilities, Audit Committee, Auditor’s Report: Contentsand Types, Auditor’s
Certificates.

References:
1. Albrecht, W. Steve. (2009). Forensic Accounting & Fraud Examination. Cengage Learning
(IndiaEdition).
2. Albrecht, Chad O., Albrecht, Conan C., Albrecht, W. Steve & Zimbelman, Mark F. (2015).
Forensic Accounting & Fraud Examination. Cengage Learning (India Edition).
3. Banerjee, Robin (2015). Who Cheats and How? Sage Publications, New Delhi.
4. Bologna, Jack and Lindquist, Robert J. (1995). Fraud Auditing and Forensic Accounting.
Wiley. Bremser, Wayne G. (1995). Forensic Accounting and Financial Fraud.American
Management Association
 CONTENTS

Sr.No. Topic Page No.

Lesson -1 Introduction to Forensic Accounting 4

Lesson-2 Forensic auditing 18

Lesson-3 Fraud auditing 30

Lesson-4 Fraud 48

Lesson-5 Corporate fraud 63

Lesson-6 Provision against Fraud under Companies Act 2013 77

Lesson-7 Types of Corporate Frauds 88

Lesson-8 Types of Corporate Frauds –II 100

Lesson-9 Fraud in e-commerce 111

Lesson - 10 Introduction to auditing 120

Lesson-11 Basic concepts in auditing 134

Lesson-12 Audit evidence 142

Lesson-13 Internal control 157

Lesson-14 Vouching 172

Lesson-15 Verification and valuation of assets and liabilities 186

Lesson-16 Dividend and Divisible Profits 199

Lesson-17 Company auditor 210

Lesson-18 Company auditor-ii 225

Lesson-19 Audit committee 241

Lesson-20 Audit report 250

 Lesson-1
Introduction to Forensic Accounting

Structure:
1.0 Learning Objectives
1.1 Introduction
1.2 Nature of forensic accounting
1.3 Scope of forensic accounting
1.4 Applications for forensic accounting
1.5 Importance of forensic accounting
1.6 Types of forensic accountings
1.7 Forensic accountant
1.8 Disadvantages of forensic accounting
1.9 Summary
1.10 Glossary
1.11 Answers: Self Assessment
1.12 Terminal Questions
1.13 Answers: Terminal Questions:
1.14 Suggested Readings

1.0 Learning Objectives

After studying the lesson, you should be able to:-
1. Scope of forensic accounting
2. Types of forensic accountings
3. Forensic accountant
4. Applications for forensic accounting

1.1 Introduction

Forensic accounting is a specialized field of accounting that involves investigating

financial records to uncover fraud, embezzlement, or other financial misconduct.
Forensic accountants utilize their accounting expertise along with investigative skills
to analyze complex financial data, detect irregularities, and provide evidence for legal
proceedings. They often work closely with law enforcement agencies, attorneys, and
corporate entities to unravel financial discrepancies, reconstruct financial transactions,
and quantify damages in cases ranging from corporate fraud to money laundering.
Through meticulous examination of financial documents, digital data trails, and
testimony, forensic accountants play a crucial role in uncovering financial improprieties
and assisting in the pursuit of justice.

The field of forensic accounting encompasses a broad spectrum of activities beyond

just fraud investigation, as highlighted by the perspectives of practitioners and
scholarly sources. While definitions may vary depending on individual backgrounds
and experiences, there are commonalities among them. Forensic accounting involves
the application of specialized skills, including accounting, auditing, finance,
quantitative methods, legal knowledge, research, and investigative techniques, to
address financial issues with a focus on meeting the standards required by courts of
law. This multifaceted approach allows forensic accountants to collect, analyze, and
evaluate evidential matter in diverse contexts, not limited to fraud, but also extending
to areas such as litigation support, dispute resolution, bankruptcy, marital disputes,
and regulatory compliance. The definition provided by Hopwood, Leiner, and Young
emphasizes the importance of interpreting and communicating findings effectively,
indicating the role of forensic accountants in providing clear, objective, and compelling
evidence to support legal proceedings and decision-making processes. Therefore,
while fraud investigation is a significant aspect of forensic accounting, its scope is
much broader, encompassing a wide range of financial issues and legal contexts
where forensic accounting expertise proves invaluable.
Forensic Accounting and Fraud Examination by Kranacher, Riley, and Wells defines
financial forensics similarly, as follows:
Financial forensics is the application of financial principles and theories to facts or
hypotheses at issue in a legal dispute and consists of two primary functions:
1. Litigation advisory services, which recognizes the role of the financial forensic
professional as an expert or consultant
2. Investigative services, which makes use of the financial forensic professional’s skills
and may or may not lead to courtroom testimony.
1.2 NATURE OF FORENSIC ACCOUNTING
The nature of forensic accounting is characterized by its multidisciplinary approach
and its focus on investigating financial matters with the aim of providing evidence for
legal proceedings or resolving financial disputes. Key aspects of the nature of forensic
accounting include:
1. Multidisciplinary Approach: Forensic accounting draws upon various
disciplines such as accounting, auditing, finance, law, investigative techniques,
and quantitative analysis. Forensic accountants need to possess a diverse skill
set to effectively investigate and analyze complex financial transactions and
data.
2. Investigative Nature: Forensic accountants are often called upon to
investigate suspected financial misconduct, fraud, embezzlement, or other
 irregularities. This involves examining financial records, transactions, and
digital data trails to identify discrepancies and potential fraudulent activities.
3. Legal Compliance: Forensic accountants work within the framework of legal
standards and procedures. They must adhere to strict rules of evidence and
maintain objectivity and independence in their findings. The evidence they
gather and the reports they produce may be used in court proceedings,
arbitration, mediation, or regulatory investigations.
4. Litigation Support: Forensic accountants frequently provide support to legal
professionals in litigation matters. They may assist in assessing financial
damages, quantifying losses, or providing expert witness testimony in court to
help clarify complex financial issues for judges and juries.
5. Preventive Measures: While much of forensic accounting involves
investigating past financial activities, it also includes proactive measures to
prevent future financial misconduct. Forensic accountants may develop internal
controls, conduct risk assessments, or provide fraud awareness training to
organizations to mitigate the risk of fraud and financial mismanagement.
6. Communication Skills: Effective communication is essential in forensic
accounting. Forensic accountants must be able to clearly convey complex
financial information and findings to non-financial stakeholders, including
attorneys, law enforcement officials, corporate executives, and regulatory
agencies.
7. Evidence Collection: They are proficient in gathering, preserving, and
analyzing financial evidence, often utilizing specialized tools and techniques to
trace transactions and uncover financial trails.
8. Fraud Detection and Prevention: While fraud investigation is a significant
aspect, forensic accountants also focus on fraud prevention through the
implementation of internal controls and risk management strategies.
9. Dispute Resolution: Forensic accountants play a crucial role in resolving
financial disputes, whether in the context of commercial litigation, marital
dissolution, business valuation, or insurance claims.
10. Compliance and Regulatory Oversight: They help organizations navigate
complex regulatory environments, ensuring compliance with financial reporting
standards and regulatory requirements.
11. Quantitative Analysis: Forensic accountants utilize quantitative methods and
financial modeling to assess damages, calculate financial losses, and evaluate
the economic impact of financial misconduct.

1.3 SCOPE OF FORENSIC ACCOUNTING

The scope of forensic accounting is broad and diverse, encompassing various aspects
of financial analysis, investigation, and legal support. Here's an in-depth overview of
the scope of forensic accounting:
1. Fraud Examination: Forensic accountants investigate allegations of fraud
within organizations, identifying fraudulent activities such as embezzlement,
asset misappropriation, and financial statement fraud.
2. Financial Statement Analysis: They analyze financial statements to detect
irregularities, discrepancies, and potential indicators of fraudulent activity.
3. Litigation Support: Forensic accountants provide expert testimony and
support in legal proceedings, offering analysis, reports, and interpretation of
financial evidence to assist in dispute resolution and litigation.
4. Quantification of Damages: They assess and quantify economic damages in
legal disputes, including matters such as breach of contract, business
interruption, personal injury claims, and intellectual property disputes.
5. Asset Tracing and Recovery: Forensic accountants trace and locate assets
in cases of fraud, bankruptcy, or divorce, assisting in asset recovery efforts
through financial analysis and investigative techniques.
6. Due Diligence Investigations: They conduct financial due diligence
investigations to assess the financial health, integrity, and risks associated with
potential business transactions, mergers, or acquisitions.
7. Internal Control Evaluation: Forensic accountants evaluate and recommend
improvements to internal control systems to prevent and detect fraud and
financial misconduct within organizations.
8. Anti-Money Laundering (AML) Compliance: They assist organizations in
complying with AML regulations by implementing controls, conducting risk
assessments, and investigating suspicious financial transactions.
9. Whistleblower Allegations: Forensic accountants investigate whistleblower
complaints and allegations of financial misconduct within organizations,
providing independent assessments and recommendations for remedial action.
10. Regulatory Compliance: They help organizations navigate complex
regulatory environments by ensuring compliance with financial reporting
standards, tax regulations, and industry-specific regulations.
11. Expert Witness Testimony: Forensic accountants serve as expert witnesses
in court proceedings, providing impartial and credible testimony on financial
matters based on their expertise and analysis.
12. Insurance Claims Investigations: They examine insurance claims to
determine the validity and extent of losses, assessing the financial impact and
providing documentation to support claims settlements.
 13. Bankruptcy and Insolvency Matters: Forensic accountants assist in
bankruptcy proceedings by analyzing financial records, assessing creditor
claims, and providing expert opinions on financial restructuring and liquidation.
14. Data Analytics and Digital Forensics: With the increasing reliance on digital
systems, forensic accountants use data analytics and digital forensics
techniques to analyze electronic records, detect fraud, and trace financial
transactions.
15. Educational and Preventive Services: They provide training and educational
programs to organizations on fraud prevention, detection, and internal control
best practices, helping to mitigate the risk of financial misconduct.

1.4 APPLICATIONS FOR FORENSIC ACCOUNTING

Beyond the spotlight on fraud, forensic accounting has various other significant
applications. In 2008, recognizing the need for specialized expertise beyond the
Certified Fraud Examiner (CFE) designation, the American Institute of Certified Public
Accountants (AICPA) introduced the Certified in Financial Forensics (CFF) credential,
effective from September 2010. This credential reflects a broader scope within forensic
accounting, encompassing specific practice areas beyond fraud examination. These
applications include but are not limited to litigation support, financial dispute resolution,
expert testimony, damage quantification, asset tracing and recovery, forensic data
analysis, regulatory compliance, due diligence investigations, insurance claims
assessments, bankruptcy proceedings, and anti-money laundering (AML) efforts. The
field of forensic accounting, as defined by the AICPA, is thus characterized by a
foundational knowledge base complemented by a diverse array of practical
applications tailored to the complexities of financial analysis and legal support.

Forensic accounting requires both fundamental and specialized knowledge to

effectively investigate financial matters and support legal proceedings.
Fundamental Knowledge:
1. Laws, Courts, and Dispute Resolution: Forensic accountants need a solid
understanding of relevant laws, court procedures, and dispute resolution
mechanisms to navigate legal frameworks and provide support in litigation
contexts.
2. Planning and Preparation: Thorough planning and preparation are essential
in forensic accounting engagements. This involves defining objectives,
identifying key stakeholders, allocating resources, and developing strategies to
achieve investigative goals effectively.
3. Information Gathering and Preserving: Forensic accountants must be adept
at gathering and preserving relevant financial information and evidence. This
 includes obtaining documents, conducting interviews, securing digital data, and
ensuring the integrity and admissibility of evidence.
4. Discovery: In the discovery phase, forensic accountants analyze collected
information, identify patterns, anomalies, and potential areas of concern, and
formulate hypotheses to guide further investigation.
5. Reporting, Experts, and Testimony: Forensic accountants are responsible
for preparing clear, concise, and comprehensive reports documenting their
findings, analyses, and conclusions. They may also provide expert testimony in
court proceedings, presenting their findings and opinions to judges, juries, and
other stakeholders.
Specialized Forensic Knowledge:
1. Bankruptcy, Insolvency, and Reorganization: Forensic accountants
specializing in bankruptcy and insolvency matters possess expertise in
analyzing financial distress, assessing creditor claims, evaluating restructuring
options, and facilitating the resolution of financial disputes in distressed
situations.
2. Computer Forensic Analysis: With the increasing reliance on digital systems,
forensic accountants specializing in computer forensic analysis are skilled in
retrieving, analyzing, and interpreting electronic data to uncover evidence of
financial misconduct, fraud, or other illicit activities.
3. Economic Damage Calculations: Damages are a key component of every
lawsuit. If a party believes it has been harmed or wronged, but cannot identify
or prove it has suffered damages, the likelihood of the party prevailing in
litigation is not good. Two key terms for this area of litigation are causation and
damages. Causation simply means the actions or inactions of one party caused
the injury or loss of the other party. Damages refer to the calculated loss
suffered as a result of causation. Forensic accountants are called upon to
calculate losses in many contexts, including lost earnings, lost profits, lost
business, and the physical loss of property (e.g., fire, flood, theft). The forensic
accountant often will rely upon historical information, conduct interviews,
physically inspect property, and perform trending in order to complete the
damage calculation.
4. Family Law: In marital dissolution engagements, forensic accountants play
multifaceted roles crucial to ensuring equitable outcomes and financial
transparency. Initially, they serve as strategists, collaborating with legal counsel
and clients pre-divorce to uncover any hidden or undisclosed income sources
or assets that should be included in financial affidavits. Detailed analysis of
each party's earnings, expenses, and earning potential informs calculations for
alimony and child support. Particularly when one party has business ownership,
forensic accountants conduct thorough business valuations to ascertain
accurate asset division. They also possess expertise in tax laws and forms,
often the sole disclosed financial documents, and assess the reliability of
financial information provided. Given the highly emotional nature of divorce
 proceedings, forensic accountants frequently serve as expert witnesses,
offering deposition and trial testimony. Despite these vital roles, cases
commonly involve issues of fraud and nondisclosure, underscoring the critical
need for their expertise in ensuring financial integrity amidst personal turmoil.
5. Financial Statement Misrepresentation: This area would entail the forensic
accountant being retained to examine the financial statements and disclosures
of publicly traded and privately held entities and organizations, to determine
whether the financial statements properly reported the balances, results, and
required disclosures. If found to be improper, the forensic accountant could
identify the improprieties of the financial statements, such as overstatements,
understatements, omissions, and improper accounting treatments, as well as
calculate the effect such identified issues would have on the financial
statements. The forensic accountant also could identify any standards, rules,
procedures, and regulations that were violated; assist in determining who was
involved; and reveal any underlying schemes or motives for intentional
misrepresentations.
6. Fraud Prevention, Detection, and Response: Fraud encompasses a large
area of opportunity for forensic accountants, in preventing fraud schemes from
occurring, investigating fraud schemes that have occurred, and assisting
owners and organizations in implementing better controls and procedures in
response to a fraud scheme having been committed. The forensic accountant
can be retained by an organization to proactively evaluate its systems of
internal controls, financial policies, and accounting procedures before any thefts
are identified, as well as to seek indications of fraud within specific areas even
when no “red flags” or indications of fraud exist. However, once fraud has been
identified, the forensic accountant can prove invaluable in investigating and
determining what happened, who was involved, how the scheme was
committed, how long the scheme went on, and other important aspects required
in order to resolve the matter. There are many types of fraud and many contexts
in which the forensic accountant can apply all of these services, and a detailed
discussion follows further emphasizing this.
7. Business Valuation: Forensic accountants are called upon to conduct
business valuations within a number of contexts. The valuation may be required
for purposes of dividing assets in a divorce, as discussed earlier, or may be part
of some other type of litigation, such as a shareholder dispute. Conversely,
valuations can be completed in nonlitigation contexts as well, such as within
business transactions, in estate planning, for post-mortem estate purposes,
and for gifting. In business transactions, such as purchases and sales of
companies, and shareholder buy-ins and partner buy-outs, the value of the
business likely may be the driving force behind the dollar amount (e.g., sales
price or buy-out amount) and other terms of the transaction. Federal and state
tax regulations for estates and gifts revolve around the value of each
transaction. In the case of estate and gift taxes, values below a certain amount
have no tax effect, but once the value exceeds the amount, taxes are due, often
 significant in amount. Planning for such transactions before they occur can
minimize the taxes due.

These specialized areas of forensic knowledge require additional training, expertise,

and technical skills beyond the fundamental knowledge base. Forensic accountants
leverage their specialized knowledge to provide targeted solutions and insights
tailored to the unique challenges and complexities of each forensic accounting
engagement.
1.5 IMPORTANCE OF FORENSIC ACCOUNTING
The primary benefits of quality forensic accountancy include:
1. Minimized Losses: Forensic accounting helps prevent and minimize financial
losses by detecting and addressing fraudulent activities and financial
discrepancies before they escalate.
2. Improved Efficiency: Forensic accountants analyze financial processes and
standards, identifying areas for improvement and implementing more efficient
solutions to enhance overall business operations.
3. Reduced Exploitation Risk: By identifying and patching vulnerabilities in
financial operations, forensic accountants reduce the risk of future exploitation,
safeguarding the business from potential threats.
4. Avoidance of Legal Problems: Forensic accounting can help prevent legal
issues stemming from fraud or financial misconduct by implementing preventive
measures and addressing potential problems early on.
5. Enhanced Brand Reputation and Authority: Effective forensic accounting
practices demonstrate a commitment to integrity and transparency, enhancing
the organization's reputation and authority in the eyes of stakeholders,
customers, and investors.
6. Increased Accountability: Forensic accounting promotes accountability within
the organization by holding individuals responsible for their actions and
ensuring compliance with ethical and legal standards.
7. Cost Savings: By identifying and addressing financial irregularities promptly,
forensic accountancy can save the organization significant costs associated
with legal disputes, regulatory fines, and financial losses.
8. Strategic Decision-Making: The insights provided by forensic accountants
enable informed decision-making, allowing management to allocate resources
more effectively and pursue growth opportunities with confidence.
9. Regulatory Compliance: Forensic accountants ensure compliance with
regulatory requirements and industry standards, reducing the risk of penalties
and reputational damage associated with non-compliance.
 10. Early Detection and Prevention: Through ongoing monitoring and analysis,
forensic accountants detect and prevent financial misconduct at an early stage,
mitigating potential damage to the organization's financial health and
reputation.

1.6 TYPES OF FORENSIC ACCOUNTINGS

Forensic accounting encompasses various specialized areas, each addressing
specific financial issues and legal contexts. Followings are the types of forensic
accounting:
1. Fraud Examination: This involves investigating allegations of fraud, including
embezzlement, asset misappropriation, and financial statement fraud, to
determine the extent and nature of fraudulent activities.
2. Litigation Support: Forensic accountants provide expert support in legal
proceedings by analyzing financial data, preparing reports, and offering expert
testimony to assist lawyers, judges, and juries in understanding complex
financial matters.
3. Business Valuation: Forensic accountants conduct business valuations to
determine the value of businesses and assets for purposes such as mergers,
acquisitions, shareholder disputes, and divorce settlements.
4. Financial Statement Analysis: Forensic accountants analyze financial
statements to detect irregularities, errors, or potential signs of financial
mismanagement, providing insights into the financial health and integrity of
organizations.
5. Insurance Claims Investigations: Forensic accountants investigate insurance
claims to assess the validity and extent of losses, ensuring compliance with
policy terms and preventing fraudulent claims.
6. Bankruptcy and Insolvency Matters: Forensic accountants assist in
bankruptcy proceedings by analyzing financial records, assessing creditor
claims, and providing expert opinions on financial restructuring and liquidation.
7. Anti-Money Laundering (AML) Compliance: Forensic accountants help
organizations comply with AML regulations by implementing controls,
conducting risk assessments, and investigating suspicious financial
transactions to prevent money laundering activities.
8. Computer Forensic Analysis: With the increasing reliance on digital systems,
forensic accountants specializing in computer forensic analysis retrieve,
analyze, and interpret electronic data to uncover evidence of financial
misconduct, fraud, or other illicit activities.
9. Marital Dissolution (Divorce): Forensic accountants assist in divorce
proceedings by analyzing financial records, conducting asset tracing, and
 providing expert opinions on asset division, alimony, and child support
calculations.
10. Regulatory Compliance Audits: Forensic accountants conduct audits to
assess compliance with regulatory requirements, industry standards, and
internal policies, identifying areas of non-compliance and recommending
corrective actions.

1.7 Forensic Accountant

A forensic accountant is a financial professional who specializes in investigating,
analyzing, and interpreting financial information for legal purposes. They utilize their
accounting expertise, investigative skills, and knowledge of legal principles to uncover
financial irregularities, detect fraud, and provide evidence for litigation or dispute
resolution. Forensic accountants are often called upon to examine complex financial
transactions, trace assets, quantify damages, and provide expert testimony in court
proceedings. They work in various industries, including public accounting firms,
consulting firms, law enforcement agencies, government organizations, and corporate
entities, assisting in cases ranging from corporate fraud investigations to marital
disputes. In addition to their technical skills, forensic accountants must possess strong
analytical abilities, attention to detail, and the ability to communicate complex financial
concepts effectively to non-financial stakeholders.

Forensic accounting services play a role whenever an organisation needs to

investigate potential financial misconduct or fraud, whether suspected or proven.

Following are the some points:

1. Investigating Financial Misconduct or Fraud: Forensic accounting services
are essential whenever there are suspicions or evidence of financial
misconduct or fraud within an organization. Forensic accountants utilize their
expertise to investigate financial records, transactions, and activities to uncover
any irregularities or fraudulent behavior.
2. Insights and Asset Recovery: Forensic accountants provide valuable insights
into financial irregularities, helping organizations identify and recover lost
assets. Through thorough analysis of financial data and transactions, they can
trace the movement of funds and assets, even in cases of complex fraud
schemes.
3. Litigation and Dispute Resolution Support: Forensic accountants play a
crucial role in litigation and dispute resolution by providing expert testimony and
presenting financial evidence to support legal cases. Their analyses and
findings can be instrumental in resolving disputes and achieving favorable
outcomes for their clients.
 4. Ethical Standards: Forensic accountants adhere to the highest ethical
standards while gathering and analyzing evidence. They ensure the integrity
and reliability of their findings, maintaining impartiality and objectivity
throughout the investigative process.
5. Proactive Fraud Detection and Prevention: Beyond addressing fraud after it
has occurred, forensic accounting services can proactively detect and prevent
potential instances of fraud. By implementing effective internal controls,
monitoring financial activities, and conducting regular audits, forensic
accountants help organizations mitigate the risk of financial misconduct.
6. Cybercrime and Financial Fraud: With the rise of cybercrime and
sophisticated financial fraud schemes, businesses increasingly rely on forensic
accounting services to protect their financial integrity. Forensic accountants
possess specialized skills in analyzing digital evidence and uncovering
fraudulent activities conducted through electronic channels.
7. Necessary Insurance Policy: Given the prevalence and potential impact of
financial fraud, businesses should view forensic accounting services as a
necessary insurance policy for safeguarding their financial interests. Investing
in forensic accounting expertise enables organizations to detect and address
fraudulent activities promptly, minimizing financial losses and reputational
damage.
8. Safeguarding Against Financial Misconduct: By leveraging the skills and
expertise of forensic accounting professionals, businesses can effectively
safeguard against potentially devastating financial misconduct. Forensic
accountants provide proactive solutions and recommendations to strengthen
internal controls and prevent future instances of fraud or financial irregularities.
9. Comprehensive Financial Protection: Forensic accounting services offer
comprehensive financial protection by identifying vulnerabilities, detecting
fraudulent activities, and implementing measures to mitigate risks.
Organizations that utilize forensic accounting expertise demonstrate a
commitment to transparency, integrity, and accountability in their financial
operations.
10. Strategic Decision-Making: Ultimately, forensic accounting services empower
organizations to make informed and strategic decisions based on reliable
financial information. By leveraging the insights and recommendations provided
by forensic accountants, businesses can mitigate risks, protect assets, and
maintain financial stability in an increasingly complex and challenging business
environment.
1.8 DISADVANTAGES OF FORENSIC ACCOUNTING
Forensic accounting, which involves the examination of financial records to uncover
potential fraud or misconduct, can be a valuable tool in identifying financial
irregularities. However, it also comes with its own set of disadvantages:
 1. Costly: Forensic accounting investigations can be expensive due to the
specialized skills and time required to conduct thorough examinations of
financial records. This cost may not be feasible for all organizations, especially
smaller businesses or individuals.
2. Time-consuming: Forensic accounting investigations can be time-consuming,
often requiring extensive analysis of financial documents and transactions. This
can disrupt normal business operations and may take weeks or even months
to complete.
3. Complexity: The field of forensic accounting is highly complex, requiring a
deep understanding of accounting principles, legal regulations, and
investigative techniques. Not all accounting professionals possess the
necessary expertise to effectively conduct forensic accounting investigations.
4. Subjectivity: Forensic accounting involves a degree of subjectivity in
interpreting financial data and identifying potential red flags. Different
investigators may reach different conclusions based on their interpretation of
the evidence, which can lead to inconsistencies in findings.
5. Legal and Ethical Challenges: Forensic accountants must adhere to strict
legal and ethical standards when conducting investigations. They must ensure
that their actions comply with relevant laws and regulations, such as those
governing privacy and confidentiality. Failure to do so could result in legal
consequences or damage to their reputation.
6. Limited Scope: Forensic accounting investigations are typically focused on
uncovering specific instances of fraud or financial misconduct. While they may
identify individual cases of wrongdoing, they may not address underlying
systemic issues within an organization's financial practices.
7. Reputation Damage: The mere initiation of a forensic accounting investigation
can tarnish the reputation of individuals or organizations involved, regardless
of whether any wrongdoing is ultimately found. Allegations of financial
impropriety can damage relationships with clients, suppliers, and stakeholders.
8. Invasion of Privacy: Forensic accounting investigations may require
accessing sensitive financial information, which can intrude on the privacy of
individuals or entities under scrutiny. This invasion of privacy can lead to
resentment and legal challenges, particularly if the investigation does not result
in any findings of wrongdoing.
9. Limited Resources: In some cases, organizations may lack the resources or
expertise to conduct comprehensive forensic accounting investigations. This
may result in incomplete or inadequate examinations of financial records,
potentially overlooking instances of fraud or misconduct.
Despite these disadvantages, forensic accounting remains a crucial tool in detecting
and preventing financial fraud, particularly in cases where traditional auditing methods
may be insufficient. It's essential for organizations to weigh the potential drawbacks
against the benefits of uncovering and addressing financial misconduct.
Self Assessment
1. What forensic accounting?
2. Describe in Applications for Forensic Accounting:
3. Explain Scope of Forensic Accounting
4. What is Computer Forensic Analysis

1.9 Summary.
Forensic accounting is a specialized branch of accounting focused on investigating
financial discrepancies and fraud, utilizing accounting, auditing, and investigative
skills. Its scope encompasses various areas including litigation support, investigative
accounting, and fraud examination. The applications of forensic accounting are
diverse, ranging from resolving disputes, uncovering financial fraud, to evaluating
damages in legal proceedings. The importance of forensic accounting lies in its ability
to provide accurate and credible financial evidence, aiding in legal proceedings,
dispute resolution, and fraud prevention. There are different types of forensic
accounting such as fraud auditing, investigative accounting, and litigation support. A
forensic accountant plays a crucial role in analyzing financial records, conducting
investigations, and presenting findings in a clear and concise manner. However, there
are some disadvantages to forensic accounting, including the potential for high costs,
lengthy investigations, and the need for specialized expertise. In summary, forensic
accounting is a vital tool in ensuring financial integrity, uncovering fraud, and providing
crucial evidence in legal matters, although it comes with its own set of challenges.
1.10 Glossary
1. Forensic accounting: Forensic accounting is a specialized field of accounting
that involves investigating financial records to uncover fraud, embezzlement, or
other financial misconduct. Forensic accountants utilize their accounting
expertise along with investigative skills to analyze complex financial data,
detect irregularities, and provide evidence for legal proceedings.
2. Computer Forensic Analysis: With the increasing reliance on digital systems,
forensic accountants specializing in computer forensic analysis are skilled in
retrieving, analyzing, and interpreting electronic data to uncover evidence of
financial misconduct, fraud, or other illicit activities.
3. Business Valuation: Forensic accountants are called upon to conduct
business valuations within a number of contexts. The valuation may be required
for purposes of dividing assets in a divorce, as discussed earlier, or may be part
of some other type of litigation, such as a shareholder dispute. Conversely,
valuations can be completed in nonlitigation contexts as well, such as within
business transactions, in estate planning, for post-mortem estate purposes,
and for gifting.
 4. Fraud Examination: This involves investigating allegations of fraud, including
embezzlement, asset misappropriation, and financial statement fraud, to
determine the extent and nature of fraudulent activities.

5. Forensic accountant: A forensic accountant is a financial professional who

specializes in investigating, analyzing, and interpreting financial information for
legal purposes. They utilize their accounting expertise, investigative skills, and
knowledge of legal principles to uncover financial irregularities, detect fraud,
and provide evidence for litigation or dispute resolution.
1.11 Answers: Self Assessment
1). Please check section 1.1 2). Please check section 1.4 3). Please check section 1.3
4). Please check section 1.10

1.12 Terminal Questions

1. Can you provide examples of situations where forensic accounting is typically
employed?
2. What areas fall under the scope of forensic accounting investigations?. Why is
forensic accounting considered crucial in the field of finance and business?.
3. What are the different types of forensic accounting specialties?
4. Are there any limitations or challenges associated with the practice of forensic
accounting?
1.13 Answers: Terminal Questions:
1). Please check section 1.2 2). Please check section 1.3 and 1.5 3). Please check
section 1.6 4). Please check section 1.8
1.14 Suggested Readings
1. Albrecht, W. Steve. (2009). Forensic Accounting & Fraud Examination. Cengage
Learning (India Edition).
2. Albrecht, Chad O., Albrecht, Conan C., Albrecht, W. Steve & Zimbelman, Mark F.
(2015). Forensic Accounting & Fraud Examination. Cengage Learning (India
Edition).
3. Banerjee, Robin (2015). Who Cheats and How? Sage Publications, New Delhi.
4. Bologna, Jack and Lindquist, Robert J. (1995). Fraud Auditing and Forensic
Accounting. Wiley.
5. Bremser, Wayne G. (1995). Forensic Accounting and Financial Fraud.American
Management Association.
 Lesson -2
FORENSIC AUDITING
Structure:
2.0 Learning Objectives
2.1 Introduction
2.2 Fraud
2.3 Stages of audit
2.4 Meaning of forensic audit
2.5 Significance of forensic
2.6 Objectives of forensic audit
2.7 Fraud and forensic audit : an introspect
2.8 Forensic audit vis-à-vis audit
2.9 Summary
2.10 Glossary
2.11 Answers: Self Assessment
2.12 Terminal Questions
2.13 Answers: Terminal Questions:
2.14 Suggested Readings
2.0 Learning Objectives
After studying the lesson, you should be able to:-
1. Describe Fraud
2. Meaning of forensic audit
3. Forensic audit vis-à-vis audit

2.1 Introduction
The field of forensic audit stands at the intersection of finance, investigation, and legal
expertise. With a blend of detective skills and financial acumen, forensic auditors delve
deep into financial records to uncover discrepancies, identify fraudulent activities, and
determine the perpetrators behind such acts within companies.
Indeed, the application of forensic auditing extends beyond the realm of criminal activity
detection. In various business contexts, such as turnarounds or mergers and acquisitions, a
thorough understanding of a company's financial landscape is essential for making informed
decisions and mitigating risks. Forensic audit plays a pivotal role in these scenarios by
providing an in-depth analysis of financial data and uncovering insights that go beyond
surface-level numbers.
For firms engaged in turnarounds, forensic audit offers valuable insights into the
financial health of distressed companies. By meticulously examining financial records,
forensic auditors can identify underlying issues, such as mismanagement,
inefficiencies, or potential fraud, that may have contributed to the company's decline.
This detailed understanding allows turnaround specialists to develop strategic plans
for restructuring and revitalizing the business.
Similarly, in the context of mergers and acquisitions, forensic audit helps prospective
buyers assess the true value and risks associated with a target company. By
scrutinizing financial statements, contracts, and other relevant documents, forensic
auditors can uncover hidden liabilities, irregularities in financial reporting, or potential
legal issues that could impact the success of the transaction. This insight enables
acquirers to negotiate more effectively and make well-informed decisions regarding
the investment.
Moreover, forensic audit goes beyond numbers to examine the connections between
financial data and related communications, such as emails, memos, and contracts.
This holistic approach provides a comprehensive understanding of the context
surrounding financial transactions, helping stakeholders identify patterns of behavior,
potential conflicts of interest, or instances of undue influence.
In summary, forensic audit serves as a powerful tool for due diligence and risk
assessment in various business scenarios, enabling organizations to navigate
complex financial landscapes with confidence and clarity. By uncovering hidden risks
and providing actionable insights, forensic auditors contribute to the success and
sustainability of businesses undergoing transformational change.

This specialized area covers a broad spectrum of tasks, including:

1. Fraud Finding: Forensic auditors are adept at identifying various forms of
fraud, ranging from embezzlement to financial statement manipulation, through
meticulous examination of financial data.
2. Fraud Detection and Prevention Techniques: They employ advanced
techniques and methodologies to detect and prevent fraudulent activities within
organizations, helping to safeguard assets and maintain financial integrity.
3. Fraud-Related Auditing: Forensic auditors conduct audits specifically focused
on identifying and addressing fraud risks, ensuring compliance with regulatory
requirements, and enhancing internal controls.
4. Investigation and Analysis of Financial Evidence: They conduct thorough
investigations into financial irregularities, gathering and analyzing evidence to
reconstruct financial transactions and determine the extent of fraudulent
activities.
5. Development of Computerized Applications: Forensic auditors leverage
technological tools and software applications to streamline the analysis and
 presentation of financial evidence, enhancing efficiency and accuracy in their
investigations.
6. Communication of Findings: They present their findings through
comprehensive reports, exhibits, and collections of documents, providing clear
and concise explanations of their analysis and conclusions.
7. Assistance in Legal Proceedings: Forensic auditors play a crucial role in legal
proceedings by serving as expert witnesses in court, providing testimony based
on their expertise and preparing visual aids to support trial evidence, thereby
assisting in the pursuit of justice.
In essence, forensic audit professionals play a vital role in safeguarding financial
integrity, uncovering fraudulent activities, and ensuring accountability within
organizations. Their expertise and meticulous approach are indispensable in
combating financial crimes and upholding ethical standards in the realm of finance.

2.2 Fraud
Definition
The term "audit," with its roots in the Latin word "audire," meaning "to hear," carries a
significant historical connotation. In medieval Britain, when manual bookkeeping was
the norm, auditors would listen as the accounts were read aloud to them. Their role
was to ensure that the organization's personnel were not negligent or engaging in
fraudulent activities.
This historical perspective underscores the fundamental purpose of auditing: to
provide assurance regarding the accuracy and reliability of financial information.
Auditors act as impartial overseers, meticulously examining financial records and
procedures to verify their integrity and compliance with established standards and
regulations.
While the methods and technologies of auditing have evolved significantly since
medieval times, the core principles remain unchanged. Auditors continue to listen,
metaphorically, to the financial story told by the organization's records, using their
expertise to detect any discrepancies or irregularities that may indicate errors or
fraudulent behavior.
In essence, the significance of auditing lies in its role as a guardian of financial integrity
and transparency. By upholding rigorous standards of scrutiny and accountability,
auditors play a vital role in fostering trust and confidence in the reliability of financial
information, benefiting stakeholders and society as a whole.

The concept of auditing encompasses providing third-party assurance to stakeholders

regarding the accuracy and reliability of various subject matters, most commonly
financial information pertaining to legal entities. However, auditing extends beyond
financial matters and encompasses other areas such as secretarial and compliance
audits, internal controls, quality management, project management, water
management, and energy conservation.
In the context of detecting fraud, auditing plays a crucial role, as highlighted by Moyer
and Chatfield. Detecting cases of fraud is considered one of the primary duties of
auditors. Historically, auditing in the United States was primarily focused on verifying
bookkeeping details.
Auditing has become pervasive in both corporate and public sectors due to its
essential role in ensuring financial health and detecting fraud. Professionals have
specialized in auditing processes, with forensic audit emerging as one such
specialized branch with specific objectives.
During an audit, auditors perceive and recognize the propositions under examination,
gather evidence, evaluate it, and form opinions based on their judgment. These
opinions are communicated through audit reports. As a result of audits, stakeholders
can effectively evaluate and enhance the effectiveness of risk management, control,
and governance processes related to the subject matter under examination.
In summary, auditing serves as a critical mechanism for providing assurance,
detecting fraud, and improving overall governance and risk management processes
within organizations and across various sectors.

2.3 STAGES OF AUDIT

Indeed, the audit process typically comprises several distinct stages, each crucial for
ensuring the thoroughness and effectiveness of the audit. Here's an overview of the
typical stages involved in an audit:
1. Know Your Client and Organization: At the outset, auditors familiarize
themselves with the client's business operations, organizational structure,
industry, and relevant regulations. Understanding the client's objectives, risks,
and internal control environment is essential for planning the audit effectively.
2. Audit Planning and Strategy: Based on the knowledge gained about the client
and its operations, auditors develop an audit plan outlining the scope,
objectives, timing, and resources required for the audit. This phase involves
identifying key audit risks, determining materiality thresholds, and outlining the
audit approach.
3. Fieldwork: The fieldwork stage involves executing the audit plan by conducting
on-site visits, gathering supporting documentation, and performing substantive
testing procedures. Auditors interact with client personnel, review financial
records, and test internal controls to obtain sufficient and appropriate audit
evidence.
4. Collect Information and Obtain Evidence: Auditors collect relevant
information and evidence to support their audit findings and conclusions. This
may include financial statements, transaction records, contracts,
correspondence, and other documentation pertinent to the audit objectives.
 5. Analysis: During this stage, auditors analyze the information and evidence
collected to assess the reliability, accuracy, and completeness of the financial
data. They may perform various analytical procedures, such as ratio analysis,
trend analysis, and benchmarking, to identify anomalies or inconsistencies that
warrant further investigation.
6. Evaluate and Assess the Impact of Evidence: Auditors evaluate the
sufficiency and persuasiveness of the audit evidence gathered to support their
audit findings and conclusions. They assess the significance of any identified
errors, deficiencies, or deviations from established criteria in relation to the audit
objectives.
7. Exercise Professional Judgment: Auditors exercise professional judgment
throughout the audit process, considering the facts and circumstances, inherent
risks, materiality considerations, and applicable auditing standards. They make
informed decisions regarding audit procedures, evidence evaluation, and the
formulation of audit opinions.
8. Reporting and Documentation: Finally, auditors prepare and communicate
their audit findings, conclusions, and recommendations to relevant
stakeholders through the audit report. The report typically includes a summary
of audit procedures, significant findings, management's responses, and the
auditor's opinion on the fairness of the financial statements or compliance with
applicable criteria. Comprehensive documentation of audit workpapers is
essential to support the audit opinion and ensure compliance with auditing
standards.
These stages collectively form a systematic and structured approach to auditing,
enabling auditors to fulfill their responsibilities effectively and provide stakeholders with
reliable assurance regarding the subject matter under audit.

2.4 MEANING OF FORENSIC AUDIT

Forensic audit refers to a specialized examination of evidence related to a specific
assertion, conducted in a manner suitable for presentation in a court of law. This type
of audit is distinct from traditional financial audits, as its primary objective is to gather
evidence that may be used as legal support in litigation or dispute resolution. Forensic
audits are often carried out in response to suspicions of fraud, embezzlement, or other
financial misconduct. The examination is thorough, aiming to uncover and document
relevant financial information and transactions.
According to Investopedia, forensic audit is defined as the examination and evaluation
of a firm's or individual's financial information specifically for use as evidence in a court
setting. This type of audit may be initiated to prosecute individuals or entities for
financial crimes such as fraud or embezzlement. However, forensic audits can also
serve broader purposes, including determining negligence or establishing financial
obligations in legal matters such as spousal or child support cases.
In summary, forensic audit combines accounting, investigative, and legal expertise to
scrutinize financial information with the goal of providing evidence that can be
presented in a court of law. It is a specialized form of audit with a focus on uncovering
financial irregularities and supporting legal proceedings related to financial claims or
disputes.

2.5 SIGNIFICANCE OF FORENSIC

Audit Forensic auditing has taken an important role in both private and public
organizations since the dawn of the 21st century especially in the advance economies.
The catastrophe of some formerly prominent public companies such as Enron and
WorldCom (MCI Inc.) in the late 1990s, coupled with the terrorist attacks of September
11, 2001 and the recent incidence of frauds taken place in the corporates including
the one in the leading public bank of Indian economy, have fueled the prominence of
forensic auditing/ accounting, creating a new, important and lucrative specialty.
Forensic auditing procedures target mostly financial and operational fraud, discovery
of hidden assets, and adherence to federal regulations.
Cressy19 (2012) in his paper explained that in forensic auditing specific procedures
are carried out in order to produce evidence. Audit techniques and procedures are
used to identify and to gather evidence to prove, for example, how long have fraudulent
activities existed and carried out in the organization, and how it was conducted and
concealed by the perpetrators. Evidence may also be gathered to support other issues
would be relevant in the event of a court case.

THE SIGNIFICANCE OF FORENSIC AUDIT

Following are the some points in significance:
Key Advantages
In this context, few key benefits of Forensic Audit are listed below:
1. Detection and Responsibility of Corruption: In a Forensic Audit, while
investigating fraud, an auditor would look out for:
• Conflicts of interest – When fraudster uses his/her influence for personal gains
detrimental to the company. For example, if a manager allows and approves
inaccurate expenses of an employee with whom he has personal relations. Even
though the manager is not directly financially benefitted from this approval, he is
deemed likely to receive personal benefits after making such inappropriate approvals.
• Bribery – As the name suggests, offering money to get things done or influence a
situation in one’s favor is bribery. For example, ABC bribing an employee of B2C
company to provide certain data to aid ABC in preparing a tender offer to B2C.
• Extortion – If B2C demands money in order to award a contract to ABC, then that
would amount to extortion. In this process, Forensic Audit aids in detecting the
corruption in the corporates and also determine responsibility of the person liable for
the corruption and its practices.
2. Detection of Asset Misappropriation: This is the most common and prevalent
form of fraud. Misappropriation of cash, raising fake invoices, payments made to non-
existing suppliers or employees, misuse of assets, or theft of Inventory are a few
examples of such asset misappropriation.
3. Detection of Financial Statement Fraud: Companies get into this type of fraud to
try to show the company’s financial performance as better than what it actually is. The
goal of presenting fraudulent numbers may be to improve liquidity, ensure top
management continue receiving bonuses, or to deal with pressure for market
performance. Some examples of the form that financial statement fraud takes are the
intentional forgery of accounting records, omitting transactions – either revenue or
expenses, non-disclosure of relevant details from the financial statements, or not
applying the requisite financial reporting standards.
4. Fraud Identification and Prevention: Fraud is quite common in big organizations
where the number of daily financial transactions is huge. In such an environment, an
employee can easily undertake fraudulent activities without being caught. Forensic
accounting helps in analyzing whether the company’s accounting policies are followed
or not, and whether all the transactions are clearly stated in the books of accounts.
Any deviation observed in the books of accounts can help in identifying fraud, and
necessary measures can be taken to prevent it in the future.
5. Making Sound Investment Decisions: As forensic accounting helps in analyzing
the financial standing and weaknesses of a business, it provides a path for investors
to make thoughtful investment decisions. A company engaged in fraud is definitely not
a good option for investment. Therefore, the reports of forensic accountants act as a
guide for potential investors of a company. Many organizations also apply for loans
from various financial institutions. By performing an analysis, such institutions can
come to a decision on whether they would like to fund a company or not.
6. Formulation of Economic Policies: Various cases of fraud that becomes evident
after forensic analysis act as a reference for the government to formulate improved
economic policies that would be able to curb such fraudulent activities in the future.
By doing so, the government can strengthen the economy and prevent such illegal
activities in the country.
7. Rewarding Career Opportunity: As a career, forensic auditing is extremely
rewarding, as it not only involves regular auditing and accounting activities, but also
involves identification, analysis, and reporting of the findings during an audit. The
acceptance of reports generated by a forensic auditors by the court of law, gives them
an upper hand as compared to other accountants. Good forensic auditors are in high
demand and can easily draw a striking starting salaries around the globe.

Other Advantages
• Objectivity and Credibility - An external party as a forensic auditor would be far
more independent and objective than an internal auditor or company accountant who
ultimately reports to management on his findings. An established firm of forensic
auditors and its team would also have credibility stemming from the firm’s reputation,
network and track record.
• Accounting Expertise and Industry Knowledge - An external forensic auditor
would add to the organization’s investigation team with breadth and depth of
experience and deep industry expertise in handling frauds of the nature encountered
by the organization.
• Provision of Valuable Manpower Resources - An organization in the midst of
reorganization and restructuring following a major fraud would hardly have the full-
time resources to handle a broad-based exhaustive investigation. The forensic audit
and his team of assistants would provide the much needed experienced resources,
thereby freeing the organization’s staff for other more immediate management
demands. This is all the more critical when the nature of the fraud calls for
management to move quickly to contain the problem and when resources cannot be
mobilized in time.
• Enhanced Effectiveness and Efficiency - This arises from the additional dimension
and depth which experienced individuals in fraud investigation bring with them to focus
on the issues at hand. Such individuals are specialists in rooting out fraud and would
recognize transactions normally passed over by the organization’s accountants or
auditors. The above discussed advantages of Forensic Audit confirms that Forensic
Audit is a strategical approach in detecting the financial frauds in the organizations
along with enhancing their financial stability at par.

2.6 OBJECTIVES OF FORENSIC AUDIT

The objectives of forensic audit encompass several key aspects aimed at detecting,
preventing, and addressing fraud and corruption within organizations. Here are the
primary objectives:
1. Identify Cases of Fraud: Forensic audit aims to identify instances of fraud,
embezzlement, corruption, or other financial misconduct within an organization.
By conducting thorough examinations of financial records and transactions,
forensic auditors uncover irregularities and gather evidence to substantiate
their findings.
2. Prevent and Reduce Fraud: Forensic audit contributes to fraud prevention by
recommending and implementing internal control measures designed to
mitigate the risk of fraudulent activities. Through proactive assessments of
internal controls and financial processes, forensic auditors help organizations
strengthen their defenses against fraud.
3. Participate in Fraud Prevention Programs: Forensic auditors play a role in
the design and implementation of fraud prevention programs within
organizations. By leveraging their expertise in identifying fraud risks and
 vulnerabilities, they assist in developing comprehensive strategies and policies
aimed at preventing future occurrences of fraud.
4. Evaluation of Internal Control Systems: Forensic audit involves evaluating
the effectiveness of internal control systems in detecting and preventing fraud.
Auditors assess the design and implementation of controls, identify
weaknesses or deficiencies, and recommend improvements to enhance the
organization's ability to detect and deter fraud.
5. Investigation and Evidence Collection: One of the primary objectives of
forensic audit is to conduct investigations and gather evidence that can be used
in legal proceedings. Forensic auditors meticulously collect and analyze
financial data, transactions, and other relevant information to build a case that
can withstand legal scrutiny. The evidence obtained is presented to judicial
authorities to support legal actions against perpetrators of fraud or corruption.
Overall, the objectives of forensic audit encompass a comprehensive approach to
addressing fraud and corruption, from detection and prevention to participation in fraud
prevention programs and providing evidence for legal proceedings. By fulfilling these
objectives, forensic auditors help organizations safeguard their assets, protect their
reputation, and uphold ethical standards.

2.7 FRAUD AND FORENSIC AUDIT : AN INTROSPECT

Forensic auditing encompasses a diverse range of activities aimed at investigating
financial matters, particularly in relation to alleged fraudulent activities. While
regulatory guidance may not strictly define the term, it generally involves investigative
work conducted by professionals to scrutinize the financial affairs of entities. This work
often includes probing into suspected fraudulent activities.
1. Scope of Forensic Auditing: Forensic auditing involves investigating financial
matters comprehensively, potentially serving as an expert witness in legal
proceedings related to fraud cases.
2. Forensic Investigation: Within forensic auditing, the term "forensic
investigation" refers to the practical steps taken by forensic auditors to gather
evidence pertinent to alleged fraudulent activities. These steps may include
data analysis, interviews, document examination, and other investigative
techniques.
3. Process Similarity to Audit: The investigation process in forensic auditing
shares similarities with traditional financial audits. It typically includes a planning
phase, evidence gathering, review and analysis of findings, and ultimately, the
preparation of a comprehensive report for the client.
Determine if Fraud Occurred: The primary objective is to ascertain whether
fraud has indeed taken place. This involves examining evidence and
conducting thorough analysis to identify any irregularities or deceptive
practices.
 4. Identify Perpetrators: Investigators aim to identify the individuals or parties
involved in the fraudulent activity. This includes determining their roles,
motivations, and methods used to perpetrate the fraud.

5. Quantify Financial Loss: Another objective is to quantify the monetary impact

of the fraud, assessing the financial losses suffered by the victim or client. This
involves calculating the amount of money misappropriated or assets misused
due to the fraudulent activity.

6. Present Findings: Ultimately, the findings of the investigation are presented to

the client and potentially to court if legal action is pursued. The evidence
gathered during the investigation serves as the basis for making informed
decisions and taking appropriate actions to address the fraud.

In the context of forensic auditing, specific procedures are carried out to

produce evidence that can be used in legal proceedings. This includes utilizing
audit techniques to gather evidence and prove various aspects of the fraud,
such as its duration, execution, and concealment by the perpetrators.
2.8 FORENSIC AUDIT VIS-À-VIS AUDIT
The differences between financial auditing and forensic auditing can be summarized
as follows:
1. Objective:
 Financial auditing aims to express an opinion on the "true and fair"
presentation of financial statements.
 Forensic audit aims to determine the correctness of accounts and
uncover whether fraud has occurred.
2. Techniques:
 Financial auditing primarily uses substantive and compliance
procedures.
 Forensic auditing involves analyzing past trends and conducting in-
depth examinations of selected transactions.
3. Scope:
 Financial audits typically cover all transactions within a specific
accounting period.
 Forensic audits may cover transactions from the beginning and are not
limited by accounting periods.
4. Verification:
  Financial auditors often rely on management certificates or
representations for accuracy of assets and liabilities.
 Forensic auditors conduct independent verification of suspected or
selected items.
5. Reporting:
 In financial auditing, adverse findings may lead to a qualified opinion
without quantification.
 In forensic auditing, adverse findings require quantification of damages
to clients and identification of culprits, often leading to legal action.
In essence, while financial auditing focuses on ensuring the accuracy and compliance
of financial statements, forensic auditing delves deeper into uncovering fraud,
quantifying damages, and identifying responsible parties, often requiring more
extensive investigation and analysis.
Self Assessment
1. What forensic audit?
2. Describe Fraud?
3. Explain stages of audit
4. What are significance of forensic
2.9 Summary
In the realm of financial scrutiny, the concept of fraud stands as a critical concern,
prompting the necessity for comprehensive auditing practices. The stages of audit
represent a systematic approach to ensuring financial integrity, encompassing
planning, execution, reporting, and follow-up. Amidst this landscape, forensic audit
emerges as a specialized investigative tool, meticulously examining financial records
to uncover irregularities, fraud, or misconduct. Its significance lies in its ability to delve
deep into complex financial transactions, offering insights that traditional audits may
overlook. The objectives of forensic audit are multifold, aiming to detect, prevent, and
mitigate fraudulent activities while safeguarding organizational assets and reputations.
When juxtaposed with fraud, forensic audit provides a nuanced understanding,
revealing patterns, motives, and perpetrators behind illicit financial activities.
2.10 Glossary
1. Forensic accounting: The field of forensic audit stands at the intersection of
finance, investigation, and legal expertise. With a blend of detective skills and
financial acumen, forensic auditors delve deep into financial records to uncover
discrepancies, identify fraudulent activities, and determine the perpetrators behind
such acts within companies
2. Fraud Finding: Forensic auditors are adept at identifying various forms of fraud,
ranging from embezzlement to financial statement manipulation, through
meticulous examination of financial data.
3. Fraud :The term "audit," with its roots in the Latin word "audire," meaning "to hear,"
carries a significant historical connotation. In medieval Britain, when manual
bookkeeping was the norm, auditors would listen as the accounts were read aloud
to them. Their role was to ensure that the organization's personnel were not
negligent or engaging in fraudulent activities.
4. FORENSIC AUDIT: Forensic audit refers to a specialized examination of evidence
related to a specific assertion, conducted in a manner suitable for presentation in
a court of law. This type of audit is distinct from traditional financial audits, as its
primary objective is to gather evidence that may be used as legal support in
litigation or dispute resolution.
2.11 Answers: Self Assessment
1). Please check section 2.1 2). Please check section 2.4 3). Please check
section 2.3 4). Please check section 2.5
2.12 Terminal Questions
1. What are the typical stages involved in conducting an audit?
2. Why is forensic audit considered an essential tool in detecting and preventing
financial fraud?
3. What are the primary objectives of conducting a forensic audit?
4. What are the key differences between a forensic audit and a regular audit?
2.13 Answers: Terminal Questions:
1). Please check section 2.3 2). Please check section 2.4 3). Please check
section 2.6 4). Please check section 2.8
2.14 Suggested Readings
1. Albrecht, W. Steve. (2009). Forensic Accounting & Fraud Examination. Cengage
Learning (India Edition).
2. Albrecht, Chad O., Albrecht, Conan C., Albrecht, W. Steve & Zimbelman, Mark F.
(2015). Forensic Accounting & Fraud Examination. Cengage Learning (India
Edition).
3. Banerjee, Robin (2015). Who Cheats and How? Sage Publications, New Delhi.
4. Bologna, Jack and Lindquist, Robert J. (1995). Fraud Auditing and Forensic
Accounting. Wiley.
 Lesson – 3
Fraud Auditing
Structure:
3.0 Learning Objectives
3.1 Introduction
3.2 Forensic audit: leading way to emergent economy
3.3 Fundamentals of forensic audit
3.4 Major fundamentals of forensic audit
3.5 Tools for handling forensic audit
3.6 Fraud auditing (forensic audit) recognition procedure
3.7 Objectives of forensic auditing3.8 benefits of forensic data analysis
3.9 Auditors liability for undetected frauds
3.10 Power and duties of auditors
3.11 Summary
3.12 Glossary
3.13 Answers: Self Assessment
3.14 Terminal Questions
3.15 Answers: Terminal Questions:
3.16 Suggested Readings
3.0 Learning Objectives
After studying the lesson, you should be able to:-
1. Describe Fraud
2. Meaning of forensic audit
3. Forensic audit vis-à-vis audit
3.1 Introduction
The passage emphasizes the critical importance of trust and faith between citizens
and the government for the well-being and progress of the nation. It highlights the idea
that trust and faith are not entitlements but must be earned by the government through
its actions and policies. The government's commitment to combating corruption and
fraud is emphasized as essential for fostering trust and ensuring the delivery of justice,
welfare, and inclusive growth.
The passage also introduces the "Vision New India, 2022" initiative adopted by the
Government of India, which aims to build an inclusive, prosperous, and corruption-free
India. It outlines the functional objectives of this vision, including addressing various
societal challenges such as terrorism, poverty, communalism, casteism, and filth.
Additionally, the "Sankalp se Siddhi" scheme is introduced as a five-year plan aimed
at achieving good governance, compliance, transparency, and accountability.
Overall, the passage underscores the government's commitment to promoting a
culture of integrity, transparency, and accountability in governance to realize the vision
of a strong, prosperous, and inclusive India. It highlights the importance of collective
efforts and resolve in achieving these objectives and emphasizes the role of citizens
and government alike in shaping the future of the nation.
A fraud audit is an intensive examination of an organization's financial records,
conducted with the specific objective of identifying instances of fraud. Unlike a
standard financial audit, which focuses on ensuring the accuracy and compliance of
financial statements, a fraud audit is more focused on uncovering deceptive practices
or fraudulent activities within the organization.
Key details about fraud audits include:
1. Detailed Examination: A fraud audit involves a thorough and detailed review
of financial records, transactions, and supporting documentation. Auditors
scrutinize various financial activities to identify irregularities or indicators of
potential fraud.
2. Lower Materiality Threshold: Since some types of fraud may involve relatively
small amounts of money or assets, a fraud audit may have a lower materiality
threshold compared to a standard audit. This allows auditors to investigate even
minor discrepancies that could be indicative of fraudulent behavior.
3. Consulting Service: Unlike a traditional audit, where the auditor provides an
opinion on the accuracy of financial statements, a fraud audit is considered a
consulting service. The primary objective is to gather evidence related to fraud,
which may be used in legal proceedings or other enforcement actions.
4. Expert Witness Testimony: In cases where fraud is detected, auditors may
be called upon to serve as expert witnesses during subsequent legal
proceedings. They may be required to present their findings and provide expert
testimony to support the prosecution's case.
5. Interviews: A significant aspect of a fraud audit involves conducting interviews
with employees and other relevant individuals within the organization. These
interviews help auditors gather additional information and insights into potential
fraudulent activities, as employees may have observed behavior or activities
that raise suspicions.

What is Fraud?
Fraud is a type of criminal activity, defined as: 'abuse of position, or false
representation, or prejudicing someone's rights for personal gain'. Put simply, fraud is
an act of deception intended for personal gain or to cause a loss to another party.
The general criminal offence of fraud can include:
• deception whereby someone knowingly makes false representation
• or they fail to disclose information
• or they abuse a position.
Apart from the general meaning let us study some notable definitions of Fraud as per
various statutes and standards. Although definitions vary, most are based around the
general theme mentioned above
3.2 FORENSIC AUDIT: LEADING WAY TO EMERGENT ECONOMY
Government of India's collaborative efforts in addressing significant challenges such
as fraud, deceit, and financial misplacement, which hinder India's path to inclusive
growth. It underscores the profound impact of fraud as one of the most critical issues
affecting not only corporate organizations but also the broader economy and society
as a whole.
Fraud is portrayed as a pervasive ailment with both short-term and long-term
repercussions. It not only undermines the integrity and stability of corporate entities
but also disrupts the overall economy and erodes public trust. The passage suggests
that combating fraud is essential for fostering inclusive growth and ensuring the well-
being of the nation.
The recent incident of financial deception faced by Punjab National Bank (PNB), has
not only dazed the Government, the Regulator, the Stakeholders, the Corporate
community, and also the Public at large, rather it has also rung the alarm bells for all
of us, specially regulators and governance professionals to critically examine the gaps
responsible for making us to a witness to this kind of financial catastrophe. In fact,
after making this discovery and unearthing this massive fraud which took place at
PNB, the second biggest state- run lender of India, the Financial Services Secretary
was constrained to direct and instruct that ‘All Bad Loan Cases above INR 50 Crores
at Public Sector Banks will be examined for fraud.” Further the respective MDs were
directed to detect bank frauds and consequential wilful default in time and refer all
such cases to the CBI.
Globally, the regulators are in the best position and are the best masters to give signals
of a financial cataclysm, but it seems that seldom do players heed to their conscience
and follow the voice of wisdom. Keeping this vigil perspective in mind, Forensic Audit
is a dynamic approach adopted which aims to have timely detection of all frauds and
also to take the requisite financial information in determining and identifying the real
culprit behind the deceit.
In this whole process of timely detection of frauds and reference of such case for due
investigation, Forensic Audit has an imperative role in assisting the corporates to
maintain efficiency as well as merit at par. In the larger perspective, Forensic Audit is
a tool which aims to improve the efficiency, compliance, governance and merit
parameters of financial and other regulatory aspects.
Aligning the augmenting need and significance of Forensic Auditing for making sure
that a company’s finances are being kept safe and in order has become a growing
concern in today’s business environment along with the rise in money laundering and
wilful default cases, the Reserve Bank of India has recently made forensic audit
mandatory for large advances and restructuring of accounts.
Along with Reserve Bank of India making forensic audit mandatory for large advances
and for cases involving re-structuring of accounts, the Enforcement Directorate and
the Serious Fraud Investigation Office have also emphasized the need for forensic
audit following the rise in money laundering and wilful default cases that are plaguing
the banking system. They referred to the example that as the enactment of The
Prohibition of Benami Property Transactions Act, 1988 increases the importance of
Forensic Audit in the country’s fight against financial offenders. There are other levels
too, where forensic audit would prove to be a boon in settling down the principles of
transparency and integrity in addition to settling down the accountability of real culprit.
The above discussion confirms that in order to assist in the paramount growth of Indian
economy on the global platform under the realm of good governance, transparency,
accountability and uprightness, Forensic Audit has become a need of the hour. With
its key benefits in the form of objectivity, credibility, expert accounting, enhanced
effectiveness and efficiency, Forensic Audit assures the growth of the corporates and
development of the Indian Economy, which in turn leads to the inclusive growth of the
emerging India. Therefore, it becomes imperative that the professionals should be well
versed with basic concepts of Forensic Audit in order to effectively implementation the
means and techniques of Forensic Audit towards mitigating the corporate frauds and
strengthening an efficient corporate culture in India.
In an era of supporting a robust economy of India, which is becoming one of the fastest
emerging economies of the world, it is significant to encounter all the challenges
affecting the directed growth of the economy. In such the efforts encountering the
challenges, the menace of frauds and scams has to be encountered at the first
instance in order to promote viable growth for corporates and economy as a whole.

With the current phase of making a New India in the year 2022 as free from corruption
on the lines of good governance, Forensic auditing is a –
 Rapidly growing area as a specialized branch of accounting and investigations
and
 Is concerned with the detection and prevention of financial fraud and white-
collar criminal activities.
In this context, this book serves as a ready reference to the principles, facets and the
concept of Forensic Audit, providing a basic understanding to the meaning and
significance of Forensic Audit, tools and techniques for conducting audit and
investigations as well as the laws applicable to Forensic Audit and investigations in
India.
3.3 FUNDAMENTALS OF FORENSIC AUDIT
Forensic auditing is a specialized discipline focused on detecting and preventing fraud
within organizations. It involves the integration of accounting, auditing, and
investigative skills to gather and present financial information in a format suitable for
use as evidence in legal proceedings against perpetrators of economic crimes.
This interdisciplinary approach allows forensic auditors to closely scrutinize financial
records and transactions to uncover signs of fraudulent activity. By combining
accounting expertise with auditing techniques and investigative methods, forensic
auditors can identify irregularities, trace financial transactions, and gather evidence
that can be presented in court to prosecute individuals involved in economic crimes.
“Forensic”, according to the Webster’s Dictionary means, “Belonging to, used in or
suitable to courts of judicature or to public discussion and debate.”
The word “Auditing” is defined as the examination or inspection of various books of
accounts by an auditor followed by physical checking to make sure that all
departments are following documented system of recording transactions. It is done to
ascertain the accuracy of financial statements provided by the organization.
With India being ranked as the 78th in the Global Corruption Perception Index, the
needs for forensic audit become all the more profound to strengthen the corporate
culture with the vibes of good governance in the country. The term forensic auditing’
refers to financial fraud investigation which includes the analysis of various books of
accounts to prove or disprove financial fraud and serving as an expert witness in Court
to prove or disprove the same.
Thus, basically, forensic auditing is the use of accounting or secretarial skills for legal
purposes.

3.4 MAJOR FUNDAMENTALS OF FORENSIC AUDIT

It involves:
1. An audit
2. An investigation
3. An agreed-upon procedures engagement
4. A proactive search for fraud
In detailed discussion we can elaborate the above in the following style;
The major fundamentals of forensic audit involve:
1. Audit: Forensic auditing begins with an audit, which involves the systematic
examination and verification of financial records, transactions, and internal
 controls. This initial step provides a baseline understanding of the
organization's financial operations.
2. Investigation: Forensic auditing includes investigative procedures to identify
and gather evidence of potential fraud or misconduct. This involves conducting
interviews, reviewing documents, and analyzing financial data to uncover
irregularities or deceptive practices.
3. Agreed-Upon Procedures Engagement: Forensic auditors may engage in
agreed-upon procedures engagements, where specific procedures are agreed
upon with the client to address particular concerns or areas of suspicion. This
tailored approach allows auditors to focus on key areas of risk or concern.
4. Predicting the Unpredictable-A Proactive Search: A Proactive search for
fraud comprises a Forensic Audit Thinking. Forensic Audit Thinking involves –

 The critical assessment throughout the audit

 Of all evidential matter and
 Maintaining a higher degree of professional scepticism
 That fraud may have occurred, is occurring, or will occur in the future.

It further involves deciphering pattern, evaluating reports with figures to study

their number patterns and comparing them with standards established looking
for prima facie area of suspicion. In this scenario, Forensic auditing aids in
detecting, investigating and preventing frauds. Whether it is stock market fraud
or bank fraud or cyber fraud; forensic auditing seems to be an essential tool for
investigation and defining evidence against perpetrators.

3.5 TOOLS FOR HANDLING FORENSIC AUDIT

Forensic Auditing is a new concept that comprises three key ingredients:
1. Forensic Audit Thinking—in other words ―thinking forensically
2. Forensic Audit Procedures—both proactive and reactive
3. Appropriate use of technology and data analysis.

1. Forensic Audit Thinking (Thinking Forensically)

Forensic audit thinking, also known as thinking forensically, is a fundamental
mindset shift that forensic auditors adopt throughout the entire audit process. It
involves maintaining a high level of critical assessment of all evidential matter
and exercising a heightened degree of professional skepticism. This skepticism
revolves around the belief that fraud or financial irregularity may have occurred,
is currently occurring, or could potentially occur in the future.
Central to forensic audit thinking is the acknowledgment that controls, even
seemingly robust ones, may be overridden or manipulated to facilitate
fraudulent activities. This mindset shift prompts auditors to delve deeper into
the audit process, scrutinizing transactions, documents, and procedures with a
keen eye for anomalies, inconsistencies, or deviations from expected patterns.
Forensic audit thinking is not limited to a specific phase of the audit but
permeates every aspect of the auditor's work, from the initial planning and risk
assessment stages through to the final reporting and recommendations. It
guides auditors in conducting thorough investigations, leveraging appropriate
tools and methodologies to uncover evidence of fraud or financial misconduct.
Ultimately, forensic audit thinking empowers auditors to adopt a proactive
approach to fraud detection and prevention, enabling them to identify potential
red flags and mitigate risks effectively. By maintaining this mindset throughout
the audit, forensic auditors can deliver comprehensive, reliable findings that add
value to stakeholders and contribute to the integrity of financial reporting
processes.

2. FRAUD AUDITING (FORENSIC AUDIT) RECOGNITION

In the realm of fraud auditing, the process of recognition stands as a pivotal

stage, representing the initial steps in uncovering potential instances of financial
misconduct or fraudulent activity within an organization. This recognition
procedure is a methodical endeavor that begins with a comprehensive
understanding of the organization's business environment. Forensic auditors
delve into the intricacies of the industry, operations, and internal control
mechanisms, discerning areas of vulnerability and heightened risk.
A critical aspect of the recognition process involves conducting a thorough risk
assessment. This entails evaluating factors such as internal control
effectiveness, management integrity, regulatory compliance, and industry-
specific risks. By identifying and prioritizing areas of concern, auditors can tailor
their investigative efforts accordingly, focusing on those segments most
susceptible to fraudulent behavior.
Analyzing financial data lies at the heart of the recognition procedure. Forensic
auditors meticulously scrutinize financial statements, transactional records, and
other pertinent documentation, seeking out anomalies, irregularities, or patterns
indicative of fraudulent activity. Through techniques such as trend analysis,
ratio examination, and benchmarking, auditors aim to unearth discrepancies
that may signal fraudulent behavior.
Simultaneously, the evaluation of internal controls is paramount. Auditors
assess the design and implementation of key controls, probing for weaknesses
or deficiencies that could be exploited by potential perpetrators. This scrutiny
extends to authorization protocols, segregation of duties, access controls, and
monitoring mechanisms, with auditors keen to identify any lapses that may
facilitate fraudulent conduct.
Moreover, forensic auditors rely on a combination of interviews, inquiries, and
data analytics to bolster their recognition efforts. Engaging with key personnel
and stakeholders provides valuable insights and uncovers potential red flags,
while data analytics tools enable auditors to sift through vast troves of data
efficiently, identifying aberrations or outliers that warrant further investigation.
 Throughout the recognition process, meticulous documentation is paramount.
Auditors meticulously record their findings, including identified fraud risks,
supporting evidence, and audit trail documentation. This comprehensive
documentation not only substantiates audit conclusions but also serves as a
critical resource in potential legal proceedings or regulatory inquiries.
Ultimately, the recognition procedure in fraud auditing serves as the foundation
upon which subsequent investigative efforts are built. By diligently scrutinizing
the organization's business environment, conducting thorough risk
assessments, analyzing financial data, evaluating internal controls, and
leveraging interviews and data analytics, forensic auditors can effectively
identify potential instances of fraud or financial irregularity, paving the way for
further investigation and resolution.

3.6 Fraud auditing (forensic audit) Recognition procedure

Forensic audit procedures are more specific and geared toward detecting the
possible material misstatements in financial statements resulting from
fraudulent activities or error.
Audit procedures should align with Fraud Risks and Fraud Risk
Assessments.
According to Donald R. Cressy, in his proposition ―Fraud Triangle

He emphasized that there are three interrelated elements that facilitate

someone in committing fraud:
(a) Motive: This represents the underlying reason or drive that compels a
person to engage in fraudulent behavior. Motives can vary widely and may
include financial pressures, personal grievances, or desires for power or
recognition.
(b) Opportunity: This refers to the circumstances or conditions that allow an
individual to carry out fraudulent acts without detection or with minimal risk of
detection. Opportunities arise from weaknesses or deficiencies in internal
controls, lax oversight, or inadequate monitoring procedures.
(c) Ability to Rationalize: This involves the psychological process by which
individuals justify or excuse their fraudulent actions to themselves.
Rationalizations often involve minimizing the perceived harm caused by the
fraud, blaming external factors, or convincing oneself that the behavior is
justified under the circumstances.

These three elements—motive, opportunity, and ability to rationalize—are

interconnected and collectively contribute to the likelihood of fraud occurring
within an organization. Identifying and addressing these factors are essential
for effective fraud prevention and detection efforts.
 Below are the key steps typically involved in the recognition procedure for fraud
auditing:
1. Understanding the Business Environment: Forensic auditors begin by
gaining a thorough understanding of the organization's industry, operations,
business model, and internal control environment. This understanding helps
auditors identify areas of heightened fraud risk and tailor their audit procedures
accordingly.
2. Risk Assessment: Conducting a comprehensive risk assessment is essential
for identifying potential fraud risks within the organization. Forensic auditors
analyze factors such as internal control weaknesses, management integrity,
regulatory compliance, and industry-specific risks to prioritize areas for further
investigation.
3. Analyzing Financial Data: Forensic auditors analyze financial statements,
transactional data, and other relevant financial records to identify anomalies,
irregularities, or suspicious patterns that may indicate fraud. This analysis may
involve techniques such as trend analysis, ratio analysis, and benchmarking
against industry norms.
4. Evaluating Internal Controls: Assessing the effectiveness of internal controls
is crucial for detecting weaknesses or deficiencies that could be exploited for
fraudulent purposes. Forensic auditors evaluate the design and implementation
of key controls related to authorization, segregation of duties, access controls,
and monitoring activities.
5. Performing Analytical Procedures: Analytical procedures involve comparing
financial data across different periods, business units, or benchmarking against
industry averages to identify deviations or inconsistencies that warrant further
investigation. These procedures help auditors detect unusual fluctuations,
outliers, or discrepancies indicative of fraud.
6. Conducting Interviews and Inquiries: Forensic auditors interview key
personnel, including management, employees, and third-party stakeholders, to
gather additional information and insights into potential fraud risks. These
interviews may uncover valuable evidence, whistleblower allegations, or
behavioral indicators of fraudulent activity.
7. Utilizing Data Analytics: Leveraging data analytics tools and techniques can
enhance the effectiveness of fraud recognition procedures by enabling auditors
to analyze large volumes of data more efficiently. Data mining, predictive
modeling, and anomaly detection algorithms help auditors identify patterns or
anomalies indicative of fraud.
8. Documenting Findings: Throughout the recognition procedure, forensic
auditors meticulously document their findings, including identified fraud risks,
supporting evidence, and audit trail documentation. Clear and comprehensive
documentation is essential for substantiating audit conclusions and supporting
potential legal proceedings.

3.8 STEPS IN FORENSIC AUDIT

 The steps in a forensic audit typically involve a systematic approach to
investigating financial irregularities, fraud, or other misconduct. While the
specific steps may vary depending on the nature and complexity of the case,
they generally include:
1. Accepting the Investigation:
 Forensic auditors initially assess whether to accept the investigation
based on factors such as jurisdiction, expertise, resources, and conflicts
of interest. Once accepted, they proceed to plan and conduct the audit.
2. Planning:
 Planning involves defining the scope and objectives of the forensic audit,
allocating resources, establishing timelines, and identifying potential
risks and fraud indicators. This phase also includes determining the
methodology and techniques to be employed during the investigation.
3. Evidence Gathering:
 Forensic auditors collect and analyze relevant evidence to support their
findings. This may involve examining financial records, conducting
interviews, reviewing documentation, analyzing electronic data, and
performing forensic testing such as handwriting analysis or forensic
accounting techniques.
4. Reporting:
 After gathering and analyzing the evidence, forensic auditors prepare a
comprehensive report documenting their findings, conclusions, and
recommendations. The report typically includes a summary of the
investigation, details of the evidence collected, analysis of financial
transactions, identification of fraudulent activities, and recommendations
for remedial actions.
5. Court Proceedings:
 In cases where legal action is pursued, forensic auditors may be required
to testify as expert witnesses in court proceedings. They present their
findings and provide expert opinions based on the evidence gathered
during the investigation. Court proceedings may include depositions,
hearings, trials, and cross-examinations.
These steps are iterative and may require revisiting earlier stages as new
information is uncovered or as circumstances evolve during the investigation.
Throughout the process, forensic auditors adhere to professional standards,
maintain objectivity, and ensure the integrity of the investigation to provide
accurate and reliable findings.

3.7 OBJECTIVES OF FORENSIC AUDITING

The objectives of forensic auditing encompass a range of goals aimed at

preventing, detecting, and addressing fraud, as well as promoting transparency
and integrity within organizations. Here are the key objectives of forensic
auditing as outlined:
1. Facilitate Settlements, Claims, or Jury Awards: Forensic auditors aim to
provide conclusions and evidence that can be used in legal proceedings to
facilitate settlements, claims, or jury awards. By thoroughly investigating
financial irregularities and presenting their findings, forensic auditors assist in
resolving disputes and ensuring fair outcomes.
2. Prevent Fraud and Theft: One of the primary objectives of forensic auditing is
to prevent and deter fraud and theft within organizations. By identifying
vulnerabilities, weaknesses in controls, and potential fraud risks, forensic
auditors help implement measures to mitigate these risks and safeguard assets
from misappropriation.
3. Restore Public Confidence: Instances of fraud or financial misconduct can
erode public trust and confidence in an organization. Forensic auditors work to
restore confidence by uncovering fraudulent activities, holding wrongdoers
accountable, and implementing corrective actions to prevent recurrence.
4. Establish Comprehensive Corporate Governance Policies: Forensic
auditing contributes to the formulation and establishment of robust corporate
governance policies and procedures. By identifying areas of weakness and
recommending improvements in internal controls, compliance frameworks, and
ethical standards, forensic auditors help organizations enhance governance
practices and minimize the risk of fraud.
5. Create a Positive Work Environment: A key objective of forensic auditing is
to foster a positive work environment characterized by integrity, transparency,
and accountability. By promoting ethical behavior, adherence to policies, and a
culture of honesty and fairness, forensic auditors contribute to a workplace
where employees are less likely to engage in fraudulent activities.

3. Appropriate Use of Technology

Forensic Data Analysis can be used to prevent, detect and control fraud along
with other irregularities.
Forensic Data Analysis
Forensic data analysis is the process of gathering, summarizing, comparing,
and aggregating existing different sets of data that organizations routinely
collect in the normal course of business with the goal of detecting anomalies
that are traditionally indicative of fraud or other misconduct (Donald, 2007).

3.8 Benefits of Forensic Data Analysis

The following are some of the benefits of using forensic data analysis tools and
techniques;
 Analyzes 100% of data sets rather than using statistical sampling—such
as Risk Based Sampling.
 Can help identify potential control environment weaknesses.
  Can assist with the assessment of the effectiveness of existing anti-fraud
and fraud risk management programs and practices.
 Can help to Identify potential policy and process violations—vendor
acceptance/approval process, bidding, etc.

3.9 Auditors liability for undetected frauds

According to Statement on Auditing Standards (SA) 240, titled "The Auditor’s

Responsibilities Relating to Fraud in an Audit of Financial Statements," the primary
responsibility for the prevention and detection of fraud lies with both management and
those charged with governance of the entity (such as the board of directors or audit
committee). This emphasizes the collaborative effort required between management
and oversight bodies to effectively address fraud risks within an organization.
SA 240 underscores the importance of management, under the oversight of those
charged with governance, placing a strong emphasis on fraud prevention and
deterrence. Fraud prevention involves implementing measures to reduce opportunities
for fraud to occur, while fraud deterrence aims to dissuade individuals from committing
fraud by increasing the likelihood of detection and punishment.
Key elements of an effective fraud prevention and deterrence program include:
1. Creating a Culture of Honesty and Ethical Behavior: Management and
governance bodies should promote a culture of honesty, integrity, and ethical
behavior throughout the organization. This involves establishing clear ethical
standards, communicating expectations to employees, and leading by
example.
2. Active Oversight by Governance Bodies: Those charged with governance
play a crucial role in providing oversight and guidance on fraud prevention and
detection efforts. This includes reviewing and approving anti-fraud policies and
procedures, monitoring the effectiveness of internal controls, and holding
management accountable for addressing fraud risks.
3. Implementing Anti-Fraud Policies and Procedures: Management should
develop and implement robust anti-fraud policies and procedures tailored to the
organization's specific risks and circumstances. This may include measures
such as segregation of duties, internal controls, whistleblower mechanisms,
and regular fraud risk assessments.
4. Training and Awareness Programs: Providing training and awareness
programs to employees at all levels of the organization helps reinforce the
importance of fraud prevention and detection. Training programs should
educate employees on identifying red flags, reporting suspicious activities, and
understanding their role in maintaining a fraud-free environment.
 5. Monitoring and Reporting Mechanisms: Implementing effective monitoring
and reporting mechanisms enables timely detection and response to potential
fraud incidents. This may include monitoring financial transactions, conducting
periodic audits and reviews, and establishing channels for employees to report
concerns or suspected fraud anonymously.
Broadly, the general principles laid down in the SA may be noted as under:
1. An auditor conducting an audit in accordance with SAs is responsible for
obtaining reasonable assurance that the financial statements taken as a whole
are free from material misstatement, whether caused by fraud or error. As
described in SA 200, “Overall Objectives of the Independent Auditor and
the Conduct of an Audit in Accordance with Standards on Auditing,” owing
to the inherent limitations of an audit, there is an unavoidable risk that some
material misstatements of the financial statements will not be detected, even
though the audit is properly planned and performed in accordance with the SAs.
2. The risk of not detecting a material misstatement resulting from fraud is higher
than the risk of not detecting one resulting from error. This is because fraud
may involve sophisticated and carefully organized schemes designed to
conceal it, such as forgery, deliberate failure to record transactions, or
intentional misrepresentations being made to the auditor. Such attempts at
concealment may be even more difficult to detect when accompanied by
collusion. Collusion may cause the auditor to believe that audit evidence is
persuasive when it is, in fact, false. The auditor’s ability to detect a fraud
depends on factors such as the skillfulness of the perpetrator, the frequency
and extent of manipulation, the degree of collusion involved, the relative size of
individual amounts manipulated, and the seniority of those individuals involved.
While the auditor may be able to identify potential opportunities for fraud to be
perpetrated, it is difficult for the auditor to determine whether misstatements in
judgment areas such as accounting estimates are caused by fraud or error.
3. Furthermore, the risk of the auditor not detecting a material misstatement
resulting from management fraud is greater than for employee fraud, because
management is frequently in a position to directly or indirectly manipulate
accounting records, present fraudulent financial information or override control
procedures designed to prevent similar frauds by other employees.
4. When obtaining reasonable assurance, the auditor is responsible for
maintaining an attitude of professional skepticism throughout the audit,
considering the potential for management override of controls and recognizing
the fact that audit procedures that are effective for detecting error may not be
effective in detecting fraud. The requirements in this SA are designed to assist
the auditor in identifying and assessing the risks of material misstatement due
to fraud and in designing procedures to detect such misstatement.

3.10 Power and Duties of Auditors

1. Section – 143 of Companies Act, 2013 talks about the power and duties of auditors and
auditing standards. It reads: “Every auditor of a company shall have a right of access at all
times to the books of account and vouchers of the company, whether kept at the registered
office of the company or at any other place and shall be entitled to require from the officers of
the company such information and explanation as he may consider necessary for the
performance of his duties as auditor and amongst other matters inquire into the following
matters, namely: –
a. whether loans and advances made by the company on the basis of security have been
properly secured and whether the terms on which they have been made are prejudicial to the
interests of the company or its members;
b. whether transactions of the company which are represented merely by book entries are
prejudicial to the interests of the company;
c. where the company not being an investment company or a banking company, whether so
much of the assets of the company as consist of shares, debentures and other securities have
been sold at a price less than that at which they were purchased by the company;
d. whether loans and advances made by the company have been shown as deposits;
e. whether personal expenses have been charged to revenue account;
f. where it is stated in the books and documents of the company that any shares have been
allotted for cash, whether cash has actually been received in respect of such allotment, and if
no cash has actually been so received, whether the position as stated in the account books
and the balance sheet is correct, regular and not misleading:
Provided that the auditor of a company which is a holding company shall also have the right
of access to the records of all its subsidiaries in so far as it relates to the consolidation of its
financial statements with that of its subsidiaries.
2. The auditor shall make a report to the members of the company on the accounts examined
by him and on every financial statements which are required by or under this Act to be laid
before the company in general meeting and the report shall after taking into account the
provisions of this Act, the accounting and auditing standards and matters which are required
to be included in the audit report under the provisions of this Act or any rules made there under
or under any order made under sub-section (11) and to the best of his information and
knowledge, the said accounts, financial statements give a true and fair view of the state of the
company’s affairs as at the end of its financial year and profit or loss and cash flow for the
year and such other matters as may be prescribed.
3. The auditor’s report shall also state –
a. whether he has sought and obtained all the information and explanations which to the best
of his knowledge and belief were necessary for the purpose of his audit and if not, the details
thereof and the effect of such information on the financial statements;
b. whether, in his opinion, proper books of account as required by law have been kept by the
company so far as appears from his examination of those books and proper returns adequate
for the purposes of his audit have been received from branches not visited by him;
c. whether the report on the accounts of any branch office of the company audited under sub-
section (8) by a person other than the company’s auditor has been sent to him under the
proviso to that sub-section and the manner in which he has dealt with it in preparing his report;
d. whether the company’s balance sheet and profit and loss account dealt with in the report
are in agreement with the books of account and returns;
e. whether, in his opinion, the financial statements comply with the accounting standards;
f. the observations or comments of the auditors on financial transactions or matters which
have any adverse effect on the functioning of the company;
g. whether any director is disqualified from being appointed as a director under sub-section
(2) of section 164;
h. any qualification, reservation or adverse remark relating to the maintenance of accounts
and other matters connected therewith;
i. whether the company has adequate internal financial controls system in place and the
operating effectiveness of such controls;
j. such other matters as may be prescribed.
4. Where any of the matters required to be included in the audit report under this section is
answered in the negative or with a qualification, the report shall state the reasons therefor.
5. In the case of a Government company, the Comptroller and Auditor-General of India shall
appoint the auditor under sub-section (5) or sub-section (7) of section 139 and direct such
auditor the manner in which the accounts of the Government company are required to be
audited and thereupon the auditor so appointed shall submit a copy of the audit report to the
Comptroller and Auditor-General of India which, among other things, include the directions, if
any, issued by the Comptroller and Auditor-General of India, the action taken thereon and its
impact on the accounts and financial statement of the company.
6. The Comptroller and Auditor-General of India shall within sixty days from the date of receipt
of the audit report under sub-section (5) have a right to, –
a. conduct a supplementary audit of the financial statement of the company by such person
or persons as he may authorize in this behalf; and for the purposes of such audit, require
information or additional information to be furnished to any person or persons, so authorized,
on such matters, by such person or persons, and in such form, as the Comptroller and Auditor-
General of India may direct; and
b. comment upon or supplement such audit report:
Provided that any comments given by the Comptroller and Auditor-General of India upon, or
supplement to, the audit report shall be sent by the company to every person entitled to copies
of audited financial statements under sub section (1) of section 136 and also be placed before
the annual general meeting of the company at the same time and in the same manner as the
audit report.
7. Without prejudice to the provisions of this Chapter, the Comptroller and Auditor- General of
India may, in case of any company covered under sub-section (5) or sub-section (7) of section
139, if he considers necessary, by an order, cause test audit to be conducted of the accounts
of such company and the provisions of section 19A of the Comptroller and Auditor-General’s
(Duties, Powers and Conditions of Service) Act, 1971, shall apply to the report of such test
audit.
8. Where a company has a branch office, the accounts of that office shall be audited either by
the auditor appointed for the company (herein referred to as the company’s auditor) under this
Act or by any other person qualified for appointment as an auditor of the company under this
Act and appointed as such under section 139, or where the branch office is situated in a
country outside India, the accounts of the branch office shall be audited either by the
company’s auditor or by an accountant or by any other person duly qualified to act as an
auditor of the accounts of the branch office in accordance with the laws of that country and
the duties and powers of the company’s auditor with reference to the audit of the branch and
the branch auditor, if any, shall be such as may be prescribed:
Provided that the branch auditor shall prepare a report on the accounts of the branch
examined by him and send it to the auditor of the company who shall deal with it in his report
in such manner as he considers necessary.
9. Every auditor shall comply with the auditing standards.
10. The Central Government may prescribe the standards of auditing or any addendum
thereto, as recommended by the Institute of Chartered Accountants of India, constituted under
section 3 of the Chartered Accountants Act, 1949, in consultation with and after examination
of the recommendations made by the National Financial Reporting Authority:
Provided that until any auditing standards are notified, any standard or standards of auditing
specified by the Institute of Chartered Accountants of India shall be deemed to be the auditing
standards.
11. The Central Government may, in consultation with the National Financial Reporting
Authority, by general or special order, direct, in respect of such class or description of
companies, as may be specified in the order, that the auditor’s report shall also include a
statement on such matters as may be specified therein.
12. Notwithstanding anything contained in this section, if an auditor of a company, in the
course of the performance of his duties as auditor, has reason to believe that an offence
involving fraud is being or has been committed against the company by officers or employees
of the company, he shall immediately report the matter to the Central Government within such
time and in such manner as may be prescribed.

POWERS OF AUDITOR
1. Right to access: Every auditor of a company shall have right to access at all
time to book of accounts and vouchers of the company. The Auditor shall be
entitled to require from officers of the company such information and
explanation as he may consider necessary for performance of his duties. There
is an inclusive list of matter for which auditor shall seek information and
explanation. The list includes issues related to: (a) Proper security for Loan and
advances, (b) Transaction by book entries, (c) Sale of assets in securities in
loss, (d) Loan and advances made shown as deposits, (e) Personal expenses
charged to revenue account, (f) Case received for share allotted for cash. The
auditor of holding company also has same rights.
2. Auditor to sign audit reports: The auditor of the company shall sign the
auditor’s report or sign or certify any other document of the company and
financial transactions or matters, which have any adverse effect on the
functioning of the company mentioned in the auditor’s report shall be read
 before the company in general meeting and shall be open to inspection by any
member of the company.
3. Auditor in general meeting: It is a prime requirement under section 146, that
the company must send all notices and communication to the auditor, relating
to any general meeting, and he shall attend the meeting either through himself
or through his representative, who shall also be an auditor. Such auditor must
be given reasonable opportunity to speak at the meeting on any part of the
business which concerns him as the auditor.
4. Right to remuneration: The remuneration of the auditor of a company shall be
fixed in its general meeting or in such manner as may be determined therein. It
must include the expenses, if any, incurred by the auditor in connection with the
audit of the company and any facility extended to him but does not include any
remuneration paid to him for any other service rendered by him at the request
of the company.
5. Consent of auditor: As per Section 26, the company must mention in their
prospectus the name, address and consent of the auditors of the company.
Self Assessment
1. What forensic audit?
2. Describe benefits of forensic data analysis?
3. Explain Fundamentals of forensic audit?
4. What are powers of auditor?
3.11 Summary
Forensic audit is increasingly recognized as a pivotal tool in emerging economies,
addressing financial irregularities, and bolstering trust in financial systems. Its
fundamentals encompass meticulous examination, utilizing specialized techniques to
uncover fraud and misconduct. Major fundamentals include thorough documentation
review, data analysis, and forensic interviews. Tools like data analytics software aid in
handling complex investigations. Recognizing fraud involves scrutinizing anomalies
and inconsistencies, aligning with the objectives of forensic auditing: identifying fraud,
supporting legal proceedings, and safeguarding organizational integrity. Benefits
include enhanced fraud detection and prevention. However, auditors may face liability
for undetected frauds, emphasizing the importance of their powers and duties in
maintaining accountability and transparency.
3.12 Glossary
Forensic auditing is a specialized discipline focused on detecting and preventing fraud
within organizations. It involves the integration of accounting, auditing, and
investigative skills to gather and present financial information in a format suitable for
use as evidence in legal proceedings against perpetrators of economic crimes.
1. Audit: Forensic auditing begins with an audit, which involves the systematic
examination and verification of financial records, transactions, and internal
 controls. This initial step provides a baseline understanding of the
organization's financial operations.
2. Motive: This represents the underlying reason or drive that compels a person
to engage in fraudulent behavior. Motives can vary widely and may include
financial pressures, personal grievances, or desires for power or recognition.
3. Opportunity: This refers to the circumstances or conditions that allow an
individual to carry out fraudulent acts without detection or with minimal risk of
detection. Opportunities arise from weaknesses or deficiencies in internal
controls, lax oversight, or inadequate monitoring procedures.
3.13 Answers: Self Assessment
1). Please check section 3.1 2). Please check section 3.8 3). Please check
section 3.3 4). Please check section 3.10
3.14 Terminal Questions
1. How does the practice of forensic audit contribute to the development of emerging
economies?
2. What are the core principles that underpin the practice of forensic audit? And
common tools and techniques used by forensic auditors to uncover financial fraud?
3. What are the primary objectives of conducting a forensic audit?
4. What are the legal implications for auditors if fraud goes undetected during a
forensic audit?
3.15 Answers: Terminal Questions:
1). Please check section 3.2 2). Please check section 3.3 and 3.4 3). Please
check section 3.7 4). Please check section 3.9
3.16 Suggested Readings
1. Albrecht, W. Steve. (2009). Forensic Accounting & Fraud Examination. Cengage
Learning (India Edition).
2. Albrecht, Chad O., Albrecht, Conan C., Albrecht, W. Steve & Zimbelman, Mark F.
(2015). Forensic Accounting & Fraud Examination. Cengage Learning (India
Edition).
3. Banerjee, Robin (2015). Who Cheats and How? Sage Publications, New Delhi.
4. Bologna, Jack and Lindquist, Robert J. (1995). Fraud Auditing and Forensic
Accounting. Wiley.
5. Bremser, Wayne G. (1995). Forensic Accounting and Financial Fraud.American
Management Association.
 Lesson – 4
Fraud
Structure:
4.0 Learning Objectives
4.1 Introduction
4.2 Fraud is a word that has many definitions
4.3 Fraud, Theft, and Embezzlement
4.4 Elements of fraud
4.5 Kinds of frauds
4.6 The different instances of fraud
4.7 Why Is Fraud Committed?
4.8 Who Commits Fraud?
4.9 Fraud taxonomies
4.10 Summary
4.11 Glossary
4.12 Answers: Self Assessment
4.13 Terminal Questions
4.14 Answers: Terminal Questions:
4.15 Suggested Readings
4.0 Learning Objectives
After studying the lesson, you should be able to:-
4. Describe Fraud
5. Meaning of forensic audit
6. Forensic audit vis-à-vis audit
4.1 Introduction
‘Fraud’, in general, refers to a wrongful or criminal deception practiced which is
intended to result in financial or personal gain to oneself and a financial or personal
loss to the other.
As per Business Dictionary, ‘Fraud’ is an act or course of deception, an intentional
concealment, omission, or perversion of truth, to:
(1) Gain unlawful or unfair advantage,
(2) Induce another to part with some valuable item or surrender a legal right, or
(3) Inflict injury in some manner.2
In law, fraud is a deliberate deception to secure unfair or unlawful gain, or to deprive
a victim of a legal right.3
Fraud can also be a civil wrong (i.e., a fraud victim may sue the fraud perpetrator to
avoid the fraud or recover monetary compensation), a criminal wrong (i.e., a fraud
perpetrator may be prosecuted and imprisoned by governmental authorities) or it may
cause no loss of money, property or legal right but still be an element of another civil
or criminal wrong.
The ultimate object of practising fraud may be some monetary gain or other benefit,
such as, obtaining a passport or travel document, driver’s license or qualifying for a
mortgage by way of false statements.4
As per Black Law Dictionary, ‘Fraud’ refers to ‘All multifarious means which human
ingenuity can devise, and which are resorted to by one individual to get an advantage
over another by false suggestions or suppression of the truth. It includes all surprises,
tricks, cunning or dissembling, and any unfair way which another is cheated.
4.2 Fraud is a word that has many definitions
The more notable ones are:
■ Fraud as a crime. Fraud is a generic term, and embraces all the multifarious means
which human ingenuity can devise, which are resorted to by one individual, to get an
advantage over another by false representations. No definite and invariable rule can
be laid down as a general proposition in defining fraud, as it includes surprise, trick,
cunning and unfair ways by which another is cheated. The only boundaries defining it
are those which limit human knavery.

■ Fraud as a tort. The U.S. Supreme Court in 1887 provided a definition of fraud in the
civil sense as: First: That the defendant has made a representation in regard to a
material fact; Second: That such representation is false; Third: That such
representation was not actually believed by the defendant, on reasonable grounds, to
be true; Fourth: That it was made with intent that it should be acted on; Fifth: That it
was acted on by complainant to his damage; and Sixth: That in so acting on it the
complainant was ignorant of its falsity, and reasonably believed it to be true. The first
of the foregoing requisites excludes such statements as consist merely in an
expression of opinion of judgment, honestly entertained; and again excepting in
peculiar cases, it excludes statements by the owner and vendor of property in respect
of its value.

Of the six, the fourth (intent) is usually the most difficult to establish in a court case.
  Guilty parties can use the excuse of an accident or carelessness as the cause
of the incident rather than a deliberate intent to steal or commit the fraud, along
with a plethora of other viable excuses.
 Corporate fraud. Corporate fraud is any fraud perpetrated by, for, or against a
business corporation.
 Management fraud. Management fraud is the intentional misrepresentation of
corporate or unit performance levels perpetrated by employees serving in
management roles who seek to benefit from such frauds in terms of promotions,
bonuses or other economic incentives, and status symbols.
 Layperson’s definition of fraud. Fraud, as it is commonly understood today,
means dishonesty in the form of an intentional deception or a willful
misrepresentation of a material fact. Lying, the willful telling of an untruth, and
cheating, the gaining of an unfair or unjust advantage over another, could be
used to further define the word fraud because these two words denote intention
or willingness to deceive.
4.3 Fraud, Theft, and Embezzlement
Fraud, theft, defalcation, irregularities, white-collar crime, and embezzlement are
terms that are often used interchangeably. Although they have some common
elements, they are not identical in the criminal law sense. For example, in English
common law, theft is referred to as larceny—the taking and carrying away of the
property of another with the intention of permanently depriving the owners of its
possession. In larceny, the perpetrator comes into possession of the stolen item
illegally. In embezzlement, the perpetrator comes into initial possession lawfully, but
then converts it to her own use. Embezzlers have a fiduciary duty to care for and to
protect the property. In converting it to their own use, they breach that fiduciary duty
Because the nature behind many white collar offenses is so similar, it can be difficult
to know the difference between each. To help with this, we’ve come up with 4 major
differences between two common white collar crimes: embezzlement and fraud.
1.Embezzlement Directly Involves a Business
Embezzlement is the illegal diversion of funds away from a company or business. This
crime typically involves altering the income of the business and falsifying reports to the
IRS. Fraud, on the other hand, refers to receiving information or money from a subject
under false pretenses (such as a fake email asking for your bank account) and does
not necessarily involve a business.
2.Fraud Sells with False Pretenses
Fraud tricks a subject by using false advertising in order to receive funds or
information. The subject of the crime voluntarily gives up the information because
they’re unaware the advertising is false. Embezzlement, however, does not involve
selling or advertising to a subject. Rather, it refers to stealing funds away from a
company directly.
3.Embezzling Involves Fraud, but Fraud Does Not Always Involve Embezzling
The simplest definition of fraud is the falsifying of information. Because embezzling
refers to falsifying financial information of a business, it involves an act of financial
fraud. But, because it can occur without a business, fraud does not always involve
embezzling. A telephone scam asking for your Social Security information is a
fraudulent crime but does not include embezzling, whereas a CEO falsifying records
to steal the company’s profits is both a case of embezzlement and fraud.
4.Fraud Punishments Are Typically Lesser Than Embezzlement Punishments
As fraud cases involve someone voluntarily offering information or money, they are
typically handled in civil court and tried as misdemeanor offenses. Fraud is punishable
by up to 1 year in California county jail and up to a $10,000 fine. If charged with a
felony fraud charge, you could face up to 5 years in prison, and fines twice the amount
of your fraud, or $50,000 – whichever amount is greater.
Depending on the severity of the crime, embezzlement can be either a misdemeanor
or a felony. As a California misdemeanor, embezzlement is punishable by up to 1 year
in jail and a fine of up to $1,000. The felony charge can lead to up to 3 years in jail and
a fine of up to $10,000. As embezzlement involves financial fraud and can involve
additional crimes as well (such as insider trading) an embezzlement sentence is
combined with the sentences of the other crimes, resulting in a more severe
punishment.

4.4 ELEMENTS OF FRAUD

Few Essential Elements of Fraud are listed as below10:
1. False and Wilful representation or Assertion: To constitute fraud there must be
some representation or assertion, which is untrue. In the absence of representation or
assertion except in the following two cases, there can be no fraud.
• Where silence may itself amount to fraud, and
• Where there is active concealment of facts
The person making the representation should not believe it to be true, otherwise
he/she will not be guilty of fraud. Moreover, to constitute fraud, the false representation
must have been made wilfully or intentionally. For example, X, intending to deceive Y,
informs him that his estate is free from encumbrance. Y thereupon buys the estate.
The estate is, however, subject to mortgage. The contract is induced by fraud.
2. Perpetrator of Representation: The false representation or misstatement must
have been made by a party to the contract or by anyone with its connivance, or by its
agent. If a stranger makes the misstatement to the contract, it cannot result in fraud.
For instance, A suggests B to buy C’s car, which according to A runs 15 kms per litre.
Later on, B finds that the car runs only 8 kms per litre. A was, however, acting neither
at the instance of C nor was his agent; he was a stranger. The contract that took place
between B and C cannot be stated to be induced by fraud.
3. Intention to deceive: Intention to deceive the other party is the essence of fraud.
In order to commit a fraud, one person asserts or misstates the fact with the intention
that it should be acted upon. As a matter of fact, misrepresentation elevates to the
level of fraud when it is prefixed by the element of intention to deceive the other party.
For example, A, intending to deceive B, falsely represents that 1,000 tons of sugar is
produced annually at his factory, although A is fully aware that only 600 tons of sugar
can be produced annually. B thereby agrees to buy the factory. A has resorted to fraud
to obtain the consent of B.
4. Representation must relate to a fact: The representation made by the party must
relate to a fact, which is material to the formation of the contract. A mere statement of
opinion, belief, or commendation cannot be treated as fraud. For instance, A states
that the detergent produced at his factory washes whiter than whitest. The statement
made by A is merely a commendation of the product and not a fact. But if A describes
the ingredients, which the detergent contains, it becomes a statement of fact. And if
that is found incorrect, it amounts to fraud provided A knows it to be a false statement.
5. Active concealment of facts: ‘Active concealment’ must be distinguished from
‘passive concealment’. Passive concealment implies mere silence as to material facts,
which barring a few cases, does not amount to fraud. Whereas, active concealment
implies ‘when the party takes positive or deliberate steps to prevent information from
reaching the other party and this is treated as fraud.’ For example, A sells a horse to
B in an auction despite knowing that the horse is unsound. A says nothing to B about
the horse’s soundness. This is a case of passive concealment of fact and cannot
tantamount to fraud.
6. Promise made without intention of performing it: If a person while entering into
a contract has no intention to perform his/her promise, there is a fraud on his/her part,
for the intention to deceive the other party is there from the very beginning. For
example, an English merchant appointed an Indian woman as his personal secretary
and promised that he would marry her. Later she came to know that he was already
married and had made the promise without any intention to perform it. It was held that
she could avoid the contract on the ground of fraud.
On similar count, a purchase of goods without any intention of paying the price is a
fraud and the contract can be avoided on this ground.
7. Representation must have actually deceived the other party: The
representation made with the intention to deceive must actually deceive. The party,
induced by fraudulent statement, must have relied on it to accord its consent.
Thus, an attempt to deceive does not amount to fraud until the other party is deceived
thereby. A case in point is the following example. A had a defective cannon. With a
view to conceal the defect, he put a metal plug on it. B without examining it bought it.
The cannon burst when used by B. B refused to pay the price and accused A of fraud.
It was held that B was bound to pay because he was not actually deceived, as he
would have bought the cannon even if the deceptive plug had not been inserted.
8. Any other act fitted to deceive: The expression ‘any other act fitted to deceive’
obviously means any act, which is done with the intention of committing fraud. This
category includes all tricks, dissembling, husband persuaded his illiterate wife to sign
certain documents telling her that by the papers he was going to mortgage her two
plots of land to secure his indebtedness. But, in fact, he mortgaged four plots of land
belonging to her. This was held as an act done with the intention of deceiving the wife.
9. Any such Act or omission that the law specially declares as void: This category
includes the act or omission that the law specially declares to be fraudulent. For
example, the Insolvency Act and the Companies Act declare certain kinds of transfers
to be fraudulent. Similarly, under the Transfer of Property Act, the transferor of real
estate is bound to disclose to the transferee the following details:
• Material defects, if any, in the property such as, cracks in the wall or in beams, and/or
• Any defect or dispute as regards transferor’s title, such as property is subject to
encumbrance, i.e., mortgaged or is subject to some dispute pending in a court of law.
An omission to make such disclosure on the part of transferor amounts to fraud.
10. Wrongful Loss and Wrongful Gain is Immaterial. For the purposes of “Fraud”
under the Companies Act, 2013, it is immaterial whether there has been some
wrongful loss to one and/or wrong gain to another. The only important thing is intention
to deceive and the act or omission actually deceiving the victim. Common corporate
frauds for example are, if the CMD husband benefits from a loan transaction
sanctioned by her it is a fraud. If a CEO take bribe to approve a contract that is a fraud.
On the same principle, Indian Penal Code too works, as for IPC to constitute an
offence, two elements are required which are Mens Rea – Intention to Commit Offence
and Actus Reus – The Wrongful Act

4.5 KINDS OF FRAUDS

Fraud in general could be categorized in two category in legal parlance, which includes
1. Fraud as a civil wrong and
2. Fraud as a criminal offence
1. Fraud as a Civil Wrong, i.e. a tort : While the precise definitions and requirements
of proof vary among jurisdictions, the requisite elements of fraud as a tort generally
are the intentional misrepresentation or concealment of an important fact upon which
the victim is meant to rely, and in fact does rely, to the harm of the victim. Proving
fraud in a court of law is often said to be difficult. That difficulty is found, for instance,
in that each and every one of the elements of fraud must be proven, that the elements
include proving the states of mind of the perpetrator and the victim, and that some
jurisdictions require the victim to prove fraud by clear and convincing evidence.
n The remedies for fraud may include rescission (i.e., reversal) of a fraudulently
obtained agreement or transaction, the recovery of a monetary award to compensate
for the harm caused, punitive damages to punish or deter the misconduct, and possibly
others.
n In cases of a fraudulently induced contract, fraud may serve as a defense in a civil
action for breach of contract or specific performance of contract.
n Fraud may serve as a basis for a court to invoke its equitable jurisdiction.
2. Fraud as a Criminal offence : It takes many different forms, some general (e.g.,
theft by false pretense) and some specific to particular categories of victims or
misconduct (e.g., bank fraud, insurance fraud, forgery). The elements of fraud as a
crime similarly vary. The requisite elements of perhaps the most general form of
criminal fraud, theft by false pretense, are the intentional deception of a victim by false
representation or pretense with the intent of persuading the victim to part with property
and with the victim parting with property in reliance on the representation or pretense
and with the perpetrator intending to keep the property from the victim. In a way mens
rea or criminal intent remains a key ingredient of the offence. In Indian Law,
implications of fraud is found in these following sections of IPC namely, 421, 422, 423
and 424.
1. Fraudulent removal or concealment of property to prevent distribution among
creditors
2. Fraudulently preventing debt being available for creditors.
3. Fraudulent execution of deed of transfer containing false statement of
consideration.
4. Fraudulent removal or concealment of property.

Kinds of Fraud specific to Economy and Financial Transactions

In specific to the impact on economy and financial transactions, frauds could be
categorized as below:
1) Bank frauds
2) Corporate frauds
3) Insurance frauds
4) Cyber frauds
5) Securities frauds

Frauds specific to the economy and financial transactions encompass various types
of deceptive practices aimed at manipulating financial systems or transactions for
personal gain. Followings are the frauds that have a significant impact on the economy
and financial transactions:
1. Bank Frauds: Bank frauds involve deceitful activities targeting financial
institutions, such as banks or credit unions. These may include fraudulent loan
 applications, check kiting, identity theft, unauthorized withdrawals, or
embezzlement of funds. Bank frauds can result in financial losses for both
financial institutions and their customers, as well as damage to trust and
confidence in the banking system.
2. Corporate Frauds: Corporate frauds occur within businesses or organizations
and involve fraudulent activities perpetrated by employees, executives, or
stakeholders. Examples include financial statement fraud, insider trading,
bribery, kickbacks, or fraudulent accounting practices aimed at inflating
revenues or concealing liabilities. Corporate frauds can have far-reaching
consequences, including investor losses, damage to reputation, and regulatory
scrutiny.
3. Insurance Frauds: Insurance frauds involve deceptive acts aimed at obtaining
undeserved benefits from insurance companies. This may include filing false
insurance claims, staging accidents or injuries, exaggerating losses, or
providing misleading information to insurers. Insurance frauds contribute to
higher premiums for policyholders and undermine the integrity of the insurance
industry.
4. Cyber Frauds: Cyber frauds involve fraudulent activities conducted online or
through electronic means, such as the internet, email, or mobile devices. This
may include phishing scams, identity theft, hacking into financial accounts,
fraudulent online purchases, or malware attacks targeting financial institutions
or individuals. Cyber frauds pose significant risks to personal and financial
information security and can lead to financial losses, data breaches, and
reputational damage.
5. Securities Frauds: Securities frauds involve deceptive practices in the buying,
selling, or trading of securities, such as stocks, bonds, or derivatives. This may
include insider trading, market manipulation, Ponzi schemes, or dissemination
of false or misleading information to investors. Securities frauds undermine
investor confidence, distort market prices, and erode trust in the financial
market.

4.6 THE DIFFERENT INSTANCES OF FRAUD

There are many ways in which fraud can occur. Here are a few instances of fraud:
Consumer Fraud: Bogus companies and fraudsters may defraud people in the name
of reliable companies using Pyramid schemes, phishing, telemarketing, and other
means. They may also target consumers online by emailing them links that can
compromise their private information when opened. The consumers themselves are
led to believe that they are taking part in business as usual. However, once they suffer
the loss of their assets, they realize that they have been defrauded.
Financial Statement Fraud: Companies may manipulate their financial statements in
order to polish their image in the public eye, or receive bonuses for meeting certain
targets when in reality they haven’t done so. They do this by overvaluing their assets,
neglecting to mention expenses and liabilities, adding non-existent revenue, and
skewing the timing of entries.
Corruption: Company officials at high levels may engage in taking bribes to appease
paying customers. They misuse their power and influence for their personal gain. The
demands of the payee, in this case, are almost always unlawful, which is why these
under-the-table transactions take place.
Asset Misappropriation: Employees of the company may be misusing the provided
assets for their own personal gain. The most common malpractice regarding assets is
swiping cash before it is recorded in the company’s systems. Detecting this type of
fraud is often quite difficult, as no records exist to unmask the fraudster. Employees
may also indulge in check tampering, payroll schemes, fake billing, and inventory
manipulation. Asset misappropriation also includes the misuse of company machinery
and software for one’s own gain. This means using it for reasons other than for its
intended purpose.
Theft of trade secrets: This happens when employees use confidential information
for their own gain. It is a form of stealing- robbing the company of its creativity and
ideas and taking credit for it. If a person or company steals the intellectual property
(such as a recipe, lyrics, or a marketing idea) of another company, then it is a type of
fraud.

4.7 Why Is Fraud Committed?

Fraud or intentional deception is a strategy to achieve a personal or organizational
goal or to satisfy a human need. However, a goal or need can be satisfied by honest
means as well as by dishonest means. So what precipitates, inspires, or motivates
one to select dishonest rather than honest means to satisfy goals and needs?
Competitive survival can be a motive for both honest and dishonest behavior. A threat
to survival may cause one to choose either dishonest or honest means. When
competition is keen and predatory, dishonesty can be rationalized quickly. Deceit,
therefore, can become a weapon in any contest for survival. Stated differently, the
struggle to survive (economically, socially, or politically) often generates deceitful
behavior. The same is true of fraud in business.
“Fraud Triangle” Of the traditional fraud research, Donald Cressey’s research in the
1950s provides the most valuable insight into the question why fraud is committed.
The result of this research is most commonly, and succinctly, presented in what is
known as the fraud triangle. Cressey decided to interview fraudsters who were
convicted of embezzlement. He interviewed about 200 embezzlers in prison. One of
the major conclusions of his efforts was that every fraud had three things in common:
(1) pressure (sometimes referred to as motivation, and usually an “unshareable
need”);
(2) rationalization (of personal ethics);
and
(3) knowledge and opportunity to commit the crime. These three points are the corners
of the fraud triangle
Understanding the motives behind fraud- the Fraud Triangle
The fraud triangle is a representation of why a person might be driven to commit fraud.
Each component of the triangle represents a motive behind fraud. So, how does the
mind of a fraudster work? Let’s find out-
1. Opportunity
The first point of the triangle is Opportunity. When calculating people see
circumstances that would allow them to commit fraud, they take it. These opportunities
are usually caused by unorganization or negligence on the company’s part.
These opportunities are born from the weakening of a company’s internal controls.
The internal controls of a company refer to the rules and guidelines put in place to
ensure that all accounting and financial processes are done diligently and without any
room for fraud.
When there are any gaps left in these quality checks, then people may take the
opportunity to commit fraud. When the organization is lacking in competent
supervision and checks on these controls, then it leaves alto of holes for employees
to take advantage of the situation. If the methods of recording accounts and other
financial transactions are inadequate as well, then it may result in employees skewing
the entries.
If the upper management of a company is lackluster and doesn’t abide by the proper
moral and ethical codes of the company- then it may reflect in the behavior of its
employees. Management that conducts themselves properly in public and work
diligently decreases the chance of fraud occurring in a company. If the management
and board directors themselves fail to do their job, then it reflects poorly on the
company, leaving the employees to act however they please. In many cases, this
leads to them taking advantage of the management’s aloof manner for personal gain.
2. Incentive/Pressure
The second point of the fraud triangle is Incentive or Pressure. Pressure usually
stems from the employees themselves, who may feel trapped or caged because of
certain conditions. They feel that committing fraud to boost their numbers is the only
way to escape from their predicament.
The most common form of pressure employees face is their performance review. In
many companies, the efficiency of an employee is measured by the revenue he or she
brings in, or by the commission they earn. If the expectations from the employees are
too high, they may resort to fraud to oversell themselves in the hopes that their
managers see them as good performers.
Many companies also offer bonuses to employees who hit certain revenue targets.
People may manipulate their numbers in order to qualify for these bonuses- which is
also a form of fraud.
Sometimes, companies may also feel pressure from their investors to perform well snd
provide good returns. They may commit fraud to maintain good stock prices and keep
the investors happy.
Employees may also be facing pressure from unfortunate circumstances in their
personal life. Crippling debt, gambling and alcohol addictions, and looming bills may
cause them to steal money from the company. People dealing with such issues are
the most likely suspects of committing fraud.
3. Rationalization
The final point is Rationalization. A fraudster may try to justify their actions to
themselves or anyone who catches them, in order to convince themselves that what
they are doing is right.
The most common causes of this reasoning are when an employee feels that they are
being overlooked or mistreated by the company. It may either be a way of getting
attention, or payback for their unhappiness.
Sometimes, in the process of rationalizing their actions to themselves, an employee
may in fact become irrational. They may get thoughts that committing fraud is the only
way they can earn money and live a good life, or that everyone else in the company
is secretly doing it as well.

4.8 Who Commits Fraud?

Based on research in criminology and sociology, certain generalizations can be made
about individuals and their propensity to commit fraud:
1. Honesty Spectrum: Individuals fall along a spectrum of honesty, ranging from
those who are consistently honest to those who are consistently dishonest.
Most people fall somewhere in between, being honest some of the time but
potentially dishonest under certain circumstances.
2. Factors Influencing Fraud Perpetration:
 Experience of Failure: Individuals who have experienced failure may
be more likely to resort to fraudulent behavior as a means of coping or
achieving success.
 Self-Perception: People who are disliked or have low self-esteem may
be more inclined to engage in deceitful behavior.
  Impulsivity and Gratification: Those who are impulsive, easily
distracted, and unable to delay gratification are more prone to engaging
in deceitful acts.
 Conscience: Individuals with a strong conscience, including a fear of
apprehension and punishment, are more resistant to the temptation to
deceive.
 Intelligence and Socioeconomic Status: Higher intelligence and
socioeconomic status tend to correlate with greater honesty, although
there are exceptions.
 Opportunity: The ease with which individuals can cheat or steal
influences the likelihood of engaging in fraudulent behavior.
 Individual Needs: Different individuals have varying needs and
motivations that may drive them to lie, cheat, or steal.
These insights suggest that while external factors such as economic, social, and
political conditions and poor controls play a role in facilitating fraud, individual
characteristics and psychological factors also contribute significantly to the likelihood
of fraud perpetration. Understanding these factors can help organizations develop
more effective fraud prevention and detection strategies, such as fostering a culture
of integrity, implementing stringent controls, and providing ethical training and support
to employees.
4.9 FRAUD TAXONOMIES
Most technical books have a glossary at the end. This one provides a taxonomy at the
beginning to lay a simple but expanded foundation for what follows in the text. Another
benefit of the taxonomy is that it provides a periodic quick review and thus reinforces
the lessons learned at the first reading. In essence, the taxonomy summarizes the
major principles of fraud auditing and forensic accounting. General Dichotomies of
Frauds
1. Consumer and Investor Frauds
Fraud, in a nutshell, is intentional deception, commonly described as lying,
cheating, and stealing. Fraud can be perpetrated against customers, creditors,
investors, suppliers, bankers, insurers, or government authorities (e.g., tax fraud),
stock fraud, and short weights and counts. For our purposes, we will limit tions.
Consumer fraud has a literature of its own. Our aim is, therefore, to assist
accountants and investigators in their efforts to detect and document fraud in
books of account.
2. Criminal and Civil Fraud
A specific act of fraud may be a criminal offense, a civil wrong, or grounds for the
rescission of a contract. Criminal fraud requires proof of an intentional deception.
Civil fraud requires that the victim suffer damages. Fraud in the inducement of a
contract may vitiate consent and render a contract voidable.
3. Management and Nonmanagement Fraud
 Corporate or organizational fraud is not restricted to high-level executives.
Organizational fraud touches senior, middle, and first-line management as well
as nonmanagement employees. There may be some notable distinctions
between the means used and the motivations and opportunities the work
environment provides, but fraud is found at all levels of an organization—if one
bothers to look for it. Even if internal controls are adequate by professional
standards, we should not forget that top managers can override controls with
impunity, and often do so.
RECENT CASES
PNB Scam: One of the most notable recent cases of financial fraud is the PNB Scam
involving Indian jeweler Nirav Modi. Once hailed as the "jeweler to the stars," Modi's reputation
took a nosedive in 2018 when Punjab National Bank (PNB), the second-largest state-run bank
in India, filed a police complaint against him, along with fellow jeweler Mehul Choksi and
others. The complaint alleged that they had conspired with PNB staff to defraud the bank of
nearly $43 million.

However, as investigations by the Central Bureau of Investigation (CBI) progressed,

the true extent of the fraud became apparent. The total amount involved was revealed
to be closer to a staggering $2 billion. It was discovered that Modi had colluded with
bank employees to fraudulently obtain Letters of Undertaking (LoUs) from PNB. LoUs
act as guarantees in international banking transactions, but the ones in question were
issued without proper authorization and were not recorded in PNB's system, allowing
Modi and Choksi to obtain loans in other countries without detection.
Before the scandal came to light, Modi fled India, and he remains a fugitive to this day.
In response to the fraud, the Reserve Bank of India (RBI) discontinued the acceptance
and issuance of LoUs and ordered financial institutions in India to integrate the SWIFT
network with their central information systems to prevent similar incidents in the future.
The PNB scam serves as a stark reminder of the vulnerabilities in the banking system
and the importance of stringent regulatory oversight to prevent fraud and protect the
interests of depositors and investors.

Self Assessment
1. What is fraud?
2. Describe fraud as civil crime?
3. Explain corporate fraud?
4. What is insurance fraud?
4.10 Summary
Fraud, a term with varied interpretations, encompasses deceitful actions aimed at
gaining unfair advantage. It involves acts such as theft and embezzlement,
characterized by intentional misrepresentation or concealment of facts. The elements
of fraud typically include deception, intent, and financial harm to victims. Various types
and instances of fraud exist, spanning from financial manipulation to identity theft.
Motives behind fraud vary widely, including financial gain, revenge, or desperation.
Perpetrators of fraud come from diverse backgrounds, including employees,
executives, and external parties. Taxonomies classify fraud based on methods,
targets, or industries. Overall, fraud poses significant challenges, requiring vigilance
and preventive measures across all sectors.
4.11 Glossary
1. ‘Fraud’, in general, refers to a wrongful or criminal deception practiced which is
intended to result in financial or personal gain to oneself and a financial or
personal loss to the other.
2. Fraud as a crime. Fraud is a generic term, and embraces all the multifarious
means which human ingenuity can devise, which are resorted to by one
individual, to get an advantage over another by false representations. No definite
and invariable rule can be laid down as a general proposition in defining fraud, as
it includes surprise, trick, cunning and unfair ways by which another is cheated.
The only boundaries defining it are those which limit human knavery.
3. Bank Frauds: Bank frauds involve deceitful activities targeting financial
institutions, such as banks or credit unions. These may include fraudulent loan
applications, check kiting, identity theft, unauthorized withdrawals, or
embezzlement of funds. Bank frauds can result in financial losses for both
financial institutions and their customers, as well as damage to trust and
confidence in the banking system.
4. Corporate Frauds: Corporate frauds occur within businesses or organizations
and involve fraudulent activities perpetrated by employees, executives, or
stakeholders. Examples include financial statement fraud, insider trading, bribery,
kickbacks, or fraudulent accounting practices aimed at inflating revenues or
concealing liabilities. Corporate frauds can have far-reaching consequences,
including investor losses, damage to reputation, and regulatory scrutiny.

4.12 Answers: Self Assessment

1). Please check section 4.2 2). Please check section 4.3 3). Please check
section 4.5 4). Please check section 4.5
4.13 Terminal Questions
1. Can you distinguish between fraud, theft, and embezzlement? And What are the
key differences in terms of legal implications and in
2. What are the essential elements that must be present for an act to be considered
fraud?
3. What are some common types of frauds that occur in financial transactions?
4. Are there specific reason for committing fraud?
4.14 Answers: Terminal Questions:
1). Please check section 4.3 2). Please check section 4.4 3). Please check
section 4.5 4). Please check section 4.8
4.15 Suggested Readings
1. Albrecht, W. Steve. (2009). Forensic Accounting & Fraud Examination. Cengage
Learning (India Edition).
2. Albrecht, Chad O., Albrecht, Conan C., Albrecht, W. Steve & Zimbelman, Mark F.
(2015). Forensic Accounting & Fraud Examination. Cengage Learning (India
Edition).
3. Banerjee, Robin (2015). Who Cheats and How? Sage Publications, New Delhi.
4. Bologna, Jack and Lindquist, Robert J. (1995). Fraud Auditing and Forensic
Accounting. Wiley.
5. Bremser, Wayne G. (1995). Forensic Accounting and Financial Fraud.American
Management Association.
 Lesson – 5
CORPORATE FRAUD

Structure:
5.0 Learning Objectives
5.1 Introduction
5.2 Categories of corporate frauds
5.3 Types of fraud
5.4 Nature of corporate fraud
5.5 Concept of corporate frauds in india
5.6 Pre-fraud and post-fraud stages
5.7 Regulators to prevent fraud in india
5.8 Measure to prevent fraud
5.9 Curbing of corporate frauds under the companies act, 2013
5.10 Penalty for corporate fraud
5.11 Summary
5.12 Glossary
5.13 Answers: Self Assessment
5.14 Terminal Questions
5.15 Answers: Terminal Questions:
5.16 Suggested Readings
5.0 Learning Objectives
After studying the lesson, you should be able to:-
1. Categories of corporate frauds
2. Pre-fraud and post-fraud stages
3. Concept of corporate frauds in india
4. Penalty for corporate fraud
5.1 Introduction
Corporate fraud encompasses illicit actions conducted by individuals or entities within
a company, characterized by dishonesty and unethical behavior. These fraudulent
activities are typically orchestrated to confer an advantage upon the perpetrating party
or organization. Unlike routine business operations, corporate fraud schemes
transcend the boundaries of an employee's official duties and are distinguished by
their intricacy and significant economic ramifications for the business, its employees,
and external stakeholders. Corporate fraud can be challenging to prevent and tricky
to catch. By creating effective policies, a system of checks and balances, and physical
security, a company may limit the extent to which fraud can take place. Corporate
fraud is considered a white-collar crime.

5.2 Categories of corporate frauds

Asset misappropriation: It is a theft or misuse of organization’s cash or assets
belonging to a company. It can be done by directors, employees or persons who are
entrusted with the company’s assets. Asset misappropriation schemes include those
frauds in which perpetrator employ tricks to steal or misuse organization’s assets.
Assets stolen can be in the form of cash, credit note or vouchers. Modus operandi for
such frauds is fictitious sales, false inventory, falsifying asset requisition and transfer.
Bribery and corruption: Bribery and corruption are serious economic crime as it
affects company’s economic development. Bribery involves offering, giving or
receiving anything that influences an official act. Corruption is much wider concept
which includes bribery, illicit gratification and economic extortion. Employees
improperly use their power in business transactions to gain some advantage for
themselves or another person. It is reflected in latest cases that CEO and managing
directors are found directly involved in bribery to get projects and approval beyond
their capabilities with the help of companies board.
Financial fraud statements: It usually involves misrepresentation of financial
statements of the company. It can be most damaging to the company. This type of
frauds take the form of manipulating accounts, Overstating revenue assets and
investments , understating liabilities and non-disclosure of certain vital information.
Enron, WorldCom and Satyam are recent, high profile cases involving financial
statement fraud.
Corporate espionage: The term ‘corporate espionage’ has become synonymous with
industrial espionage. With the increase in competition in business ventures, corporates
started resorting to innovative methods to obtain information about other companies
or competitors. Officials steal the trade secrets by removing or copying confidential or
valuable information of a competitor for its company’s benefit. Corporates gets
benefited financially through this kind of frauds.
Investment trends: Investment scams leads to financial loss to the investors and
even loss of their lives. Loopholes in the investment system give way to the perpetrator
to procure proceeds from the scam. Bogus companies are formed just to manipulate
and hide the bogus transactions. Harshad Mehta, Ketan Parekh and Sahara Group
scams are few names which the Stock market in India will always remember with grief.
Insider trading: Insider trading is defined as a trading in company’s stocks or
securities by persons who are predicted to gain access to the subtle information in
respect to such securities. Taking advantage of such information is prohibited under
the respective securities laws of different countries. The Rajat Gupta Case is one of
the biggest scandals in history of US for the offence of insider trading.

5.3 TYPES OF FRAUD

There are many types of corporate fraud, including the following common frauds:
1. Theft: This includes the unauthorized taking of cash, physical assets, or
confidential information from the company for personal gain.
2. Misuse of Accounts: Involves the improper use or manipulation of financial
accounts or records for fraudulent purposes.
3. Procurement Fraud: Occurs when individuals or vendors engage in fraudulent
activities related to the purchasing process, such as overcharging for goods or
services, bid rigging, or kickbacks.
4. Payroll Fraud: Involves schemes to fraudulently inflate employee salaries or
benefits, create fictitious employees, or manipulate timekeeping records.
5. Financial Accounting Misstatements: Involves intentionally misrepresenting
financial information in company records or financial statements to deceive
stakeholders or investors.
6. Inappropriate Journal Vouchers: Involves the improper or unauthorized
creation, modification, or deletion of journal entries to conceal fraudulent
transactions or manipulate financial results.
7. Suspense Accounting Fraud: Involves the misuse of suspense accounts or
other temporary holding accounts to conceal fraudulent transactions or
misappropriated funds.
8. Fraudulent Expense Claims: Occurs when employees submit false or inflated
expense reports for reimbursement, often for personal expenses unrelated to
business activities.
9. False Employment Credentials: Involves providing false or misleading
information on job applications or resumes to secure employment or advance
within the company.
10. Bribery and Corruption: Involves offering, giving, receiving, or soliciting
something of value, such as money or gifts, to influence business decisions or
gain an unfair advantage.

5.4 NATURE OF CORPORATE FRAUD

The nature of corporate fraud is multifaceted, often involving complex schemes and
deceptive practices aimed at achieving illicit gains or advantages. Key aspects that
characterize the nature of corporate fraud:
1. Deception: Corporate fraud typically involves intentional deception, where
individuals or entities within a company engage in dishonest or misleading
behavior to conceal their actions or manipulate outcomes for personal or
organizational benefit.
2. Complexity: Corporate fraud schemes can be highly intricate and
sophisticated, often requiring detailed planning and coordination to execute
successfully. These schemes may involve multiple parties, transactions, or
layers of concealment to avoid detection.
3. Illicit Gains: The primary motive behind corporate fraud is usually financial gain
or other advantages, such as gaining a competitive edge, avoiding regulatory
scrutiny, or advancing personal interests at the expense of the company or its
stakeholders.
4. Scope: Corporate fraud can affect various aspects of a company's operations,
including financial reporting, procurement, payroll, and internal controls. It may
involve misappropriation of assets, manipulation of financial statements, or
abuse of authority for personal gain.
5. Impact: The consequences of corporate fraud can be far-reaching and
damaging, both internally and externally. It can lead to financial losses,
reputational damage, legal liabilities, regulatory penalties, and erosion of trust
among investors, customers, and other stakeholders.
6. Persistence: Corporate fraud is often a recurring issue within organizations,
with perpetrators exploiting weaknesses in internal controls or oversight
mechanisms. Without effective preventive measures and detection systems in
place, fraud schemes may persist or escalate over time.
7. Adaptability: Perpetrators of corporate fraud may adapt their tactics and
strategies in response to changes in internal or external environments,
regulatory requirements, or detection methods. This adaptability makes it
challenging for companies to anticipate and mitigate fraud risks effectively.
8. Ethical Considerations: Corporate fraud raises ethical concerns regarding
integrity, accountability, and trust within organizations. It highlights the
importance of ethical leadership, corporate governance, and a culture of
transparency and integrity in deterring fraudulent behavior.
5.5 Concept of corporate frauds in India
India has become a corporate hub in past decades. Corporate frauds have become a
threat to the society and financial Industry specifically as financial loss by these kinds
of frauds are much greater than loss from robberies, theft, swindling etc. The society
cannot survive with them but cannot even live even without them In India,
organizations irrespective of their gamut and orbit are subject to fraud. It causes
enormous consequences to the organization, stakeholders and general public. Our
country being a silent spectator of several corporate frauds, few of them being the
Harshad Mehta scam of 1992, Satyam scandal in 2009, Saradha Chit Fund scam and
Sahara Fraud Case. These infamous scandals have adversely affected the
development of the economic sector of our country.
Regulations pertaining to corporate frauds
The Companies Act 2013 is a significant legislation in India aimed at preventing and
addressing corporate frauds. One of its key provisions pertaining to corporate fraud is
Section 447, which defines fraudulent activities within the context of the Act. Here's an
overview of some regulations and provisions within the Companies Act 2013 related
to corporate frauds:
1. Section 447 - Fraudulent Activities: This section defines fraudulent activities
within the company, encompassing acts, omissions, concealment of facts, or
abuse of position with the intent to deceive, gain undue advantage, or harm the
interests of the company, shareholders, creditors, or any other person.
2. Civil and Criminal Liability: The Companies Act 2013 imposes both civil and
criminal liability on individuals or entities involved in fraudulent activities. This
means that perpetrators of corporate fraud can face legal consequences,
including fines, penalties, and imprisonment, depending on the severity of the
offense.
3. Reporting Requirements: The Companies Act 2013 mandates companies to
report frauds to the relevant authorities, including the Serious Fraud
Investigation Office (SFIO), within a specified timeframe. Failure to comply with
reporting requirements can lead to penalties for the company and its officers.
4. Corporate Governance: The Act promotes good corporate governance
practices to prevent frauds and enhance transparency, accountability, and
integrity within companies. It mandates the establishment of robust internal
control systems, audit committees, and independent directors to oversee
corporate affairs and detect fraudulent activities.
5. Auditor's Responsibilities: The Act outlines the duties and responsibilities of
auditors in detecting and reporting frauds during the audit process. Auditors are
required to exercise due diligence, independence, and professional skepticism
to identify irregularities and report them to the appropriate authorities.
6. Whistleblower Protection: The Act provides protection to whistleblowers who
report instances of fraud or wrongdoing within the company. It prohibits
retaliation or victimization against whistleblowers and encourages a culture of
transparency and accountability.
5.6 PRE-FRAUD AND POST-FRAUD STAGES
Provisions in the Companies Act 2013 address both civil and criminal liability for
corporate fraud, dividing them into pre-fraud and post-fraud stages:
Pre-fraud Stage:
 1. Incorporation of Company Related Fraud: This includes fraudulent activities
related to the incorporation process, such as providing false information or
documents to obtain incorporation or registration.
2. Share Capital Frauds: Fraudulent practices related to share capital, such as
issuing shares at inflated prices, falsifying shareholding records, or
manipulating share prices.
3. Transfer/Transmission of Shares to Defraud: Involves fraudulent transfer or
transmission of shares to deceive shareholders or other stakeholders.
4. Misstatement in Prospectus: Refers to providing false or misleading
information in the prospectus issued by a company to attract investors.
5. Fraudulent Inducement for Investment: Involves inducing individuals or
entities to invest in a company through false promises, misrepresentation, or
other fraudulent means.
Post-fraud Stage:
1. Carrying Business for Unlawful Purpose: Engaging in business activities
with the intent to commit fraud, evade legal obligations, or engage in illegal
practices.
2. Fraudulent Conduct of Business: Involves conducting business operations
in a fraudulent manner, such as misappropriation of funds, embezzlement, or
manipulation of financial records.
3. Financial Statement Fraud: Falsifying financial statements, accounts, or
records to deceive investors, creditors, or regulatory authorities.
4. Failure to Repay Deposits: Failure to repay deposits accepted from
shareholders or depositors, as required by law or contractual agreements.
5. Insider Trading: Illegally trading securities based on non-public, material
information about the company, its operations, or financial performance.
6. Fraudulent Removal of Name of Company: Illegally removing the name of a
company from the register of companies to evade legal obligations or liabilities.
7. Removal of Auditors or Penalties for Fraud: Removing auditors who identify
fraudulent activities or imposing penalties on companies or individuals involved
in fraud.
5.7 REGULATORS TO PREVENT FRAUD IN INDIA
Regulators play a crucial role in detecting, investigating, and addressing corporate
frauds under the Companies Act. The two primary regulators tasked with these
responsibilities are the Serious Fraud Investigation Office (SFIO) and the National
Company Law Tribunal (NCLT):
1. Serious Fraud Investigation Office (SFIO):
  SFIO is a specialized investigative agency mandated to detect and
investigate serious financial frauds within companies.
 It comprises experts from various fields and is empowered to conduct
thorough and timely investigations into cases of financial fraud as
assigned by the Central Government.
 SFIO has the authority to make arrests in cases where individuals are
suspected of committing offenses under the Companies Act.
2. National Company Law Tribunal (NCLT):
 NCLT is a quasi-judicial authority established to adjudicate corporate
disputes and matters arising under the Companies Act.
 It has jurisdiction over a wide range of corporate matters, including class
action suits, cases of oppression and mismanagement, disputes related
to share transfers, and punishment for fraudulent conduct of business.
 NCLT's powers extend to providing relief, issuing orders to remedy
situations, correcting wrongs, imposing penalties or costs, and making
decisions based on principles of natural justice.
 Unlike traditional courts, NCLT is not bound by strict procedural rules,
allowing it to adjudicate cases efficiently while ensuring fairness and
adherence to legal principles.
5.8 MEASURE TO PREVENT FRAUD
One of the best ways to develop policies and procedures that are effective in
prevention corporate fraud is with the assistance of an experienced anti-fraud
professional who has investigated hundreds of frauds to develop the most relevant
and most effective anti-fraud controls including:
1. Establish Clear Standards: Set clear and easily understandable standards for
ethical conduct and compliance from the top down. Develop an employee
manual that outlines these standards to prevent ambiguity.
2. Perform Background Checks: Conduct thorough background checks,
including employment, credit, licensing, and criminal history screenings, for all
new hires to identify any potential red flags.
3. Secure Physical and Data Assets: Implement security measures to
safeguard physical assets, access to data, and financial resources. This
includes using pre-numbered checks, keeping checks locked up, and having
strict procedures for check issuance and voiding.
4. Segregation of Duties: Divide responsibilities among employees to prevent
one individual from having excessive control over a particular area or function.
Separate key accounting and financial tasks, and ensure that payroll checks
are personally reviewed by management.
 5. Authorization Controls: Implement controls to ensure that transactions are
properly authorized and that employees do not exceed their authority levels
when conducting business activities.
6. Independent Checks: Conduct regular audits, surprise inspections, inventory
counts, and other independent checks to verify compliance with policies and
procedures and ensure the accuracy of financial records.
7. Anonymous Reporting Mechanism: Establish an anonymous reporting
mechanism, such as an employee fraud hotline, to encourage staff to report
suspicions or concerns about fraudulent activities without fear of retaliation.
8. Control Sensitive Documents: Control access to sensitive documents, such
as bank statements and customer receipts, and consider using a separate post
office box for receiving such documents to prevent unauthorized access.
9. Independent Reviews: Ensure that all account reconciliations and general
ledger balances undergo independent reviews by individuals outside the
responsible area, such as external accountants, to detect and deter fraudulent
activities.
10. Conduct Annual Audits: Conduct annual audits to assess the effectiveness
of internal controls and motivate staff to adhere to policies and procedures. The
uncertainty of audit procedures can serve as a deterrent to potential fraudsters.
11. Strengthen Internal Controls: Continuously strengthen internal control
policies, processes, and procedures to mitigate the risk of fraud and make the
company less attractive to both internal and external perpetrators.
5.9 Curbing of Corporate Frauds under the Companies Act, 2013

1. Section 447 of the Companies Act, 2013, plays a pivotal role in preventing and
curbing corporate frauds by introducing the concept of fraud and providing for stringent
punishment for perpetrators. Here is the text of Section 447:
"Without prejudice to any liability including repayment of any debt under this Act or any
other law for the time being in force, any person who is found
 to be guilty of fraud,
 shall be punishable with imprisonment for a term which shall not be less than
six months but which may extend to ten years and shall also be liable to fine
which shall not be less than the amount involved in the fraud, but which may
extend to three times the amount involved in the fraud;
 provided that where the fraud in question involves public interest, the term of
imprisonment shall not be less than three years."
This provision empowers the authorities to take strict action against individuals found
guilty of fraud, imposing significant penalties including imprisonment and fines. By
incorporating such provisions, the Companies Act 2013 aims to deter fraudulent
activities, protect the interests of stakeholders, and uphold the integrity of the
corporate sector.
The new act has included the concept of fraud which is inclusive, not comprehensive,
and pertains only to the affairs of a company or body corporate. Certain terms used in
the definition need elaboration. While the term fraud not only includes any ‘act’ but
also ‘the omission, not to act’, concealment of any fact, and abuse of position by a
person. Such an act, omission and concealment, can pertain to any person himself or
by him with the connivance of any other person in any manner.
1. Act/Omission to Act: While an act of omission is the failure to perform an act
expected to be done by a person, an act of commission is doing an act that causes
harm. According to the Oxford Law Dictionary, the word ‘omission’ means ‘a failure to
act' that means when a person is bound to do an act but he omits to do it or deliberately
neglects that, it is called omission.
2. Fraudulent Concealment: The meaning of the word ‘concealment’ as found in the
Shorter Oxford English Dictionary, 3rd Edition, reads, “In law, the intentional
suppression of truth or fact known, to the injury or prejudice of another.”[C.I.T. vs.
J.K.A. Subravania Chettiar, (1977) 110 ITR 602, 608 (Mad). [Income Tax act, 1961, s.
271(1)(c)] The word ‘fraudulently’, appearing in Section 206 of the IPC, cannot be
interpreted as meaning nothing more than ‘dishonestly’. The two words do not mean
exactly the same thing.

Fraud by Abuse of Position: Many cases of the most serious frauds and corruption
are committed by the people at the top who have the power to conduct fraudulent
transactions and cover them up. There are several things which suggest someone is
abusing his position and could actually be committing fraud. A fraud by abuse of
position is defined in section 4 of the Fraud Act, 2006 (UK),
which reads: Section 4: Fraud by Abuse of Position (1) A person is in breach of this
section if he— (a) occupies a position in which he is expected to safeguard, or not to
act against, the financial interests of another person,
(b) dishonestly abuses that position, and

(c) intends, by means of the abuse of that position— (i) to make a gain for himself or
another, or (ii) to cause loss to another or to expose another to a risk of loss. (2) A
person may be regarded as having abused his position even though his conduct
consisted of an omission rather than an act.

Pre-fraud Measures
(1) Fraud in respect of Incorporation of a Company: Sections 7(5), 7(6) and 8(11) of
the Companies Act deal with the action specified under Section 447, which provides
that a company’s promoters, first directors, and the persons who have given any
declaration, shall be liable to the action provided under Section 447, if they have
furnished any false or incorrect information or suppressed any material information
with the Registrar of Companies for incorporating the company. They are liable at the
time of formation or after formation of the company. Furthermore, if it is proved that if
the affairs of the company formed with charitable objects were conducted fraudulently,
then the directors and every officer of the company shall be liable for action under
Section 447.
(2) Frauds related to Company’s Share Capital: Numerous Sections under the
Companies Act, deal with the raising of share capital and its treatment by a company
and offences under those Sections are liable to action under Section 447.
(a) Raising capital by misstatement in the prospectus: The penalty has been
broadened in the new Companies Act. As per Section 34, a person who has authorised
someone to issue a prospectus containing any untrue and misleading statement shall
also be punishable under Section 447. The provisions read as follows:
(b) Fraudulently inducing others to invest money: Any person who induces others to
invest money by making any statement which is false, deceptive, misleading or
deliberately concealing any facts, shall be liable for punishment for fraud under Section
447.
(c) Impersonation for acquisition of securities: A person who makes an application in
a fictitious name, makes multiple applications in different names or in different
combinations of names, for acquiring or subscribing for securities, or induces a
company to allot or register any transfer of securities in a fictitious name, shall be liable
for punishment under Section 447.
(d) Issuing duplicate share certificates: If a company issues a duplicate share
certificate with an intention to defraud, every officer of the company who is in default
shall be liable for action under Section 447 of the Act.
(e) Transfer/transmission of shares by depository: Where any depository or depository
participant, having an intention to defraud a person, transfers shares, such depository
or depository participant, besides incurring the liability under the Depositories Act,
1996, shall be liable for punishment under Section 447 of the Act.
(f) Reduction of share capital under: An officer of the company shall be liable for action
under Section 447 of the Act, if he knowingly conceals the name of any creditor who
was entitled to object to the reduction of share capital or knowingly misrepresents the
nature or debt amount or claim of any creditor or encourages or assists or concerned
to any such concealment.

Post-fraud Measures
(1) Repayment of Deposits: Section 75(1) of the new Companies Act provides that
every officer of the company who is responsible for acceptance of any deposit shall
be liable to action under Section 447, if such company fails to repay the deposits or
any part thereof or any interest thereon, within the time specified, and if it is proved
that the deposit was accepted with an intent to defraud the depositors or for any
fraudulent purpose. Under this Section, an action can be taken by any person/group
of persons or any association of person who had incurred any loss as a result of the
company’s failure to repay the deposit or part thereof or interest accrued thereon. The
officer shall be personally responsible without any limitation of liability.
(2) Removal/Resignation of Auditors: The new Act also imposes penalties on
‘Independent Professionals’. While in the case of contravention of an auditor’s duties,
the penalty for the auditor has been made more stringent, if any partner/ partners of
the audit firm has or have acted in a fraudulent manner, they shall also be punishable
for fraud. The Act specifically provides that the partner/partners of the audit firm and
the firm shall be jointly and severally responsible for the liability, whether civil or
criminal as provided in the Companies Act or in any other law for the time being in
force.
(3) Carrying On of Unlawful Business: The Registrar of Companies has been
empowered to call for information, explanation of documents or inspect books of the
company, either on the basis of information available with him or furnished to him or
on a representation given to him by any person, if the business of the company is
carried on for fraudulent or unlawful purposes. In such case, every officer of the
company who is in default shall be punishable for fraud under Section 447.
(4) Inspection/Investigation into Company’s Affairs: The Central Government shall
appoint one or more competent person as inspectors to investigate into the affairs of
the company. If after the investigation, it is found that the company was formed with a
fraudulent or unlawful purpose or the business is conducted to defraud its members,
creditors or any other person concerned in the formation of the company, or manage
its affairs has been guilty of fraud, then every officer who is in default or any other
person concerned in the formation of the company and managing its affairs shall be
punishable for fraud under Section 447.
(5) Furnishing False Statement/Mutilation/ Destruction of Documents: A new
Section 229 has been added in the Companies Act which provides punishment as per
Section 447 to such person who, during the course of inspection, investigation or
inquiry, furnishes any false statement, or mutilates, destroys, conceals, tampers with,
or removes any document relating to property, assets or affairs of the company.
(6) Fraudulent Removal of Name: When the Registrar of Companies finds that an
application for removal of name (voluntarily striking off of the name) has been filed
with an objective to evade liabilities of the company or with an intent to defraud its
creditors or any person(s), then the person in charge of management of the company
shall be liable for punishment under Section 447. Such person(s) shall also be liable
to the person(s) who had incurred loss or damages due to the dissolution of the
company.
(7) Damages against Delinquent Directors: Section 266 (1) empowers the
Company Law Tribunal to assess the damages against delinquent directors during
scrutiny or implementation of a scheme of a sick company. If the Tribunal finds that
any person, who took part in the formation, promotion of or managing the affairs of
such company has misapplied money or property of such company or found guilty of
any misfeasance in relation to the sick company, such a person shall be punishable
under Section 447.
(8) Fraudulent Conduct of Business: During the course of winding up of the
company, if it appears that any business of the company has been carried out with an
intention to defraud creditors or any other person or for fraudulent purposes, then
every person who was knowingly a party to the carrying off of the business, shall be
liable for action under Section 447. The Tribunal on the application of the Official
Liquidator, Company Liquidator, any creditor or contributory of the company can
declare such a person liable personally for debts or other liabilities of the company.
(9) Making of False Statement: If any person makes a statement, in any return,
report, certificate, financial statement, prospectus, statement or other document
required by, or, for, the purposes of this Act, or rules there under, which is false or omit
any material fact, shall be punishable for fraud under Section 447.

5.10 Penalty for Corporate Fraud

The new Act provides stringent penalties for corporate frauds. Any person who is
found guilty of fraud shall be punishable with imprisonment for a minimum period of 6
months, which may extend to 10 years, and also a fine equivalent to the amount
involved in the fraud, which may extend to three times the amount involved in the
fraud. However, where the fraud involves public interest, the imprisonment shall be for
a minimum period of three years.
Self Assessment
1. What is corporate fraud?
2. Describe Asset misappropriation?
3. Explain Corporate espionage?
4. What are the various penalties for fraud in India?
5.11 Summary
Corporate fraud encompasses various categories and types, with its nature spanning
pre-fraud and post-fraud stages. In India, regulators like SEBI and RBI aim to prevent
fraud, while measures such as internal controls and audits are crucial for prevention.
The Companies Act of 2013 addresses corporate fraud, imposing penalties for
offenders. Overall, understanding and addressing corporate fraud is essential for
maintaining integrity and trust in the business environment.
5.12 Glossary
1. Corporate fraud: Corporate fraud encompasses illicit actions conducted by
individuals or entities within a company, characterized by dishonesty and unethical
behavior. These fraudulent activities are typically orchestrated to confer an
advantage upon the perpetrating party or organization.
2. Asset misappropriation: It is a theft or misuse of organization’s cash or assets
belonging to a company. It can be done by directors, employees or persons who
are entrusted with the company’s assets. Asset misappropriation schemes include
those frauds in which perpetrator employ tricks to steal or misuse organization’s
assets. Assets stolen can be in the form of cash, credit note or vouchers. Modus
operandi for such frauds is fictitious sales, false inventory, falsifying asset
requisition and transfer.
3. Bribery and corruption: Bribery and corruption are serious economic crime as it
affects company’s economic development. Bribery involves offering, giving or
receiving anything that influences an official act. Corruption is much wider concept
which includes bribery, illicit gratification and economic extortion. Employees
improperly use their power in business transactions to gain some advantage for
themselves or another person. It is reflected in latest cases that CEO and
managing directors are found directly involved in bribery to get projects and
approval beyond their capabilities with the help of companies board.
4. Corporate espionage: The term ‘corporate espionage’ has become synonymous
with industrial espionage. With the increase in competition in business ventures,
corporates started resorting to innovative methods to obtain information about
other companies or competitors. Officials steal the trade secrets by removing or
copying confidential or valuable information of a competitor for its company’s
benefit. Corporates gets benefited financially through this kind of frauds.
5. Investment trends: Investment scams leads to financial loss to the investors and
even loss of their lives. Loopholes in the investment system give way to the
perpetrator to procure proceeds from the scam. Bogus companies are formed just
to manipulate and hide the bogus transactions. Harshad Mehta, Ketan Parekh and
Sahara Group scams are few names which the Stock market in India will always
remember with grief.

5.13 Answers: Self Assessment

1). Please check section 5.1 2). Please check section 5.3 3). Please check
section 5.12 4). Please check section 5.10

5.14 Terminal Questions

1. What are the main categories of corporate fraud, and can you provide examples
of each?
2. Could you elaborate on specific types of fraud commonly encountered in
corporate environments?
3. How is corporate fraud defined and perceived in the Indian legal context? How
is corporate fraud defined and perceived in the Indian legal context?
4. What are the key indicators or warning signs during the pre-fraud stages?
Which regulatory bodies in India play a role in preventing and investigating
corporate fraud and What proactive measures can companies implement to
prevent corporate fraud?
5.15 Answers: Terminal Questions:
1). Please check section 5.2 2). Please check section 5.3 3). Please check
section 5.5 and 5.6 4). Please check section 5.7 and 5.8
5.16 Suggested Readings
1. Albrecht, W. Steve. (2009). Forensic Accounting & Fraud Examination. Cengage
Learning (India Edition).
2. Albrecht, Chad O., Albrecht, Conan C., Albrecht, W. Steve & Zimbelman, Mark F.
(2015). Forensic Accounting & Fraud Examination. Cengage Learning (India
Edition).
3. Banerjee, Robin (2015). Who Cheats and How? Sage Publications, New Delhi.
4. Bologna, Jack and Lindquist, Robert J. (1995). Fraud Auditing and Forensic
Accounting. Wiley.
5. Bremser, Wayne G. (1995). Forensic Accounting and Financial Fraud.American
Management Association.
 Lesson – 6
Provision against Fraud under Companies Act 2013
Structure:
6.0 Learning Objectives
6.1 Introduction
6.2 Meaning and Definition under Criminal Procedure Code, 1973
6.3 Meaning and Definition under Indian Contact Act, 1872
6.4 Definition of Fraud: The Judicial View
6.5 Frauds for and against a company
6.6 Objectives for provision against fraud under companies act 2013
6.7 Fraud reporting under the provisions of companies act, 2013
6.8 Summary
6.9 Glossary
6.10 Answers: Self Assessment
6.11 Terminal Questions
6.12 Answers: Terminal Questions:
6.13 Suggested Readings
6.0 Learning Objectives
After studying the lesson, you should be able to:-
1. Meaning and Definition under Criminal Procedure Code, 1973
2. Frauds for and against a company
3. Fraud reporting under the provisions of companies act, 2013

6.1 Introduction
Meaning and Definition under Companies Act, 2013
Explanation of Section 447 of Companies Act 2013 defines Fraud and related terms
as below:
(i) ‘Fraud’ in relation to affairs of a company or anybody corporate, includes any act,
omission, concealment of any fact or abuse of position committed by any person or
any other person with the connivance in any manner, with intent to deceive, to gain
undue advantage from, or to injure the interests of, the company or its shareholders
or its creditors or any other person, whether or not there is any wrongful gain or
wrongful loss;
(ii) ‘Wrongful gain’ means the gain by unlawful means of property to which the person
gaining is not legally entitled;
(iii) ‘Wrongful loss’ means the loss by unlawful means of property to which the person
losing is legally entitled.
or any corporate body as defined in the explanations of Section 447 of Companies Act
2013, which includes
a. Any act,
b. Omission,
c. Concealment of any fact or
d. Abuse of position committed by any person or any other person with the connivance
in any manner, -
i. with intent to deceive,
ii. to gain undue advantage from, or
iii. to injure the interests of,
a. the company or
b. its shareholders or
c. its creditors or any other person,
Whether or not there is any wrongful gain or wrongful loss.

6.2 Meaning and Definition under Criminal Procedure Code, 1973

The Code of Criminal Procedure, 1973 is the procedural law providing the machinery
for punishment of offenders under substantive criminal law. The Code contains
elaborate details/provisions regarding the procedure to be followed in every
investigation, inquiry and trial, for every offence under the IPC or any other criminal
law. In general, the Code does not provide for the definition of various terms rather it
only describes certain limited terms like Complaint, Cognizable Offence, Warrant Case
and alike, which helps in the interpretation of the Code. For rest of the terms, section
2(y) of Code says that “words and expressions used herein and not defined but defined
in the Indian Penal Code (45 of 1860) have the meanings respectively assigned to
them in that Code.” Therefore, to understand the meaning of ‘Fraud’ in the sphere of
criminal law, one has to take recourse of Indian Penal Code, 1860.

Meaning and Definition under Indian Penal Code, 1860

The term ‘Fraud’ is not defined in the Indian Penal Code per se, but Section 25 defines
as to what would amount to ‘fraudulently’. As per the definition, fraudulently refers –
“A person is said to do a thing fraudulently if he does that thing with intent to defraud
but not otherwise.”
This shows that fraud as a crime is nowhere defined in the Indian Penal Code, but
implication of this term is made at various places in Indian Penal Code.

Whenever the term fraud or defraud appears in the context of criminal law, two things
are automatically to be assumed.
• First is deceit or deceiving someone; and
• Second is, injury to someone because of such deceit.
Implications of fraud are found in the following sections of IPC namely, 421, 422, 423
and 424.
• Fraudulent removal or concealment of property to prevent distribution among
creditors.
• Fraudulently preventing debt being available for creditors.
• Fraudulent execution of deed of transfer containing false statement of consideration.
• Fraudulent removal or concealment of property.
Though Fraud is not clearly defined in CrPC and IPC, yet Indian Contract Act, 1872
defines the term Fraud quite clearly. In the context of Corporate Fraud, there is no
harm in exploring the definition of Fraud as per the other related statutes.

6.3 Meaning and Definition under Indian Contact Act, 1872

Section 17 of the Act defines Fraud as –
“Fraud” means and includes any of the following acts committed by a party to a
contract, or with his connivance, or by his agents, with intent to deceive another party
thereto his agent, or to induce him to enter into the contract.
Section 17 (1) – the suggestion as to a fact of that which is not by one who does not
believe it to be true – is known as SUGGESTIO FALSI or suggestion of falsehood.
Section 17 (2) – the active concealment of a fact by one having the knowledge or
belief of the fact – is known as SUPPRESIO VERI or suppression of a fact.
Section 17 (3) – a promise made without any intention of performing it. It means a
promise made falsely with the intention of inducing the other party to make a reciprocal
promise and thereby enter into a contract.
Section 17 (4) – any other Act fitted or designed to deceive.
Section 17 (5) – any such act or omission as the law specially declares to be
fraudulent
Explanation to Section 17
This explanation states a very important proposition of law. According to Explanation
to Section 17 – the mere silence as to a fact likely to affect the willingness of a person
to enter into a contract is not fraud. However, such silence is to be held as fraud, if the
circumstances of the case that –
• It is the duty of the person keeping silence – to speak
• That his silence in itself is equivalent to speech.

6.4 Definition of Fraud: The Judicial View

The definition of fraud, as interpreted by the judiciary, encompasses two essential
elements: deceit and injury to the person deceived. The Supreme Court of India, in the
case of Dr. S. Dutt v. State of Uttar Pradesh, elucidated on the phrase "with intent to
deceive," stating that it denotes not merely an intent to deceive but an intent to induce
a person to act or refrain from acting due to the deception, to their advantage.
Additionally, the inclusion of the phrase "but not otherwise" after "with intent to
deceive" in the definition of 'fraudulently' indicates that the intent to defraud is not
synonymous with the intent to deceive, but it necessitates some action resulting in a
disadvantage that the deceived person would have avoided without the deception.
Furthermore, the court in the case of Dr. Vimla v. Delhi Administration emphasized
that fraud comprises both deceit and injury to the person deceived. Injury, in this
context, extends beyond economic loss and includes harm inflicted on the deceived
person in various aspects such as body, mind, reputation, or other forms of harm.
Therefore, under Indian law, to establish a penal offense of fraud, two key elements
must be present:
1. An intent to deceive another person.
2. An intent to cause injury to that person as a result of the deception.
As emphasized by Lord Denning in Lazarus Estates Ltd. (1956), fraud undermines the
validity of judgments, contracts, and transactions once proven, highlighting the serious
consequences of fraudulent activities.
Sections of Companies Act 2013 Related to Corporate Fraud:
1. Section 447: Punishment for Fraud This section of the Companies Act 2013
provides the legal framework related to the punishment of a person who has
committed fraud against a company. It states that any person who is found to be guilty
of fraud shall be punished with imprisonment for a period of up to 10 years and/or with
a fine which shall not be less than the amount of fraud involved, but which may extend
to three times the amount of fraud involved.
2. Section 447A: Punishment for False Statement This section of the Companies Act
2013 states that if any person makes a false statement in any return, report or other
document to be furnished to the registrar, he shall be punishable with imprisonment
which may extend upto three years or with a fine which may extend to five thousand
rupees or with both.
3. Sections 448, 449, 450: Punishment for forgery These sections of the Companies
Act 2013 deal with forgery offences against the company. Any person who is found
guilty of forgery, either of the company’s documents or of any other documents
falsifying the likeness of the company’s documents, shall be punished with
imprisonment which may extend upto 7 years, along with a fine of five thousand rupees
or thrice the amount of fraud involved, whichever is higher.
4. Section 517: Punishment for Non-Compliance of Orders of Central Government
This Section of the Companies Act 2013 provides the legal sanction and punishment
for non-compliance of the orders of the Central Government in respect of fraud and
misfeasance committed by any company. It states that any company or any officer of
the company who is found guilty of non-compliance of the Central Government’s
orders shall be liable to a fine which may extend to one lakh rupees and in case of
continuing default, a further fine which may extend to five thousand rupees for each
day during which such default continues.
5. Sections 542 to 548: Penalty for Non-Compliance of various Provisions of
Companies Act These sections of the Companies Act 2013 provide legal sanction and
punishment for non-compliance of various provisions of the Companies Act by a
company or its officers. Any officer who is found guilty of non-compliance of any of the
provisions mentioned in the Companies Act shall be liable to a fine which may extend
to five thousand rupees and, in the case of continuing defaults, to further fine which
may extend to hundred rupees for each day during which such default continues.

6.5 FRAUDS FOR AND AGAINST A COMPANY

Frauds against a company encompass a spectrum of deceptive practices perpetrated
by external parties or employees within the organization, aimed at causing financial
harm or extracting illicit gains. Vendor fraud, a prevalent form, involves overbilling,
false invoicing, or kickbacks, where vendors exploit their relationship with the company
for personal enrichment. Embezzlement, another common scheme, sees employees
misappropriating company funds through fictitious expenses, ghost employees, or
diversion of assets, betraying the trust placed in them. Financial statement fraud, a
more sophisticated manipulation tactic, entails inflating revenues, understating
expenses, or concealing liabilities to present a false picture of the company's financial
health. Procurement fraud adds to the risk, with instances of bid rigging, price fixing,
or delivery of substandard products undermining the integrity of procurement
processes. Additionally, cyber fraud poses a significant threat, as malicious actors
leverage technology to execute phishing attacks, ransomware schemes, or data theft,
compromising sensitive company information and financial resources.
Frauds Against a Company:
 1. Vendor Fraud:
 Overbilling: Vendors may inflate prices or charge for goods or services
not provided.
 False Invoicing: Vendors may submit invoices for fictitious purchases
or for quantities greater than what was actually delivered.
 Kickbacks: Vendors may offer bribes or kickbacks to company
employees in exchange for lucrative contracts.
2. Embezzlement:
 Misappropriation of Funds: Employees entrusted with handling
company finances may siphon off funds for personal use.
 Fictitious Expenses: Employees may create fake expenses or
reimbursements to channel funds illicitly.
 Ghost Employees: Employees may create fake employee records and
divert salary payments to themselves.
3. Financial Statement Fraud:
 Revenue Recognition Fraud: Inflating revenues by recognizing
revenue prematurely or recording fictitious sales.
 Expense Manipulation: Understating expenses or delaying the
recognition of expenses to artificially inflate profits.
 Asset Misappropriation: Manipulating asset values or concealing
liabilities to misrepresent the company's financial position.
4. Procurement Fraud:
 Bid Rigging: Colluding with other vendors to rig the bidding process and
ensure the award of contracts.
 Price Fixing: Illegally coordinating prices with competitors to eliminate
competition and secure higher prices.
 Substandard Products: Delivering low-quality goods or services while
billing for premium products.
5. Cyber Fraud:
 Phishing Attacks: Sending fraudulent emails or messages to trick
employees into divulging sensitive information or transferring funds.
 Ransomware: Using malware to encrypt company data and demanding
payment for its release.
 Data Theft: Illegally accessing and stealing sensitive company
information, such as customer data or intellectual property.
Frauds For a Company:
 1. Management Fraud:
1. Financial Statement Manipulation: Falsifying financial statements to mislead
investors, creditors, or regulatory authorities.
2. Insider Trading: Trading company stocks based on non-public, material
information to gain an unfair advantage.
3. False Disclosures: Making false or misleading disclosures to conceal adverse
information or inflate the company's value.
2. Insurance Fraud:
1. False Claims: Submitting fraudulent insurance claims for fictitious losses or
exaggerated damages.
2. Staged Accidents: Orchestrating fake accidents or incidents to file fraudulent
insurance claims.
3. Policy Fraud: Providing false information or misrepresenting facts to obtain
insurance coverage at lower premiums.
3. Market Manipulation:
1. Pump-and-Dump Schemes: Inflating the company's stock price through false
or misleading statements, then selling shares at inflated prices before the price
collapses.
2. Short-and-Distort Schemes: Spreading false negative information about the
company to drive down its stock price for personal gain.
4. Tax Evasion:
1. Underreporting Income: Concealing or underreporting income earned by the
company to evade taxes.
2. Overstating Deductions: Inflating deductions or expenses to reduce taxable
income and evade taxes owed to tax authorities.
5. Intellectual Property Theft:
1. Patent Infringement: Illegally using or reproducing patented inventions or
products without authorization.
2. Trademark Counterfeiting: Manufacturing or selling counterfeit goods bearing
the company's trademarks or logos.
3. Trade Secret Theft: Stealing or misappropriating proprietary information or
trade secrets belonging to the company for personal gain.
6.6 OBJECTIVES FOR PROVISION AGAINST FRAUD UNDER COMPANIES ACT
2013
The objectives for provisions against fraud under the Companies Act 2013 are
multifaceted and aim to protect the interests of various stakeholders while promoting
transparency, accountability, and integrity in corporate operations. Some key
objectives include:
1. Prevention of Fraud: The primary objective is to prevent fraudulent activities
within companies by establishing stringent regulations, procedures, and
penalties to deter individuals from engaging in fraudulent behavior.
2. Protection of Shareholders: The provisions aim to safeguard the interests of
shareholders by ensuring accurate financial reporting and disclosure, thereby
reducing the risk of investment losses due to fraudulent practices.
3. Protection of Creditors: By addressing fraud, the Act seeks to protect the
interests of creditors, including banks and financial institutions, by minimizing
the risk of financial mismanagement or misrepresentation that could lead to
defaults or insolvency.
4. Enhanced Corporate Governance: The provisions promote good corporate
governance practices by requiring companies to adopt robust internal controls,
transparency measures, and ethical standards to prevent fraud and
misconduct.
5. Promotion of Investor Confidence: By fostering an environment of trust and
transparency, the Act aims to enhance investor confidence in the integrity of
corporate operations, thereby attracting investment and promoting economic
growth.
6. Legal Remedies and Enforcement: The Act provides legal remedies and
enforcement mechanisms for investigating, prosecuting, and penalizing
individuals or entities involved in fraudulent activities, thereby ensuring
accountability and justice.
7. Detection and Investigation: The provisions facilitate the detection and
investigation of fraudulent activities through mechanisms such as mandatory
reporting requirements, forensic audits, and the establishment of investigative
agencies like the Serious Fraud Investigation Office (SFIO).
8. Corporate Social Responsibility (CSR): By discouraging fraudulent practices
and promoting ethical conduct, the Act encourages companies to fulfill their
CSR obligations and contribute positively to society's welfare.
9. Compliance and Accountability: The provisions promote compliance with
legal and regulatory requirements, ensuring that companies adhere to ethical
standards, disclose accurate information, and maintain accountability to
stakeholders.
10. Overall Corporate Integrity: Ultimately, the provisions aim to uphold the
overall integrity and reputation of the corporate sector by deterring fraudulent
practices, punishing wrongdoers, and fostering a culture of honesty,
transparency, and ethical conduct within companies.
6.7 FRAUD REPORTING UNDER THE PROVISIONS OF COMPANIES ACT, 2013
Section 143(12) of the Companies Act, 2013 (hereinafter referred to as the Act)
provides that if an auditor of a company, in the course of the performance of his duties
as auditor, has reason to believe that an offence involving fraud is being or has been
committed against the company by officers or employees of the company, he shall
report the matter to the Central Government immediately within such time and in such
manner as may be prescribed.
Section 143(13) of the Act further provides that no duty to which an auditor of a
company may be subject to (e.g. duty of confidentiality under the CA Act, 1949) shall
be regarded as having been contravened by reason of his reporting the matter as
above if it is done in good faith.
Section 143(14) extends obligation cast by section 143 mutas mutandis to Cost
Auditors appointed under section 148 as well as Secretarial Auditors appointed under
section 204.
Non-Compliance with the provisions of Section 143(12) shall be punishable with fine
which shall be not less than Rs. 1,00,000/- but which may extend to Rs. 25,00,000/-
[Section 143(15)].
Section 447 of the Act further provides that any person who is found to be guilty of
fraud, shall be punishable with imprisonment for a term which shall not be less than
six months but which may extend to ten years and shall also be liable to fine which
shall not be less than the amount involved in the fraud, but which may extend to three
times the amount involved in the fraud:
Provided that where the fraud in question involves public interest, the term of
imprisonment shall not be less than three years.

Reporting fraud under Rule 13 of the Companies (Audit & Auditors) Rules, 2014 is a
crucial step in ensuring transparency and accountability within companies. Here's a
breakdown of the key points outlined in the rule:
a) Reporting Procedure: i. The auditor must report any suspected fraud involving
company officers or employees to the Central Government immediately, but not later
than sixty days after becoming aware of the fraud. ii. Upon discovering the fraud, the
auditor should promptly forward a report to the Board or Audit Committee, seeking
their response or observations within forty-five days. iii. After receiving the Board or
Audit Committee's response, the auditor must submit his report, along with their
comments, to the Central Government within fifteen days. iv. If the auditor does not
receive a response from the Board or Audit Committee within the stipulated forty-five
days, he must still submit his report to the Central Government, accompanied by a
note detailing the lack of response.
b) Submission Process: i. The report must be sent to the Secretary, Ministry of
Corporate Affairs, in a sealed cover via Registered Post with Acknowledgement Due
or by Speed post, followed by an email for confirmation.
c) Format and Content: i. The report should be on the auditor's letterhead, including
postal address, email address, contact number, and signed by the auditor with his
seal, indicating his Membership Number. ii. The report must be in the form of a
statement as specified in Form ADT-4.

Self Assessment
1. What is Insider Trading?
2. Describe Asset misappropriation?
3. Explain Phishing Attacks?
4. What is Meaning and Definition under Indian Contract Act, 1872?

6.8 Summary
Fraud, as defined under various legal frameworks in India, encompasses deceptive
practices aimed at wrongful gain or causing loss. The Criminal Procedure Code, 1973,
and the Indian Contract Act, 1872, provide legal interpretations of fraud, while judicial
views further refine its definition. Frauds against companies pose significant threats,
prompting provisions in the Companies Act, 2013, aimed at prevention and
accountability. Objectives of these provisions include safeguarding shareholder
interests and maintaining corporate integrity. Reporting mechanisms under the Act
emphasize transparency and accountability, ensuring timely detection and prevention
of fraudulent activities within corporate entities.
6.9 Glossary
1. Financial Statement Manipulation: Falsifying financial statements to mislead
investors, creditors, or regulatory authorities.
2. Insider Trading: Trading company stocks based on non-public, material
information to gain an unfair advantage.
3. False Disclosures: Making false or misleading disclosures to conceal adverse
information or inflate the company's value.
4. Phishing Attacks: Sending fraudulent emails or messages to trick employees
into divulging sensitive information or transferring funds.
5. Ransomware: Using malware to encrypt company data and demanding
payment for its release.
6. Data Theft: Illegally accessing and stealing sensitive company information,
such as customer data or intellectual property.
7. The Judicial View: The definition of fraud, as interpreted by the judiciary,
encompasses two essential elements: deceit and injury to the person deceived.
The Supreme Court of India, in the case of Dr. S. Dutt v. State of Uttar Pradesh,
 elucidated on the phrase "with intent to deceive," stating that it denotes not
merely an intent to deceive but an intent to induce a person to act or refrain
from acting due to the deception, to their advantage.
6.10 Answers: Self Assessment
1). Please check section 6.5 2). Please check section 6.5 3). Please check
section 5.5 and 6.5 4). Please check section 6.3
6.11 Terminal Questions
1. How does the Criminal Procedure Code, 1973, and Indian Contract Act, 1872
define and address fraud?
2. What are examples of frauds perpetrated against a company by external parties?
3. What are the primary objectives of including provisions against fraud in the
Companies Act 2013?
4. What are the reporting requirements for fraud under the Companies Act 2013?
6.12 Answers: Terminal Questions:
1). Please check section 6.2 and 6.3 2). Please check section 6.5 3). Please
check section 6.6 4). Please check section 6.7
6.13 Suggested Readings
1. Albrecht, W. Steve. (2009). Forensic Accounting & Fraud Examination. Cengage
Learning (India Edition).
2. Albrecht, Chad O., Albrecht, Conan C., Albrecht, W. Steve & Zimbelman, Mark F.
(2015). Forensic Accounting & Fraud Examination. Cengage Learning (India
Edition).
3. Banerjee, Robin (2015). Who Cheats and How? Sage Publications, New Delhi.
4. Bologna, Jack and Lindquist, Robert J. (1995). Fraud Auditing and Forensic
Accounting. Wiley.
5. Bremser, Wayne G. (1995). Forensic Accounting and Financial Fraud.American
Management Association.
 Lesson – 7
Types of Corporate Frauds:
Bribery and corruption, Misappropriation of assets
Structure:
7.0 Learning Objectives
7.1 Introduction
7.2 Types of corporate fraud
7.3 Bribery and corruption
7.4 Differences between corruption and bribery
7.5 The impact of bribery at work
7.6 Examples of bribery
7.7 Causes of corruption
7.8 Corruption prevention
7.9 Misappropriation of assets
7.10 Causes of misappropriation of assets
7.11 Types of asset misappropriation
7.12 Significant impact of misappropriation of assets
7.13 Prevention of misappropriation of assets
7.14 Summary
7.15 Glossary
7.16 Answers: Self Assessment
7.17 Terminal Questions
7.18 Answers: Terminal Questions:
7.19 Suggested Readings
7.0 Learning Objectives
After studying the lesson, you should be able to:-
1. Bribery and corruption
2. The impact of bribery at work
3. Corruption prevention
4. Misappropriation of assets
7.1 Introduction
corporate fraud is defined as fraudulent or illegal activities perpetrated within a
corporation or organization. These activities are typically conducted with the aim of
obtaining additional financial gains covertly, without proper reporting to governmental
authorities. Corporate fraud scandals can arise due to a variety of reasons and factors,
and they may involve individuals in prominent positions within the organization, such
as directors or top executives. The consequences of corporate fraud can be severe,
leading to financial losses, accounting irregularities, or data theft within the firm. It is
emphasized that exposing such fraudulent activities is crucial to prevent potential
bankruptcy and maintain the integrity of the organization.
7.2 Types of corporate fraud
1. Bribery and corruption,
2. Misappropriation of assets
3. Manipulation of financial statements,
4. Procedure-related frauds,
5. Corporate espionage

7.3 Bribery and corruption

Corruption is dishonest or fraudulent conduct by those in power, typically involving
bribery. Bribery is offering, giving or receiving anything of value with the intention of
inducing a person to act or to reward a person for having acted. It is important to
understand that a corrupt act has occurred even if:
1. A bribe does not succeed.
2. A person authorizes or provides direction for a bribe but no bribe is ultimately
offered or paid.

“Anything of value” includes, but is not limited to:

1. Cash, cash equivalents (such as gift certificates/cards), stock, personal
property and assumption or forgiveness of a debt.
2. Gifts, meals, entertainment, travel – Any corporate travel, gifts, entertainment
and meals must be proportionate to the occasion and comply with Principal’s
gift & entertainment policy.
3. Political contributions.
4. Charitable contributions – if made to a charity at the direct request of a
government official or private business partner, it could be considered an
indirect bribe made in order to obtain or retain business or to secure other
improper business advantage.
 5. Job offers or internship awards – offers to Government Officials (or their
relatives) can present a risk of violating anti-bribery or anticorruption laws and
regulations. Compliance must be consulted prior to making such offers.

7.4 DIFFERENCES BETWEEN CORRUPTION AND BRIBERY

1. Broad Scope: Corruption encompasses a wide range of unethical behavior and

misconduct in various contexts, including politics, business, and government,
while bribery specifically refers to the act of offering, giving, receiving, or
soliciting something of value to influence someone's actions or decisions.
2. Definition: Bribery is a specific form of corruption where individuals or entities
offer or accept something of value, such as money, gifts, or favors, to gain an
unfair advantage or influence decisions.
3. Legal Framework: Many countries have specific laws and regulations that
address bribery, while corruption may be covered by a broader range of
statutes and legal provisions.
4. Motives: Corruption can involve various motives beyond financial gain, such
as power, influence, or personal interests, while bribery typically revolves
around financial incentives or benefits.
5. Variety of Forms: Corruption can manifest in different forms, including fraud,
embezzlement, nepotism, extortion, and cronyism, whereas bribery specifically
involves the exchange of bribes for favors or advantages.
6. Impact: Both corruption and bribery can have significant negative impacts on
societies, economies, and institutions, including eroding trust, distorting
markets, undermining fairness, and impeding development.
7. Participants: Corruption may involve multiple parties, including public officials,
private sector entities, intermediaries, and individuals, while bribery typically
involves at least two parties—the giver and the recipient of the bribe.
8. Visibility: Bribery may be more visible and direct compared to other forms of
corruption, as it often involves direct exchanges of money or gifts, whereas
corruption can be more covert and systemic, affecting entire organizations or
systems.
9. Enforcement: Governments and regulatory bodies often focus on combating
bribery through anti-corruption laws, enforcement agencies, and international
initiatives, while addressing broader corruption issues may require
comprehensive measures, including transparency, accountability, and
institutional reforms.
 10. International Context: Bribery is a focal point in international efforts to combat
corruption, as seen in initiatives such as the United Nations Convention against
Corruption (UNCAC) and the Organisation for Economic Co-operation and
Development (OECD) Anti-Bribery Convention, while addressing broader
corruption challenges often requires coordinated efforts among countries and
stakeholders.

7.5 THE IMPACT OF BRIBERY AT WORK

The impact of bribery at work can be profound and far-reaching, affecting both
individuals and organizations. Here's a breakdown of the consequences outlined in
the provided text:
1. Legal Consequences: Individuals found guilty of bribery may face severe
penalties, including up to ten years in prison and/or substantial fines. Similarly,
companies involved in bribery could also be prosecuted and subjected to
significant fines.
2. Financial Implications: The financial repercussions of bribery can be
substantial. For instance, the luxury car manufacturer Rolls-Royce had to pay
a hefty £671 million settlement in 2017 after engaging in bribery practices to
secure orders. Additionally, companies found guilty of bribery may face
unlimited fines, which can severely damage their finances.
3. Reputational Damage: Bribery tarnishes a company's reputation and integrity.
Businesses with poor anti-bribery and corruption compliance often attract less
business, as commercial organizations become wary of associating with them.
A damaged reputation can result in lost opportunities and decreased trust from
customers and stakeholders.
4. Lost Business Opportunities: Companies involved in bribery may find it
challenging to secure contracts and partnerships with reputable firms. Potential
clients and partners may be hesitant to engage with a company known for
unethical practices, leading to a loss of business opportunities and revenue.
5. Lower Employee Morale and Productivity: The presence of bribery within the
workplace can significantly impact employee morale and productivity.
Employees may feel demotivated and disillusioned if they perceive that
unethical behavior is tolerated or condoned. This can result in decreased
productivity and overall performance, further exacerbating the negative effects
on the business.
6. Cumulative Effects: The combination of legal consequences, financial
penalties, reputational damage, and decreased employee morale can create a
detrimental cycle for a business. This downward spiral may ultimately lead to
the downfall of the company if not effectively addressed and remediated.
7.6 EXAMPLES OF BRIBERY
To understand examples of bribery, you must understand the two forms. You can
break down bribery into two forms: active and passive.
Active bribery:
1. Bribing a public official to circumvent local laws: For instance, offering
money to a government official to overlook regulatory violations or expedite
permits/licenses.
2. Covering up an employee or business mistake by offering gifts: Providing
gifts or favors to officials or stakeholders in exchange for concealing errors or
wrongdoing within the organization.
3. Bribing a member of staff of higher authority to gain a pay rise: Offering
money or other benefits to a supervisor or manager to secure a salary increase
or promotion.
Passive bribery:
1. A foreign public official requesting luxury accommodation in return for
favorable treatment: A government official demands expensive
accommodations or other perks in exchange for granting business favors or
contracts.
2. An executive accepts a bribe to provide contract specifications in a tender
ahead of time: A company executive accepts money or gifts from a contractor
in exchange for sharing confidential bidding information or rigging the tender
process.
3. A bank or security employee accepts a gift and gives the briber access to
someone’s private details: An employee of a financial institution accepts a
bribe from an outsider in return for providing unauthorized access to confidential
customer information.
7.7 CAUSES OF CORRUPTION
The provided text outlines several causes of corruption, as identified by the
International Monetary Fund (IMF), along with additional insights. Here's a breakdown
of the causes mentioned:
1. Government Intervention in the Economy: When governments heavily
intervene in economic activities, such as through regulations, subsidies, and
controls, it creates opportunities for corruption. This intervention can distort
market mechanisms and incentivize dishonest behavior among officials and
participants.
2. Liberalization of Policies: The process of liberalizing policies, which involves
reducing government control and increasing market competition, can also
contribute to corruption. As regulations are relaxed, there may be gaps or
loopholes that individuals exploit for personal gain.
 3. Deregulation and Privatization: Similarly, deregulation and privatization
efforts, aimed at reducing government involvement in certain industries and
promoting private sector participation, can inadvertently foster corruption.
Privatization processes may lack transparency, leading to opportunities for
bribery and favoritism.
4. Wage Disparities: Discrepancies in wages between civil servants and those in
the private sector can incentivize corruption. Lower salaries for government
employees may push them to seek additional income through illicit means, such
as accepting bribes or engaging in other forms of corruption.
5. Price Controls: Government-imposed price controls on goods and services
can create distortions in the market and encourage corrupt practices. Price
controls may lead to shortages, black markets, and opportunities for rent-
seeking behavior by individuals seeking to manipulate prices for personal gain.
6. Trade Restrictions and Tariffs: Policies that restrict foreign competition
through trade barriers, tariffs, and regulations can foster corruption. Domestic
players may exploit protectionist measures to maintain their market dominance,
resorting to bribery and other illicit means to influence trade policies and protect
their interests.
7. Misallocation of Government Grants and Subsidies: Corruption can occur
when corporations and groups receive government grants and subsidies
intended for other purposes or beneficiaries. Lack of oversight and
accountability in the allocation of public funds can facilitate corrupt practices.
8. Discretion in Law Enforcement: The wider the discretion granted to
lawmakers and enforcement agencies, the greater the potential for corrupt
behavior. When regulations are ambiguous or selectively enforced, it creates
opportunities for individuals to engage in bribery and other forms of dishonest
conduct.

7.8 CORRUPTION PREVENTION

Corruption can increase criminal activity and organized crime in the community when
left unchecked. But there are a number of steps that can help to manage it. The
following is a list of possible steps that can be taken to prevent corruption.
 Education: A strong educational focus must reinforce best business practices
and alert managers and employees where to look for corruption. This can be
achieved by introducing mandatory education such as anti-money
laundering (AML) courses. Senior executives and managers must set a strong
culture of honesty and integrity by leading by example.
 Environment: A robust control environment reduces the risk of corruption as
do thorough background checks before hiring or promoting employees.
  Accountability: When there are mechanisms in place, there's a likelihood of
reinforcing a culture that fosters strong ethical behavior while holding those to
account who violate the norms.
 Regulation: Setting up codes of conduct and ethics can help avoid situations
that can create conflicts of interest. This is common in areas like the financial
industry, where chartered financial analysts and other financial professionals
must adhere to these rules or be penalized.
 Reporting: Corruption can further be reduced by making it easy to report,
whether by managers, employees, suppliers, and customers. It's also important
to ensure that those reporting are able to do so safely and securely.
There must also be clear penalties in place to dissuade people and organizations from
engaging in corrupt behavior. This can include financial penalties and even legal
action—prosecution and perhaps jail time.

7.9 MISAPPROPRIATION OF ASSETS

Definition
Misappropriation of assets occurs when an employee diverts or takes the
organisation’s resources for personal gain. It is the most common form of workplace
fraud and the losses vary depending on how fast it is detected or if there are strategies
in place to prevent it. In most cases, the criminals are trusted employees such as
directors or senior managers. This is because they have greater control of business
assets and are usually responsible for deciding how to use them.
Assets can include cash, vehicles, devices, office equipment and more. Anything that
an employee can use at work or take home without getting caught. This is the main
reason misappropriation of assets can be classified as theft.
7.10 CAUSES OF MISAPPROPRIATION OF ASSETS
The fraud triangle clearly explains the reasoning behind fraud. An individual needs:
1. Motivation
2. Opportunity
3. Rationalisation

1. Motivation:
 Employees who engage in misappropriation of assets are typically
driven by some form of pressure, whether financial or non-financial. This
pressure may stem from personal financial difficulties or the desire to
ensure the success of their own ventures.
 The inability or reluctance to share these pressures with supervisors or
colleagues may lead employees to seek alternative means of addressing
 their problems, even if it involves unethical behavior contrary to their
moral values.
2. Opportunity:
 Misappropriation of assets occurs when employees have access to
assets and are trusted to handle them responsibly. Weak internal
controls or inadequate oversight can provide opportunities for
employees to misuse assets, as they may believe they are unlikely to
get caught.
 Employees who find themselves in positions where they have control
over assets may succumb to temptation if they perceive a lack of
monitoring or consequences for their actions.
3. Rationalization:
 To justify their fraudulent actions and alleviate feelings of guilt,
individuals engaging in misappropriation of assets rationalize their
behavior. They may convince themselves that their actions are
necessary to solve their problems or that the assets they are misusing
are insignificant to the organization.
 Rationalizations often involve minimizing the perceived harm caused by
their actions or framing the misappropriation as a victimless crime, such
as taking money that the company won't miss.

7.11 TYPES OF ASSET MISAPPROPRIATION

Employees can be creative when fraud is involved. The term itself can cover different
crimes in the workplace. There are many ways misappropriation of assets can take
place in a workplace. The most common types are:
 Payroll fraud
 Embezzlement
 Data theft
1. Payroll fraud: A fraudster may choose to obtain money by creating fake profiles of
employees, also known as glost employees. These employees get paid but they do
not work for the company and they do not exist. The money goes directly to the
fraudster who set up the profile.
Payroll fraud includes the falsification of timesheets when employees submit hours
they have not worked or overtime that was not authorised or approved. This can lead
to staff getting paid more than they should be and receiving money they had not
earned. The fraudster can do this for themselves or for another employee.
Employees who commit these kinds of fraud have control over payroll and know that
no one will be checking their entries or think a check is unlikely to happen. This gives
them the ‘opportunity’ to misappropriate company resources without getting caught.
2. Embezzlement: Embezzlement and misappropriation of assets are two terms that
sometimes are used interchangeably. Embezzlement includes fake invoices that
employees forge to steal money through payments. They may create shell companies
and claim that they are doing business with them while in reality, all the funds go to
their bank accounts. They might also bill the company for invoices related to their
personal purchases. It can be a very expensive crime with severe consequences.
In 2015, an executive and his wife were sentenced after being found guilty for
embezzling about $16 million. The business affected was a bakery, which highlights
that all businesses carry some kind of fraud risk, no matter the industry or the size.
Embezzlement can also include the theft of office supplies for personal use outside of
work. For example, an employee might borrow a work laptop daily or go home with
printer inks and paper.
3. Data theft: Employees responsible for sensitive information might use it to commit
misappropriation of assets along with other crimes. They could use customer data to
contact them and acquire them as their customer for their own business, or they might
sell that data to third parties including competitors. Essentially they are trying to steal
customers from the company, which will also result in revenue losses. This might be
one of the easiest strategies for fraudsters to rationalise. While they are stealing
personal data, they are leaving the option to the clients, to choose who they do
business with.
A more serious issue is identity theft which refers to employees using sensitive data
to take over customer accounts, emails and passwords. This will allow the fraudster
to benefit financially at the expense of the company.

7.12 SIGNIFICANT IMPACT OF MISAPPROPRIATION OF ASSETS

Significant impact of misappropriation of assets on both the perpetrators and the
affected company. Here's a breakdown of the key points made:
1. Financial Losses: Misappropriation of assets can lead to substantial financial
losses for the company, which may go undetected for some time due to the
trust placed in the employee responsible. Depending on the size of the
company and the position of the perpetrator, the damage could reach millions
of dollars. Additionally, the company may incur expenses related to hiring new
employees and reevaluating internal processes.
2. Productivity and Employee Trust: The revelation of asset misappropriation
can negatively impact employee morale and productivity. Trusted employees
who betray the company's trust may cause other staff members to feel betrayed
and lose trust in the organization. This loss of trust can result in decreased
 productivity and a decline in employee retention rates as individuals may seek
employment elsewhere.
3. Customer Loyalty and Revenue Loss: The company's reputation may suffer
as customers may lose confidence in purchasing products or services from an
unethical organization. This loss of trust can lead to a decline in sales and
revenue, which may persist until the company's reputation is restored.
4. Difficulty in Recruitment: Companies may face challenges in recruiting new
staff as potential candidates may be hesitant to work for an organization with
questionable ethical standards. Additionally, existing employees who were
managed or supervised by the perpetrator may suffer from mental health issues
due to feeling deceived and facing consequences for a crime they did not
commit.
5. Legal and Career Consequences for Perpetrators: Perpetrators of
misappropriation of assets face significant legal consequences, including hefty
fines and potential imprisonment. Their career prospects may be permanently
tainted, with other organizations being unlikely to hire individuals with a criminal
record or association with fraudulent activities.
6. Risk vs. Reward: Ultimately, the paragraph emphasizes that while
misappropriation of assets may seem beneficial in the short term for the
perpetrator, the risks far outweigh the potential rewards.

7.13 Prevention of misappropriation of assets

Effective strategies for preventing misappropriation of assets within a business. Here's

a breakdown of the key prevention measures mentioned:
1. Thorough Background Checks: Conducting thorough background checks on
potential employees, including verifying references and ensuring their
legitimacy, can help identify any red flags before hiring them. This can mitigate
the risk of hiring individuals with a history of fraudulent behavior.
2. Establish Strong Policies and Procedures: Implementing robust policies and
procedures, along with establishing a zero-tolerance policy against fraud,
creates a clear framework for addressing and preventing misappropriation of
assets. Ensuring that all employees are aware of what constitutes
misappropriation, how to report it, and the consequences for those found guilty
fosters a risk-aware environment in the workplace.
3. Client and Partner Checks: Conducting checks on clients and partners can
help uncover any fraudulent businesses or entities, discouraging potential
fraudsters from taking advantage of the organization. This demonstrates to
fraudsters that the organization is vigilant and proactive in identifying and
addressing fraudulent activities.
 4. Job Rotation: Implementing job rotation policies can prevent employees from
becoming too familiar with their roles and responsibilities, reducing the
opportunity for them to commit fraud without detection. Job rotation also
provides additional experience to employees and can enhance their skill set.
5. Delegation of Duties: Delegating duties to multiple employees or
implementing oversight mechanisms where one employee monitors the
activities of another can help prevent misappropriation of assets. This ensures
accountability and reduces the risk of fraud going unnoticed.
6. Audits: Regular audits are essential for detecting and preventing fraud, as they
can uncover unusual transactions or system weaknesses. Audits provide an
independent review of financial records and internal controls, helping identify
any discrepancies or irregularities that may indicate fraudulent activity.
Self Assessment
1. What is payroll fraud?
2. Describe Asset misappropriation?
3. Explain data theft?
4. How the Prevention of misappropriation of assets?
7.14 Summary
Corporate fraud encompasses various types, including financial statement
manipulation, embezzlement, and insider trading. Bribery and corruption involve
offering or accepting favors or gifts to influence decisions or gain unfair advantages.
While corruption is a broader term for dishonest conduct, bribery specifically involves
offering or receiving something of value. The impact of bribery at work extends to
financial losses, damaged reputation, and decreased employee morale. Examples
include bribing public officials or offering gifts for favorable treatment. Causes of
corruption include government intervention and lack of transparency. Prevention
strategies involve establishing strong policies, conducting thorough checks, and
promoting a zero-tolerance approach. Misappropriation of assets occurs due to
motivation, opportunity, and rationalization, leading to significant financial and
reputational damage. Prevention methods include background checks, job rotation,
and regular audits.
7.15 Glossary
1. Corruption: Corruption is dishonest or fraudulent conduct by those in power,
typically involving bribery. Bribery is offering, giving or receiving anything of value
with the intention of inducing a person to act or to reward a person for having acted.
2. MISAPPROPRIATION OF ASSETS: Misappropriation of assets occurs when an
employee diverts or takes the organisation’s resources for personal gain. It is the
most common form of workplace fraud and the losses vary depending on how fast
it is detected or if there are strategies in place to prevent it.
3. Payroll fraud: A fraudster may choose to obtain money by creating fake profiles
of employees, also known as glost employees. These employees get paid but they
 do not work for the company and they do not exist. The money goes directly to the
fraudster who set up the profile.
4. Embezzlement: Embezzlement and misappropriation of assets are two terms that
sometimes are used interchangeably. Embezzlement includes fake invoices that
employees forge to steal money through payments. They may create shell
companies and claim that they are doing business with them while in reality, all the
funds go to their bank accounts.
7.16 Answers: Self Assessment
1). Please check section 7.11 2). Please check section 7.11 3). Please check
section 7.11 4). Please check section 7.13
7.17 Terminal Questions

1. Can you provide examples of different types of corporate fraud? And What are the
key distinctions between corruption and bribery?
2. What measures can be implemented to prevent corruption within organizations and
governments?
3. What are the different ways in which assets can be misappropriated within
organizations?
4. What strategies can organizations employ to prevent and detect misappropriation
of assets?
7.18 Answers: Terminal Questions:
1). Please check section 7.3 and 7.4 2). Please check section 7.7 3). Please
check section 7.9 4). Please check section 7.12 and 7.13
7.19 Suggested Readings
1. Albrecht, W. Steve. (2009). Forensic Accounting & Fraud Examination. Cengage
Learning (India Edition).
2. Albrecht, Chad O., Albrecht, Conan C., Albrecht, W. Steve & Zimbelman, Mark F.
(2015). Forensic Accounting & Fraud Examination. Cengage Learning (India
Edition).
3. Banerjee, Robin (2015). Who Cheats and How? Sage Publications, New Delhi.
4. Bologna, Jack and Lindquist, Robert J. (1995). Fraud Auditing and Forensic
Accounting. Wiley.
5. Bremser, Wayne G. (1995). Forensic Accounting and Financial Fraud.American
Management Association.
 Lesson – 8
Types of Corporate Frauds -II

Structure:
8.0 Learning Objectives
8.1 Introduction
8.2 Manipulation of financial statement
8.3 Reason for manipulation of financial statements
8.4 Types of financial statement fraud
8.5 Financial statement fraud warning signs
8.6 Disadvantages of manipulation of financial statements
8.7 Industrial espionage
8.8 Types of industrial
8.9 Reason for unenticing of industrial espionage
8.10 Practices to detect and prevent industrial espionage
8.11 Summary
8.12 Glossary
8.13 Answers: Self Assessment
8.14 Terminal Questions
8.15 Answers: Terminal Questions:
8.16 Suggested Readings
8.0 Learning Objectives
After studying the lesson, you should be able to:-
1. Manipulation of financial statement
2. Financial statement fraud warning signs
3. Industrial espionage
4. Reason for unenticing of industrial espionage
8.1 Introduction
Fraud is as an intentional and deliberate act to deprive another person or institution of
property or money by deception or other unfair means. Similarly most of the financial
frauds in the corporate fall under asset misappropriation and the submission of
fraudulent statements such as concealment of liabilities, improper asset valuation,
fictitious revenues, improper disclosures, etc. are some types of frauds. These
practices cause severe damage to the financial system of institutions across countries.
Similarly, with the help of leakages in systems of cyber and technology, fraudsters
commit financial crimes. These damage the personal finance of individuals and the
entire economy.
Types of corporate fraud
⇒ Bribery and corruption
⇒ Misappropriation of assets
⇒ Manipulation of financial statement
⇒Procedure related frauds
⇒ Corporate espionage

8.2 Manipulation of financial statement

Definition
Financial statement manipulation is a type of accounting fraud that remains an
ongoing problem in corporate America. Although the Securities and Exchange
Commission (SEC) has taken many steps to mitigate this type of corporate
malfeasance, the structure of management incentives, the enormous latitude afforded
by the Generally Accepted Accounting Principles (GAAP), and the ever-present
conflict of interest between the independent auditor and the corporate client continues
to provide the perfect environment for such activity.
Due to these factors, investors who purchase individual stocks or bonds must be
aware of the issues, warning signs, and the tools that are at their disposal in order to
mitigate the adverse implications of these problems.

8.3 Reason for Manipulation of Financial Statements

High-paid executives who run major corporations can be tempted to “cook the books”
on their financials for several potential reasons, such as:
1. Feeling intense pressure to show a positive picture
Public company executives may give in to the enormous pressure they’re under, with
large pay packages and expectations they will direct their companies to ever-
increasing growth and profitability, amid an increasingly competitive business
landscape.
2. Tapering investors’ expectations
Manipulation might be something as relatively innocent as not wanting investors to
develop unrealistic expectations. What happens if the company got lucky on a number
of fronts, and it ended up achieving its best year ever? An executive might think
investors will expect to see these excellent numbers going forward. Therefore, the
executive might change accounting entries to make the year look less incredible.
In the example above, the guilty party isn’t even manipulating the numbers to try to
make the company look better – instead, they’re making it look worse. And their
motives aren’t terribly nefarious – they’re not actively scheming to rip someone off.
3. Triggering executive bonuses
A very common motivation for manipulating financial statements is to meet
sales/revenue goals that trigger a big bonus for upper-level management. The
structure of such incentive bonuses has often been criticized as being, in effect, an
incentive for an executive to “cheat.”
One option to prevent this would be to offer performance bonuses based on a non-
financial metric. For example, the CEO and CFO could be paid bonuses if customer
service satisfaction rises five percentage points.

8.4 Types of Financial Statement Fraud

Business fraud comes in many forms, including bribery, kickbacks and payroll fraud.
When it comes to financial statement fraud, most cases involve intentionally
misrepresenting accounting so that share prices, financial data or other valuation
methods make a company seem more profitable. Wrongdoers manipulate revenue,
expenses, liabilities and assets to portray the company in a more positive light. Here
are some typical approaches:
 Overstating revenue. A company can commit fraud by claiming money as
received before the goods or services have been delivered. This can be done
by prematurely recording future expected sales or uncertain sales. If the
company overstates its revenue, it creates a false picture of fiscal health that
may inflate its share price.
 Fictitious revenue and sales. Fictitious revenue involves claiming the sale of
goods or services that did not occur, such as double-counting sales, creating
phantom customers or overstating or otherwise altering the legitimate invoices
of existing customers. Perpetrators of this kind of fraud may reverse the false
sales at the end of the reporting period to help conceal the deceit. Famously,
this is what Wells Fargo did in a fraud that came to light in 2016: To meet
impossible sales goals, employees created millions of checking and savings
accounts on behalf of clients — but without their consent.
 Timing differences. This one involves understating revenue in one accounting
period by creating a reserve that can be claimed in future, less robust periods.
Other forms of this type of fraud are posting sales before they are made or prior
to payment, reinvoicing past due accounts and prebilling for future sales.
 Inflating an asset’s net worth. This form of fraud occurs when a company
overstates assets by failing to apply an appropriate depreciation schedule or
 valuation reserve, like inventory reserves. It will result in overstated net income
and retained earnings, which inflates shareholders’ equity.
 Concealment of liabilities or obligations. Concealment is a type of fraud
where liabilities or obligations are kept off the financial statements to inflate
equity, assets and/or net earnings. Examples of concealed liabilities can include
loans, warranties attached to sales and underreported health benefits, salaries
and vacation time. The easiest way to conceal liabilities is to simply fail to record
them.
 Improper or inadequate disclosures. The information disclosed in financial
statements must be accurate and clear so as not to mislead the reader.
Accounting changes must be disclosed if they have a material impact on the
financial statements. When this type of fraud is committed, items such as
significant events, related-party transactions, contingent liabilities and
accounting changes are obscured or omitted from the financial statements.
 Falsifying expenses. Another form of financial statement fraud occurs when a
company does not fully record its expenses. The company’s net income is
exaggerated and costs are understated, creating a false impression of the
amount of net income the company is earning.
 Misappropriations. A serious form of financial statement fraud is altering the
statement to mask theft or embezzlement through double-entry bookkeeping or
the inclusion of fake expenses. This form of fraud is usually perpetrated by an
individual looking to enrich themselves, as opposed to forms of fraud that are
intended to inflate the valuation of the company to investors and the business
community.
8.5 Financial Statement Fraud Warning Signs
When a forensic accountant investigates financial statement fraud, they look for red
flags that indicate suspicious business practices and raise concern. By becoming
familiar with these common fraud indicators, management can minimize the potential
for financial statement fraud and mitigate future risks. Warning signs can be grouped
into the following categories: financial, behavioral, organizational and business.
1. Financial warning signs. When someone has “cooked the books”, certain patterns
jump out as suspicious and anomalous to investigators:
 Rising revenue without corresponding growth in cash flow — this is the most
common warning sign of financial statement fraud.
 Consistent sales growth while competitors are struggling.
 A spike in performance in the final reporting quarter of the year.
 A significant, unexplained change in assets or liabilities.
 Unusual increases in the book value of assets, such as inventory and
receivables.
  Frequent, complex third-party transactions that have no logical business
purpose, don’t appear to add value and make it hard to determine the actual
nature of a particular transaction.
 Missing or altered documents.
 Discrepancies and unexplained items and/or transactions on accounting
reconciliations, such as invoices that go unrecorded in the company’s financial
books.
 Aggressive revenue recognition practices, such as recognizing revenue in
earlier periods than when the product was sold or the service was delivered.
 Growth in sales without commensurate growth in inventory — or vice versa.
 Improper capitalization of expenses in excess of industry norms.
2. Behavioral warning signs. According to the Association of Certified Fraud
Examiners (ACFE), 85% of fraudsters displayed at least one behavioral red flag while
committing their crimes. These behavioral red flags will crop up at work and in the
fraudster’s personal life:
 A manager or accountant living beyond their means and/or having financial
difficulties.
 Dishonest, hostile, aggressive and unreasonable management attitudes.
 Control issues, such as an unwillingness to share duties pertaining to company
finances.
 Management displays inordinate concern with managing the reputation of the
business.
 Loans to executives or other related parties that are written off.
 Inexperienced or lax management and/or accountants.
 Sudden replacement of an auditor resulting in missing paperwork.
 Refusal to take time off for fear that their “pinch-hitter” will uncover the scam.
3. Organizational warning signs. The corporate structure and operational practices
of a business can reveal circumstances that are more favorable to those who wish to
commit financial statement fraud. An environment where accounting systems and
controls are weak and fail to conform to governance best practices allows for false or
misleading information to remain unchallenged. Examples include:
 Frequent organizational changes, such as unusually high turnover in
management or key accounting personnel.
 Unexplained or disproportionate management bonuses based on short-term
targets.
 Operating and financial decisions dominated by a single person or a few people
acting in concert.
  A board of directors full of insiders.
 Undue emphasis on meeting quantitative targets.
 Sloppy or manual management/operational business processes, as opposed
to automated processes embodied in business software.
4. Business warning signs. External factors such as overall industry downturns and
wild divergence from peer company norms can be indicators of potential fraud. A keen
auditor will notice business results and organizational behavior that seem out of
alignment with the overall patterns in that particular industry, such as:
 Profitability and/or operating margins that are out of line with peers.
 Significant investments in volatile industries or during industry turndowns.
 Unusually high revenue and low expenses at times that can’t be explained by
seasonality.
 Operating results that are highly sensitive to economic factors, like inflation,
interest rates and unemployment.

8.6 DISADVANTAGES OF MANIPULATION OF FINANCIAL STATEMENTS,

Manipulation of financial statements, while potentially providing short-term benefits to
individuals or organizations, carries significant disadvantages and risks. Some of the
disadvantages include:
1. Loss of Investor Trust: Manipulating financial statements undermines the
trust and confidence of investors, shareholders, and other stakeholders in the
accuracy and reliability of the company's financial reporting. This loss of trust
can lead to decreased investment, a decline in stock prices, and damage to the
company's reputation.
2. Legal and Regulatory Consequences: Engaging in financial statement
manipulation can lead to legal and regulatory repercussions. Companies and
individuals involved may face civil lawsuits, regulatory investigations, fines,
penalties, and even criminal charges. Violations of securities laws, such as the
Sarbanes-Oxley Act in the United States, impose severe penalties for
fraudulent financial reporting.
3. Financial Losses: While manipulation may artificially inflate the company's
financial performance in the short term, it can ultimately result in financial losses
when the true financial position is revealed. Investors who relied on false
financial information may suffer losses, and the company may face financial
instability or bankruptcy.
4. Damage to Reputation: Companies found guilty of financial statement
manipulation may suffer long-term damage to their reputation and brand image.
Negative publicity surrounding fraudulent practices can deter customers,
 suppliers, and business partners, leading to loss of business opportunities and
market share.
5. Impact on Employee Morale: Financial statement manipulation can have
adverse effects on employee morale and motivation. Employees who discover
or suspect fraudulent activities may lose trust in management, leading to
decreased job satisfaction, productivity, and loyalty to the company.
6. Creditworthiness and Financing Challenges: Manipulation of financial
statements can affect a company's creditworthiness and ability to secure
financing. Lenders and creditors rely on accurate financial information to assess
risk and determine loan terms. False financial reporting may result in higher
borrowing costs or difficulty obtaining credit.
7. Legal and Ethical Violations: Financial statement manipulation violates
ethical principles and standards of conduct in accounting and finance. It
compromises the integrity of financial markets and undermines the fairness and
transparency of corporate reporting practices.

8.7 INDUSTRIAL ESPIONAGE

Corporate espionage is also known as industrial espionage, economic espionage or
corporate spying. That said, economic espionage is orchestrated by governments and
is international in scope, while industrial or corporate espionage generally occurs
between organizations.
The term industrial espionage refers to the illegal and unethical theft of business trade
secrets for use by a competitor to achieve a competitive advantage. This activity is a
covert practice often done by an insider or an employee who gains employment for
the express purpose of spying and stealing information for a competitor. Industrial
espionage is conducted by companies for commercial purposes rather than by
governments for national security purposes.

8.8 TYPES OF INDUSTRIAL

espionage Industrial espionage and corporate spying are conducted through a variety
of channels and for various purposes. Some espionage is conducted through legal
channels and some is conducted illegally. The following are examples of some
common types of industrial espionage.

Industrial espionage encompasses various methods and tactics aimed at obtaining

valuable information from competitors or organizations for strategic or economic gain.
Here are some common types of industrial espionage:
1. Intellectual Property (IP) Theft: This involves the unauthorized acquisition or
theft of valuable intellectual property, such as engineering designs, formulas,
recipes, manufacturing processes, pricing sheets, or customer lists.
 Perpetrators may include outsiders, foreign governments, or disgruntled insider
employees seeking to sell or transfer the stolen information to competitors.
2. Property Trespass: Perpetrators may physically break into company premises
or access confidential files to obtain sensitive information. This type of
espionage targets critical corporate assets that are still stored in physical form
and may involve insider employees or external intruders gaining unauthorized
access.
3. Employee Recruitment: Competitors often attempt to hire away employees
from rival companies to gain access to their knowledge and expertise. While
most acquired knowledge is legitimately transferrable, there are instances
where departing employees may take valuable trade secrets or proprietary
information to their new employers.
4. Wiretapping or Eavesdropping: This involves the use of portable listening
devices or recording equipment to intercept confidential conversations or
communications within a company. While some instances of wiretapping may
be legal and authorized, others are conducted illegally for economic or strategic
advantage.
5. Cyber Attacks and Malware: Perpetrators utilize various cyber tactics, such
as distributed denial-of-service (DDoS) attacks or malware infections, to disrupt
a company's network and operations. These attacks aim to sabotage daily
operations, disable critical systems, or steal sensitive data for economic or
competitive advantage.
8.9 REASON FOR UNENTICING OF INDUSTRIAL ESPIONAGE
Industrial espionage often goes unnoticed for several reasons, making it challenging
for companies to detect and prove instances of malicious activity. Here are some
factors contributing to the difficulty of identifying and addressing industrial espionage:
1. Difficulty in Identification: Malicious actions of insiders often blend in with
normal everyday activities, making them challenging to distinguish. Even
trusted employees with access to sensitive data may engage in espionage
without raising suspicion for extended periods.
2. Accountability Challenges: Laws regarding trade secrets and industrial
espionage vary globally, complicating the process of holding perpetrators
accountable, especially if they operate internationally. Legal procedures may
be prolonged, making it impractical for companies to pursue cases against
perpetrators.
3. Reputational Risk: Public disclosure of security breaches resulting from
industrial espionage can harm a company's stock price and undermine investor
and customer trust. Companies may be reluctant to report incidents to avoid
negative publicity and reputational damage.
4. Compliance Requirements: Companies are responsible for safeguarding
sensitive customer data, and failure to do so may result in fines and penalties.
 In some jurisdictions and industries, companies may be penalized for data
breaches caused by industrial espionage, even if they are victims of the
espionage themselves.

8.10 PRACTICES TO DETECT AND PREVENT INDUSTRIAL ESPIONAGE

To detect and prevent industrial espionage effectively, organizations should

implement a comprehensive security strategy that addresses various aspects of
cybersecurity. Here are some best practices to detect and prevent industrial
espionage:
1. Conduct a Risk Assessment: Identify your company's most valuable data and
potential targets for espionage. Evaluate the attractiveness of your trade
secrets to competitors and assess possible threats and attack vectors. Develop
a cyber incident response plan to ensure a swift and efficient response in case
of a breach.
2. Secure Your Infrastructure: Establish a secure perimeter around your
network and implement multilayered security measures to protect valuable
data. Separate sensitive data from the corporate network, limit access to it, and
consider implementing a zero-trust model within your network. Utilize tools like
firewalls, antivirus software, and two-factor authentication to enhance security.
3. Establish an Effective Security Policy: Develop a cybersecurity policy that
outlines rules and procedures to minimize the risks of industrial espionage.
Cover topics such as network security, security awareness, employee
onboarding/termination, password management, access management, audit
and accountability, and incident response. Comply with industry standards and
regulations such as NIST guidelines.
4. Educate Employees on Cybersecurity Risks: Train employees to recognize
and mitigate insider threats and educate them about the potential
consequences of industrial espionage. Conduct regular cybersecurity
awareness training sessions and teach employees simple security practices
they can use in their daily workflow.
5. Conduct Employee Background Checks: Screen potential employees before
hiring to minimize the risk of hiring spies. Consider repeating background
checks periodically, especially for employees with privileged access, to ensure
they do not become insider threats.
6. Implement Proper Termination Procedures: Develop and enforce
procedures for terminating employees' access to company data and systems
upon termination. Ensure that credentials of terminated employees are
deactivated promptly to prevent unauthorized access.
7. Monitor Employee Activity: Monitor user activity, especially privileged users
and system administrators, to detect suspicious behavior indicative of industrial
 espionage. Utilize user activity monitoring solutions like Ekran System to track
and record user actions for investigation purposes.
8. Manage Data Access Wisely: Implement the principle of least privilege and
restrict access to critical data and infrastructure only to employees who need it
for their work. Limit access rights and automate access management to
minimize the risk of data exposure to competitors.
9. Develop a Reliable Incident Response Plan: Create an incident response
plan that outlines procedures for responding to cybersecurity incidents
promptly. Utilize tools like Ekran System to proactively detect threats and
automate incident response actions to mitigate risks effectively.
Self Assessment
1. What is Financial statement manipulation?
2. What is Corporate espionage?
3. Explain Reason for unenticing of industrial espionage?
4. What is Wiretapping or Eavesdropping?

8.11 Summary
Financial statement manipulation involves intentionally misrepresenting accounting
data to portray a company more favorably. Executives may manipulate statements to
meet investor expectations, trigger executive bonuses, or conceal financial problems.
Types of fraud include overstating revenue, inflating asset values, and concealing
liabilities. Warning signs include inconsistent financial data and unusual accounting
practices. Manipulation can lead to loss of investor trust and legal repercussions.
Industrial espionage encompasses theft of intellectual property and sabotage for
competitive advantage. Types include IP theft, wiretapping, and malware attacks.
Reasons for espionage include gaining a competitive edge and obtaining valuable
information. Detecting and preventing espionage involves risk assessment, securing
infrastructure, educating employees, and monitoring activity closely.
8.12 Glossary
1. Financial statement manipulation: Financial statement manipulation is a type
of accounting fraud that remains an ongoing problem in corporate America.
Although the Securities and Exchange Commission (SEC) has taken many
steps to mitigate this type of corporate malfeasance, the structure of
management incentives, the enormous latitude afforded by the Generally
Accepted Accounting Principles (GAAP), and the ever-present conflict of
interest between the independent auditor and the corporate client continues to
provide the perfect environment for such activity.
2. Behavioral warning signs. According to the Association of Certified Fraud
Examiners (ACFE), 85% of fraudsters displayed at least one behavioral red flag
while committing their crimes. INDUSTRIAL ESPIONAGE
 3. Corporate espionage: Corporate espionage is also known as industrial
espionage, economic espionage or corporate spying. That said, economic
espionage is orchestrated by governments and is international in scope, while
industrial or corporate espionage generally occurs between organizations.
4. Property Trespass: Perpetrators may physically break into company premises
or access confidential files to obtain sensitive information. This type of
espionage targets critical corporate assets that are still stored in physical form
and may involve insider employees or external intruders gaining unauthorized
access.
5. Wiretapping or Eavesdropping: This involves the use of portable listening
devices or recording equipment to intercept confidential conversations or
communications within a company. While some instances of wiretapping may
be legal and authorized, others are conducted illegally for economic or strategic
advantage.

8.13 Answers: Self Assessment

1). Please check section 8.1 2). Please check section 8.7 3). Please check
section 8.9 4). Please check section 8.12
8.14 Terminal Questions

1. What are some common methods used in the manipulation of financial

statements? Can you explain the different types of financial statement fraud?
2. What are some red flags or warning signs that might indicate financial statement
fraud?
3. What are the potential consequences of engaging in the manipulation of financial
statements?
4. What are the different methods used in industrial espionage? What are some best
practices for detecting industrial espionage?
8.15 Answers: Terminal Questions:
1). Please check section 8.2 and 8.4 2). Please check section 8.3 3).
Please check section 8.6 4). Please check section 8.9 and 8.10
8.16 Suggested Readings
1. Albrecht, W. Steve. (2009). Forensic Accounting & Fraud Examination. Cengage
Learning (India Edition).
2. Albrecht, Chad O., Albrecht, Conan C., Albrecht, W. Steve & Zimbelman, Mark F.
(2015). Forensic Accounting & Fraud Examination. Cengage Learning (India
Edition).
3. Banerjee, Robin (2015). Who Cheats and How? Sage Publications, New Delhi.
4. Bologna, Jack and Lindquist, Robert J. (1995). Fraud Auditing and Forensic
Accounting. Wiley.
 Lesson – 9
Fraud in e-commerce

Structure:
9.0 Learning Objectives
9.1 Introduction
9.2 Types of ecommerce fraud
9.3 Warning signs of ecommerce fraud
9.4 Prevent ecommerce fraud
9.5 Fraud detection and prevention methods
9.6 Importance of fraud detections
9.7 Summary
9.8 Glossary
9.9 Answers: Self Assessment
9.10 Terminal Questions
9.11 Answers: Terminal Questions:
9.12 Suggested Readings
9.0 Learning Objectives
After studying the lesson, you should be able to:-

9.1 Introduction
Fraud in retail and ecommerce refers to the act of using illegal or deceitful practices to
obtain goods or services from online retailers, with the intent of not paying for them.
This type of fraud can occur at any stage of the transaction process, from the initial
order to the final payment. eCommerce fraud is a significant issue for online retailers,
as it can result in substantial financial losses and damage to their reputation.
There are various types of ecommerce fraud that online retailers must be aware of,
including stolen credit card numbers, fake identities, and fraudulent payment methods.
That said, one of the most common is through password theft. This happens when a
fraudster obtains customer information, including passwords and account details.
Once attackers have this information, they can perform account takeover fraud and
make purchases, withdraw funds, or access other accounts owned by the user.
Cybercriminals rely on other scams to obtain sensitive information from unsuspecting
customers, which they can then use to commit fraud. In some cases, criminals may
even use bad bots or other automated tools to carry out fraudulent activities, making
it difficult for online retailers to detect and prevent fraudulent transactions.

9.2 Types of eCommerce fraud

Online fraud within ecommerce can take many forms, from stolen card information to
identity theft and chargeback fraud. As the ecommerce industry continues to expand,
so does the risk of cybercrime. It is important for businesses to understand the different
types of ecommerce fraud, how they occur, and what measures they can take to
protect themselves and their customers.
1. Fake website fraud is a type of scam in which a fraudster creates a website
that mimics the appearance of a legitimate business site, but is actually
designed to trick card holders into entering their personal details. Scammers
can collect sensitive financial information and use it for fraudulent purposes. It
is essential to be vigilant when browsing the internet, particularly when making
online purchases.
2. Phishing happens when scammers send out emails or other types of
communication that appear to originate from a legitimate business or
organization—but these messages are actually attempts to deceive the
recipient into providing their personal information, such as payment card
details.

3. Account takeover fraud takes place when a scammer uses stolen login
credentials to gain access to an individual's or business's online account. With
account takeover fraud, once the threat actor has access, they can make
unauthorized transactions or changes, causing financial losses and potentially
damaging the victim's reputation.
4. Stolen credit card fraud involves the use of stolen credit card information,
obtained through phishing scams or data breaches. Bad actors make bogus
purchases online using this information. Retailers can use payment gateway
filters and other fraud detection software to protect themselves from this type
of fraud.
 5. Identity fraud involves the use of fake identities to obtain goods or services
online. Criminals can create fake accounts using stolen personal information or
bots to generate accounts. They can make fraudulent purchases or steal
sensitive information using legitimate accounts. Retailers can use fraud
detection software and verify customer identities to protect themselves from this
type of fraud.
6. Friendly fraud happens when a customer disputes a legitimate transaction,
claiming it was unauthorized or fraudulent. Although the customer may be
acting in good faith, this type of fraud can result in financial losses for the
retailer.
7. Card testing fraud happens when fraudsters test stolen credit card numbers
by making small purchases. Card testing fraud can be prevented by
implementing best practices, such as checking for suspicious activity, being
aware of red flags, and monitoring cardholder data.
8. Refund abuse is a growing concern for online merchants. Refund abuse
occurs when customers return broken, damaged, or even stolen items to a
retailer in exchange for a refund. Scammers may use various tactics, such as
buying a product with the intention of returning it after use, swapping out the
original product with a defective or damaged one, or even returning stolen
merchandise for a refund.
9. Refund abuse can result in significant losses for businesses, as they are
essentially giving away products or refunds without receiving the intended
benefit of the sale. In addition to financial losses, refund abuse can also lead to
a decline in customer trust and brand reputation, as customers may become
dissatisfied with the quality of products or the customer service offered by the
retailer.
10. Interception fraud occurs when fraudsters purchase goods from an online
retailer using a stolen credit card—but avoid certain checks by providing
legitimate, matching shipping and billing addresses. Upon placing the order, the
goal is to intercept the package before it gets to the address provided.
11. Triangulation fraud involves a legitimate customer, a legitimate online store,
and a fake online store operated by a fraudster. Triangulation fraud can be
difficult to detect, as the fake store may appear to be legitimate. However, there
are some signs to look for, such as cheap goods or promotions that seem too
good to be true.

9.3 Warning signs of eCommerce fraud.

Followings are the warning signs of eCommerce fraud:
1. Unusually Large Orders: Fraudsters may place significantly larger orders than
typical customers, often including multiple high-value items. These large orders
are aimed at maximizing their profits.
2. Testing Orders: Fraudsters might initially place smaller orders to test the
waters and assess the business's fraud detection systems. If these smaller
 orders go through without issue, they may proceed to make larger fraudulent
transactions.
3. Mismatched Shipping and Billing Addresses: When the shipping address
differs from the billing address associated with the payment method, it can
indicate potential fraud. Fraudsters may use stolen card details to place orders
and have items shipped to different addresses.
4. International Orders: Orders shipped internationally can pose higher risks for
eCommerce fraud as it may be more challenging for businesses to verify the
authenticity of the transaction, especially if shipping to high-risk countries.
5. Unusual Payment Methods: Payment methods such as gift cards or
cryptocurrencies, which offer anonymity and are difficult to trace, may be used
by fraudsters. They exploit these methods to conceal their identity and
activities.
6. Rushed or Overnight Shipping Requests: Scammers may request expedited
shipping to receive the merchandise quickly before their fraudulent activity is
detected. They aim to minimize the time available for businesses to identify and
prevent unauthorized transactions.
7. Suspicious IP Addresses: IP addresses associated with high-risk countries
or known for fraudulent activity can be a red flag for eCommerce fraud.
Fraudsters may use VPNs or other anonymizing services to hide their true
location.
8. Repeated Attempts with the Same Information: Fraudsters may make
multiple attempts to place orders using the same credit card or shipping
address. They may use automated tools or botnets to bypass fraud detection
systems and increase their chances of success.

9.4 Prevent ecommerce fraud

Online vendors can rely on various tools and techniques to combat fraud, such as
advanced detection software, payment gateway filters, and customer identity
verification. Third-party services that specialize in fraud prevention may also be
employed. These measures help retailers identify and prevent fraudulent transactions,
protecting their revenue and reputation.

Following are the several measures that businesses can take to prevent ecommerce
fraud, including:
 Fraud detection software uses machine learning algorithms to analyze
customer behavior and identify fraudulent transactions.
  Payment gateway filters can be used to block transactions from high-risk
countries, prevent certain types of transactions, and set up rules for
transactions that require further verification.
 Customer identities should be verified by businesses through methods such
as two-factor authentication or by requesting government-issued identification.
 Monitor transactions regularly to detect and prevent ecommerce fraud. This
includes analyzing transaction patterns, verifying shipping addresses, and
tracking IP addresses.
 Third-party services that specialize in cybercrime prevention can help
businesses identify and prevent fraudulent transactions.
 Educate customers on how to protect themselves from ecommerce fraud,
such as by using secure payment methods, verifying the authenticity of
websites, and being cautious of unsolicited requests for personal or financial
information.

9.5 Fraud Detection and Prevention Methods

Fraud detection and prevention requires a three-pronged approach, combining
education about fraud risks, anti-fraud technology, and a risk strategy. Let’s break it
all down in detail.
1. Anti-Fraud Education and Training
An often overlooked yet highly effective way to reduce fraud is to educate your
employees and customers about it. This is particularly powerful when it comes to
teaching users about the value of their accounts, for instance, as it can drastically curb
rates of account takeover attacks.
Similarly, you may be able to prevent sophisticated attacks such as phishing, social
engineering, and even CEO fraud, simply by teaching your staff and employees how
to recognize suspicious online interactions.
2. User Fingerprinting
When it comes to fraud detection and prevention, the more data you have about your
users, the better. This is why a complete user fingerprinting process is recommended.
This can be done thanks to a number of tools, such as:
 Digital footprinting: To learn more information based on a single data point.
This process aggregates external data to complete a picture about a user, for
instance. A good example is reverse email lookup, which lets you get a
complete picture of a user based on a single email address.
 Social media lookup: A powerful way to learn if your user has a social media
presence. This can be useful for compliance reasons, or simply to verify
someone’s ID. Make sure that your solution can check as many social media
networks as possible, and in as many regions as possible.
  Device fingerprinting: Looking at your users’ configurations of software and
hardware is a great way to ID them or to spot suspicious devices that may point
to fraud.
 AML lookups: Businesses within regulated verticals are increasingly exposed
to noncompliance risk and money laundering risk. Understanding whether your
users are high-risk as soon as possible is a great way to reduce fraud in the
long run.
There is no one-size-fits-all solution for user fingerprinting, which is why the best risk
managers will rely on a combination of tools in order to decide who is risky and who
isn’t.
3. Custom Rules and Risk Scoring
Most online fraud prevention tools work by using risk rules. They can be simple,
blocking certain IP addresses, or complex, looking at how often a user performs a
certain action. Since fraudsters adapt to your strategy, however, it is important to be
able to edit the rules or to create new custom ones as needed.
Another crucial point to consider is the deployment of risk scores, in order to calculate
risk to make sure the results adapt to your business needs. This is not only important
to improve accuracy, but also to automate the approval, review, or rejection of certain
user actions.
4. Transaction Monitoring
The payment stage is the best one to catch fraudsters, as they will often use stolen
credit card details. This is why it’s vital to gather as much payment data as possible
for transaction monitoring – ideally in real-time.
For instance, a card BIN lookup can instantly let you know whether the credit card is
valid, where it was issued, and what kind of card it is. It’s worth noting that pre-paid
and gift cards are usually considered high-risk, for instance.
All the transaction data should also be used in combination with the user data you
have gathered. This is to identify suspicious discrepancies, such as, say, a credit card
issued in Cyprus for an item that is shipped in Brazil.
5. Machine Learning
If you are dealing with complex fraud attacks on a daily basis, you might be
overwhelmed by the data. This is precisely where machine learning systems can help.
By analyzing fraudulent users, payments, or behavior, an ML system can extract
valuable patterns and suggest risk rules.
Machine learning systems work best when you have a large volume of historical data
to train the models on, and the key advantage is that it may identify patterns that a risk
manager would have missed by manually poring over the data. This kind of system’s
accuracy also improves over time.
9.6 IMPORTANCE OF FRAUD DETECTIONS
Detecting fraud is of paramount importance for several reasons:
1. Financial Loss Prevention: Fraudulent activities can result in significant
financial losses for businesses, including stolen funds, unauthorized
transactions, and lost revenue. By detecting fraud early, businesses can
prevent or minimize these financial losses.
2. Protecting Reputation: Fraud can damage a company's reputation and erode
customer trust. Customers may lose confidence in a business if they perceive
it as being vulnerable to fraud. Detecting and preventing fraud helps safeguard
the reputation and integrity of the business.
3. Legal Compliance: Many industries are subject to regulatory requirements
and legal obligations related to fraud prevention. Failure to detect and prevent
fraud can result in legal penalties, fines, and sanctions. Compliance with
regulations such as the Sarbanes-Oxley Act (SOX) and the Payment Card
Industry Data Security Standard (PCI DSS) often necessitates robust fraud
detection measures.
4. Preserving Customer Trust: Customer trust is vital for the success of any
business. Detecting and preventing fraud demonstrates a commitment to
protecting customer interests and data. It reassures customers that their
sensitive information is secure and fosters long-term relationships based on
trust and transparency.
5. Maintaining Operational Efficiency: Fraudulent activities can disrupt
business operations, leading to inefficiencies, delays, and resource wastage.
By detecting fraud promptly, businesses can maintain operational continuity
and minimize disruptions to day-to-day activities.
6. Preventing Future Fraud: Effective fraud detection mechanisms enable
businesses to identify patterns, trends, and vulnerabilities that can be exploited
by fraudsters. By analyzing past incidents, businesses can implement proactive
measures to prevent future instances of fraud.
7. Preserving Market Share: In highly competitive markets, the reputation of
being a safe and trustworthy brand can be a competitive advantage. Detecting
and preventing fraud helps businesses differentiate themselves from
competitors and retain market share.
8. Protecting Stakeholder Interests: Fraud can affect various stakeholders,
including employees, investors, suppliers, and business partners. Detecting
fraud helps protect the interests and investments of these stakeholders,
fostering a stable and sustainable business environment.
Self Assessment
1. What do you mean by fraud in ecommerce ?
2. What is Interception fraud ?
 3. Explain Triangulation fraud ?
4. What is Fake website fraud ?
9.7 Summary
E-commerce fraud encompasses various types, from account takeovers to payment
fraud. Warning signs include unusually large orders, mismatched shipping addresses,
and suspicious payment methods. Preventative measures involve educating
employees and customers, implementing user fingerprinting, and employing
transaction monitoring. Advanced fraud detection methods, such as machine learning,
are crucial for identifying patterns and mitigating risks. The importance of fraud
detection lies in preventing financial losses, protecting reputation, ensuring legal
compliance, preserving customer trust, maintaining operational efficiency, preventing
future fraud, and safeguarding stakeholder interests. Overall, robust fraud detection
and prevention measures are essential for safeguarding businesses and their
stakeholders in the e-commerce landscape.
9.8 Glossary
1. Fraud: Fraud in retail and ecommerce refers to the act of using illegal or deceitful
practices to obtain goods or services from online retailers, with the intent of not
paying for them. This type of fraud can occur at any stage of the transaction
process, from the initial order to the final payment. eCommerce fraud is a
significant issue for online retailers, as it can result in substantial financial losses
and damage to their reputation.
2. Phishing happens when scammers send out emails or other types of
communication that appear to originate from a legitimate business or
organization—but these messages are actually attempts to deceive the recipient
into providing their personal information, such as payment card details.
3. Identity fraud involves the use of fake identities to obtain goods or services online.
Criminals can create fake accounts using stolen personal information or bots to
generate accounts. They can make fraudulent purchases or steal sensitive
information using legitimate accounts. Retailers can use fraud detection software
and verify customer identities to protect themselves from this type of fraud.
4. Friendly fraud happens when a customer disputes a legitimate transaction,
claiming it was unauthorized or fraudulent. Although the customer may be acting
in good faith, this type of fraud can result in financial losses for the retailer.

9.9 Answers: Self Assessment

1). Please check section 9.1 2). Please check section 9.2 3). Please
check section 9.2 4). Please check section 9.2
9.10 Terminal Questions
1. Can you explain some common types of eCommerce fraud and how they
occur?
 2. What are the key indicators or red flags that businesses should be aware of to
detect potential eCommerce fraud?
3. What proactive measures can businesses take to prevent eCommerce fraud
before it occurs?
4. Why is it crucial for businesses to prioritize fraud detection and prevention in
the eCommerce sector?
9.11 Answers: Terminal Questions:
1). Please check section 9.2 2). Please check section 9.3 3). Please
check section 9.4 4). Please check section 9.6
9.12 Suggested Readings
1. Albrecht, W. Steve. (2009). Forensic Accounting & Fraud Examination. Cengage
Learning (India Edition).
2. Albrecht, Chad O., Albrecht, Conan C., Albrecht, W. Steve & Zimbelman, Mark F.
(2015). Forensic Accounting & Fraud Examination. Cengage Learning (India
Edition).
3. Banerjee, Robin (2015). Who Cheats and How? Sage Publications, New Delhi.
4. Bologna, Jack and Lindquist, Robert J. (1995). Fraud Auditing and Forensic
Accounting. Wiley.
 Lesson – 10
INTRODUCTION TO AUDITING

Structure:
10.0 Learning Objectives
10.1 Introduction
10.2 Nature and purpose of financial statements
10.3 The nature and purpose of financial statements include
10.4 Auditing and assurance standards
10.5 Procedure for issuing the statements on standard auditing practices
10.6 Definition of auditing
10.7 Functional classification of auditors 10.8 objective of an audit
10.9 Scope of audit
10.10 Principal aspects covered in audit
10.11 Types of audit
10.12 Different types of audit
10.13 Advantages of audit of financial statements
10.14 Summary
10.15 Glossary
10.16 Answers: Self Assessment
10.17 Terminal Questions
10.18 Answers: Terminal Questions:
10.19 Suggested Readings
10.0 Learning Objectives
After studying the lesson, you should be able to:-
1. Nature and purpose of financial statements
2. The nature and purpose of financial statements include
3. Principal aspects covered in audit
4. Types of audit

10.1 INTRODUCTION
Auditing along with other disciplines such as accounting and law, equips you with all
the knowledge that is required to enter auditing as a profession. No business or
institution can effectively carry on its activities without the help of proper records and
accounts, since transactions take place at different points of time with numerous
persons and entities. Historically, the word ‘auditing’ has been derived from Latin word
“audire” which means “to hear”. In fact, such an expression conveyed the manner in
which the auditing was conducted during ancient time.
However, over a period of time, the manner of conducting has undergone revolutionary
change.
According to Dicksee, traditionally auditing can be understood as an examination of
accounting records
undertaken with a view to establishing whether they completely reflect the transactions
correctly for the
related purpose. But this is not the end of matter. In addition the auditor also expresses
his opinion on the character of the statements of accounts prepared from the
accounting records so examined as to whether they portray a true and fair picture.

Definition of Audit
The term “audit” has been derived from the Latin word “audire,” which means “to hear.”
Hence, an auditor is a person who hears or listens.
For centuries, audits were “oral hearings” in which people entrusted with fiscal
responsibilities justified their stewardship. An audit is one assurance service provided
by competent and qualified professional accountants.
10.2 NATURE AND PURPOSE OF FINANCIAL STATEMENTS
For correctly realising the role of auditing, you must understand the nature and
purpose of the financial statements. ‘Financial statements’ is a set of documents which
show the result of business operation during a period - how the result was achieved
and the position of assets and liabilities on the given date. Progress made or success
achieved during a certain period can also be readily ascertained from such a set of
documents. It also makes an implied representation that it has been properly prepared,
shows correct figures and the figures are set against correct description and context.
Regardless of the type of entity - whether in the public or private sector or whether for
profit or not – all entities use economic resources to pursue their goals. Financial
statements enable an entity’s management to provide useful information about its
financial position at a particular point of time and the results of its operations and its
changes in financial position for a particular period of time. External financial reporting
for these entities is directed toward the common interest of various users. Financial
statements provide owners with information about the stewardship of management.
They also provide a basis for investors’ decisions about whether to buy or sell
securities; for credit rating services’ decisions about the credit worthiness of entities;
for bankers’ decisions about whether to lend money, and for decisions of other
creditors, regulators and others outside the entity.

10.3 THE NATURE AND PURPOSE OF FINANCIAL STATEMENTS INCLUDE

1. Communication of Financial Information: Financial statements serve as a
means of communicating the financial performance and position of an entity to
external parties, such as investors, creditors, regulators, and analysts. They
provide a snapshot of the financial health and operational efficiency of the
organization.
2. Transparency and Accountability: Financial statements promote
transparency and accountability by disclosing the financial transactions and
results of an entity's operations. This transparency is crucial for building trust
among stakeholders and ensuring that management is accountable for its
financial stewardship.
3. Basis for Decision-making: Financial statements provide essential
information for decision-making by various stakeholders. Investors use them to
assess the financial viability and growth potential of a company, creditors
evaluate creditworthiness, and management utilizes them for strategic planning
and performance evaluation.
4. Legal and Regulatory Compliance: Financial statements are often required
by law or regulation for certain entities. For example, public companies are
typically required to prepare and disclose financial statements to comply with
securities regulations and stock exchange listing requirements.
5. Evaluation of Financial Performance: Financial statements enable
stakeholders to evaluate the financial performance of an entity over a specific
period. By analyzing key financial ratios, trends, and comparisons with industry
benchmarks, stakeholders can assess profitability, liquidity, solvency, and
efficiency.
6. Assessment of Financial Position: Financial statements provide insights into
the financial position of an entity by presenting its assets, liabilities, and equity.
Stakeholders can analyze the composition of assets and liabilities, assess
liquidity and leverage ratios, and evaluate the entity's overall financial health.
7. Disclosure of Financial Information: Financial statements include
disclosures that provide additional information about significant accounting
policies, contingent liabilities, related party transactions, and other relevant
matters. These disclosures enhance the transparency and completeness of
financial reporting.

10.4 AUDITING AND ASSURANCE STANDARDS

International Auditing and Assurance Standards Board
In 1977, the International Federation of Accountants (IFAC) was set up with a view to
bringing harmony in the profession of accountancy on an international scale. In
pursuing this mission, the IFAC Board has established the International Auditing and
Assurance Standards Board (IAASB) to develop and issue, in the public interest and
under its own authority, high quality auditing and assurance standards for use around
the world. The IFAC Board has determined that designation of the IAASB as the
responsible body, under its own authority and within its stated terms of reference, best
serves the public interest in achieving this aspect of its mission.
The International Auditing and Assurance Standards Board (IAASB) is a key entity
established by the International Federation of Accountants (IFAC) to develop and
issue high-quality auditing and assurance standards for global use. Key points
regarding the IAASB's role and objectives:
1. Establishment and Authority: The IAASB was established by the IFAC Board
to develop and issue auditing and assurance standards. It operates under its
own authority and within its stated terms of reference, serving the public
interest.
2. Objective: The primary objective of the IAASB is to serve the public interest by
setting high-quality auditing and assurance standards. These standards aim to
enhance the quality and uniformity of auditing and assurance practices
worldwide and strengthen public confidence in the auditing and assurance
profession.
3. Independence: The IAASB functions as an independent standard-setting body
under the auspices of IFAC. This independence ensures that its standards are
developed objectively and without undue influence from any specific
stakeholders.
4. Scope of Standards: The IAASB develops standards and guidance for various
types of engagements, including financial statement audits, other assurance
services (both financial and non-financial), and related services. These
standards cover a wide range of activities undertaken by auditors and
assurance service providers.
5. Quality Control Standards: In addition to specific engagement standards, the
IAASB also establishes quality control standards that cover the overall scope
of services addressed by the board. These standards aim to ensure that firms
maintain high-quality practices and procedures in conducting their audit and
assurance engagements.
6. Public Interest Focus: The IAASB's activities are driven by a commitment to
the public interest. It seeks to establish standards that are generally accepted
and recognized by various stakeholders, including investors, auditors,
regulators, and governments.
7. Publication of Pronouncements: The IAASB publishes various
pronouncements on auditing and assurance matters to advance public
 understanding of the roles and responsibilities of professional auditors and
assurance service providers. These pronouncements help promote
transparency and accountability in the profession.

10.5 Procedure for Issuing the Statements on Standard Auditing Practices

The procedure for issuing statements on standard auditing practices, as outlined,
involves several key steps:
1. Determination of Areas and Priorities: The Auditing and Assurance
Standards Board (AASB) identifies the broad areas where Auditing and
Assurance Standards (AASs) are needed and establishes priorities for their
formulation.
2. Formation of Study Groups: The AASB sets up study groups consisting of
members from the Institute to delve into specific subjects related to auditing
and assurance. These study groups assist the AASB in researching and
developing standards.
3. Preparation of Exposure Draft: Based on the work of the study groups, the
AASB prepares an exposure draft outlining the proposed AAS. This draft is
circulated among members of the Institute for comments and feedback.
4. Finalization of Proposed AAS: After considering the received comments, the
AASB finalizes the draft of the proposed AAS. This finalized version is then
submitted to the Council of the Institute.
5. Review and Modification by Council: The Council of the Institute reviews the
final draft of the proposed AAS. If necessary, modifications may be made in
consultation with the AASB to ensure the standards meet the required criteria
and address any concerns raised during the review process.
6. Issuance of AAS: Once the final draft is approved by the Council, the AAS is
issued under the authority of the Council. This issuance provides formal
recognition and endorsement of the standards, making them official guidelines
for auditing and assurance practices within the Institute.

10.6 DEFINITION OF AUDITING

According to General Guidelines on Internal Auditing issued by the ICAI, “Auditing is
defined as a systematic and independent examination of data, statements, records,
operations and performances (financial or otherwise) of an enterprise for a stated
purpose. In any auditing situation, the auditor perceives and recognises the
propositions before him for examination, collects evidence, evaluates the same and
on this basis formulates his judgement which is communicated through his audit
report.”
The nature of the propositions which an auditor is called upon to review varies. Thus
an auditor may review the financial statements of an enterprise to ascertain whether
they reflect a true and fair view of its state of affairs and of its working results. In
another situation, he may analyse the operations of an enterprise to appraise their
cost-effectiveness and in still another, he may seek evidence to review the managerial
performances in an enterprise. In yet another type of audit, the auditor may examine
whether the transactions of an enterprise have been executed within the framework of
certain standards of financial propriety. However, the variations in the propositions do
not change the basic philosophy of auditing, though the process of collection and
evaluation of evidence and that of formulating a judgment

Thereon may have to be suitably modified.

According to AAS-1 on “Basic Principles Governing an Audit”, “An audit is 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.” The person conducting this process should
perform his work with knowledge of the use of the accounting statements discussed
above and should take particular care to ensure that nothing contained in the
statements will ordinarily mislead anybody. This he can do honestly by satisfying
himself that :
(i) the accounts have been drawn up with reference to entries in the books of account;
(ii) the entries in the books of account are adequately supported by underlying papers
and documents and by other evidence;
(iii) none of the entries in the books of account has been omitted in the process of
compilation and
nothing which is not in the books of account has found place in the statements;
(iv) the information conveyed by the statements is clear and unambiguous;
(v) the financial statement amounts are properly classified, described and disclosed in
conformity with accounting standards; and
(vi) the statement of accounts taken as an integrated whole, present a true and fair
picture of the operational results and of the assets and liabilities.
THE AUDITOR
The auditor, tasked with conducting audits, plays a pivotal role in examining
accounting records and financial statements to render an opinion to the appointing
authority. This opinion primarily focuses on whether the financial statements present
a true and fair view of the entity's financial position.
Over time, auditing, especially in the context of companies and for public purposes,
has become the domain of professionals with recognized training and qualifications.
In jurisdictions like India, the Companies Act, 1956, mandates that only Chartered
Accountants possess the requisite professional qualifications for auditing company
accounts.
It's noteworthy that the provision concerning restricted state auditors, once relevant,
has now become obsolete. Chartered Accountants are uniquely equipped to
undertake audits across various accounting domains, unlike cost accountants, whose
purview is typically confined to auditing cost accounting records and statements.

10.7 Functional Classification of Auditors : Internal Audit vs. External Audit

Auditors can be functionally classified into two broad categories: external auditors and
internal auditors.
1. External Auditors: External auditors are individuals who are qualified professionals
in the field of accountancy and conduct audits externally to the organization they are
auditing. They are typically appointed by the owners of the organization, such as the
shareholders of a company. External auditors may also be referred to as statutory
auditors when appointed under specific statutes. Their scope of work is determined by
the relevant statutes or regulations.
Key points about external auditors include:
 They are independent of the organization's management responsible for
preparing the financial statements.
 Their appointment is usually mandated by law or regulation.
 They provide assurance on the accuracy and fairness of financial statements
to external stakeholders, such as shareholders, regulators, and creditors.
 Their primary focus is on financial accounting and reporting standards.
 Examples of their work include conducting financial audits, reviewing internal
controls, and providing an opinion on the financial statements' accuracy and
compliance with accounting standards.
2. Internal Auditors: Internal auditors are professionals who may also be qualified in
accountancy and are employed by the organization internally. They are appointed by
management to perform specific audit functions within the organization. Their scope
of work is determined by the management, and they may be appointed either on a
contract basis or as permanent employees.
Key points about internal auditors include:
 They are internal to the organization and report to management.
 Their appointment and scope of work are determined by management.
 They may conduct various types of audits beyond financial accounting,
including cost investigation, performance audits, production audits, and
inquiries into losses and wastages.
  While they are employees of the organization, internal auditors are expected to
maintain independence to the extent practicable.
 They play a vital role in evaluating and improving internal controls, risk
management processes, and operational efficiencies.

10.8 OBJECTIVE OF AN AUDIT

The objectives of an audit can indeed be categorized into primary objectives and
subsidiary objectives:
Primary Objectives of Audit: The primary objectives of an audit represent the main
goals or purposes of conducting the audit. They include:
1. Examining the system of internal checks: Assessing the effectiveness of the
organization's internal control system to ensure accuracy and reliability of
financial reporting.
2. Checking arithmetical accuracy of books of accounts: Verifying the
accuracy of mathematical calculations in the accounting records, such as
postings, castings, and balances.
3. Verifying the authenticity and validity of transactions: Ensuring that
transactions recorded in the financial statements are legitimate, properly
authorized, and supported by appropriate documentation.
4. Checking the proper distinction between capital and revenue nature of
transactions: Ensuring that transactions are correctly classified as either
capital or revenue items, which is essential for accurate financial reporting and
taxation purposes.
5. Confirming the existence and value of assets and liabilities: Verifying the
presence, ownership, and valuation of assets and liabilities reported in the
financial statements.
Subsidiary Objectives of Audit: Subsidiary objectives of an audit support the
achievement of primary objectives by addressing specific areas of concern or risk.
They include:
1. Detection and prevention of errors: Identifying unintentional mistakes or
inaccuracies in the financial records and implementing measures to prevent
future occurrences.
2. Detection and prevention of fraud: Identifying intentional misstatements or
fraudulent activities in the financial statements and implementing controls to
prevent fraud in the future.
3. Detection of under- or over-valuation of stock: Identifying discrepancies in
the valuation of inventory, ensuring that it is valued correctly to reflect its true
worth and prevent misstatement of financial results.
10.9 SCOPE OF AUDIT
The scope of an audit refers to the extent and coverage of activities and records
subject to examination during the audit process. It can be briefed as follows:

1. Comprehensive Coverage: The audit should encompass all relevant aspects

of the financial statements of the entity under audit. This includes examining
various accounts, transactions, balances, and disclosures to ensure
completeness and accuracy.
2. Obtaining Reasonable Assurance: The auditor aims to obtain reasonable
assurance that the information contained in the underlying accounting records
and other source data is reliable and sufficient for the preparation of the
financial statements. This involves thorough examination and evaluation of the
accounting system and internal controls.
3. Proper Communication of Information: The auditor assesses whether the
relevant information is properly communicated in the financial statements. This
includes ensuring that the financial statements accurately represent the
underlying financial position, performance, and cash flows of the entity.
4. Evaluation of Accounting System and Internal Controls: The auditor
evaluates the reliability and sufficiency of information by examining the
accounting system and internal controls in place. This assessment helps
determine the level of reliance that can be placed on the financial statements
and guides the audit procedures.
5. Comparison and Disclosure: The auditor compares the financial statements
with the underlying accounting records and other source data to ensure
consistency and proper disclosure of relevant information. This involves
verifying the accuracy of financial statement presentations and disclosures.
6. Limitations of Auditor's Responsibilities: The auditor is not expected to
undertake responsibilities or perform functions outside the scope of their
competence. They focus on auditing financial information and may collaborate
with other professionals or experts when specialized knowledge is required for
specific areas.

10.10 PRINCIPAL ASPECTS COVERED IN AUDIT

Examination of the structure of accounting and internal control to ascertain whether it
is appropriate for the business and helps in properly recording all transactions. This is
followed by those tests and inquiries as are considered necessary to ascertain whether
the system is in actual operation. These steps are necessary to form an opinion as to
whether reliance can be placed on the records as a basis for the preparation of final
statements of account;
 1. Examination of Accounting Structure and Internal Controls: Assessing the
structure of accounting and internal control systems to determine their
appropriateness for the business. This includes verifying whether the system is
effectively recording all transactions and conducting necessary tests and
inquiries to ensure its operational effectiveness.
2. Review of System and Procedures: Reviewing systems and procedures to
identify any inadequacies or weaknesses that could potentially lead to fraud or
errors going unnoticed. This involves evaluating the adequacy and
completeness of controls in place.
3. Arithmetical Accuracy Verification: Checking the arithmetical accuracy of the
books of account by verifying postings, balances, and other calculations to
ensure accuracy and consistency.
4. Verification of Transaction Validity: Verifying the validity of transactions by
examining entries in the books of account against relevant supporting
documents. This helps ensure that transactions are properly authorized,
documented, and recorded.
5. Capital vs. Revenue Distinction: Ensuring that a proper distinction is made
between items of capital and revenue nature and that income and expenditure
items are appropriately adjusted for the relevant accounting period.
6. Comparison with Underlying Records: Comparing the balance sheet, profit
and loss account, or other financial statements with the underlying records to
ensure consistency and accuracy.
7. Verification of Assets: Verifying the title, existence, and value of assets
appearing in the balance sheet through physical inspection, documentation
review, or other verification methods.
8. Verification of Liabilities: Verifying the liabilities stated in the balance sheet
to ensure accuracy and completeness.
9. Scrutiny of Profit and Loss Results: Scrutinizing the results shown by the
profit and loss account to assess their accuracy and fairness, ensuring that they
reflect the true financial performance of the organization.
10. Statutory Compliance Confirmation: Confirming compliance with statutory
requirements, particularly in the case of audits for corporate bodies, to ensure
adherence to legal obligations.
11. Reporting on True and Fair View: Reporting to the appropriate person or body
whether the statements of account examined present a true and fair view of the
organization's state of affairs and financial performance.

10.11 TYPES OF AUDIT

Auditing encompasses various types tailored to specific needs and objectives within
different business contexts. These types can range from routine internal audits
conducted by the business itself to external audits performed by third-party
professionals. Internal audits, typically conducted by in-house employees, focus on
reviewing financial records and transactions to ensure accuracy and compliance with
internal policies and procedures. These audits may occur regularly, such as annually,
and help businesses maintain organizational integrity and operational efficiency.
External audits, on the other hand, are conducted by independent third-party auditors,
such as government agencies or accounting firms like the IRS. These audits are often
more comprehensive and rigorous, aiming to verify the accuracy and fairness of
financial statements and compliance with external regulations and standards.
Additionally, audits can be tailored to specific areas or aspects of business operations.
For example, a construction business might conduct project audits to analyze the costs
and performance of individual projects, including expenses for contractors, supplies,
and overall project management. Such audits help businesses identify areas for
improvement and ensure optimal resource allocation and profitability.
Overall, the types of audits vary based on the specific needs, objectives, and
regulatory requirements of businesses, with the common goal of ensuring accuracy,
compliance, and efficiency in financial and operational processes.

10.12 DIFFERENT TYPES OF AUDIT

Types of audits encompass a wide array of examinations tailored to various aspects
of a business's operations and compliance requirements. Different types of audits:
1. Internal Audit: Conducted within the business by internal personnel to propose
improvements, monitor effectiveness, ensure compliance with laws and
regulations, review financial information, evaluate risk management policies,
examine operational processes, and update shareholders or board members
on financial matters.
2. External Audit: Carried out by a third-party auditor, such as an accountant,
IRS, or tax agency, to verify the accuracy of accounting records. External audits
follow generally accepted auditing standards (GAAS) and are often required by
investors and lenders to ensure financial information's accuracy and fairness.
3. IRS Tax Audit: Conducted by the IRS to assess the accuracy of a company's
filed tax returns, identify discrepancies in tax liabilities, and review errors on tax
returns. IRS audits may be conducted randomly or through mail or in-person
interviews.
4. Financial Audit: One of the most common types of audits, usually external, to
analyze the fairness and accuracy of a business's financial statements.
Financial audits review transactions, procedures, and balances to provide an
audit opinion to stakeholders.
 5. Operational Audit: Similar to internal audits, operational audits analyze a
company's goals, planning processes, procedures, and operational results to
evaluate operations and identify areas for improvement.
6. Compliance Audit: Examines a business's policies and procedures to ensure
compliance with internal or external standards, such as IRS regulations or
workers' compensation requirements.
7. Information System Audit: Particularly relevant for software and IT
companies, information system audits assess software development, data
processing, and computer systems to ensure accuracy, security, and
compliance with regulations.
8. Payroll Audit: Reviews a company's payroll processes, including pay rates,
tax withholdings, and employee information, to ensure accuracy and
compliance with payroll regulations.
9. Pay Audit: Focuses on identifying pay discrepancies among employees,
including disparities due to race, religion, age, gender, and industry standards,
to ensure fair and equitable pay practices.

10.13 ADVANTAGES OF AUDIT OF FINANCIAL STATEMENTS

Auditing of financial statements offers several advantages, which are valuable for both
the entity being audited and external stakeholders. These advantages include:
1. Safeguarding Financial Interests: Audited financial statements provide
assurance to stakeholders, including investors, creditors, and shareholders,
about the accuracy and reliability of financial information, thereby safeguarding
their financial interests.
2. Prevention of Fraudulent Activities: The audit process acts as a deterrent
against fraudulent activities such as embezzlement and defalcations by
employees, as they are aware that their actions will be scrutinized and detected
during the audit.
3. Settling Tax Liabilities and Claims: Audited financial statements help in
accurately determining tax liabilities and other statutory payments, ensuring
compliance with tax laws. They also facilitate the settlement of claims related
to taxes and other statutory payments.
4. Resolution of Trade Disputes: Audited financial statements can be used as
evidence in settling trade disputes, such as claims related to wages, bonuses,
or other financial matters, providing a reliable basis for resolving disputes.
5. Detection of Wastages and Losses: Auditors help in identifying and
addressing wastages and losses, especially those arising from inadequate
internal controls and checks, thereby promoting operational efficiency and cost-
effectiveness.
 6. Ensuring Proper Record-keeping: Audits ensure that necessary books of
account and auxiliary records are properly maintained, enhancing transparency
and accountability in financial reporting and record-keeping practices.
7. Reviewing Control Measures: The audit process involves reviewing and
evaluating internal control measures, helping management identify
weaknesses and implement improvements to enhance control effectiveness.
8. Assistance in Partner Settlements: Audits play a crucial role in the settlement
of accounts during the entry and exit of partners in a business, ensuring
transparency and fairness in financial dealings among partners.
9. Compliance with Regulatory Requirements: Various authorities often
require audited and certified financial statements as a prerequisite for issuing
licenses, permits, or approvals, ensuring compliance with regulatory
requirements and enhancing credibility.

Self Assessment
5. What is External auditors?
6. What is auditing?
7. Explain types of audit?
8. What are the advantages of audit of financial statement?

10.14 Summary
Financial statements serve as crucial tools for stakeholders to assess the financial
health and performance of a company. They provide a snapshot of the organization's
financial position, performance, and cash flows, aiding investors, creditors, and
management in making informed decisions. Auditing and assurance standards ensure
the accuracy and reliability of these statements, with auditors conducting thorough
examinations to verify compliance and detect errors or fraud. Audits serve to enhance
transparency, instill confidence in financial reporting, and protect stakeholders'
interests. However, audits also have limitations, including the inability to detect all
forms of fraud or errors due to inherent constraints in sampling and reliance on
management representations.
10.15 Glossary
1. AUDIT: The term “audit” has been derived from the Latin word “audire,” which
means “to hear.” Hence, an auditor is a person who hears or listens.
2. AUDITING: According to General Guidelines on Internal Auditing issued by the
ICAI, “Auditing is defined as a systematic and independent examination of data,
statements, records, operations and performances (financial or otherwise) of
 an enterprise for a stated purpose. In any auditing situation, the auditor
perceives and recognises the propositions before him for examination, collects
evidence, evaluates the same and on this basis formulates his judgement which
is communicated through his audit report.”
3. External Auditors: External auditors are individuals who are qualified
professionals in the field of accountancy and conduct audits externally to the
organization they are auditing. They are typically appointed by the owners of
the organization, such as the shareholders of a company. External auditors may
also be referred to as statutory auditors when appointed under specific statutes.
Their scope of work is determined by the relevant statutes or regulations.
4. Internal Auditors: Internal auditors are professionals who may also be
qualified in accountancy and are employed by the organization internally. They
are appointed by management to perform specific audit functions within the
organization. Their scope of work is determined by the management, and they
may be appointed either on a contract basis or as permanent employees.

10.16 Answers: Self Assessment

1). Please check section 10.12 2). Please check section 10.6 3). Please
check section 10.12 4). Please check section 8.9 and 10.13
10.17 Terminal Questions

1. What is the purpose of financial statements in business? And What are the main
components of financial statements?
2. Can you outline the procedure for issuing financial statements based on standard
auditing practices?
3. How are auditors classified based on their functions and roles? And What are the
main aspects or areas covered during an audit?
4. What are the different types of audits conducted in business? What are the benefits
of conducting audits of financial statements?
10.18 Answers: Terminal Questions:
1). Please check section 10.2 and 10.3 2). Please check section 10.4 3).
Please check section 10.7 and 10.9 4). Please check section 10.11 and 10.12
10.19 Suggested Readings
1. Albrecht, W. Steve. (2009). Forensic Accounting & Fraud Examination. Cengage
Learning (India Edition).
2. Albrecht, Chad O., Albrecht, Conan C., Albrecht, W. Steve & Zimbelman, Mark F.
(2015). Forensic Accounting & Fraud Examination. Cengage Learning (India
Edition).
3. Banerjee, Robin (2015). Who Cheats and How? Sage Publications, New Delhi.
4. Bologna, Jack and Lindquist, Robert J. (1995). Fraud Auditing and Forensic
Accounting. Wiley.
 Lesson – 11
BASIC CONCEPTS IN AUDITING
Structure:
11.0 Learning Objectives
11.1 Introduction
11.2 Independence of auditors
11.3 Principles of auditor independence
11.4 Inherent limitations of audit
11.5 International auditing and assurance standard board
11.6 Summary
11.7 Glossary
11.8 Answers: Self Assessment
11.9 Terminal Questions
11.10 Answers: Terminal Questions:
11.11 Suggested Readings
11.0 Learning Objectives
After studying the lesson, you should be able to:-
1. Basic concepts in auditing
2. International auditing and assurance standard board

11.1 CONCEPT OF AUDITOR’S INDEPENDENCE

In society, professional accountants play a significant role. Professional accountants
are trusted by creditors, employers, investors, and other business community
members as well as the government and general public to provide accurate financial
accounting and reporting, efficient financial management, and knowledgeable counsel
on a range of business and tax-related issues. The way in which qualified accountants
conduct themselves when rendering these services has an effect on the financial
security of clients nation and community. The only way professional accountants can
maintain this beneficial position is if they keep offering the public these exceptional
services at a calibre that proves the public's trust is well-founded. Notifying service
users of this is in the best interest of the global accounting profession.
It is in the best interest of the worldwide accountancy profession to make known to
users of the services provided by professional accountants that they are executed at
the highest level of performance and in accordance with ethical requirements that
strive to ensure such performance. In order to achieve the objectives of the
accountancy profession, professional accountants have to observe a number of
prerequisites or fundamental principles as under:
2. Integrity: Auditors should demonstrate honesty, straightforwardness, and
ethical behavior in performing professional services. They should uphold high
moral and ethical standards in their conduct and decision-making.
3. Objectivity: Auditors must maintain impartiality and avoid conflicts of interest
that could compromise their judgment and independence. They should be fair
and unbiased in assessing financial information and reporting their findings.
4. Professional Competence and Due Care: Auditors should possess the
necessary knowledge, skills, and expertise to perform audits effectively and
diligently. They have a duty to stay informed about relevant developments in
auditing standards, regulations, and practices to ensure the quality and
accuracy of their work.
5. Confidentiality: Auditors are required to maintain the confidentiality of
information obtained during the audit process. They should not disclose
sensitive or confidential information without proper authorization, except where
there is a legal or professional obligation to do so.
6. Professional Behavior: Auditors should conduct themselves in a manner that
upholds the good reputation and integrity of the auditing profession. They
should avoid any behavior that could bring discredit to the profession or
undermine public trust in their independence and objectivity.

7. Technical Standards: A professional accountant should carry out professional

services in accordance with the relevant technical and professional standards.
Professional accountants have a duty to carry out with care and skill, the
instructions of the client or employer insofar as they are compatible with the
requirements of integrity, objectivity and, in the case of professional
accountants in public practice, independence. Independence is the keystone
upon which the respect and dignity of a profession is based. Independence
stands for the strength of individuals to adopt an unbiased view on the matters
undaunted by any favour or frown. In all matters relating to the assignment, an
independence in mental attitude is to be maintained. Only so long as the auditor
maintains a high standard of independence and impartiality, the audit reports
will continue to be accepted and respected by business, financial institutions,
Government and investors. Professional integrity and independence are
essential characteristics of all the learned professions but are more so in the
case of accounting profession.

11.2 INDEPENDENCE OF AUDITORS

The Guidance Note issued by the Institute of Chartered Accountants of India (ICAI) on
"Independence of Auditors" emphasizes that while independence cannot be precisely
defined, it implies that an auditor's judgment is not influenced by external pressures,
including the wishes or directions of those who engage them or their own self-interest.
Independence is viewed as a state of mind and personal character, rather than merely
complying with legal standards of independence, which can vary in stringency.
According to the guidance, independence should not only exist in reality but also
appear to exist to all reasonable persons. This means that the auditor-client
relationship should be such that the auditor is personally satisfied about their client's
integrity and that an unbiased observer would not perceive any compromise of the
auditor's independence based on an objective assessment of the circumstances.
Furthermore, there is a collective aspect of independence that is crucial to the
accounting profession as a whole. This collective independence refers to maintaining
the profession's reputation for integrity and objectivity, which requires individual
auditors to uphold high ethical standards and maintain their independence in practice.
Overall, the guidance underscores the importance of independence as a fundamental
principle of auditing and highlights the need for auditors to maintain both actual and
perceived independence in their professional engagements to uphold the credibility
and trustworthiness of the audit process.
The chartered accountant is not personally known to the third parties who rely on
professional opinion and accept his opinion principally on a larger faith on the entire
accounting profession.
The Companies Act, 1956 has enacted specific provisions to give concrete shape to
this vital concept
The provisions outlined, which disqualify certain individuals from conducting audits of
limited companies, impose limits on the number of audits a chartered accountant can
undertake, require special resolutions for appointing auditors in certain cases, and
detail procedures for appointing, reappointing, and removing auditors, are all aimed at
bolstering the independence of the audit profession.
These measures are designed to ensure that auditors can carry out their duties in the
best interest of shareholders and other stakeholders without undue influence or
interference. By disqualifying certain individuals from conducting audits, such as those
with conflicts of interest or those lacking requisite qualifications, the integrity and
objectivity of the audit process are preserved.
Limiting the number of audits a chartered accountant can undertake helps prevent
overextension and ensures that auditors can dedicate sufficient time and attention to
each engagement, thereby enhancing the quality of audit services rendered.
Requiring special resolutions for appointing auditors in certain cases adds an
additional layer of scrutiny and accountability, ensuring that auditor appointments are
made transparently and with the consent of shareholders.
Granting auditors vast powers of access to company books and documents further
reinforces their independence, enabling them to thoroughly examine financial records
and identify any irregularities or discrepancies.
Additionally, empowering auditors to qualify their reports provides them with a
mechanism to flag potential issues or concerns regarding the accuracy or
completeness of financial statements, thereby safeguarding their independence and
integrity.
Enacting specific instances of misconduct in legislation, such as the Chartered
Accountants Act, 1949, serves to uphold the independence and professional
competence of the accounting profession by setting clear standards of conduct and
accountability for auditors.
11.3 PRINCIPLES OF AUDITOR INDEPENDENCE
The external auditor plays a critical role in lending independent credibility to published
financial statements used by investors, creditors and other stakeholders as a basis for
making capital allocation decisions.
Regulations regarding the appointment of auditors aim to ensure the independence
and impartiality of auditors in carrying out their duties. Accordingly, certain individuals
are disqualified from being appointed as auditors under these regulations:
(i) Officers or Employees of the Company: Individuals who hold an officer or
employee position within the company itself are disqualified from acting as auditors.
This restriction prevents conflicts of interest and ensures that auditors remain
independent from the management of the company.
(ii) Partners or Employees of Company Officers or Employees: Similarly,
individuals who are partners or employees of officers or employees of the company
are disqualified from serving as auditors. This provision extends the disqualification to
those closely associated with company management, further safeguarding auditor
independence.
(iii) Indebted to the Company: Individuals who owe a debt to the company exceeding
a certain threshold (e.g., Rs. 1,000) are disqualified from being appointed as auditors.
This restriction helps prevent potential bias or undue influence that may arise from
financial indebtedness to the company.
(iv) Holding Securities of the Company: Individuals who hold any securities of the
company, particularly those with voting rights, are disqualified from being appointed
as auditors after a specified period from the commencement of relevant legislation
(e.g., Companies (Amendment) Act, 2000). This provision aims to prevent conflicts of
interest and ensure that auditors maintain independence from the company's interests.
The following are some specific instances where the question of independence vis a
vis indebtedness has been considered :
1. Progressive Fee Recovery: The Research Committee of the Institute of
Chartered Accountants of India (ICAI) has opined that if an auditor recovers
fees from a client on a progressive basis, without waiting for the completion of
 the entire audit engagement, the auditor cannot be considered indebted to the
company at any stage. In such cases, the auditor's fee recovery method does
not create a financial obligation that would compromise independence.
2. Purchase of Goods or Services on Credit: If an auditor purchases goods or
services from a company audited by them on credit, they become indebted to
the company. If the outstanding amount exceeds the specified threshold (e.g.,
rupees one thousand), the auditor is disqualified from being appointed as the
company's auditor and must vacate their office. This disqualification applies
regardless of whether the company extends credit to the auditor as it does to
other customers in the ordinary course of business.
3. Indebtedness of Partners: If a partner of an audit firm is indebted to the
company for an amount exceeding the specified threshold, the partner is
disqualified from being appointed as the company's auditor. Similarly, if a firm
in which a partner is involved is indebted to the company for an amount
exceeding the threshold, the firm itself is disqualified. This provision ensures
that the independence of the audit firm and its partners is not compromised by
financial obligations to the audited company.

11.4 INHERENT LIMITATIONS OF AUDIT

Inherent limitations are such features of audit that constrains the auditor to obtain
absolute assurance. It is because of these inherent limitations of audit the independent
professional cannot assure the users of financial statements that financial statements
are absolutely free of (material) misstatements. The Auditor is not expected to and
even cannot practically reduce the audit risk to zero. Following are the reasons of the
inherent limitations of Audit:
1. Use of Estimations: In financial reporting, management often relies on
estimations for certain financial quantities, such as depreciation expense or bad
debt provisions. However, these estimations introduce inherent inaccuracies
into the financial statements, as they are based on assumptions and subjective
judgments.
2. Subjectivity in Financial Reporting: The preparation of financial statements
involves management's judgment and decision-making regarding the inclusion
or exclusion of particular entries. This subjectivity can lead to uncertainties and
inaccuracies in financial reporting.
3. Incomplete or Misleading Information: Management may intentionally or
unintentionally withhold or manipulate information provided to the auditor,
leading to incomplete or misleading financial reporting.
4. Limited Investigative Powers of Auditor: Auditors do not possess the powers
of search and investigation comparable to those of law enforcement agencies.
This limitation restricts their ability to uncover certain types of fraud or financial
irregularities.
 5. Time and Cost Constraints: While time and cost should not dictate the audit
procedures, they are practical limitations that may impact the thoroughness of
the audit process. Limited time and resources may prevent auditors from
conducting comprehensive audits, increasing the risk of oversight or errors.
6. Relevance and Adequacy of Information: The effectiveness of an audit
depends on the relevance and adequacy of the information available to the
auditor. If essential information is lacking or inadequate, it may impair the
auditor's ability to form accurate opinions on the financial statements.
7. Difficulty in Detecting Fraud: Fraudulent activities are often well planned and
concealed by those involved, making them challenging for auditors to detect
using ordinary audit procedures. Fraudsters take deliberate measures to avoid
detection, such as manipulating records or colluding with others.
8. Non-compliance with Laws and Regulations: Non-compliance with statutory
and non-statutory laws by the entity poses a serious threat to the efficient
conduct of an audit. Failure to comply with legal requirements may lead to
inaccurate financial reporting or legal consequences for the entity.
11.5 INTERNATIONAL AUDITING AND ASSURANCE STANDARD BOARD
In the International Federation of Accountants (IFAC) was set up with a view to
bringing harmony in the profession of accountancy on an international scale. For
achieving this purpose, the IFAC Board has established International Auditing and
Assurance Standard Board (IAASB). ISSAB is an independent body which issued
standards, like the International Standards on Auditing, Quality Control Guidelines and
other services, to support the international auditing of financial statements. Following
are the ways through which ISSAB achieves the stated objective:
Establishing the high quality standards and guidance for financial audits that are in
adherence to applicable laws and regulations;
Establishing the high quality standards and guidance for other types of assurance
services inclusive of financial and non-financial matters;
Establishing the high quality standards and guidance for related services;
Establishing the high quality standards for quality control;
Publishing pronouncements on auditing and assurance matters.
Structure of Standards

 SAs Applied in the audit of historical financial information.

 SREs Applied in the review of historical financial information.
 SAEs Applied in assurance engagements, dealing with subject matters other than
historical financial information. Applied to engagements to apply agreed upon
procedures to information and other related services engagements such as
compilation engagements.
Self Assessment
1. What is Technical Standards in audit ?
2. Describe the Independence of Auditors?
3. Full form of IAASB?
4. What are the disadvantages of audit of financial statement?

11.6 Summary
The independence of auditors is critical to maintaining the integrity and objectivity of
audit processes. Guided by principles of auditor independence, auditors must remain
impartial and free from any conflicts of interest to ensure unbiased assessments.
Despite rigorous standards, audits have inherent limitations, such as reliance on
sampling and the inability to detect all fraud. The International Auditing and Assurance
Standards Board (IAASB) sets global standards to promote consistent and high-quality
auditing practices worldwide. Upholding auditor independence and recognizing the
limitations of audits are essential for fostering trust in financial reporting and ensuring
the reliability of audit outcomes.

11.7 Glossary
1. Technical Standards: A professional accountant should carry out professional
services in accordance with the relevant technical and professional standards.
Professional accountants have a duty to carry out with care and skill, the
instructions of the client or employer insofar as they are compatible with the
requirements of integrity, objectivity and, in the case of professional
accountants in public practice, independence.
2. Independence of Auditors" emphasizes that while independence cannot be
precisely defined, it implies that an auditor's judgment is not influenced by
external pressures, including the wishes or directions of those who engage
them or their own self-interest. Independence is viewed as a state of mind and
personal character, rather than merely complying with legal standards of
independence, which can vary in stringency.
3. Indebtedness of Partners: If a partner of an audit firm is indebted to the
company for an amount exceeding the specified threshold, the partner is
disqualified from being appointed as the company's auditor. Similarly, if a firm
in which a partner is involved is indebted to the company for an amount
exceeding the threshold, the firm itself is disqualified. This provision ensures
that the independence of the audit firm and its partners is not compromised by
financial obligations to the audited company.

11.8 Answers: Self Assessment

1). Please check section 11.1 2). Please check section 11.7 3). Please
check section 11.5 4). Please check section 11.4
11.9 Terminal Questions

1. Why is auditor independence important in the auditing profession?

2. What are the fundamental principles of auditor independence?
3. What are some inherent limitations of audits, particularly regarding
independence?
4. What is the role of the International Auditing and Assurance Standards Board
(IAASB) in setting global auditing standards?
11.10 Answers: Terminal Questions:
1). Please check section 11.2 2). Please check section 11.3 3). Please
check section 11.4 4). Please check section 11.5
11.11 Suggested Readings
1. Dalal, Chetan. (2015). Novel & Conventional Methods of Audit, Investigation
and Fraud Detection. Wolters Kluwer India Pvt. Ltd.
2. Gupta, Sanjeev (2016). Corporate Frauds and their Regulation in India. Bharat
Law House Pvt. Ltd
3. Kaul, Vivek (2013). Easy Money. Sage Publications, New Delhi.
4. Manning, George A. (2010). Financial Investigation and Forensic Accounting.
CRC Press: Taylor & Francis Group.
5. Sharma, B. R. (2014). Bank Frauds. Universal Law Publishing, New Delhi
 Lesson - 12
AUDIT EVIDENCE

Structure:
12.0 Learning Objectives
12.1 Introduction
12.2 Audit Procedures to Obtain Audit Evidence
12.3 Audit Procedure
12.4 Types of audit evidence
12.5 Evaluation of audit evidence
12.6 Special considerations in audit evidence
12.7 Emerging trends in collecting and processing audit evidence
12.8 Importance of audit evidence
12.9 Reliability of Audit Evidence
12.10 Methods to obtain audit evidence
12.11 Summary
12.12 Glossary
12.13 Answers: Self Assessment
12.14 Terminal Questions
12.15 Answers: Terminal Questions:
12.16 Suggested Readings
12.0 Learning Objectives
After studying the lesson, you should be able to:-
1. Audit Procedures to Obtain Audit Evidence
2. Emerging trends in collecting and processing audit evidence
3. Methods to obtain audit evidence
12.1 Introduction
Auditing is a logical process. An auditor is called upon to assess the actualities of the
situation, review the statements of account and give an expert opinion about the
truthness and fairness of such accounts. This he cannot do unless he has examined
the financial statements objectively.
Objective examination connotes critical examination and scrutiny of the accounting
statements of the undertaking with a view to assessing how far the statements present
the actual state of affairs in the correct context and whether they give a true and fair
view about the financial results and state of affairs.
An opinion founded on a rather reckless and negligent examination and evaluation
may expose the auditor to legal action with consequential loss of professional standing
and prestige.
He needs evidence to obtain information for arriving at his judgment. Statements of
account are mainly two : one dealing with the revenue earning activity and the other
showing the consequential position of assets and liabilities. The former in our country
is known as “profit and loss account” and the latter “balance sheet”. In each case there
are a number of items, which are in fact account heads under which the various
transactions are classified for a correct evaluation of the state of affairs; the
examination process should aim at verification of each such item.
AAS-1 on Basic Principles Governing an Audit states, “the auditor should obtain
sufficient appropriate audit evidence through the performance of compliance and
substantive procedures to enable him to draw reasonable conclusions therefrom on
which to base his opinion on the financial information”.
AAS- 5 on Audit Evidence further expounds this concept. According to it, sufficiency
and appropriateness are inter-related and apply to evidence obtained from both
compliance and substantive procedures.
Sufficiency refers to the quantum of audit evidence obtained while appropriateness
relates to its relevance and reliability. Normally, the auditor finds it necessary to rely
on audit evidence which is persuasive rather than conclusive. He may often seek
evidence from different sources or of different nature to support the same assertions.
The various factors which influence the auditor’s judgment as to
what is sufficient and appropriate audit evidence are as under :
(a) The degree of risk of misstatement which may be affected by factors such as :
(i) the nature of the item;
(ii) the adequacy of internal control;
(iii) the nature or size of the business carried on by the entity;
(iv) situations which may exert an unusual influence on management;
(v) the financial position of the entity.
(b) The materiality of the item.
(c) The experience gained during previous audits.
(d) The results of auditing procedures, including fraud and errors which may have been
found.
(e) The type of information available.
(f) The trend indicated by accounting ratios and analysis.

The auditor obtains evidence through compliance procedures and substantive

procedures to satisfy assertions contained in the financial statements.

12.2 Audit Procedures to Obtain Audit Evidence

Compliance procedures are tests designed to obtain reasonable assurance that those
internal controls on which audit reliance is to be placed are in effect. In obtaining audit
evidence from compliance procedures, the auditor is concerned with assertions that
the control exists, the control is operating effectively, and the control has so operated
throughout the period of intended reliance. So the auditor is concerned with the
existence, effectiveness and continuity of the control system.
Substantive procedures are tests designed to obtain evidence as to the completeness,
accuracy and validity of the data produced by accounting system. They are of two
types:
(1) tests of details of transactions and balances.
(2) analysis of significant ratios and trends including the resulting investigation of
unusual fluctuations and items.
The following chart illustrates different audit procedures :
12.3 Audit Procedure
1. Compliance Procedures
2. Substantive Procedures
(i) Tests of Detail
(i)Tests of Transactions
i.e. vouching
(ii)Tests of Balances
i.e. verification
In obtaining audit evidence from substantive procedures, the auditor is concerned with
the following
assertions:

(ii) Analytical Procedures

i.e. analysis of significant
ratios and verification of trends
In the process of obtaining audit evidence through substantive procedures, auditors
focus on verifying various assertions related to the financial statements. These
assertions help ensure that the financial information presented in the statements is
accurate, complete, and reliable. The following are the key assertions that auditors
consider:
1. Existence: Auditors verify whether assets and liabilities reported in the financial
statements actually exist as of the balance sheet date. This involves confirming
the physical presence of assets and validating the existence of liabilities
through supporting documentation.
2. Rights and Obligations: Auditors ascertain that assets represent rights of the
entity and liabilities represent obligations of the entity as of the balance sheet
date. This involves reviewing contracts, agreements, and legal documentation
to confirm ownership rights and obligations.
3. Occurrence: Auditors ensure that transactions and events recorded in the
financial statements actually occurred during the reporting period. This involves
examining supporting documentation such as invoices, receipts, contracts, and
bank statements to validate the occurrence of transactions.
4. Completeness: Auditors verify that all relevant transactions, assets, and
liabilities have been recorded and disclosed in the financial statements. This
includes assessing whether there are any unrecorded or undisclosed items that
could materially impact the completeness of the financial information.
5. Valuation: Auditors assess whether assets and liabilities are recorded at
appropriate carrying values in the financial statements. This involves evaluating
the methods used for valuation and ensuring that they are in accordance with
applicable accounting standards and principles.
6. Measurement: Auditors confirm that transactions are recorded in the financial
statements at the correct amounts and that revenues and expenses are
allocated to the appropriate accounting periods. This involves reviewing
supporting documentation and assessing the accuracy and appropriateness of
accounting treatments applied.
7. Disclosure: Auditors verify that all material information relevant to the financial
statements is adequately disclosed in the notes to the financial statements. This
includes information about significant accounting policies, contingencies,
related party transactions, and other pertinent details that may impact the users'
understanding of the financial position and performance of the entity.

12.4 TYPES OF AUDIT EVIDENCE

Audit evidence refers to the information that auditors gather and use to form their
opinions on the financial statements of an organization. This evidence can come from
various sources, and it is categorized into internal evidence and external evidence:
1. Internal Evidence:
1. Internal evidence originates within the organization being audited.

2. Examples of internal evidence include:

1. Sales invoices generated by the organization.

2. Copies of internal documents such as sales challans, forwarding

notes, goods received notes, inspection reports, cash memos,
debit notes, and credit notes.
3. Internal evidence is typically generated as part of the organization's
internal processes and transactions. Auditors rely on internal evidence
to verify the accuracy and completeness of transactions recorded in the
financial statements.
2. External Evidence:
1. External evidence originates outside the client's organization.

2. Examples of external evidence include:

1. Purchase invoices received from suppliers.

2. Supplier's challans and forwarding notes.

3. Debit notes and credit notes received from external parties.

4. Quotations received from vendors.

5. Confirmations obtained directly from external parties, such as

banks, customers, suppliers, or legal advisors.
3. External evidence provides independent verification of transactions and
balances recorded in the organization's financial statements. Auditors
use external evidence to corroborate information obtained from internal
sources and to gain assurance about the reliability of the financial
statements.
3. Documentary evidence
Documentary evidence is the most common type of audit evidence and typically
includes written records and documents. It provides a tangible and often irrefutable
source of information.
Some examples of documentary evidence include:
 Invoices and receipts: Invoices from suppliers, customer receipts, and other
financial documents can be used to verify transactions, amounts, and the timing
of financial events.
  Contracts and agreements: Contracts and agreements with suppliers, clients,
employees, and other stakeholders can provide evidence of obligations, terms,
and commitments that affect an organization’s financial statements.
 Bank statements: Bank statements and related documents offer critical
evidence of cash balances, transactions, and bank reconciliations, helping
auditors confirm the accuracy of an organization’s cash accounts.

4. Analytical evidence
Analytical evidence involves the use of financial and non-financial data analysis to
identify patterns, trends, anomalies, or unusual fluctuations that may indicate potential
issues or areas of concern. Examples of analytical evidence include:
 Ratio analysis: Auditors often use financial ratios to assess the financial health
and performance of a company. Ratios like liquidity ratios, profitability ratios,
and leverage ratios provide valuable insights.
 Trend analysis: Comparing financial data over multiple periods to identify
significant changes or anomalies can provide insights into potential risks or
areas requiring further investigation.
 Testimonials and confirmations: Testimonials and confirmations involve
obtaining written or oral statements from knowledgeable individuals, both within
and outside the organization. These can include:
o Confirmation letters: Auditors may send confirmation letters to third
parties, such as banks, customers, or suppliers, to independently verify
balances, transactions, or other financial information.
o Expert opinions: Expert opinions from specialists or professionals in
specific fields can provide evidence related to complex issues, such as
the valuation of unique assets or liabilities

5. Observational evidence
Observational evidence is gathered through direct observation and physical
inspection. Auditors may use this type of evidence to assess the physical existence
and condition of assets or the operation of internal controls. Examples include:
 Inspection of assets: Auditors may physically inspect inventory, property, or
equipment to verify their existence and condition.
 Observation of internal controls: Auditors may observe internal control
procedures in action to assess their effectiveness in preventing and detecting
fraud or errors.
6. External evidence
External evidence is obtained from sources outside of the organization and can
provide an independent perspective on financial information. Examples include:
 External reports: Credit ratings, market research reports, or industry-specific
reports can provide external perspectives on an organization’s financial health
and industry performance.
 Industry benchmarks: Comparing an organization’s performance against
industry benchmarks or standards can provide valuable context for evaluating
its financial position.

7. Electronic and digital evidence

In today’s digital age, electronic and digital evidence play a significant role in auditing.
This includes information stored electronically and digitally, such as:
 Email correspondence: Emails and electronic communications can provide
evidence of agreements, transactions, or decisions made by the organization.
 Computerized accounting records: Auditors often rely on digital accounting
records, including ledgers, financial software, and databases, to gather
evidence about an organization’s financial transactions and accounts.
8. Physical evidence
Sometimes, auditors need to go beyond documents and observe tangible assets. By
physically inspecting items like inventory, equipment, or property, they can confirm
their existence, condition, and valuation. For instance, in a manufacturing plant audit,
auditors may physically count the inventory to reconcile it with the financial records.
9. Oral evidence
Interviews and discussions with individuals within the organization are essential for
clarifying details, gathering explanations, and obtaining a deeper understanding of
specific transactions or practices. Through dialogue with management, employees,
and stakeholders, auditors gain valuable context for their assessments.
10. . Re-performance evidence
To ensure the effectiveness of internal controls, auditors may replicate certain
procedures or transactions performed by the organization. By reperforming these
activities independently, they verify that controls are functioning as intended and
that the organization’s practices align with its documented policies.
11. Expert opinion evidence
In complex or specialized areas, auditors may seek input from experts. These experts,
often external to the audit firm, offer professional opinions based on their expertise.
For instance, in the case of complex financial instruments, auditors may engage
financial experts to assess their valuation.
Each of these evidence types has a specific role in the audit process. Auditors carefully
select and combine these forms of evidence to ensure a comprehensive and accurate
assessment.
Their judgment, expertise, and strategic use of evidence types are vital in delivering
reliable audit opinions on an organization’s financial health and internal controls. The
synergy of these evidence types enhances the audit’s credibility and trustworthiness.
Auditors must carefully select and combine these types of evidence to obtain sufficient
and appropriate evidence to support their audit opinions and conclusions.

12.5 Evaluation of audit evidence

The evaluation of audit evidence is a critical step in the audit process. After auditors
have gathered various types of evidence, they must assess its relevance and reliability
to draw conclusions and form their audit opinions. This evaluation includes the following
key aspects:

1. Sufficiency of evidence
The sufficiency of evidence refers to whether the quantity of evidence obtained is
adequate to support the audit objectives.
Auditors must consider the following factors when assessing sufficiency:
 The size and complexity of the organization: Larger and more complex
organizations typically require more extensive audit procedures and evidence.
 Materiality: Auditors should focus on areas and account balances that are
more likely to contain material misstatements.
 Risk assessment: Higher levels of assessed risk may necessitate more
extensive audit procedures and evidence to address potential misstatements.
2. Appropriateness of evidence
The appropriateness of evidence is determined by its relevance and reliability.
Auditors must consider:
 Relevance: Evidence should be directly related to the assertions being tested
and the audit objectives. Irrelevant evidence does not contribute meaningfully
to the audit.
 Reliability: Reliable evidence is trustworthy and free from bias. Factors such
as the source, the quality of internal controls, and the nature of the evidence
influence its reliability.
3. Completeness of evidence
Auditors must ensure that they have gathered evidence from a wide range of sources
and procedures to obtain a comprehensive view of the financial statements. The
evidence collected should cover all significant areas and assertions, and any gaps
should be addressed through additional procedures.
4. Reliability of audit evidence
The reliability of audit evidence is essential to ensuring that it is accurate, unbiased,
and can be trusted for making informed decisions.
Factors affecting the reliability of evidence include:
a. Source reliability
The source of the evidence significantly influences its reliability. Internal sources, such
as financial records generated by the organization itself, may be more reliable if the
organization maintains robust internal controls. External sources, while often reliable,
can vary in reliability based on the source’s reputation and independence.
b. Auditor’s independence
Auditors must maintain their independence and objectivity throughout the audit
process. The more independent the auditor, the more reliable the evidence they
gather. Independence helps prevent conflicts of interest and bias that could
compromise the quality of the evidence.
c. External vs. internal evidence
External evidence, such as third-party confirmations or industry reports, is generally
more reliable than internal evidence produced by the organization being audited.
However, internal evidence can still be reliable if the organization has strong internal
controls and processes in place to ensure data accuracy.
12.6 Special considerations in audit evidence
In some situations, auditors must apply special considerations when obtaining and
evaluating audit evidence. These considerations are necessary to address unique
challenges and risks that may arise during the audit process.
Key special considerations include:
1. Fraud detection and audit evidence
Auditors are responsible for detecting material misstatements resulting from fraud.
Special audit procedures, including forensic audit techniques, may be employed to
gather evidence of potential fraud. This involves a higher level of professional
skepticism and scrutiny.
2. Going concern assumption and audit evidence
When assessing an entity’s ability to continue as a going concern, auditors must
consider evidence related to the organization’s financial health and viability. Events or
conditions that cast doubt on the going concern assumption may require the auditor
to modify the audit opinion or include an explanatory paragraph in the audit report.
3. Audit evidence in a computerized environment
In today’s technology-driven world, auditors encounter unique challenges in gathering
evidence from computerized systems. They must assess the integrity, accuracy, and
reliability of electronic and digital evidence. The use of data analytics and advanced
technologies may also play a significant role in obtaining audit evidence.
These special considerations highlight the need for auditors to adapt their audit
procedures and evidence-gathering techniques to address specific risks and
complexities in the audit environment.
By addressing these considerations, auditors can enhance the quality and relevance
of the audit evidence obtained and provide more reliable audit opinions.
12.7 Emerging trends in collecting and processing audit evidence
The field of auditing is continually evolving, driven by technological advancements,
changes in business practices, and regulatory developments. Several emerging
trends in audit evidence are shaping the profession:
1. Artificial intelligence and data analytics
The use of artificial intelligence (AI) and data analytics is becoming increasingly
prevalent in auditing. Auditors can leverage AI to process vast datasets and identify
anomalies or patterns that may be indicative of fraud or errors. Data analytics can also
provide more in-depth insights into financial performance and internal controls.
2. Blockchain technology in auditing
Blockchain technology, with its transparent and tamper-resistant ledger, has the
potential to revolutionize auditing. It can provide a secure and immutable record of
financial transactions and other critical data. Auditors are exploring how blockchain
technology can be harnessed to enhance the reliability and integrity of audit evidence.
3. Continuous auditing and monitoring
Continuous auditing and monitoring involve real-time or near-real-time assessment of
financial transactions and controls. This approach allows auditors to identify issues
promptly rather than relying solely on periodic audits. It enhances the relevance and
timeliness of audit evidence.
4. Environmental, Social, and Governance (ESG) reporting
As organizations place a greater emphasis on sustainability and responsible business
practices, auditors are increasingly involved in auditing ESG data. Auditing ESG
disclosures requires specialized knowledge and additional audit procedures to ensure
the reliability of non-financial data.
5. Cybersecurity auditing
With the growing threat of cyberattacks and data breaches, cybersecurity auditing has
become a critical area of focus. Auditors must assess the adequacy of an
organization’s cybersecurity controls to protect sensitive data and financial
information.
These emerging trends reflect the evolving landscape of audit evidence and the need
for auditors to adapt to changing business environments and technologies.
Staying informed about these trends is crucial for auditors and audit firms to remain
effective and relevant in the field. Auditors should be prepared to leverage new tools
and methodologies to improve the quality and efficiency of their work.
12.8 IMPORTANCE OF AUDIT EVIDENCE
Audit evidence is crucial for several reasons, as it serves as the foundation upon which
auditors form their opinions on the financial statements of an organization. The
importance of audit evidence can be summarized as follows:
1. Basis for Opinion: Audit evidence forms the basis for auditors' opinions on the
fairness and reliability of the financial statements. It enables auditors to provide
assurance to stakeholders regarding the accuracy, completeness, and validity
of the financial information presented by the organization.
2. Verification of Transactions: Audit evidence helps auditors verify the
occurrence, completeness, and accuracy of transactions recorded in the
financial statements. By examining supporting documentation and conducting
tests, auditors ensure that transactions are properly recorded and reported in
accordance with relevant accounting standards and principles.
3. Assessment of Internal Controls: Audit evidence provides insights into the
effectiveness of the organization's internal control systems. By analyzing
internal evidence such as policies, procedures, and documentation, auditors
can assess the design and implementation of internal controls and identify any
weaknesses or deficiencies that may increase the risk of material misstatement
in the financial statements.
4. Detection of Errors and Fraud: Audit evidence helps auditors detect errors,
irregularities, or instances of fraud that may impact the accuracy of the financial
statements. By scrutinizing financial records, reconciling accounts, and
performing analytical procedures, auditors can identify discrepancies or
anomalies that require further investigation.
5. Support for Legal and Regulatory Compliance: Audit evidence provides
documentation to support the organization's compliance with legal and
regulatory requirements. By obtaining external evidence and reviewing relevant
contracts, agreements, and disclosures, auditors ensure that the organization
adheres to applicable laws, regulations, and industry standards.
6. Enhancement of Stakeholder Confidence: Reliable audit evidence enhances
stakeholder confidence in the integrity and transparency of the financial
reporting process. By providing independent verification of financial
information, auditors instill trust and credibility in the organization's financial
statements, thereby promoting investor confidence and facilitating informed
decision-making.
12.9 Reliability of Audit Evidence
The reliability of audit evidence is essential for auditors to form sound conclusions and
opinions on the financial statements of an organization. The reliability of audit evidence
can be influenced by various factors, including its source (internal or external) and its
nature (visual, documentary, or oral). Some general principles to consider when
assessing the reliability of audit evidence:
1. Source of Evidence:
 External evidence obtained from independent third parties is generally
more reliable than internal evidence generated within the organization.
Third-party confirmations, such as bank statements or vendor invoices,
carry greater credibility as they come from external sources.
 Internal evidence may be more reliable if the organization's internal
control systems are effective and trustworthy. When internal controls are
strong, auditors can have greater confidence in the reliability of internal
evidence.
2. Auditor's Obtained Evidence:
 Evidence collected directly by the auditor through observation,
inspection, or inquiry is often more reliable than evidence obtained from
the entity itself. Auditors' direct involvement in gathering evidence
enhances its credibility and reduces the risk of manipulation or bias.
3. Nature of Evidence:
 Documentary evidence, such as written records, contracts, invoices, and
financial statements, is generally more reliable than oral representations.
Written documentation provides a clear and permanent record of
transactions and communications, reducing the likelihood of
misinterpretation or manipulation.
 Visual evidence, such as physical observation or inspection of assets,
can also be reliable if properly documented and supported by other
evidence.
4. Best Evidence:
 "Best evidence" refers to the most compelling and persuasive form of
evidence that provides the highest level of assurance. While best
evidence may not always be attainable in audit situations, auditors
should strive to obtain the most reliable evidence available under the
circumstances.
 In the absence of suspicious circumstances, auditors typically rely on
prima facie evidence that is readily available and appears credible.
However, when faced with doubts or suspicions, auditors should seek
additional corroborative evidence to strengthen their conclusions.
12.10 METHODS TO OBTAIN AUDIT EVIDENCE
Methods used by auditors to obtain audit evidence can vary depending on the nature
of the audit engagement and the specific procedures being performed. Followings are
the common methods employed by auditors to gather evidence during compliance and
substantive procedures:
1. Inspection:
 Inspection involves examining documentation, records, or physical
assets to obtain audit evidence.
 Auditors may inspect financial statements, accounting records, invoices,
contracts, agreements, bank statements, physical inventory, and other
relevant documents to assess their accuracy and completeness.
 Through inspection, auditors verify the existence, authenticity, and
proper recording of transactions and events.
2. Observation:
 Observation entails witnessing processes, activities, or operations to
obtain audit evidence.
 Auditors may observe inventory counts, manufacturing processes, cash
handling procedures, or internal control activities to assess their
effectiveness and adherence to prescribed policies and procedures.
 By directly observing operations, auditors can assess the reliability of
internal controls and identify potential areas of risk or weakness.
3. Inquiry and Confirmation:
 Inquiry involves obtaining information from management, employees, or
other relevant parties through questioning or discussion.
 Auditors may interview personnel, including management, to gain
insights into business operations, internal controls, accounting policies,
and significant transactions.
 Confirmation involves obtaining written or oral representations from
external parties, such as customers, vendors, banks, or legal advisors,
to corroborate information provided by the entity.
 Confirmations are often used to verify accounts receivable balances,
bank balances, loans, or other financial arrangements.
4. Computation:
 Computation involves performing mathematical calculations or analyses
to verify the accuracy and consistency of financial data.
  Auditors may calculate financial ratios, perform trend analyses, or
conduct mathematical accuracy tests to assess the reasonableness of
financial statement amounts.
 Through computation, auditors can identify anomalies, errors, or
inconsistencies that may require further investigation or adjustment.
5. Analytical Review:
 Analytical review involves comparing financial data or performance
metrics over time or against industry benchmarks to identify significant
fluctuations, trends, or anomalies.
 Auditors may analyze financial statements, key performance indicators,
budgets, forecasts, or industry data to assess the reasonableness and
consistency of financial results.
 By conducting analytical reviews, auditors can identify areas of potential
risk, assess the reasonableness of account balances, and prioritize audit
procedures.
Self Assessment
1. What is Cybersecurity auditing?
2. Describe the Blockchain technology in auditing?
3. Describe the Artificial intelligence and data analytics?
4. How the Reliability of Audit Evidence is checked?

12.11 Summary
In auditing, procedures are employed to obtain evidence that supports the assessment
of financial statements' accuracy and compliance. Various methods, such as
inspection, observation, inquiry, and analytical procedures, are utilized to gather audit
evidence. The reliability and sufficiency of evidence are critical for auditors to draw
valid conclusions. Emerging trends involve leveraging technology for data analytics
and forensic techniques to enhance evidence collection and processing. Ultimately,
the importance of audit evidence lies in its role in substantiating audit opinions and
providing stakeholders with confidence in the integrity of financial reporting. Ensuring
evidence reliability through careful evaluation and diverse collection methods is
paramount in maintaining audit quality.

12.12 Glossary
1. Best Evidence:"Best evidence" refers to the most compelling and persuasive
form of evidence that provides the highest level of assurance. While best
evidence may not always be attainable in audit situations, auditors should strive
to obtain the most reliable evidence available under the circumstances.
 2. Cybersecurity auditing: With the growing threat of cyberattacks and data
breaches, cybersecurity auditing has become a critical area of focus. Auditors
must assess the adequacy of an organization’s cybersecurity controls to protect
sensitive data and financial information.
3. Continuous auditing and monitoring: Continuous auditing and monitoring
involve real-time or near-real-time assessment of financial transactions and
controls. This approach allows auditors to identify issues promptly rather than
relying solely on periodic audits. It enhances the relevance and timeliness of
audit evidence.
4. Artificial intelligence and data analytics: The use of artificial intelligence (AI)
and data analytics is becoming increasingly prevalent in auditing. Auditors can
leverage AI to process vast datasets and identify anomalies or patterns that
may be indicative of fraud or errors. Data analytics can also provide more in-
depth insights into financial performance and internal controls.

12.13 Answers: Self Assessment

1). Please check section 12.7 2). Please check section 12.7 3). Please
check section 12.7 4). Please check section 12.9
12.14 Terminal Questions.

1. What are the primary audit procedures used to obtain audit evidence?
2. Describe the typical steps involved in conducting audit procedures.
3. What are the different types of audit evidence that auditors may encounter? How
do auditors evaluate the sufficiency and appropriateness of audit evidence?
4. Why is audit evidence considered the cornerstone of the audit process? What are
the various methods auditors use to obtain audit evidence?
12.15 Answers: Terminal Questions:
1). Please check section 12.2 2). Please check section 12.3 3). Please
check section 12.5 and 12.6 4). Please check section 12.8 and 12.9

12.16 Suggested Readings

1. Dalal, Chetan. (2015). Novel & Conventional Methods of Audit, Investigation
and Fraud Detection. Wolters Kluwer India Pvt. Ltd.
2. Gupta, Sanjeev (2016). Corporate Frauds and their Regulation in India. Bharat
Law House Pvt. Ltd
3. Kaul, Vivek (2013). Easy Money. Sage Publications, New Delhi.
4. Manning, George A. (2010). Financial Investigation and Forensic Accounting.
CRC Press: Taylor & Francis Group.
5. Sharma, B. R. (2014). Bank Frauds. Universal Law Publishing, New Delhi
 Lesson – 13
INTERNAL CONTROL
Structure:
13.0 Learning Objectives
13.1 Introduction
13.2 Concept of internal control
13.3 Objectives of internal control
13.4 Components of internal controls
13.5 Environment of internal control
13.6 Inherent limitations of internal control
13.7 Internal control and management
13.8 Internal control and the auditor
13.9 Preliminary assessment of control risk
13.10 Review of internal control by the auditor
13.11 Internal check
13.12 Internal audit
13.13 Objectives of internal audit
13.14 Summary
13.15 Glossary
13.16 Answers: Self Assessment
13.17 Terminal Questions
13.18 Answers: Terminal Questions:
13.19 Suggested Readings
13.0 Learning Objectives
After studying the lesson, you should be able to:-
1. Concept of internal control
2. Internal control and management
3. Review of internal control by the auditor
4. Internal check

13.1 Introduction
Human activity in the realm of business is inherently complex and has become even
more intricate with the advancement of technology in society. The formalization of
the concept of internal control within business administration is a relatively recent
development.
In the context of business, control serves as a recognized mechanism for optimizing
resource utilization and maximizing profits. Every aspect of business operations
relies on human agents and equipment. Therefore, effective supervision is
necessary to ensure that assigned tasks are executed properly and to prevent
avoidable wastage and losses from diminishing the fruits of enterprise.

13.2 CONCEPT OF INTERNAL CONTROL

According to AAS-6 (Revised) entitled, “Risk Assessment and Internal Control”, the
system of internal control may be defined as “the plan of organization and all the
methods and procedures adopted by the management of an entity to assist in
achieving management’s objective of ensuring, as far as practicable, the orderly and
efficient conduct of its business, including adherence to management policies, the
safeguarding of assets, prevention and detection of fraud and error, the accuracy
and completeness of the accounting records, and the timely preparation of reliable
financial information. The system of internal control extends beyond those matters
which relate directly to the functions of the accounting system. The internal audit
function constitutes a separate component of internal control with the objective of
determining whether other internal controls are well designed and properly
operated.”

13.3 OBJECTIVES OF INTERNAL CONTROL

AAS-6 lists the following objectives of internal control in relation to an accounting
systems. The objectives of internal control within an organization are multifaceted
and crucial for ensuring effective and efficient operations. Some key objectives:
1. Encouraging adherence to prescribed policies: Internal control systems
are implemented to ensure that the entity's plans, policies, and procedures
are followed diligently, promoting consistency and compliance across all
levels of the organization.
2. Preventing frauds and errors: A primary objective of internal controls is to
detect and prevent frauds and errors by establishing checks and balances
within the organization's processes and systems.
3. Promoting operational efficiency: Internal controls aim to streamline
operations, minimize duplication of efforts, and discourage wasteful practices,
thereby enhancing overall operational efficiency.
4. Safeguarding assets and records: Internal control systems are designed to
protect the organization's assets and records from unauthorized access, use,
or disposition, safeguarding against potential losses or misuse.
 5. Providing accurate and reliable data: Internal controls ensure that
transactions are accurately recorded, classified, and reported in the financial
statements, contributing to the integrity and reliability of the organization's
financial data.
6. Assisting in timely preparation of financial information: Internal control
systems facilitate the timely preparation of financial statements by ensuring
that relevant data is recorded, processed, and reported in a timely manner,
enabling management to make informed decisions based on up-to-date
information.

13.4 COMPONENTS OF INTERNAL CONTROLS

The components of internal controls play a crucial role in ensuring the integrity,
reliability, and effectiveness of an organization's operations. Here are the key
components:
1. Control environment: This sets the tone for the organization regarding the
importance of internal controls and integrity. It involves the commitment of
management and the board of directors to establish and maintain a culture of
ethical behavior and accountability.
2. Risk assessment: Regular assessment and identification of potential risks or
losses are essential. This allows the organization to implement appropriate
controls to mitigate risks and ensure compliance with regulations.
3. Monitoring: Continuous monitoring of the internal control system is
necessary to ensure its ongoing effectiveness. This involves periodic
evaluations, updates, and adjustments to address changing risks and
business environments.
4. Information and communication: Clear communication of roles,
responsibilities, and expectations is vital for effective internal controls.
Employees should be well-informed about policies, procedures, and
compliance requirements to perform their duties effectively.
5. Control activities: These are the specific policies, procedures, and actions
implemented to maintain the integrity of internal controls and ensure
compliance with regulations. They include preventive and detective measures
to identify and address potential issues.
6. Compliance with laws and regulations: Adherence to relevant laws,
regulations, and standards is essential for ensuring legal and regulatory
compliance. Organizations must stay updated on changes in regulations and
implement measures to ensure compliance in their financial activities.
7. Separation of duties: Distributing responsibilities among different individuals
helps prevent errors and fraud by ensuring that no single individual has
 control over all aspects of a transaction. Separation of duties involves dividing
authorization, custody, and record-keeping roles to create checks and
balances.
8. Physical controls: Implementation of physical security measures is
necessary to safeguard assets such as cash, inventory, and equipment. This
includes measures such as secure storage facilities, access controls, and
surveillance systems to protect against theft, loss, or unauthorized access.

13.5 ENVIRONMENT OF INTERNAL CONTROL

The environment in which internal control operates has an impact on the
effectiveness of the specific control procedures. The control environment means the
overall attitude awareness and actions of directors and managements regarding the
internal control system and its importance in the entity. A strong control environment,
for example, one with tight budgetary controls and an effective internal audit function,
can significantly complement specific control procedures. However, a strong
environment does not, by itself, ensure the effectiveness of the overall system of
internal control. The internal control environment may be affected by :
(a) Organisational structure : The organisational structure of an entity serves as a
framework as practicable, to preclude an individual from overriding the control
system and should provide for the segregation of incompatible functions. Functions
are incompatible if their combination may permit the commitment and concealment
of fraud or error. Functions that typically are segregated are access to assets,
authorisation, execution of transactions, and record keeping.
(b) Management supervision : Management is responsible for devising and
maintaining the system of internal control. In carrying out its supervisory
responsibility, management should review the adequacy of internal control on a
regular basis to ensure that all significant controls are operating effectively. When an
entity has an internal audit department, management may delegate to it some of its
supervisory functions, especially with respect to the review of internal control. This
particular internal audit function constitutes a separate component of internal control
undertaken by specially assigned staff within the entity with the objective of
determining whether other internal controls are well designed and properly operated.
(c) Personnel : The proper functioning of any system depends on the competence
and honesty of those operating it. The qualifications, selection and training as well as
the personal characteristics of the personnel involved are important features in
establishing and maintaining a system of internal control. It is clear from above that
internal control means not only internal check and internal audit but it encompasses
the whole system of accounting as well as non-accounting controls established by
the management in order to carry on the business of the company in an orderly
manner, safeguard its assets and secure as far as possible the accuracy and
reliability of its records. It also follows that a good system of internal control should
comprise among other the following;
(i) the proper allocation of functional responsibilities within the organisation;
(ii) proper operating and accounting procedures to ensure the accuracy and reliability
of accounting data, efficiency in operation and safeguarding of assets;
(iii) quality of personnel commensurate with their responsibilities and duties; and
finally
(iv) the review of the work of one individual by another whereby the possibility of
fraud or error in the absence of collusion is minimised.

13.6 INHERENT LIMITATIONS OF INTERNAL CONTROL

These are indeed common limitations of internal controls that organizations should
be aware of:
1. Reasonable Assurance: Internal controls provide reasonable, not absolute,
assurance. They cannot guarantee the prevention or detection of all errors,
fraud, or non-compliance. There is always a possibility of controls failing or
being circumvented.
2. Human Error: Internal controls are dependent on human action and
judgment, making them susceptible to errors or omissions. Employees may
inadvertently make mistakes or intentionally bypass controls for personal gain,
leading to control failures.
3. Resistance to Change: Implementing internal controls often requires
changes in organizational processes and procedures, which may face
resistance from employees accustomed to existing practices. Resistance to
change can hinder the effectiveness of control implementation and
enforcement.
4. Cost: Establishing and maintaining effective internal controls can be costly,
involving expenses related to identifying control needs, designing control
systems, training personnel, and monitoring compliance. The financial
investment required may outweigh the benefits, particularly for smaller
organizations with limited resources.
5. Continuous Monitoring and Follow-Up: Internal controls require ongoing
monitoring and follow-up to ensure they remain effective over time. This
process demands significant time and resources, detracting from other value-
added activities. Failure to consistently monitor and enforce controls can
result in control weaknesses or lapses.

13.7 INTERNAL CONTROL AND MANAGEMENT

Before any discussion on the effect of internal control on the auditor’s work is
undertaken it is necessary to appreciate that devising and installation of internal
control is the responsibility of the management. Following are the key points to
consider:
1. Responsibility of Management: Management holds the primary
responsibility for establishing internal controls within the organization. This
includes safeguarding assets, recording transactions accurately, and ensuring
the smooth operation of the business.
2. Adequate Accounting System: According to AAS-1, management is
accountable for maintaining an adequate accounting system with internal
controls appropriate to the size and nature of the business.
3. Uniform Treatment and Operation: Internal control systems ensure uniform
treatment and operation within the organization. They establish lines of
authority and specify tasks for each employee.
4. Review by Management: Management should periodically review the internal
control system to ensure its effectiveness. This includes verifying whether
management policies are being properly interpreted and implemented,
assessing the need for revisions due to changing circumstances, and
promptly addressing any breakdowns in the system.
5. Internal Audit Function: It is recommended that management also
establishes an internal audit function as an independent check on the
effectiveness of internal controls. The internal audit team monitors the actual
operation of the internal control system, identifies deviations or non-
compliances, and reports them to management for corrective action.

13.8 INTERNAL CONTROL AND THE AUDITOR

Auditing and Assurance Standard (AAS) 6, “Risk Assessments and Internal Control”
establishes standards on the procedures to be followed to obtain an understanding
of the accounting and internal control systems and on audit risk and its components:
inherent risk, control risk and detection risk. As per this Standard, the auditor should
obtain an understanding of the accounting and internal control systems sufficient to
plan the audit and develop an effective audit approach. The auditor should use
professional judgement to assess audit risk and to design audit procedures to ensure
that it is reduced to an acceptably low level.
"Audit risk" means the risk that the auditor gives an inappropriate audit opinion when
the financial statements are materially misstated. Audit risk has three components:
inherent risk, control risk and detection risk.
"Inherent risk" is the susceptibility of an account balance or class of transactions to
misstatement that could be material, either individually or when aggregated with
misstatements in other balances or classes, assuming that there were no related
internal controls. To assess To assess inherent risk, the auditor would use
professional judgement to evaluate numerous factors, having regard to his
experience of the entity from previous audit engagements of the entity, any controls
established by management to compensate for a high level of inherent risk, and his
knowledge of any significant changes which might have taken place since his last
assessment. Examples of such factors are:
At the Level of Financial Statements:
1. Integrity and Experience of Management: The integrity and experience of
management can influence the preparation of financial statements.
Inexperienced or unethical management may increase the risk of
misstatement.
2. Unusual Pressures on Management: External factors, such as industry
challenges or financial difficulties, may pressure management to misstate
financial statements.
3. Nature of Entity's Business: Factors such as technological obsolescence,
capital structure complexity, and presence of related parties can impact
financial statement reliability.
4. Industry Factors: Economic conditions, competition, technological changes,
and accounting practices specific to the industry can affect financial statement
accuracy.
At the Level of Account Balance and Class of Transactions:
1. Quality of Accounting System: The effectiveness of the accounting system
influences the accuracy of account balances and transactions.
2. Likelihood of Misstatement: Certain accounts may be more susceptible to
misstatement due to past adjustments, estimation requirements, or
complexity.
3. Complexity of Transactions: Complex transactions may require expert
judgment, increasing the risk of misstatement.
4. Judgment in Determining Balances: Accounts requiring significant
judgment in their determination may be more prone to misstatement.
5. Susceptibility of Assets to Loss or Misappropriation: Assets that are
highly desirable or easily movable, such as cash, are at higher risk of
misappropriation.
6. Unusual or Complex Transactions: Unusual or complex transactions,
especially near period-end, may increase the risk of misstatement.
7. Transactions Not Subjected to Ordinary Processing: Transactions that
bypass regular processing procedures may be at higher risk of misstatement.
Control Risk: Control risk refers to the risk that misstatements, whether individually
or in aggregate, will not be prevented or detected and corrected by the accounting
and internal control systems in a timely manner. It encompasses the effectiveness of
internal controls in mitigating the risk of material misstatement.

13.9 Preliminary Assessment of Control Risk

The preliminary assessment of control risk is a crucial step in the audit process,
involving the evaluation of an entity's accounting and internal control systems to
determine their effectiveness in preventing or detecting material misstatements. Key
points regarding the preliminary assessment of control risk:
1. Basis of Assessment: The assessment is made on the assumption that the
controls generally operate as described and are effective throughout the
period of intended reliance. However, it's recognized that there will always be
some level of control risk due to inherent limitations in any accounting and
internal control system.
2. Factors Influencing High Control Risk Assessment: The auditor may
assess control risk at a high level for some or all assertions under certain
circumstances:
 When the entity's accounting and internal control systems are not
effective.
 When evaluating the effectiveness of the entity's systems would not be
efficient.
3. Obtaining Sufficient Audit Evidence: In cases where control risk is
assessed at a high level, the auditor relies more on substantive procedures to
obtain sufficient appropriate audit evidence. This includes gathering evidence
from substantive testing and any audit work conducted during the preparation
of financial statements.
4. Conditions for Lowering Control Risk Assessment: The preliminary
assessment of control risk for a financial statement assertion should be high
unless:
 The auditor identifies internal controls relevant to the assertion that are
likely to prevent or detect and correct material misstatements.
 The auditor plans to perform tests of control to support the
assessment.
13.10 REVIEW OF INTERNAL CONTROL BY THE AUDITOR
The review of internal controls by the auditor is a crucial aspect of the overall audit
process. it's indispensable and what the auditor aims to achieve through this review:
1. Ensuring Adequacy of Accounting System: The auditor needs reasonable
assurance that the accounting system is adequate and that all necessary
 accounting information has been accurately recorded. Reviewing internal
controls helps the auditor assess whether the accounting system is capable of
achieving this objective.
2. Detecting Errors and Fraud: By gaining an understanding of the internal
control system, the auditor can assess whether errors and frauds are likely to
be detected in the ordinary course of business operations. Effective internal
controls should help prevent, detect, and correct such issues.
3. Evaluating Operational Effectiveness: The auditor evaluates whether the
internal control system is operating effectively as planned by the
management. This involves assessing whether controls are being
implemented consistently and whether they are achieving their intended
objectives.
4. Assessing Internal Audit Function: The review of internal controls also
includes an evaluation of the internal audit department, if one exists. The
auditor assesses whether the internal audit function is effective in providing
independent and objective evaluations of internal controls and business
processes.

13.11 INTERNAL CHECK

Internal check has been defined by the Institute of Chartered Accountants of
England and Wales as the “checks on day-to-day transactions which operate
continuously as part of the routine system whereby the work of one person is proved
independently or is complementary to the work of another, the object being the
prevention or early detection of errors or fraud”. Internal check is a part of the overall
internal control system and operates as a built-in device as far as the staff
organisation and job allocation aspects of the control system are concerned. A
system of internal check in accounting implies organisation of system of book
keeping and arrangement of staff duties in such a manner that no one
person can completely carry through a transaction and record every aspect thereof.
The essential elements of a goods system of internal check are :
(i) Existence of checks on the day-to-day transaction.
(ii) Which operate continuously as a part of the routine system.
(iii) Whereby the work of each person is either proved independently or is made
complementary to
the work of another.
Its objective is to prevent and to bring about a speedy detection of frauds, wastes
and errors. The system is based on the principle that when the performance of each
individual in an organisation, normally and automatically, is checked by another, the
chances of occurrence of errors, or their remaining undetected, are greatly reduced;
also that, when two or more persons essentially must combine either to receive or to
make a payment, there will be lesser possibility of a fraud being perpetrated by them.
For instance, let us consider the simple case of a trading concern. It would have a
cashier to receive cash who also shall issue receipts. There would be separate
persons to write the cash book and ledgers, the stores accounts would be
maintained by the store-keeper, and so on; there would be thus a large number of
functionaries. In such an organisation, for putting through a transaction of sale, first
of all a bill would be prepared and the same would be checked and authorised by the
sales manager; afterwards the cashier would collect the sale price and finally the
store-keeper would issue the goods, on being satisfied that each of the functionaries
earlier to him had carried out his part of duties.

General Considerations in Framing a System of Internal Check

In framing a system of internal check, several general considerations should be

taken into account to ensure its effectiveness and reliability. These considerations
include:
6. Segregation of Duties: No single individual should have sole control over
critical aspects of the business. Every employee's actions should be subject to
review or verification by another.
7. Rotation of Duties: Employees' responsibilities should be periodically rotated
to prevent any one individual from performing the same function for an
extended period. This helps in detecting any irregularities that may occur due
to familiarity or complacency.
8. Annual Leave Requirement: Employees should be encouraged to take
annual leave, as this can uncover any fraudulent activities that may have
been concealed while they were present. The absence of an employee may
reveal discrepancies or irregularities in their absence.
9. Separation of Custody and Accounting: Individuals responsible for physical
assets should not have access to accounting records. This prevents potential
conflicts of interest and reduces the risk of misappropriation.
10. Asset Controls and Inspection: There should be controls in place for each
significant class of assets, coupled with periodic inspections to verify their
physical condition. This ensures that assets are properly safeguarded and
accounted for.
11. Use of Mechanical Devices: Mechanical devices such as automatic cash
registers can help prevent loss or misappropriation of cash by providing
accurate records and reducing the opportunity for manipulation.
12. Budgetary Control and Reconciliation: Businesses employing budgetary
control should have a separate team for collecting statistical data, which
 should be compared with corresponding financial figures. Any significant
variances should be investigated and reconciled to ensure accuracy and
reliability.
13. Suspension of Trading Activities during Stock-Taking: Ideally, trading
activities should be suspended during the stock-taking process at the end of
the year. This ensures that the focus remains solely on the accurate
assessment and evaluation of inventory. Involving staff from various sections
of the organization in the stock-taking process helps minimize the risk of
manipulation or misstatement.
14. Distribution of Financial and Administrative Powers: Financial and
administrative powers should be distributed among different officers in a
balanced and judicious manner. This helps prevent any individual from having
excessive authority, which could lead to misuse or abuse of power. Periodic
reviews of how these powers are exercised can help ensure accountability
and transparency.
15. Periodical Verification and Testing: Procedures should be established for
the periodic verification and testing of different sections of accounting records
to ensure their accuracy and reliability. This may involve conducting audits,
reconciliations, and other checks to identify and rectify any discrepancies or
errors promptly.
16. Regular Review of Accounting Procedures: Accounting procedures should
be subject to regular review and evaluation to ensure their continued
effectiveness. Over time, changes in business operations, regulations,
technology, or other factors may render existing procedures obsolete or
inadequate. Regular reviews help identify areas for improvement and ensure
that the internal check system remains robust and relevant.

13.12 INTERNAL AUDIT

Determine whether resources are being used effectively and whether the
organization's objectives are being achieved. This may involve evaluating the
efficiency of internal processes, identifying areas for improvement, and making
recommendations to management for enhancing operational performance.
Internal audit also encompasses a broader range of activities beyond financial
record-keeping. It may involve assessing risks across various functions of the
organization, such as operations, compliance, and strategic planning. Internal
auditors may conduct reviews of internal controls, assess compliance with laws and
regulations, investigate allegations of fraud or misconduct, and provide insights into
emerging risks and opportunities.
Unlike internal check, which is primarily focused on ensuring the accuracy and
reliability of accounting records through established procedures, internal audit takes
a more holistic approach to evaluating the overall effectiveness and efficiency of the
organization's operations and governance processes. It serves as a valuable tool for
management to gain assurance that internal controls are operating effectively and
that the organization is achieving its objectives in a sustainable manner.
13.13 OBJECTIVES OF INTERNAL AUDIT
Internal audit serves as an independent and objective function within an
organization, aiming to provide continuous assessment and improvement of its
operations. The primary objectives of internal audit can be summarized as follows:
1. Verification of Financial Records: Internal audit verifies the accuracy and
authenticity of financial accounting and statistical records presented to the
management, ensuring the reliability of financial information.
2. Adherence to Standard Practices: Internal audit ensures that the
organization follows standard accounting practices established for accurate
and consistent financial reporting.
3. Authorization of Transactions: It confirms that proper authorization is
obtained for every acquisition, retirement, and disposal of assets, preventing
unauthorized activities.
4. Legitimacy of Liabilities: Internal audit ensures that liabilities are incurred
only for legitimate activities of the organization, avoiding unauthorized or
fraudulent obligations.
5. Enhancement of Internal Check System: It analyzes and improves the
system of internal check, ensuring its effectiveness, soundness, and efficiency
in preventing errors and fraud.
6. Fraud Prevention and Detection: Internal audit facilitates the prevention and
detection of frauds by identifying vulnerabilities and recommending controls to
mitigate risks.
7. Asset Protection and Utilization: It examines the protection afforded to
assets and evaluates their efficient utilization, safeguarding against
misappropriation or misuse.
8. Special Investigations: Internal audit conducts special investigations as
required by management to address specific concerns or issues.
9. Channel for New Ideas: It provides a channel for employees to bring new
ideas or concerns to the attention of management, fostering innovation and
improvement in organizational processes.
10. Review of Internal Control System: Internal audit reviews the operation of
the overall internal control system, identifying material departures and non-
compliances to ensure effectiveness and efficiency. It aims to strengthen
weak controls and eliminate unnecessary ones to make the entire control
system robust and economical.
According to AAS-7, the scope and objectives of internal audit can vary depending
on factors such as the size and structure of the entity and the specific requirements
of its management. However, internal audit typically operates in the following areas:
(a) Review of Accounting System and Internal Controls: Internal audit may be
tasked with reviewing the adequacy of the accounting system and related internal
controls. This includes monitoring the operation of controls, identifying weaknesses
or deficiencies, and recommending improvements to management.
(b) Examination of Financial and Operating Information: Internal audit may
examine the processes used to identify, measure, classify, and report financial and
operating information. This could involve detailed testing of transactions, balances,
and procedures to ensure accuracy and reliability.
(c) Evaluation of Economy, Efficiency, and Effectiveness: Internal audit may
assess the economy, efficiency, and effectiveness of the organization's operations,
including non-financial controls. While external auditors may be interested in the
results of such audits, particularly if they impact the reliability of financial records, the
primary focus is on internal management.
(d) Physical Examination and Verification: Internal audit may conduct physical
examinations and verifications to ensure the existence and condition of tangible
assets owned by the entity. This could involve inspecting physical assets such as
inventory, equipment, and property to confirm their presence and condition.
Self Assessment
1. What is concept of internal control?
2. Describe the environment of internal control?
3. Describe the relationship between internal control and the auditor?
4. What are the Preliminary Assessment of Control Risk

13.14 Summary
Internal control encompasses the processes and procedures implemented by an
organization to safeguard assets, ensure accuracy in financial reporting, and
promote operational efficiency. Its objectives include safeguarding assets, ensuring
accuracy and reliability of financial information, promoting operational efficiency, and
compliance with laws and regulations. Components include control environment, risk
assessment, control activities, information and communication, and monitoring.
Despite its benefits, internal control has inherent limitations, and its effectiveness
depends on management's commitment. Internal control is crucial for both
management and auditors, aiding in risk assessment and review processes. Internal
audit further evaluates and improves control effectiveness, ensuring alignment with
organizational objectives.
13.15 Glossary
 1. INTERNAL CONTROL: According to AAS-6 (Revised) entitled, “Risk
Assessment and Internal Control”, the system of internal control may be
defined as “the plan of organization and all the methods and procedures
adopted by the management of an entity to assist in achieving management’s
objective of ensuring
2. Control environment: This sets the tone for the organization regarding the
importance of internal controls and integrity. It involves the commitment of
management and the board of directors to establish and maintain a culture of
ethical behavior and accountability.
3. Control Risk: Control risk refers to the risk that misstatements, whether
individually or in aggregate, will not be prevented or detected and corrected
by the accounting and internal control systems in a timely manner. It
encompasses the effectiveness of internal controls in mitigating the risk of
material misstatement.
4. 11 INTERNAL CHECK: Internal check has been defined by the Institute of
Chartered Accountants of England and Wales as the “checks on day-to-day
transactions which operate continuously as part of the routine system
whereby the work of one person is proved independently or is complementary
to the work of another, the object being the prevention or early detection of
errors or fraud”.
13.16 Answers: Self Assessment
1). Please check section 13.2 2). Please check section 13.5 3). Please
check section 13.8 4). Please check section13.9
13.17 Terminal Questions
1. What is the concept of internal control, and What are the main objectives of
internal control in an organization?
2. Identify and explain the key components of internal controls and Describe the role
of the organizational environment in influencing internal control effectiveness.
3. What is the significance of a preliminary assessment of control risk in the audit
process? .
4. Discuss the objectives of an internal audit and its role in organizational
governance.
13.18 Answers: Terminal Questions:
1). Please check section 13.2 and 13.3 2). Please check section 13.4 and 13.5
3). Please check section 13.9 4). Please check section 13.13
13.19 Suggested Readings
1. Dalal, Chetan. (2015). Novel & Conventional Methods of Audit, Investigation
and Fraud Detection. Wolters Kluwer India Pvt. Ltd.
2. Gupta, Sanjeev (2016). Corporate Frauds and their Regulation in India. Bharat
Law House Pvt. Ltd
3. Kaul, Vivek (2013). Easy Money. Sage Publications, New Delhi.
4. Manning, George A. (2010). Financial Investigation and Forensic Accounting.
CRC Press: Taylor & Francis Group.
5. Sharma, B. R. (2014). Bank Frauds. Universal Law Publishing, New Delhi
 Lesson – 14
Vouching
Structure:
14.0 Learning Objectives
14.1 Introduction
14.2 Audit of cash transactions
14.3 Steps involved in the verification of the system of internal control
14.4 Objectives of vouching
14.5 Principles or techniques of vouching
14.6 Points to be noted while vouching
14.7 Vouching of trading transactions
14.8 Auditor’s duties while vouching credit purchases
14.9 Vouching of purchase returns
14.10 Vouching of purchase returns
14.11 Importance of vouchings
14.12 Summary
14.13 Glossary
14.14 Answers: Self Assessment
14.15 Terminal Questions
14.16 Answers: Terminal Questions:
14.17 Suggested Readings
14.0 Learning Objectives
After studying the lesson, you should be able to:-
1. Audit of cash transactions
2. Vouching of trading transactions
3. Vouching of purchase returns
4. Importance of vouching
14.1 Introduction
The act of examining vouchers is referred to as vouching. It is the practice followed
in an audit, with the objective of establishing the authenticity of the transactions
recorded in the primary books of account. It essentially consists of verifying a
transaction recorded in the books of account with the relevant documentary evidence
and the authority on the basis of which the entry has been made; also confirming
that the amount mentioned in the voucher has been posted to an appropriate
account which would disclose the nature of the transaction on its inclusion in the final
statements of account. On these considerations, the essential points to be borne in
mind while examining a voucher are:
(i) that the date of the voucher falls within the accounting period;
(ii) that the voucher is made out in the client’s name;
(iii) that the voucher is duly authorised;
(iv) that the voucher comprised all the relevant documents which could be expected
to have been received or brought into existence on the transactions having been
entered into, i.e., the voucher is complete in all respects; and
(v) that the account in which the amount of the voucher is adjusted is the one that
would clearly disclose the character of the receipts or payments posted thereto on its
inclusion in the final accounts.

14.2 AUDIT OF CASH TRANSACTIONS

General Considerations
The transaction and that proper authorization has been obtained before recording
the transaction. Additionally, the auditor should verify the physical existence of cash
on hand through count procedures and reconcile the cash balance per the books
with the actual cash counted.
In reviewing the system of accounting and internal control, the auditor should assess
the effectiveness of controls related to cash transactions. This includes evaluating
procedures for receiving, depositing, and disbursing cash, as well as segregation of
duties to prevent fraud and error. Any weaknesses or deficiencies in the internal
control system should be identified and reported to management for corrective
action.
Furthermore, the auditor should examine individual cash transactions to ensure they
have been accurately recorded and properly authorized. This involves tracing
transactions from source documents to accounting records, verifying mathematical
accuracy, and confirming compliance with organizational policies and procedures.
Overall, thorough verification of cash transactions requires a combination of
reviewing the system of internal control, examining individual transactions, and
performing physical verification of cash balances. This ensures that cash
transactions are accurately recorded, properly authorized, and adequately
safeguarded against fraud and error.
It includes:
1. INTERNAL CONTROL SYSTEM
The internal control system plays a crucial role in ensuring the integrity and reliability
of financial reporting. Its inclusion in the final accounts provides transparency
regarding the measures in place to safeguard assets, prevent fraud and errors, and
facilitate effective decision-making. Here's how the nature of the internal control
system is truly disclosed in the final accounts:
1. Protection Against Losses: By disclosing the internal control system in the
final accounts, stakeholders are informed about the entity's efforts to mitigate
risks such as fraud, waste, and mistakes. This transparency instills confidence
among investors, creditors, and other stakeholders regarding the reliability of
the financial information presented.
2. Accurate Recording of Transactions: The internal control system ensures
that transactions are accurately recorded in the books of accounts. By
disclosing this system in the final accounts, users gain assurance that the
reported financial data reflects the true economic substance of the entity's
operations and transactions.
3. Facilitation of Policy Decisions: The internal control system not only
safeguards assets but also enables the entity to make informed policy
decisions related to planning and operations. Disclosing this system in the
final accounts indicates the entity's commitment to sound governance
practices and strategic decision-making processes.
14.3 Steps involved in the verification of the system of Internal Control

(a) Study of Accounting Routines: The auditor begins by studying the accounting
routines to ensure that they effectively account for all receipts of cash, materials, or
other assets, and prevent any unauthorized payments or disposals.
(b) Examination of Financial Powers: The auditor examines the financial powers
vested in different individuals within the organization and the conditions under which
they can exercise these powers to prevent misuse or unauthorized transactions.
(c) Supervision Evaluation: The auditor evaluates the adequacy of supervision
over various managerial and accounting functions to ensure that responsibilities are
properly assigned and monitored.
(d) Mechanical Aids Inspection: The auditor checks whether the organization
employs any mechanical aids, such as cash registers or security systems, to ensure
proper accounting of receipts and prevent pilferage or theft of assets.
(e) Observation of Accounting System: The auditor observes the working of the
accounting system and performs procedural tests to verify if the checks and counter-
checks envisaged by the internal control system are being correctly applied.
(f) Reconciliation and Reporting: The auditor confirms the existence of a system
for periodically reconciling the physical existence of assets with their balances in the
books and for reconciling balances of customers, creditors, bankers, and other
parties. Any discrepancies noticed must be reported and adjusted.
(g) Periodic Review and Policy Implementation: The auditor verifies that the
internal control system is periodically reviewed and necessary changes are made to
address any identified weaknesses or loopholes. Additionally, the auditor ensures
that policy decisions made by management are effectively translated into practice.
It's crucial for auditors to remember that a comprehensive internal control system is
essential for providing the expected protection against fraud, errors, and
misappropriation. By meticulously verifying the system of internal control, auditors
can provide assurance regarding its effectiveness in safeguarding the organization's
assets and ensuring the integrity of its financial reporting processes.

2. Correctness of book-keeping records : The audit of cash transactions entails

detailed checking of
the record of transactions for verifying that entries have been made in the books of
account
according to the system of accounting which is being regularly followed and the
books of account
balance as under :
(a) Vouching;
(b) Posting;
(c) Casting, cross-casting and tracing; and
(d) Reconciliation, scrutiny, confirmation, etc.

3. Observance of accounting principles : It is of utmost importance that the

transactions should be recorded in the books of accounts having regard to the
principles of accounting. The principles include :
(a) Distinction being drawn between capital expenditure and revenue expenditure;
(b) Distinction being drawn between capital receipts and revenue receipts;
(c) The expenses or cost should be matched to the income or benefit;
(d) The expenditure and income should be treated on accrual basis;
(e) That the fixed assets should be depreciated on a consistent basis;
(f) That book debts should be valued only at realisable amounts;
(g) That fictitious assets are written off at the earliest; and
(h) Outstanding assets and liabilities have been properly adjusted.
4. Evidence of Transactions : Entries in the account books are usually made on
the basis of some kind of documentary evidence. It generally exists in a variety of
forms e.g., payee’s receipts, suppliers’ invoices, statements of account of parties,
minutes of Board of Directors or of the shareholders, contracts, documents of title,
entries in subsidiary ledger,etc. The process of verification of entries in the books of
account with the documentary evidence is referred to as vouching. As stated earlier,
documentary evidence is of two types : (1) Internal; and (2) External.

14.4 OBJECTIVES OF VOUCHING

Main objective of vouching is to find out the regularity or irregularity of transactions,
frauds and errors. Regularity means maintaining record and performing the work
compliance with the rules, regulation and law. But irregularity means doing the work
crossing to the line of rules, regulation and laws. Some of the major objectives of
vouching are given below:
1. Detection of Errors and Frauds: Vouching helps auditors detect errors and
fraudulent activities by verifying each transaction against supporting evidence.
It is instrumental in uncovering discrepancies and inconsistencies that may
indicate errors or intentional misstatements in financial records.
2. Verification of Transactions: By meticulously examining supporting
documents, auditors can verify the authenticity and accuracy of transactions
recorded in the books of accounts. This process ensures that only legitimate
business transactions are included in the financial statements.
3. Identification of Unrecorded Transactions: Vouching also helps auditors
identify any transactions that may have been omitted or left unrecorded in the
books. By cross-referencing vouchers and other documentary evidence,
auditors can uncover any missing transactions and ensure their proper
inclusion in the financial records.
4. Authorization of Transactions: Auditors use vouching to ascertain whether
all transactions have been duly authorized by the appropriate authority.
Unauthorized transactions or fictitious entries can be flagged during the
vouching process, helping prevent fraudulent activities and ensure
compliance with organizational policies and procedures.
5. Separation of Business and Personal Transactions: Vouching enables
auditors to distinguish between business-related transactions and personal
expenses or non-business activities. This distinction is crucial for accurately
assessing the financial performance and position of the organization and
preventing the misclassification of expenses.
14.5 Principles or Techniques of Vouching
These principles or techniques of vouching serve as guidelines for auditors to ensure
thorough and accurate verification of financial transactions. Let's summarize them:
 1. Arranged Vouchers: Auditors should ensure that vouchers are properly
arranged and numbered, corresponding to the order of entries in the books.
2. Checking of Date: Auditors should compare the dates on vouchers with
those recorded in the cash book to verify the timing of transactions.
3. Compare Words and Figures: Auditors should verify that the amounts
written in words and figures on vouchers match and are consecutively
numbered.
4. Checking of Authority: Auditors should confirm that vouchers are authorized
by the appropriate officer to prevent unauthorized transactions.
5. Handling of Cutting or Changes: Any cutting or changes on vouchers
should be properly authorized and explained, ensuring transparency and
accuracy.
6. Transactions Must Relate to Business: Auditors should ensure that all
entries in vouchers relate to legitimate business activities and expenses.
7. Personal Vouchers: Vouchers in personal names should be scrutinized
carefully to avoid including personal expenses as business expenses.
8. Checking of Account Head: Auditors should verify the account head on
which cash is deposited or withdrawn to ensure proper classification.
9. Revenue Stamp: Vouchers should bear any required revenue stamps as per
legal requirements.
10. Cancelled Vouchers: Auditors should not accept cancelled vouchers to
prevent the risk of double payment or erroneous entries.
11. Taking Important Notes: Auditors should make notes on items requiring
further evidence or explanation for thorough follow-up.
12. Payment Description: Auditors should verify whether payments described on
vouchers are for partial or complete transactions.
13. Reviewing Agreements: Auditors should review agreements,
correspondence, and relevant documents to gain insight into transactions.
14. Printer Vouchers: Printed vouchers are considered authentic and legally
acceptable, whereas handwritten vouchers may raise suspicion.
15. List of Missing Vouchers: Auditors should maintain a list of missing
vouchers to detect any potential fraud or errors in record-keeping.

14.6 POINTS TO BE NOTED WHILE VOUCHING

1. Arranged Vouchers: Auditors should meticulously examine the arrangement
of vouchers to ensure they are properly organized and sequentially
 numbered. This helps in tracing transactions accurately and facilitates easy
cross-referencing with entries in the books of accounts.
2. Checking of Date: Auditors must verify the dates on vouchers and compare
them with corresponding entries in the cash book. Discrepancies in dates may
indicate timing errors or deliberate attempts to manipulate transaction records.
3. Compare Words and Figures: Auditors should cross-check the amounts
written in words and figures on vouchers to ensure consistency and accuracy.
Any inconsistencies may signal errors or fraudulent activities that need further
investigation.
4. Checking of Authority: Auditors need to ascertain that vouchers are
authorized by the appropriate personnel in accordance with the organization's
internal control procedures. This ensures that only legitimate transactions are
recorded, and unauthorized activities are prevented.
5. Handling of Cutting or Changes: Auditors should scrutinize any instances of
cutting or changes on vouchers. These alterations should be properly
authorized and explained to maintain transparency and accuracy in financial
records.
6. Transactions Must Relate to Business: Auditors must confirm that all
transactions recorded in vouchers pertain to genuine business activities and
expenses. Personal expenses disguised as business transactions should be
identified and excluded to reflect the true financial position of the organization.
7. Personal Vouchers: Vouchers issued in personal names should undergo
thorough scrutiny to prevent the inclusion of personal expenses as business
expenditures. This ensures that only legitimate business transactions are
recorded in the books of accounts.
8. Checking of Account Head: Auditors need to verify the account heads under
which cash is deposited or withdrawn to ensure proper classification and
accurate financial reporting. This helps in maintaining the integrity and
reliability of financial statements.
9. Revenue Stamp: Auditors should confirm that vouchers bear any required
revenue stamps as per legal obligations. Failure to adhere to stamp duty
requirements may lead to legal repercussions and financial penalties.
10. Cancelled Vouchers: Auditors should reject cancelled vouchers to avoid the
risk of double payment or incorrect entries in the books of accounts.
Accepting cancelled vouchers could result in financial misstatements and
inaccuracies.
11. Taking Important Notes: Auditors should make detailed notes on items that
require further evidence or explanation during the vouching process. These
notes serve as reminders for follow-up procedures and help in resolving any
discrepancies identified.
 12. Payment Description: Auditors must verify the description of payments
recorded on vouchers to determine whether they represent partial or complete
transactions. This ensures accuracy in financial reporting and prevents
misrepresentation of transaction details.
13. Reviewing Agreements: Auditors should carefully review agreements,
correspondence, and relevant documents associated with transactions to gain
deeper insights and validate the authenticity of recorded transactions. This
helps in detecting any discrepancies or irregularities that require further
investigation.
14. Printer Vouchers: Auditors should consider printed vouchers as authentic
and legally acceptable, as they are generated using standardized processes.
However, handwritten vouchers may raise suspicions and warrant closer
scrutiny to ensure their accuracy and validity.
15. List of Missing Vouchers: Auditors need to maintain a comprehensive list of
missing vouchers to identify any gaps or irregularities in the record-keeping
process. This list serves as a valuable tool for detecting potential fraud or
errors and ensures the completeness and reliability of financial records.

14.7 VOUCHING OF TRADING TRANSACTIONS

Vouching of purchase books is a critical aspect of the auditing process, ensuring the
accuracy and reliability of recorded purchases. Here are key points to consider:
1. Ensuring Completeness and Accuracy: The primary objective of vouching
purchases is to verify that all purchases invoices are accurately recorded in
the purchases book. The auditor must confirm that each purchase transaction
is supported by a valid invoice and that no invoices are omitted or falsely
recorded.
2. Verification of Receipt of Goods: In addition to verifying the recording of
purchases, the auditor must confirm that the goods listed in the purchases
book are actually received by the business. This involves cross-referencing
purchase invoices with receiving reports or other evidence of receipt to ensure
that payments are made only for goods that have been delivered by the
supplier.
3. Consideration of Frequency and Size: The extent and depth of vouching
procedures may vary based on factors such as the frequency of purchases
and the size of the organization. Larger organizations with higher purchase
volumes may require more extensive vouching procedures to ensure
accuracy and completeness.
4. Importance of Internal Control: The effectiveness of the internal control
system for purchases significantly impacts the auditor's vouching procedures.
If the internal control system is robust and well-designed, the auditor may rely
 more heavily on it and perform fewer substantive tests. However, if internal
controls are weak or inadequate, the auditor must exercise greater caution
and conduct more thorough vouching procedures to mitigate the risk of
misstatement or fraud.

14.8 Auditor’s Duties While Vouching Credit Purchases

1. Any discrepancies between the purchase orders, goods received notes, and
invoices should be investigated and resolved.
2. The auditor should review the terms of payment to ensure they are consistent
with the credit terms agreed upon with the supplier.
3. Any unusual or significant fluctuations in purchase amounts should be
investigated to identify potential errors or irregularities.
4. The auditor should confirm that all necessary approvals and authorizations
are obtained before making purchases.
5. The auditor should assess the adequacy of the documentation supporting
each purchase transaction, including purchase orders, invoices, and goods
received notes.
6. Special attention should be given to purchases from related parties or unusual
suppliers to ensure they are legitimate and properly recorded.
7. The auditor should verify that purchases are recorded in the correct
accounting period and allocated to the appropriate expense accounts.
8. Finally, the auditor should document their findings and conclusions from the
vouching process, including any issues or discrepancies identified, and
communicate them to management as necessary.

14.9 VOUCHING OF PURCHASE RETURNS

Vouching of purchase returns involves verifying that the returns are properly
recorded and supported by appropriate documentation. Here are the key steps and
considerations for the auditor:
1. Review of Documentation: The auditor should examine the returns book to
ensure that all returns are properly recorded. This includes verifying that each
return entry includes details such as the date of return, the reason for return,
the quantity returned, and the value of the returned goods.
2. Matching with Original Purchase: The auditor should compare the details of
the purchase returns with the original purchase transactions to ensure
consistency and accuracy. This includes verifying that the returned goods
correspond to the items originally purchased and that the quantities and
values match.
 3. Documentation of Returns: The auditor should verify that proper
documentation is maintained for each return. This may include return
invoices, credit notes from suppliers, or other relevant documents. The auditor
should ensure that these documents are authorized and properly filed for
future reference.
4. Verification of Credit Notes: If credit notes are obtained from suppliers for
the returned goods, the auditor should verify that these credit notes accurately
reflect the amount originally invoiced for the returned goods. The auditor
should also ensure that credit notes are properly authorized and recorded in
the returns book.
5. Notification to Departments: If returned goods are replaced by the supplier,
the auditor should verify that this information is communicated to the relevant
departments, such as the purchasing department and the inventory
management department. This ensures that inventory records are updated
accordingly.
6. Segregation of Duties: The auditor should assess the segregation of duties
related to purchase returns to prevent potential fraud or errors. For example,
the individual responsible for processing purchase returns should not have the
authority to approve or authorize purchases.
7. Review of Internal Controls: The auditor should evaluate the internal
controls related to purchase returns to ensure that they are effective in
preventing and detecting errors or irregularities. This may include reviewing
policies and procedures, authorization processes, and monitoring
mechanisms.
8. Testing for Completeness and Accuracy: The auditor should perform
substantive tests to ensure that all purchase returns are properly recorded
and accounted for. This may involve selecting a sample of transactions and
tracing them back to supporting documentation to confirm their accuracy and
completeness.
9. Documentation of Audit Procedures: The auditor should document the
procedures performed during the vouching of purchase returns, including the
nature, timing, and extent of audit tests conducted. This documentation
serves as evidence of the auditor's work and provides support for their
findings and conclusions.
By following these steps and considerations, the auditor can effectively verify the
accuracy and completeness of purchase returns, thereby ensuring the reliability of
the financial statements.
14.10 VOUCHING OF PURCHASE RETURNS
The auditor's duty regarding the vouching of purchase returns involves several
important considerations:
 1. Verification of Documentation: The auditor should ensure that proper
documentation, such as debit notes sent to the supplier or credit notes
received from the supplier, exists for each purchase return transaction. These
documents serve as evidence of the return and its approval.
2. Matching Quantities: The auditor should verify that the quantity of goods
returned matches the records maintained by the storekeeper, return outward
register, and gatekeeper's outward register. This ensures consistency and
accuracy in recording the returns.
3. Verification of Amounts: The auditor should carefully examine the amounts
shown in credit notes received from the supplier to confirm that they
accurately reflect the value of the goods returned. Any discrepancies should
be investigated further.
4. Recording of Purchases Returns: The auditor should pay close attention to
the recording of purchases returns in the current accounting year. This
includes ensuring that returns are properly recorded in the correct period and
that there are no manipulations to artificially inflate or deflate profits for the
period.
5. First and Last Month Transactions: Special attention should be given to
purchases returns recorded in the first and last months of the accounting year.
These transactions may be susceptible to manipulation, such as including
returns from the previous year in the first month of the current year or delaying
recording returns from the last month to the subsequent year. The auditor
should carefully review these transactions to detect any irregularities or
misstatement.

14.11 IMPORTANCE OF VOUCHINGS

Vouching holds significant importance in the auditing process for several reasons:
1. Ensures Accuracy: Vouching helps verify the accuracy and authenticity of
financial transactions recorded in the books of accounts by examining
supporting documents such as invoices, receipts, contracts, and bank
statements. This ensures that transactions are properly recorded and reported
in the financial statements.
2. Detects Errors and Fraud: By systematically examining individual
transactions, vouching helps auditors identify errors, discrepancies, and
potential instances of fraud. Discrepancies between the recorded transactions
and supporting documents can indicate errors in recording or intentional
misrepresentation.
3. Strengthens Internal Controls: Vouching involves assessing the
effectiveness of internal control procedures implemented by the organization.
It helps identify weaknesses or deficiencies in internal controls, allowing
 management to take corrective actions to improve control measures and
mitigate risks.
4. Enhances Reliability of Financial Information: Through thorough vouching
procedures, auditors can provide assurance to stakeholders, such as
investors, creditors, and regulators, regarding the reliability and accuracy of
the financial information presented in the audited financial statements. This
helps maintain trust and confidence in the financial reporting process.
5. Supports Legal Compliance: Vouching ensures that financial transactions
comply with relevant laws, regulations, and accounting standards. Auditors
verify adherence to legal requirements by examining supporting documents
and confirming that transactions are properly authorized, recorded, and
reported in accordance with applicable regulations.
6. Provides Basis for Audit Opinion: Vouching provides auditors with the
evidence and documentation necessary to form an opinion on the fairness
and accuracy of the financial statements. The results of vouching procedures
contribute to the auditor's assessment of the overall financial reporting
process and determine the audit opinion issued to stakeholders.
7. Facilitates Decision-Making: Reliable financial information obtained through
vouching enables stakeholders to make informed decisions regarding
investments, lending, and other financial matters. Audited financial statements
based on thorough vouching procedures provide stakeholders with a clear
and transparent view of the organization's financial position and performance.
Self Assessment
1. What is vouching of purchase returns?
2. Describe the Auditor’s Duties While Vouching Credit Purchases?
3. Describe the Observance of accounting principles?
4. What is the internal control system?

14.12 Summary
In auditing cash transactions, meticulous scrutiny ensures accuracy and integrity.
Verification of internal control involves assessing systems to prevent errors and
fraud. Vouching aims to authenticate transactions, ensuring compliance and
detecting irregularities. Techniques like examination, inspection, and comparison
validate transactions. Attention to detail is crucial, ensuring no discrepancies slip
through. Vouching trading transactions involves confirming sales and purchases'
authenticity. While vouching credit purchases, auditors ensure invoices match orders
and goods receipt. For purchase returns, verifying the reason and documentation is
essential. Vouching safeguards against misstatements, ensuring financial
statements' reliability. In summary, vouching is integral, ensuring transparency and
trustworthiness in financial records, benefiting stakeholders and organizational
governance.
14.13 Glossary
1. AUDIT OF CASH TRANSACTIONS: The transaction and that proper
authorization has been obtained before recording the transaction. Additionally,
the auditor should verify the physical existence of cash on hand through count
procedures and reconcile the cash balance per the books with the actual cash
counted.
2. INTERNAL CONTROL SYSTEM: The internal control system plays a crucial
role in ensuring the integrity and reliability of financial reporting. Its inclusion in
the final accounts provides transparency regarding the measures in place to
safeguard assets, prevent fraud and errors, and facilitate effective decision-
making.
3. Matching Quantities: The auditor should verify that the quantity of goods
returned matches the records maintained by the storekeeper, return outward
register, and gatekeeper's outward register. This ensures consistency and
accuracy in recording the returns.

14.14 Answers: Self Assessment

1). Please check section 14.10 2). Please check section 14.8 3). Please check
section 14.3 4). Please check section 14.2

14.15 Terminal Questions

1. Why is the audit of cash transactions important for auditors? Outline the steps
involved in verifying the system of internal control in an organization.
2. Discuss the objectives of vouching in the audit process. Explain the principles or
techniques commonly used in vouching.
3. What are the key points auditors should consider while vouching transactions?
What are the responsibilities of auditors when vouching credit purchases?
4. Why is vouching considered an essential aspect of the audit process?
14.16 Answers: Terminal Questions:
1). Please check section 14.2 and 14.3 2). Please check section 14.4
3). Please check section 14.6 4). Please check section 14.11

14.17 Suggested Readings

1. Dalal, Chetan. (2015). Novel & Conventional Methods of Audit, Investigation
and Fraud Detection. Wolters Kluwer India Pvt. Ltd.
2. Gupta, Sanjeev (2016). Corporate Frauds and their Regulation in India.
Bharat Law House Pvt. Ltd
3. Kaul, Vivek (2013). Easy Money. Sage Publications, New Delhi.
4. Manning, George A. (2010). Financial Investigation and Forensic Accounting.
CRC Press: Taylor & Francis Group.
5. Sharma, B. R. (2014). Bank Frauds. Universal Law Publishing, New Delhi
 Lesson – 15
VERIFICATION AND VALUATION OF ASSETS AND LIABILITIES
Structure:
15.0 Learning Objectives
15.1 Introduction
15.2 Meaning of valuation
15.3 Objectives for the verification of assets and liabilities
15.4 Principles of verification of asset and liability
15.5 Liabilities of auditor as regard to verification
15.6 Verification of assets
15.7 General principles regarding verification of assets
15.8 Verification of liabilities
15.9 Verification of liabilities may be carried out by employing following procedure
15.10 General principles regarding verification of liabilities
15.11 Advantages verification of assets and liabilities
15.12 Summary
15.13 Glossary
15.14 Answers: Self Assessment
15.15 Terminal Questions
15.16 Answers: Terminal Questions:
15.17 Suggested Readings
15.0 Learning Objectives
After studying the lesson, you should be able to:-
1. Meaning of valuation
2. Objectives for the verification of assets and liabilities
3. Verification of assets
4. Verification of liabilities
15.1 Introduction
Verification means proving the correctness. One of the main works of auditor is
verification of assets and liabilities. Verification is the act of assuring the correctness
of value of assets and liabilities, title and their existence in the organization. An
auditor should be satisfied himself about the actual existence of assets and liabilities
appearing in the balance sheet is correct
Key aspects of verification include:
1. Existence: The auditor confirms that the assets and liabilities reported in the
financial statements actually exist and are not fictitious. This may involve
physically inspecting assets, such as inventory or property, and obtaining
external confirmations for liabilities.
2. Ownership: The auditor verifies that the assets and liabilities belong to the
company and are properly owned or incurred by it. This may involve reviewing
legal documents, contracts, and agreements to establish ownership rights.
3. Valuation: The auditor assesses whether the assets and liabilities are
correctly valued in the financial statements. This may require comparing the
reported values to market prices, appraisals, or other relevant benchmarks to
ensure they are fairly stated.
4. Authorization: The auditor ensures that the acquisition or incurrence of
assets and liabilities was properly authorized by the company's management
or governing body. This involves reviewing documentation such as purchase
orders, contracts, and board resolutions.
5. Absence of Encumbrances: The auditor verifies that the assets are not
subject to any liens, mortgages, or other encumbrances that could affect their
ownership or use. This may involve reviewing legal records and agreements
to confirm the absence of any restrictions or claims on the assets.

15.2 Meaning of Valuation

Valuation is the act of determining the value of assets and critical examination of
these values on the basis of normally accepted accounting standard. Valuation of
assets is to be made by the authorized officer and the duty of auditor is to see
whether they have been properly valued or not. For ensuring the proper valuation,
auditor should obtain the certificates of professionals, approved values and other
competent persons. Auditor can rely upon the valuation of concerned officer but it
must be clearly stated in the report because an auditor is not a technical person.
An auditor should consider the following points regarding the assets while making
valuation off assets:
1. Original cost
2. Expected working life
3. Wear and tear
4. Scrap value

15.3 OBJECTIVES FOR THE VERIFICATION OF ASSETS AND LIABILITIES

The objectives for the verification of assets and liabilities are crucial for ensuring the
accuracy, reliability, and transparency of the financial statements. key objectives:
 1. Accurate and Fair View: The primary objective is to ensure that the financial
statements present an accurate and fair view of the organization's assets and
liabilities. Verification methods help in portraying the true financial position of
the company.
2. Accuracy: Verification aims to validate the information provided in the
financial statements, ensuring its validity and reliability. Stakeholders rely on
accurate financial information for making informed decisions.
3. Existence and Possession: Verification confirms the existence of assets and
liabilities stated in the financial position. It ensures that assets and liabilities
are held by the organization and are rightfully owned.
4. Fraud and Irregularity Detection: The verification process helps in detecting
any instances of fraud or irregularities in the financial statements. This
ensures the integrity and credibility of the reported financial information.
5. Arithmetical Accuracy: Verification ensures the mathematical accuracy of
asset and liability balances in the balance sheet. It aims to identify and rectify
any mathematical errors or discrepancies.
6. Ownership and Title: Verification verifies the ownership and title of assets,
determining the rightful owner and the legal status of the assets. It ensures
that assets are properly recorded and accounted for.
7. Disclosure: Verification ensures that relevant and important information
about assets and liabilities is disclosed in the financial statements. This
includes details such as the amount, period, and risks associated with the
liabilities, providing stakeholders with a comprehensive understanding of the
organization's financial position.

15.4 Principles of Verification of Asset and Liability

The principles of verification of assets and liabilities outline the fundamental
guidelines and approaches that auditors follow to ensure the accuracy, reliability,
and completeness of financial statements. Its key principles:
1. Independence and Objectivity: Auditors must maintain independence and
objectivity throughout the verification process. They should remain impartial
and unbiased in their assessment of assets and liabilities.
2. Systematic Approach: Verification should be conducted in a systematic
manner, following a structured process that covers all relevant aspects of
assets and liabilities. This ensures thoroughness and consistency in the audit
procedures.
3. Professional Competence: Auditors should possess the necessary
professional competence and expertise to effectively verify various types of
assets and liabilities. They should stay updated with relevant accounting
standards and regulations.
 4. Evidence-Based: Verification should be based on sufficient and appropriate
audit evidence. Auditors gather evidence through various methods such as
inspection, observation, inquiry, and documentation review to support their
conclusions.
5. Substantive Testing: Auditors perform substantive testing to verify the
accuracy and completeness of asset and liability balances. This may involve
detailed examination of transactions, records, and supporting documentation.
6. Materiality: Auditors consider the materiality of assets and liabilities when
planning and performing verification procedures. Material items are those
whose omission or misstatement could influence the decisions of users of
financial statements.
7. Risk Assessment: Auditors assess the risks associated with asset and
liability verification to determine the nature, timing, and extent of audit
procedures. They identify and respond to risks of material misstatement,
including fraud and errors.
8. Comparative Analysis: Auditors may conduct comparative analysis to verify
changes in asset and liability balances over time or in comparison to industry
benchmarks. This helps in identifying significant fluctuations or abnormalities.
9. Documentation and Documentation: Auditors maintain comprehensive
documentation of the verification process, including audit plans, working
papers, and findings. Documentation provides a record of audit procedures
performed and supports the auditor's conclusions.
10. Professional Judgment: Auditors exercise professional judgment and
skepticism throughout the verification process. They critically assess audit
evidence and make informed decisions based on their assessment of risks
and materiality.

15.5 LIABILITIES OF AUDITOR AS REGARD TO VERIFICATION

“Auditor is not a valuer and cannot be expected to act as such. All that he can do is
to verify the original cost price and to ascertain as far as possible that the current
values are fair and reasonable and are in accordance with the accepted commercial
principles.” Lansacart

“An auditor is not liable, if in the absence of suspicious circumstances, he relies on

trusted official of the company”. In re: Kingston Cotton Mills Ltd.
The auditor will be held liable for any loss incurred due to his being negligent in his
duties. In the following judgments the auditor was held negligent.
These cases illustrate instances where auditors were held liable for negligence in
their duties:
a) London Oil Storage Co. vs. Sean Husluch & Co. (1904): In this case, the
auditor failed to verify the existence of assets stated in the balance sheet. As a
result, the auditor was held liable for any damages suffered by the client due to this
negligence.
b) Deputy Secretary Minister of Finance, Government of India vs. S.N. Dass
Gupta: The auditor did not verify the cash in hand during the winding up of Aryan
Bank Ltd., which led to the inability to detect fraud committed by the management.
The auditor was found guilty of negligence for not verifying cash in hand and held
liable for any resulting loss.
c) Register of Companies vs. P.M. Hedge: The auditor was deemed grossly
negligent for failing to verify cash-in-hand and the balance sheet. This negligence
resulted in liability for any loss incurred.
d) McKesson and Robbins Case (1939): The court emphasized the auditor's
responsibility to physically inspect some of the assets and verify all assets and
liabilities appearing in the balance sheet. Failure to do so could lead to liability for
damages.
In each of these cases, the auditors were found negligent in fulfilling their duties to
verify assets and liabilities adequately. As a result, they were held liable for any
losses incurred by their clients due to this negligence.

15.6 VERIFICATION OF ASSETS

The verification of assets involves several key aspects to ensure the accuracy and
reliability of the right-hand side of the balance sheet. According to Spicer and Pegler
and Joseph Lancaster, this process includes the following objectives:
1. Enquiry into Value, Ownership, and Title: The auditor investigates the
value, ownership, and legal title of the assets listed on the balance sheet. This
involves confirming that the assets are correctly owned by the entity and that
their valuation is in accordance with accepted accounting principles.
2. Existence and Possession: The auditor verifies the physical existence and
possession of the assets. This ensures that the assets claimed to exist in the
company's records are actually present and under the company's control.
3. Presence of Any Change on the Assets: The auditor examines whether
there have been any changes to the assets since they were acquired or
recorded in the company's records. This includes investigating any disposals,
impairments, or changes in the status of the assets.
Joseph Lancaster further breaks down the verification of assets into three distinct
objectives:
a) Verification of Existence: This involves confirming that the assets listed on the
balance sheet actually exist and are owned by the entity. The auditor may physically
inspect assets, review documentation, or obtain confirmations from third parties to
verify their existence.
b) Valuation of Assets: The auditor assesses the value of assets to ensure they are
accurately recorded on the balance sheet. This may involve obtaining valuations
from independent experts, comparing asset values to market prices or appraisals,
and ensuring compliance with accounting standards.
c) Authority of Acquisition: The auditor investigates the authority under which the
assets were acquired to ensure they were obtained legally and in accordance with
company policies and procedures. This involves examining purchase agreements,
contracts, and other documentation to verify the legitimacy of asset acquisitions.
By thoroughly conducting the verification of assets, auditors can provide assurance
to stakeholders regarding the accuracy and reliability of the company's financial
statements.
15.7 GENERAL PRINCIPLES REGARDING VERIFICATION OF ASSETS
The general principles regarding the verification of assets, as laid down by the
Institute of Chartered Accountants of India (ICAI), include the following points:
1. Existence of Assets: The auditor should ensure that the assets listed on the
balance sheet actually existed on the date of the balance sheet.
2. Purpose of Acquisition: Assets should have been acquired for the purpose
of the business and under proper authority. This ensures that assets were
acquired legitimately and for the benefit of the business.
3. Ownership: The right of ownership of the assets should belong to the
undertaking. The auditor must confirm that the company legally owns the
assets listed on the balance sheet.
4. Lien or Charge: Assets should be free from any undisclosed lien or charge
not disclosed in the balance sheet. The auditor must verify that there are no
undisclosed encumbrances on the assets.
5. Valuation: Assets should be correctly valued, taking into account their
physical condition and market value. The auditor must ensure that the
valuation method used is appropriate and consistent with accounting
standards.
6. Disclosure: The values of assets should be correctly disclosed in the balance
sheet. The auditor must confirm that asset values are accurately represented
in the financial statements.
7. Acquisition of Assets: When a company acquires assets from a going
concern, the auditor should inspect the agreement of sale and ascertain the
amount paid for them. It should be verified that the allocation of the total cost
among the various assets is fair and reasonable.
 8. Verification of Cost: The cost of assets acquired should be verified with
supporting documents such as invoices, purchase agreements, or ownership
rights. Expenditure on newly acquired assets and on the renewal and
replacement of old assets should be correctly recorded.
9. Sale of Assets: When an asset is sold, the sale proceeds should be verified
by reference to the sales agreement, receipt issued to the purchaser, or any
other available evidence. Any resulting capital profit or loss should be
appropriately accounted for in the financial statements.
10. Depreciation: A company must provide for depreciation out of profits before
distributing any profits to shareholders. The auditor should ensure that
depreciation is calculated and accounted for in accordance with relevant
accounting standards.
11. Physical Inspection: Whenever feasible, the existence of fixed assets should
be verified through physical inspection. This involves physically examining the
assets to confirm their presence and condition. Alternatively, the particulars of
assets listed in the schedule attached to the balance sheet should be
compared with the plant or property register. The total values should also be
reconciled with the balances in the general ledger.
12. Verification of Securities and Documents: All securities, documents of title,
cash, negotiable instruments, etc., representing assets should ideally be
inspected on the last day of the accounting period. If this is not possible, a
careful review of transactions after the balance sheet date should be
conducted to ensure that subsequent changes in asset balances are
adequately supported by evidence.
13. Checking for Unauthorized Charges: It should be ensured that no
unauthorized charges have been created against assets. All charges should
be properly registered and disclosed. For example, if shares or securities are
pledged with a bank as security for a loan or overdraft, a certificate should be
obtained from the bank detailing the nature of the charge.
14. Inspection of Assets Held by Third Parties: Assets held by third parties,
such as government securities, share scrips, or debenture bonds, should be
inspected if they are not held by a bank. This ensures that these assets are in
the custody of the intended parties and are accounted for properly.
15. Disclosure of Surplus or Deficiency: When depreciable assets are
disposed of, discarded, demolished, or destroyed, any net surplus or
deficiency resulting from such actions should be disclosed separately in the
financial statements if it is material. This ensures transparency regarding the
impact of such events on the company's financial position.

15.8 VERIFICATION OF LIABILITIES

Verification of liabilities is as important as assets. If any liability omitted or overstated
or understated in the Balance Sheet then Balance Sheet would not show true and fair
view of the state of affairs of the business. Therefore the auditor must verify that the
liabilities stated in the Balance Sheet are in fact payable, accurate, related to and exist
in the business.
The judgment in the Westminster Road Construction and Engineering Co. Ltd, 1932
is of great significance in this regard. As per this judgment, “if the auditor found that a
company in the course of its business was incurring liabilities of a particular kind and
that the trade payables sent in their invoices after an interval and that liabilities of the
kind in question must have been incurred during the accountancy period under audit
when he was making his audit, sufficient time has not elapsed for the invoices relating
to such liabilities to have been received and recorded in the company‟s books, it
become his duty to make specific inquiries as to the existence of such liabilities and
also before he signed a certificate as to the accuracy of the Balance Sheet to go
through the invoices files of the company in order to see that no invoice relating to
liabilities has been omitted. The evidence has established to my satisfaction that no
experienced auditor would have failed to ascertain the existence of the liabilities
omitted from the Balance Sheet.”
When verifying liabilities, auditors must consider several key points to ensure accuracy
and completeness in the financial statements:
1. Existence and Origin: The auditor verifies the existence of liabilities presented
in the balance sheet and ensures that they have arisen from legitimate business
operations. This involves reviewing supporting documentation such as
invoices, contracts, and agreements to confirm the origin of liabilities.
2. Payability: Auditors verify that the liabilities reported in the balance sheet are
actually payable. This includes confirming the timing and terms of payment for
each liability and ensuring that there are no disputes regarding their payment.
3. Valuation: The auditor ensures that liabilities are correctly valued in
accordance with accounting standards. This may involve assessing the
accuracy of interest rates, discount rates, and other factors used to calculate
the present value of future cash flows associated with long-term liabilities.
4. Completeness: Auditors verify that all existing liabilities are properly included
in the financial statements. They also assess the adequacy of provisions for
contingent liabilities and ensure that any potential liabilities are disclosed in the
notes to the financial statements.
5. Disclosure: The auditor verifies the adequacy of disclosure regarding liabilities
in the financial statements. This includes ensuring that all material liabilities are
appropriately disclosed in the balance sheet and related notes, providing
stakeholders with transparent and informative information about the company's
financial obligations.
15.9 Verification of liabilities may be carried out by employing following
procedure
When conducting the verification of liabilities, auditors employ various procedures to
ensure accuracy and completeness. Some of these procedures include:
1. Examination of Records: Auditors review relevant accounting records, such
as invoices, contracts, loan agreements, and other documentation to verify the
existence and accuracy of reported liabilities. This involves tracing transactions
through the accounting system to ensure proper recording and classification.
2. Direct Confirmation Procedures: Auditors directly confirm the balances of
certain liabilities with third parties, such as lenders, creditors, and suppliers.
This may involve sending confirmation letters or emails requesting confirmation
of outstanding balances, terms of payment, and other relevant details.
3. Examination of Disclosures: Auditors examine the disclosures related to
liabilities in the financial statements and accompanying notes. They ensure that
all material liabilities are appropriately disclosed, including contingent liabilities
and other obligations that may affect the financial position of the company.
4. Analytical Review Procedures: Auditors perform analytical procedures to
assess the reasonableness of reported liabilities relative to historical data,
industry benchmarks, and other relevant financial metrics. This involves
comparing current liabilities to prior periods and industry norms to identify any
significant fluctuations or anomalies that may require further investigation.
5. Obtaining Management Representation: Auditors obtain representations
from management regarding the completeness and accuracy of reported
liabilities. Management may provide written or oral representations confirming
the existence, valuation, and disclosure of liabilities in accordance with
accounting standards and regulatory requirements.

15.10 GENERAL PRINCIPLES REGARDING VERIFICATION OF LIABILITIES

It is not possible to detail the procedures for verifying all possible liabilities. However
some general principles can be discerned and these should be applied according to
the particular set of circumstances met with in practice in an examination. These are:
Verification of Liabilities Schedule:
1. Schedule Creation: Request or create a schedule for each liability or class of
liabilities. Include the opening balance, if any, all changes, and the closing
balance.
2. Cut-off Verification: Ensure proper cut-off. For example, verify that a trade
creditor is not included unless the goods were acquired before the year-end.
3. Reasonableness Assessment: Consider the reasonableness of each liability.
Evaluate if there are any circumstances that should raise suspicion.
4. Internal Control Evaluation: Determine, evaluate, and test internal control
procedures, especially for trade creditors.
 5. Previous Date Clearance: Review liabilities at the previous accounting date to
ensure they have all been cleared.
6. Terms and Conditions Compliance: Verify compliance with all terms and
conditions associated with loans or other liabilities.
7. Authorization Confirmation: Seek authorization for all liabilities, referencing
company minutes, directors' minutes, and the Memorandum and Articles of
Association as necessary.
8. Description Adequacy Check: Ensure that the description of each liability in
the accounts is adequate.
9. Document Examination: Examine all relevant documents, including invoices,
correspondence, and debenture deeds, depending on the type of liability.
10. Security Assessment: Investigate any security associated with liabilities, such
as fixed or floating charges, and ensure proper registration.
11. Vouching Process: Verify the creation of each liability through proper
vouching, such as the receipt of a loan.
12. Accounting Policies Review: Confirm that appropriate accounting policies
have been adopted and consistently applied.
13. Interest and Ancillary Evidence Review: Review evidence of loans, such as
interest payments and related activities stemming from the existence of the
loan.
14. Disclosure Assurance: Ensure that all necessary disclosures are made to
provide a true and fair view in the financial statements.

15.11 ADVANTAGES VERIFICATION OF ASSETS AND LIABILITIES

Verification of assets and liabilities offers several advantages, including:
1. Ensures Accuracy: Verification helps ensure that the assets and liabilities
reported in the financial statements are accurate and reliable. By confirming
their existence, ownership, valuation, and other relevant factors, verification
enhances the overall accuracy of financial reporting.
2. Enhances Reliability: Reliable financial statements are crucial for
stakeholders, investors, creditors, and other users. Verification adds credibility
to financial statements by confirming the validity of reported assets and
liabilities, thereby enhancing their reliability.
3. Detects Errors and Fraud: Verification procedures can help detect errors,
discrepancies, or instances of fraud in the recording or reporting of assets and
liabilities. By scrutinizing documentation, conducting physical inspections, and
evaluating internal controls, auditors can uncover any irregularities or
fraudulent activities.
 4. Improves Decision Making: Accurate and reliable financial information
enables better decision-making by management, investors, creditors, and
other stakeholders. Verification ensures that the reported assets and liabilities
reflect the true financial position of the organization, facilitating informed
decision-making processes.
5. Compliance with Regulations: Verification helps ensure compliance with
accounting standards, regulatory requirements, and legal obligations. By
verifying the completeness and accuracy of assets and liabilities,
organizations can demonstrate adherence to applicable rules and regulations.
6. Enhances Transparency: Transparent financial reporting is essential for
building trust and maintaining credibility with stakeholders. Verification
promotes transparency by providing assurance that assets and liabilities are
properly disclosed and fairly presented in the financial statements.
7. Identifies Risks: Through the verification process, auditors can identify
potential risks associated with assets and liabilities, such as inadequate
internal controls, valuation uncertainties, or legal liabilities. This enables
management to take proactive measures to mitigate risks and safeguard the
interests of the organization.
8. Facilitates Due Diligence: In mergers, acquisitions, or other business
transactions, verification of assets and liabilities plays a critical role in due
diligence processes. Potential investors or buyers rely on verified financial
information to assess the value and risk profile of the target company.
9. Builds Stakeholder Confidence: By providing assurance on the accuracy
and reliability of financial reporting, verification helps build confidence and
trust among stakeholders, including investors, creditors, customers, and
regulatory authorities.
Self Assessment
1. What is liabilities of auditor as regard to verification?
2. Describe the term verification of liabilities?
3. Describe the term verification of assets?
4. What are four general principles regarding verification of liabilities?
15.12 Summary
Valuation is the process of determining the monetary worth of assets and liabilities.
The objectives for verifying assets and liabilities include ensuring their existence,
ownership, completeness, and valuation accuracy. Principles guiding asset and
liability verification involve scrutiny, examination of supporting documentation, and
reliance on reliable sources. Auditors bear the responsibility of verifying assets and
liabilities accurately, ensuring compliance with auditing standards. Verification of
assets entails assessing their physical presence, ownership, and valuation
authenticity, while liabilities verification involves confirming their existence, valuation,
and terms. These procedures ensure financial statements reflect a true and fair view,
enhancing transparency and credibility for stakeholders, ultimately bolstering trust
and confidence in the organization's financial health.
15.13 Glossary
1. VERIFICATION OF LIABILITIES: Verification of liabilities is as important as
assets. If any liability omitted or overstated or understated in the Balance Sheet
then Balance Sheet would not show true and fair view of the state of affairs of the
business. Therefore the auditor must verify that the liabilities stated in the
Balance Sheet are in fact payable, accurate, related to and exist in the business.
2. VERIFICATION OF ASSETS: The verification of assets involves several key
aspects to ensure the accuracy and reliability of the right-hand side of the
balance sheet. Verification means proving the correctness. One of the main
works of auditor is verification of assets and liabilities. Verification is the act of
assuring the correctness of value of assets and liabilities, title and their existence
in the organization. V
3. Verification: Verification means proving the correctness. One of the main works
of auditor is verification of assets and liabilities. Verification is the act of assuring
the correctness of value of assets and liabilities, title and their existence in the
organization.
15.14 Answers: Self Assessment
1). Please check section 15.5 2). Please check section 15.6
3). Please check section 15.8 4). Please check section 15.10

15.15 Terminal Questions

1. Objectives for the verification of assets and liabilities and Define valuation and its
significance in accounting and auditing.
2. Discuss the principles guiding the verification of assets and liabilities. Outline the
general principles that auditors follow when verifying assets.
3. Explain the specific procedures auditors can employ to verify liabilities. What
general principles guide auditors when verifying liabilities?
4. Discuss the advantages of thoroughly verifying assets and liabilities during an
audit.
15.16 Answers: Terminal Questions:
1). Please check section 15.2 and 15.3 2). Please check section 15.4
3). Please check section 15. And 15.9 4). Please check section 15.11
15.17 Suggested Readings
1. Dalal, Chetan. (2015). Novel & Conventional Methods of Audit, Investigation
and Fraud Detection. Wolters Kluwer India Pvt. Ltd.
2. Gupta, Sanjeev (2016). Corporate Frauds and their Regulation in India.
Bharat Law House Pvt. Ltd
3. Kaul, Vivek (2013). Easy Money. Sage Publications, New Delhi.
4. Manning, George A. (2010). Financial Investigation and Forensic Accounting.
CRC Press: Taylor & Francis Group.
5. Sharma, B. R. (2014). Bank Frauds. Universal Law Publishing, New Delhi
 Lesson – 16
Dividend and Divisible Profits
Structure:
16.0 Learning Objectives
16.1 Introduction
16.2 Divisible profits and dividends
16.3 Provisions of the companies act, 1956
16.4 Procedure legal requirements
16.5 Distribution of capital profit
16.6 Auditor's duty regarding dividends
16.7 Importance of proper ascertainment of profit
16.8 Importance of consideration of in determinig divisible profit
16.9 Summary
16.10 Glossary
16.11 Answers: Self Assessment
16.12 Terminal Questions
16.13 Answers: Terminal Questions:
16.14 Suggested Readings
16.0 Learning Objectives
After studying the lesson, you should be able to:-
1. Provisions of the companies act, 1956.
2. Distribution of capital profit
3. Importance of proper ascertainment of profit
16.1 Introduction
MEANING OF PROFIT
The term 'profit' can be defined differently by various authorities. Economists
typically ascertain profits by comparing the market values of a company's net assets
at two accounting dates, considering the increase or decrease in net worth over the
intervening period. However, accountants have a distinct perspective on profit. They
compute profit based on the assumption that the business will continue operating as
a going concern, a fundamental principle underlying financial statement preparation.
Unlike economists who may consider realizable values of assets, accountants focus
on revenue and expenses within an accounting period to compute profit. Objective
measurement of market prices for business assets, especially fixed assets, can be
challenging. Therefore, accountants rely on the revenue and expense figures to
determine profit.
An illustrative case in this context is the judgement in the Spanish Prospecting Co.
Ltd. (1911) case, which highlights the accounting approach to defining profit.
16.2 Divisible profits and dividends
Divisible profits" refer to the portion of a company's profits that can be legally
distributed among its shareholders as dividends. The concept is not explicitly defined
in the relevant legislation but is determined based on generally accepted accounting
principles and relevant provisions of the Companies Act, 1956 (or the applicable
company law).
It's important to note that not all profits generated by a company need to be
distributed among shareholders. Retaining a portion of profits within the company is
crucial for financing its growth, diversification, and future operations.
The determination of divisible profits involves considering various factors, including:
1. Generally accepted accounting principles (GAAP): These principles guide the
preparation of financial statements and help in ascertaining the true and fair
view of a company's financial position. Profits calculated in accordance with
GAAP provide a basis for determining divisible profits.
2. Provisions of the Companies Act, 1956 (or relevant company law): The
Companies Act imposes certain restrictions and regulations on the distribution
of profits among shareholders. It outlines the procedures and limitations
regarding dividend payments, ensuring compliance with legal requirements.
3. Judicial pronouncements: Court cases and judicial interpretations play a
significant role in shaping the understanding and application of laws related to
dividend distribution. Precedents established through various court decisions
provide guidance on issues related to divisible profits and dividends.

16.3 PROVISIONS OF THE COMPANIES ACT, 1956

FOR DIVIDEND
Section 205 of the Act enumerates the sources from which dividends can be paid. It
makes it compulsory for a company to provide for depreciation before declaring
dividends. A company may also be asked to transfer some part of its profit to
reserves if its intends to pay dividend exceeding certain limit. It also lays down the
procedure for declaration and payment of dividends including the manner of dealing
with any unpaid or unclaimed dividends. In this the context, it is equally important
that leading judicial pronouncements on the issue are given due attention.
The Companies Act, 1956, specifies regulations regarding the declaration and
payment of dividends. Key points outlined in the provided text:
1. Sources of Dividends:
  Dividends can only be declared or paid by a company out of its profits
for the current financial year, profits from previous financial years that
remain undistributed, or from funds provided by the Central
Government or a State Government under a guarantee.
 If the company has not provided for depreciation in previous financial
years after the commencement of the Companies (Amendment) Act,
1960, it must do so before declaring dividends.
 If the company has incurred losses in previous financial years after the
commencement of the Companies (Amendment) Act, 1960, the
amount of the loss or the amount provided for depreciation for those
years, whichever is less, must be set off against the profits of the
current year or previous years before declaring dividends.
 The Central Government may allow a company to declare dividends
without providing for depreciation if it deems it necessary in the public
interest.
 Companies are not required to provide for depreciation if dividends are
paid out of profits from financial years before the commencement of the
Companies (Amendment) Act, 1960.
2. Interim Dividend:
 The Board of Directors has the authority to declare interim dividends,
which must be deposited in a separate bank account within five days of
declaration.
 The amount deposited for interim dividends must be used solely for
paying interim dividends.
 Sections 205, 205-A, 205-C, 206, 206-A, and 207 of the Companies
Act, 1956, apply to interim dividends as far as possible.
3. Depreciation:
 Depreciation can be provided according to the methods specified in
Section 350 of the Companies Act, 1956, or based on other approved
methods that effectively write off ninety-five percent of the original cost
of depreciable assets.
 The written-down value of depreciable assets sold, discarded,
demolished, or destroyed at the end of the financial year must be
written off in accordance with Section 350.
4. Transfer to Reserves:
 From the commencement of the Companies (Amendment) Act, 1974,
no dividends can be declared or paid out of profits for a financial year
without transferring to reserves a percentage of profits not exceeding
ten percent as prescribed.
 5. Cash Dividends:
 Dividends must be paid in cash, except in cases of capitalization of
profits or reserves for issuing fully paid-up bonus shares or paying
unpaid amounts on shares.
16.4 Procedure Legal Requirements
The procedural and legal requirements for the declaration and payment of dividends
are governed primarily by Sections 205-207 of the Companies Act, as well as the
Articles of Association of the company. Additionally, regulations 85-94 of Table A of
Schedule I to the Act provide further guidance on various aspects of dividends.
However, companies have the flexibility to prescribe their own rules regarding
dividend declaration and payment. These rules typically cover the following aspects:
1. Board Resolution: The board of directors must pass a resolution declaring
the dividend, specifying the amount per share and the record date.
2. Approval: The declaration of dividends must be approved by the
shareholders at a general meeting.
3. Record Date: A record date is established to determine which shareholders
are entitled to receive the declared dividend. Shareholders recorded on this
date will receive the dividend, regardless of when they purchased their
shares.
4. Payment Date: The payment date for dividends should be specified,
indicating when shareholders can expect to receive their dividends.
5. Dividend Warrants: Dividends are typically paid by check or warrant sent
through the post to the registered address of the shareholder.
6. Bank Account: The company should ensure that it has sufficient funds in its
bank account to cover the payment of dividends.
7. Compliance: The company must comply with all relevant legal requirements
and provisions of the Companies Act regarding dividend declaration and
payment.
8. Documentation: Proper documentation, including board resolutions,
shareholder approvals, and records of dividend payments, should be
maintained by the company.
9. Communication: Shareholders should be notified of the dividend declaration,
record date, and payment date through official communication channels.
10. Taxation: Consideration should be given to any tax implications associated
with the declaration and payment of dividends, both for the company and the
shareholders.
 11. Transfer of Unpaid or Unclaimed Dividend to Central Government
(Section 205A):
 Unpaid or unclaimed dividends transferred by a company to a special
bank account.
 If the amount remains unpaid or unclaimed for three years from the
transfer date, it should be transferred to the general revenue account of
the central government.
 Claimants must apply to the central government for payment.
12. Dividends Payment to Registered Shareholders (Section 206):
 Dividends must be paid to registered holders of shares, their order, or
their bankers.
 In the case of share warrants, dividends are paid to the bearer of the
warrant or their bankers.
13. Rights to Dividend and Bonus Shares Held in Abeyance (Section 206A):
 If a transfer of shares has not been registered by the company,
dividends are transferred to the Unpaid Dividend Account.
 Dividend payment to the transferee is subject to authorization by the
registered shareholder.
 Any rights shares or fully-paid bonus shares in respect of such shares
are held in abeyance.
14. Right to Dividend:
 The right to claim dividends arises after the declaration of dividends in
the company's general meeting.
 Once declared, dividends become a debt and cannot be revoked
without shareholder consent.
15. Dividends for Past Years:
 Dividends cannot be declared for past years after the accounts have
been closed in a previous annual general meeting.
 The company cannot declare further dividends after the declaration at
the annual general meeting.
16. Prohibition on Dividend Declaration for Failure to Redeem Preference
Shares (Section 205(10B)):
 If a company fails to redeem preference shares as required by Section
80A, it is prohibited from declaring dividends on its equity shares until
the failure is rectified.
16.5 DISTRIBUTION OF CAPITAL PROFIT
The distribution of capital profits, which arise from sources such as the sale of fixed
assets or long-term investments, presents a question regarding their eligibility for
distribution as dividends under the Companies Act, 1956. While the Act does not
specifically address this issue, rulings from key cases provide guidance for
determining whether such profits can be distributed as dividends. Let's examine the
insights gleaned from two notable cases:
1. Lubbock v. The British Bank of South America Ltd (1891):
 In this case, the British Bank of South America sold its branches in
Brazil and repurchased them at a profit. The directors intended to credit
the Profit and Loss Account with this profit and pay dividends to
shareholders.
 The court ruled in favor of the directors, stating that dividends can be
paid from realized capital profits if: a. The Articles of Association of the
company permit such distribution. b. A surplus remains after deducting
the paid-up capital and liabilities from the sale proceeds, representing
profit.
2. Foster v. The New Trinidad Lake Asphalt Co. Ltd. (1901):
 In this case, the company took over assets, including promissory notes,
which were initially considered valueless. However, the company later
realized these promissory notes in full and credited the amount to the
Profit and Loss Account for distribution as dividends.
 A shareholder challenged this action, arguing that these profits should
not be treated as capital profits since they arose from the realization of
assets taken over by the company at its formation.
 The court did not explicitly rule on this matter, but it raised concerns
about the treatment of such profits and the circumstances under which
they could be distributed as dividends.
16.6 AUDITOR'S DUTY REGARDING DIVIDENDS
The auditor plays a crucial role in ensuring compliance with relevant provisions and
procedures of the Companies Act, 1956, regarding the declaration and payment of
dividends. The audit procedures involved:
1. Examine Memorandum and Articles of Association:
 Review the company's Memorandum and Articles of Association to
understand the dividend rights of various classes of shares.
2. Verify Dividend Rate and Authority:
 Confirm the rate of dividend and the authority for payment by
examining entries in the Shareholders' Minute Book.
3. Check Procedural Requirements:
  Verify compliance with procedural requirements for declaring dividends
by examining minutes of the board meeting where the resolution
recommending dividend declaration was passed.
 Review minutes of the general meeting where dividends were
declared.
4. Ensure Timely Payment:
 Confirm that dividends declared by the company were paid within the
prescribed time limit by examining dividend registers showing despatch
dates of cheques or dividend warrants.
5. Vouch Dividend Payments:
 Verify payment of dividends by cross-referencing entries in the
Dividend Account, Profit and Loss Account, Cash Book, and
shareholders' receipts.
 Confirm that unclaimed dividends are appropriately recorded as a
current liability in the Balance Sheet and either deposited with a
Scheduled Bank or the Government of India Account with the Reserve
Bank.
6. Verify Dividend Amounts:
 Check the amount of gross dividends payable against the paid-up
share capital.
 Reconcile net dividends payable with gross dividends payable and
income tax deducted at source.
 Sample check gross and net dividends payable to individual members.
7. Examine Unclaimed Dividends:
 Review the statement of unclaimed dividends against bank statements
to ensure accuracy.
 Verify compliance with Act requirements regarding handling of
unclaimed dividends.

16.7 IMPORTANCE OF PROPER ASCERTAINMENT OF PROFIT

The proper ascertainment of profit is of paramount importance for several reasons:
1. Basis for Decision Making: Profit is a key metric used by management,
investors, creditors, and other stakeholders to assess the financial health and
performance of a business. Accurate profit figures provide valuable insights
for making informed decisions regarding investments, expansions, dividend
distributions, and resource allocations.
 2. Performance Evaluation: Profitability measures such as net profit margin,
return on investment (ROI), and earnings per share (EPS) are widely used to
evaluate the effectiveness of business operations and management
strategies. Properly ascertained profits enable stakeholders to assess
whether the company is meeting its financial objectives and generating
satisfactory returns.
3. Investor Confidence: Investors rely on profit figures to gauge the potential
returns on their investments. Accurate and transparent reporting of profits
enhances investor confidence in the company's financial stability and growth
prospects, thereby attracting investment and supporting stock prices.
4. Creditor Confidence: Creditors, including banks and suppliers, assess a
company's profitability to evaluate its creditworthiness and repayment
capacity. Properly ascertained profits provide assurance to creditors that the
company can generate sufficient cash flows to meet its financial obligations.
5. Compliance and Legal Obligations: Companies are required to report their
profits accurately in compliance with accounting standards, regulatory
requirements, and taxation laws. Proper ascertainment of profit ensures
compliance with legal obligations and reduces the risk of penalties, fines, or
legal disputes.
6. Dividend Distributions: Profit is the primary source of funds for dividend
distributions to shareholders. Accurate determination of profits is essential to
ensure fair and timely payment of dividends, maintaining shareholder
satisfaction, and upholding the company's reputation in the market.
7. Strategic Planning: Profit figures serve as a basis for formulating business
strategies, budgeting, and forecasting future financial performance. Properly
ascertained profits enable management to identify areas of strength and
weakness, allocate resources efficiently, and implement corrective measures
to improve profitability.

16.8 IMPORTANCE OF CONSIDERATION OF IN DETERMINIG DIVISIBLE

PROFIT
Consideration of various factors is crucial in determining divisible profit, which refers
to the portion of profits that can be distributed among shareholders as dividends. The
importance of considering these factors lies in ensuring fairness, transparency, and
compliance with legal and regulatory requirements. Here are some key reasons why
the consideration of factors is important in determining divisible profit:
1. Legal Compliance: Companies must adhere to legal provisions outlined in
the Companies Act or other relevant legislation regarding the declaration and
distribution of dividends. Proper consideration of these legal requirements
 ensures that the company operates within the bounds of the law and avoids
potential legal consequences for non-compliance.
2. Protection of Shareholder Rights: Divisible profit directly impacts
shareholders, who are entitled to a portion of the company's profits as
dividends. Considering various factors ensures that shareholders receive a
fair and equitable distribution of profits in line with their ownership stakes and
expectations.
3. Solvency and Financial Stability: Determining divisible profit requires
assessing the company's financial health and solvency. By considering factors
such as current and accumulated profits, liabilities, reserves, and capital
requirements, companies can ensure that dividend payments are sustainable
and do not jeopardize the company's long-term financial stability.
4. Business Growth and Investment: Dividend payments should not hinder the
company's ability to reinvest in growth opportunities or fund future projects.
Considering factors such as retained earnings, capital expenditure
requirements, and growth prospects helps strike a balance between
rewarding shareholders and retaining funds for future expansion and
investment.
5. Creditors' Interests: Dividend payments should not undermine the interests
of creditors, who have a legitimate claim on the company's assets.
Considering factors such as outstanding debts, loan covenants, and creditor
obligations ensures that dividend distributions do not impair the company's
ability to meet its financial obligations to creditors.
6. Tax Implications: Dividend distributions may have tax implications for both
the company and its shareholders. Considering factors such as tax liabilities,
withholding tax requirements, and tax-efficient dividend strategies helps
optimize tax outcomes for both the company and its shareholders.
7. Transparency and Accountability: Proper consideration of various factors in
determining divisible profit promotes transparency and accountability in
corporate governance. It enables stakeholders, including shareholders,
regulators, and the public, to understand the rationale behind dividend
decisions and assess the company's financial performance and
management's stewardship.
Self Assessment
1. What do you mean by the divisible profit?
2. Describe the term interim dividend?
3. What are the various sources of dividend ?
4. What are auditor's duty regarding dividends?
16.9 Summary
In accordance with the Companies Act, 1956, several provisions outline the legal
requirements and procedures regarding the distribution of capital profits and
dividends. Auditors play a crucial role in ensuring compliance with these regulations
and in verifying the accuracy of dividend declarations. Proper ascertainment of profit
is essential for maintaining transparency and reliability in financial reporting. Factors
such as reserves, depreciation, and taxation must be carefully considered in
determining divisible profits. Overall, adherence to legal requirements, accurate profit
ascertainment, and consideration of various factors ensure fair and lawful distribution
of profits in accordance with regulatory standards.
16.10 Glossary
1. PROFIT: The term 'profit' can be defined differently by various authorities.
Economists typically ascertain profits by comparing the market values of a
company's net assets at two accounting dates, considering the increase or
decrease in net worth over the intervening period. However, accountants have
a distinct perspective on profit. They compute profit based on the assumption
that the business will continue operating as a going concern, a fundamental
principle underlying financial statement preparation.
2. Divisible profits" refer to the portion of a company's profits that can be
legally distributed among its shareholders as dividends. The concept is not
explicitly defined in the relevant legislation but is determined based on
generally accepted accounting principles and relevant provisions of the
Companies Act, 1956 (or the applicable company law).
3. Interim Dividend: The Board of Directors has the authority to declare interim
dividends, which must be deposited in a separate bank account within five
days of declaration.

16.11 Answers: Self Assessment

1). Please check section 16.2 2). Please check section 16.5
3). Please check section 16.3 4). Please check section 16.6
16.12 Terminal Questions
1. What are some key provisions related to the distribution of profits and dividends
outlined in the Companies Act, 1956?
2. Outline the procedure and legal requirements for the distribution of capital profits
under the Companies Act, 1956.
3. Explain the concept of capital profit and its distribution among shareholders.
4. What are the responsibilities of auditors concerning the declaration and
distribution of dividends?
16.13 Answers: Terminal Questions:
1). Please check section 16.3 2). Please check section 16.4
3). Please check section 16.5 4). Please check section 16.6
16.14 Suggested Readings
1. Dalal, Chetan. (2015). Novel & Conventional Methods of Audit, Investigation
and Fraud Detection. Wolters Kluwer India Pvt. Ltd.
2. Gupta, Sanjeev (2016). Corporate Frauds and their Regulation in India.
Bharat Law House Pvt. Ltd
3. Kaul, Vivek (2013). Easy Money. Sage Publications, New Delhi.
4. Manning, George A. (2010). Financial Investigation and Forensic Accounting.
CRC Press: Taylor & Francis Group.
5. Sharma, B. R. (2014). Bank Frauds. Universal Law Publishing, New Delhi
 Lesson – 17
Company Auditor
Structure:
17.0 Learning Objectives
17.1 Introduction
17.2 Essentials to become a auditor
17.3 Educational qualification of auditor
17.4 Qualification of auditor: professional certifications
17.5 Statutory qualification of auditor
17.6 Personal qualification of auditor
17.7 Need for a company auditor
17.8 Benefits of hiring a company auditor
17.9 Qualifications of a company auditor
17.10 Disqualifications of auditors
17.11 Appointment of an auditor
17.12 Summary
17.13 Glossary
17.14 Answers: Self Assessment
17.15 Terminal Questions
17.16 Answers: Terminal Questions:
17.17 Suggested Readings
17.0 Learning Objectives
After studying the lesson, you should be able to:-
1. Appreciate the need for auditors in the company .
2. Understand the difference between partnership audit and company audit
3. Identify the statutory position of a company auditor
4. Explain the essential steps before the commencement of audit.

17.1 Introduction
In the study of auditing, fundamental concepts such as internal control, vouching,
verification, and valuation are crucial aspects applicable across various types of
business organizations. However, it's important to note that while auditing for entities
other than companies is typically voluntary and not mandatory, the audit of a
company is compulsory under the provisions outlined in the Companies Act.
As a result, the appointment, powers, and duties of auditors in the context of
companies are governed by specific rules laid out in the Companies Act. This unit
aims to provide a detailed understanding of these rules pertaining to the
qualifications, appointment, powers, and duties of a company auditor.
By delving into the regulations and requirements outlined in the Companies Act,
learners will gain insights into the intricacies of auditing within the corporate context,
thereby enhancing their comprehension of the unique challenges and responsibilities
associated with auditing companies.

17.2 ESSENTIALS TO BECOME A AUDITOR

Becoming an auditor typically involves a combination of education, experience,

certifications, and ongoing professional development. Here's a detailed breakdown of
the steps to become an auditor:
1. Obtain the necessary education: Most auditors start by earning a bachelor's
degree in accounting, finance, or a related field. Some employers may require
or prefer candidates with a master's degree in accounting or a relevant field.
It's essential to choose a program accredited by a recognized accrediting
body and covers the core concepts of auditing, accounting principles, financial
reporting, and relevant laws and regulations.
2. Gain relevant work experience: Many auditing roles require prior work
experience in accounting or finance. Entry-level positions such as junior
auditor or internal auditor may require a few years of experience in related
roles before advancing to more senior auditing positions. Internships or entry-
level positions in accounting or finance departments can provide valuable
experience.
3. Obtain professional certifications: Professional certifications can enhance
your credentials and demonstrate your expertise in auditing. Common
certifications for auditors include:
 Certified Public Accountant (CPA): Focuses on auditing, taxation,
financial accounting, and business law. Requirements typically include
education, experience, and passing the CPA exam.
 Certified Internal Auditor (CIA): Focuses on internal audit processes,
risk management, governance, and internal controls. Requirements
include education, experience, and passing the CIA exam.
 Certified Information Systems Auditor (CISA): Focuses on information
systems auditing, control, and security. Requirements include
education, experience, and passing the CISA exam.
4. Stay updated with auditing standards and regulations: Auditors must stay
informed about the latest auditing standards, regulations, and industry trends.
This may involve participating in continuing professional education (CPE)
programs, attending seminars, workshops, and conferences, and staying
connected with professional associations and industry publications.
5. Develop skills and knowledge in auditing: Auditors need a strong
understanding of accounting principles, financial statements, internal controls,
risk assessment, and auditing techniques. Developing skills in data analysis,
communication, problem-solving, and critical thinking is also essential for
auditors.
6. Gain practical experience: Practical experience is crucial for auditors to
develop their skills and expertise. This can be gained through on-the-job
training, exposure to various types of audits (e.g., financial audits, internal
audits, compliance audits), and mentorship from experienced auditors.
7. Follow professional ethics: Auditors are expected to adhere to high ethical
standards, including independence, integrity, confidentiality, and objectivity.
Following professional ethics is critical to maintaining the integrity of the
auditing profession and ensuring the credibility of audit results.
8. Comply with regulatory requirements: Depending on the jurisdiction and
industry, auditors may be subject to various regulatory requirements, such as
licensing, registration, or reporting obligations. It's important to understand
and comply with these requirements to legally practice as an auditor.
9. Seek career opportunities: Auditors can work in various settings, including
public accounting firms, internal audit departments of organizations,
government agencies, or as independent consultants. Networking, building
professional relationships, and seeking career opportunities can help auditors
advance in their careers.

1. Professional Competence: Auditors should demonstrate a high level of

professional competence and proficiency in auditing techniques,
methodologies, and standards. This includes staying updated on
developments in auditing and accounting practices and continually enhancing
their skills and knowledge.
2. Compliance with Ethical Standards: Auditors are expected to adhere to strict
ethical standards and professional code of conduct. This includes maintaining
confidentiality, objectivity, and integrity in their interactions with clients and
stakeholders.
3. Registration with Regulatory Authorities: In some jurisdictions, auditors may
be required to register with regulatory authorities or professional bodies and
comply with their licensing or certification requirements.
17.3 EDUCATIONAL QUALIFICATION OF AUDITOR
Absolutely, a strong educational background is indeed crucial for auditors to
effectively carry out their responsibilities. Here's following typical educational
qualifications of auditors:
1. Bachelor's Degree: Most auditors hold at least a bachelor's degree in
accounting, finance, or a related field. A bachelor's degree provides a
foundational understanding of accounting principles, financial reporting,
auditing concepts, taxation, and business law. Courses in statistics,
economics, and business management may also be included in the
curriculum. A bachelor's degree is often the minimum requirement for entry-
level auditing positions.
2. Master's Degree: While not always mandatory, some auditors pursue a
master's degree in accounting, finance, or business administration to further
enhance their knowledge and expertise. A master's degree can provide a
more in-depth understanding of advanced accounting topics, managerial
concepts, and specialized areas of auditing. Additionally, a master's degree
may open up opportunities for advancement to higher-level positions within
auditing firms or organizations.
3. Professional Certifications: In addition to formal education, many auditors
choose to obtain professional certifications to demonstrate their expertise and
enhance their credibility. Common certifications for auditors include the
Certified Public Accountant (CPA), Certified Internal Auditor (CIA), Certified
Information Systems Auditor (CISA), and Chartered Accountant (CA), among
others. These certifications typically require meeting specific educational
requirements, passing rigorous exams, and fulfilling experience criteria.
4. Continuing Education: Auditors are required to stay updated with changes in
accounting standards, auditing regulations, and industry best practices. This
often involves participating in continuing professional education (CPE)
programs offered by professional organizations, attending seminars,
workshops, and conferences, and staying informed about emerging trends
and developments in the field of auditing.
5. Specialized Training: Depending on the industry or sector in which they
work, auditors may benefit from specialized training or certifications relevant
to their area of focus. For example, auditors working in healthcare may pursue
certifications such as Certified Healthcare Auditor (CHA) or Certified
Professional in Healthcare Quality (CPHQ) to better understand the unique
challenges and regulations in the healthcare industry.

17.4 QUALIFICATION OF AUDITOR: PROFESSIONAL CERTIFICATIONS

Obtaining relevant professional certifications is another important qualification for
auditors. These certifications demonstrate their expertise and commitment to
maintaining high standards of professional competence. Some of the commonly
recognized certifications for auditors include:
1. Certified Public Accountant (CPA):
 The CPA certification is one of the most recognized and respected
credentials in the accounting profession.
 CPAs are licensed by state boards of accountancy and are authorized
to provide a wide range of accounting services, including auditing, tax
preparation, and financial advisory.
 To become a CPA, candidates typically need to meet specific
educational requirements (usually a bachelor's degree in accounting or
related field), accumulate a certain amount of professional experience
(usually around 1-2 years), and pass the Uniform CPA Examination.
 CPAs are also required to adhere to a code of ethics and fulfill
continuing professional education (CPE) requirements to maintain their
license.
2. Certified Internal Auditor (CIA):
 The CIA certification is awarded by the Institute of Internal Auditors
(IIA) and is focused on internal auditing roles.
 CIA candidates must meet certain educational requirements (usually a
bachelor's degree or equivalent), have at least two years of
professional experience in internal auditing or a related field, pass a
rigorous exam covering internal audit basics, internal control and risk,
and business analysis and information technology, and adhere to the
IIA's code of ethics.
 The CIA credential demonstrates proficiency in internal audit principles
and practices and is highly valued by employers in various industries.
3. Certified Information Systems Auditor (CISA):
 The CISA certification is offered by ISACA and is specifically designed
for auditors specializing in auditing information systems.
 CISA candidates must have a minimum of five years of professional
experience in information systems auditing, control, or security, pass a
comprehensive exam covering information systems audit, control, and
assurance, and adhere to ISACA's code of professional ethics.
 The CISA credential demonstrates expertise in assessing
vulnerabilities, managing risks, and implementing controls within
information systems, making it particularly valuable in today's digital
landscape.
17.5 Statutory Qualification of Auditor
In the case of sole traders and partnerships, there are no specific qualifications
prescribed by law for auditors. However, for auditors of joint stock companies, the
auditor must be a chartered accountant as defined by the Chartered Accountants
Act, 1949.
To become a chartered accountant, one must pass the Chartered Accountant (C.A.)
examination conducted by the Institute of Chartered Accountants of India (ICAI). In
order to practice as a chartered accountant, a certificate of practice must be obtained
from the council of the ICAI upon payment of a prescribed annual fee.
There are two categories of members within the ICAI: associates and fellows. An
individual is considered an associate member when their name is entered in the
Members Register maintained by the Institute, and they are entitled to use the letters
A.C.A. after their name.
An associate who has been in continuous practice in India for at least five years
under any other associate who has been a member of the Institute for five years and
possesses the qualifications prescribed by the Council of the Institute can be
enrolled as a Fellow of the Institute. Fellows are entitled to use the letters F.C.A.
after their name.
Note: It's important to refer to the specific laws and regulations of the Institute of
Chartered Accountants of India (ICAI) for the most up-to-date and accurate
information on the qualifications and categories of membership.
17.6 Personal Qualification of Auditor
The professional qualifications required for auditors are diverse and essential for the
successful performance of audit work. These qualities include:
1. Comprehensive knowledge of the principles, theory, and practice of
accountancy. The auditor should be well-versed in different accounting
systems and their aspects, and be aware of the latest developments in the
field of accounting.
2. Thorough understanding of various legislations regulating business, such as
the Companies Act, the Indian Partnership Act, Banking and Insurance Act,
Sale of Goods Act, Foreign Exchange Management Act, the Indian Contract
Act, etc.
3. In-depth knowledge of auditing techniques and staying updated with new
changes and developments in the principles and practices of auditing.
4. Familiarity with computer accounting and other automatic machine devices
used in the office.
5. Sound knowledge of commercial laws and provisions related to income tax,
wealth tax, VAT, gift tax, etc.
6. Familiarity with principles of economics and economic laws as businesses
operate within specific economic laws and social environments that impact
their operations.
 7. Proficiency in statistics and mathematics to effectively deal with complicated
problems.
8. Study of important judgments in audit cases to understand the duties,
responsibilities, and liabilities of an auditor.
9. Knowledge of business organization, financial administration, and industrial
management.
10. Familiarity with technical details of the business under audit.
Qualification of Auditor: Skills and Competencies
In addition to education and certifications, auditors should possess certain skills and
competencies to perform their duties effectively. Some of the key skills and
competencies for auditors include:
 Analytical Skills: Auditors need to analyze financial data and statements to
identify patterns, trends, and anomalies. Strong analytical skills are crucial for
auditors to identify potential risks and irregularities in financial reporting.
 Communication Skills: Auditors need to communicate effectively with clients,
colleagues, and other stakeholders. Good communication skills, both written
and verbal, are essential for auditors to explain complex financial concepts,
present findings, and provide recommendations.
 Attention to Detail: Auditors need to pay meticulous attention to detail to
ensure the accuracy and reliability of financial information. Minor errors or
omissions can have significant implications on financial reporting, and
auditors need to be thorough in their work.
 Ethical Conduct: Auditors are expected to maintain the highest standards of
professional ethics and integrity. They should demonstrate objectivity,
independence, and confidentiality in their work and avoid any conflicts of
interest that may compromise their independence.
Qualification of Auditor: Roles & Responsibilities
The role of an auditor is multifaceted and involves various responsibilities. Some of
the key roles and responsibilities of an auditor include:
1. Financial Statement Audit: The primary role of an auditor is to conduct a
thorough examination of an organization's financial statements to ensure that
they are presented fairly and accurately in accordance with applicable
accounting standards. This involves verifying the accuracy and completeness
of financial data, examining supporting documents, conducting substantive
testing, and assessing the overall financial reporting process.
2. Risk Assessment: Auditors assess the risks that an organization faces,
including financial, operational, and compliance risks, and evaluate the
effectiveness of internal controls in mitigating those risks. They identify
 potential areas of material misstatement or fraud, and design audit
procedures accordingly.
3. Internal Control Evaluation: Auditors evaluate the effectiveness of an
organization's internal controls over financial reporting, including the design,
implementation, and operation of controls. They provide recommendations for
improving internal controls to minimize the risk of errors or fraud.
4. Compliance Audit: Auditors may also perform audits to ensure that an
organization is in compliance with applicable laws, regulations, and
contractual agreements. This may include assessing compliance with tax
laws, industry regulations, and internal policies and procedures.
5. Audit Planning and Execution: Auditors plan and execute audits in
accordance with established audit methodologies, including determining the
scope and timing of audit procedures, selecting appropriate audit evidence,
documenting audit work, and analyzing findings to arrive at conclusions and
opinions.
6. Reporting and Communication: Auditors communicate the results of their
audit findings to management, audit committees, and other stakeholders
through written reports. These reports may include an auditor's opinion on the
fairness of the financial statements, recommendations for improvement, and
other relevant information.
7. Professional Ethics: Auditors are expected to adhere to high ethical
standards, including independence, objectivity, confidentiality, and
professional competence. They must comply with relevant professional
standards, codes of conduct, and regulations.
8. Continuing Professional Development: Auditors are required to continuously
update their knowledge and skills through ongoing professional development
activities, such as training, seminars, and certifications, to stay abreast of
changes in accounting standards, auditing regulations, and industry
developments.
9. Relationship Management: Auditors interact with management, audit
committees, and other stakeholders to understand the organization's
operations, systems, and controls. They build professional relationships
based on trust, integrity, and effective communication.

17.7 NEED FOR A COMPANY AUDITOR

The need for a company auditor arises from several critical factors:
1. Legal Requirement: Companies are often legally required to undergo audits
as per the regulations stipulated by the Companies Act or other relevant
legislation. Compliance with these regulations is mandatory to ensure the
company operates within the bounds of the law.
 2. Financial Transparency: Auditors play a crucial role in ensuring the accuracy
and transparency of a company's financial statements. Through independent
verification and examination, auditors provide assurance to stakeholders that
the financial information presented is reliable and free from material
misstatement.
3. Investor Confidence: External audits enhance investor confidence by
providing an independent assessment of a company's financial health and
performance. Investors are more likely to trust audited financial statements,
which can positively impact the company's ability to attract investment and
access capital markets.
4. Creditor Assurance: Audited financial statements provide assurance to
creditors regarding a company's ability to meet its financial obligations.
Lenders often require audited financial statements as part of their due
diligence process when extending credit to a company.
5. Risk Management: Auditors help identify and assess financial risks, internal
control weaknesses, and areas of operational inefficiency within a company.
By highlighting these risks, auditors enable management to implement
appropriate risk mitigation strategies and improve overall business
performance.
6. Fraud Detection: Auditors are trained to detect and investigate instances of
fraud or financial irregularities within a company. Their independent scrutiny
helps deter fraudulent activities and protects the interests of shareholders and
other stakeholders.
7. Regulatory Compliance: Auditors ensure that companies comply with
relevant accounting standards, regulations, and reporting requirements.
Compliance with these regulations is essential to avoid penalties, fines, or
legal repercussions.
8. Corporate Governance: External audits contribute to sound corporate
governance practices by promoting transparency, accountability, and ethical
conduct within the organization. Auditors play a vital role in upholding
corporate governance standards and protecting shareholder interests.
17.8 Benefits of Hiring a Company Auditor
Hiring a company auditor can provide a number of benefits to businesses, including:
1. Financial Accuracy: An auditor ensures the accuracy of financial statements,
providing stakeholders with reliable information about the company's financial
position, performance, and cash flows.
2. Compliance Assurance: Auditors ensure that financial statements comply
with relevant accounting standards, regulations, and legal requirements,
reducing the risk of non-compliance and associated penalties.
3. Enhanced Transparency: Audited financial statements enhance
transparency by providing an independent assessment of the company's
 financial affairs, fostering trust among investors, creditors, and other
stakeholders.
4. Improved Decision-Making: Reliable financial information enables
management to make informed decisions regarding investments, resource
allocation, strategic planning, and risk management, ultimately contributing to
the company's growth and profitability.
5. Risk Mitigation: Auditors identify internal control weaknesses, operational
inefficiencies, and areas of financial risk, enabling management to implement
corrective measures and mitigate potential risks.
6. Fraud Detection: Auditors help detect and prevent fraudulent activities by
assessing internal controls, conducting thorough examination of financial
transactions, and identifying irregularities or anomalies.
7. Investor Confidence: Audited financial statements instill confidence in
investors, lenders, and shareholders, facilitating access to capital, reducing
borrowing costs, and attracting investment.
8. Legal Protection: Audited financial statements provide legal protection in
case of disputes, litigation, or regulatory investigations, as they serve as
credible evidence of the company's financial position and compliance with
laws and regulations.
9. Improved Governance: Auditors contribute to sound corporate governance
practices by providing independent oversight, ensuring accountability, and
promoting ethical conduct within the organization.
10. Stakeholder Trust: Overall, hiring a company auditor helps build trust and
credibility with stakeholders, including shareholders, customers, suppliers,
and regulators, enhancing the company's reputation and long-term viability..

17.9 QUALIFICATIONS OF A COMPANY AUDITOR

According to Section 226(1) and (2) of the Companies Act, 1956, the prescribed
qualifications for a person to be appointed as a company auditor are as follows:
4. Membership of a Recognized Professional Accounting Body: The Companies
Act typically requires that a company auditor be a member in good standing of
a recognized professional accounting body. This could include bodies such as
the Institute of Chartered Accountants of India (ICAI), Institute of Cost
Accountants of India (ICAI), or other similar recognized accounting bodies.
5. Experience and Expertise: Additionally, the auditor should possess the
requisite experience and expertise in auditing and accounting practices. This
typically involves having a certain number of years of practical experience in
auditing financial statements and a thorough understanding of relevant
accounting standards and regulations.
 6. Independence and Integrity: Auditors must uphold high standards of
independence and integrity in their professional conduct. They should be free
from any conflicts of interest that could impair their objectivity and impartiality
in carrying out their audit responsibilities.

17.10 DISQUALIFICATIONS OF AUDITORS

[Section 141(3) and Rule 10 of Companies (Audit and Auditors) Rules, 2014]:
The following persons shall not be eligible for appointment as an auditor of a
company, namely:
(a) “a body corporate other than a limited liability partnership (LLP) registered
under the Limited Liability Partnership Act, 2008”;
Explanation
It means – If chartered accountants form a company (Whether public/private – like
RK Private Ltd./RK Limited) – This Company of CAs cannot be qualified for
appointment as auditor of another company.
What is body corporate?
Body corporate u/s 2(11) includes a company as per the Companies Act, 2013 and a
foreign company which is incorporated outside India.
Logic behind why a body corporate is not eligible to be an auditor?
As you know a Limited company has “limited liability” & Separate legal entity – The
members of the company are responsible only to the extent of unpaid capital (if any).
In case of any issue – We cannot make members personally responsible.
In case of LLP, at least one partner will have unlimited liability; hence it is allowed to
be auditor.
(b) an officer or employee of the company;
Explanation
As per Section 2(59), ‘Officer’ includes


 Any director;
 Manager;
 Key managerial personnel (KMP); or
 Any person in accordance with whose directions or instructions
the BOD or any one or more of the directors is or are
accustomed to act.
As per Section 2(51), ‘Key Managerial Personnel’, in relation to a company, means:


 the chief executive officer (CEO) or the managing director or the

manager;
 the company secretary;
 the whole-time director;
 the chief financial officer (CFO); and
 such other officer as may be prescribed. Like Chief Operating
Officer (COO), etc.
Reason
An officer or employee – cannot be independent – If those are appointed as auditors
of the company, they cannot express independent opinion on the financial
statements.
(c) a person who is a partner, or who is in the employment (employee), of
an officer or employee of the company;
(d) a person who, or his relative or partner
(i) is holding any security of or interest in the company or its subsidiary, or of
its holding or associate company or a subsidiary of such holding company;
(ii) is indebted to the company, or its subsidiary, or its holding or associate company
or a subsidiary of such holding company, in excess of ` 5 Lacs; OR
(iii) has given a guarantee or provided any security in connection with the
indebtedness of any third person to the company, or its subsidiary, or its holding or
associate company or a subsidiary of such holding company, in excess of ` 1 Lac;

17.11 APPOINTMENT OF AN AUDITOR

1. Appointment of the First Auditor [Sec. 139(6)]


 The first auditor of a company, other than a Government company,

shall be appointed by the Board of Directors (only by BOD) within
30 days from the date of registration (i.e., Date of Incorporation) of
the company.
 In the case of failure of the Board to appoint such auditor, it
shall inform the members of the company, who shall appoint within
90 days at an extraordinary general meeting (EGM).
  The first auditor shall hold office from the date of appointment
to till the conclusion of the first AGM.
2. Appointment of the First Auditor of Government Company [Sec. 139(7)]
For a government company; or

 First auditor shall be appointed by the CAG within 60 days from the
date of registration of the company.
 In case the CAG does not appoint such auditor within the said period,
the Board of Directors of the company shall appoint such
auditor within 30 days.
 In the case of failure of the Board to appoint such auditor, it shall
inform the members of the company within the next 30 days and who
shall appoint such auditor within the 60 days at an EGM.
 The auditor so appointed shall hold office from the date of
appointment till the conclusion of the 1st AGM.
3. Appointment of Subsequent Auditor/Reappointment of Auditor
[Section 139(1) & Rules 3 and 4 of Companies (Audit and Auditors) Rules,
2014]
(1) Every company shall, at the First AGM, appoint an individual or a firm (includes
LLP) as an auditor of the company.


 Every company means ALL the companies incorporated under

the Act which includes one-person company, Sec. 8 company,
etc.;
 Ordinary resolution is sufficient to appoint an auditor.
(2) The auditor shall hold office from the conclusion of 1st AGM till the conclusion
of its 6th AGM (i.e., for 5 years); Appointment takes place only for 5 years, it means
– No company can appoint auditor for less than 5 years. The AGM, in which he is
appointed is counted as 1st AGM.

Manner and Procedure for Appointment

[Rule 3 of Companies (Audit and Auditor’s) Rules, 2014]
The competent authority to appoint auditor is Audit committee of the company (if the
company has); If it does not have audit committee, Board of directors are competent
authority.
Term & Rotation of Auditor
Sec. 139(2) & Rule 5 of Companies (Audit and Auditors) Rules, 2014
Rotation of auditors is a new topic introduced in the Companies Act, 2013. As per
the section, a company should rotate auditors after specified time. It means, the
same auditor cannot continue forever. Let us get into the details of the section.
TERM
Rotation is applicable only to
(1) Listed companies;
(2) Other prescribed class of companies (except One person & small companies)
(a) all unlisted public companies having paid up share capital ≥ ` 10 crore;
(b) all private limited companies having paid up share capital ≥ ` 50 crore; or
(c) all companies having public borrowings from financial institutions, banks or
public deposits ≥ ` 50 crores.
The above companies shall not appoint or re-appoint:
(a) an individual as auditor for more than ONE term of five consecutive years;
and
(b) an audit firm as auditor for more than TWO terms of five consecutive years

17.12 Summary
To become an auditor, one must possess essential qualifications including
educational background, professional certifications, statutory requirements, and
personal attributes. Educational qualifications typically involve a degree in
accounting, finance, or related fields. Professional certifications such as Certified
Public Accountant (CPA), Chartered Accountant (CA), or Certified Internal Auditor
(CIA) are often required. Statutory qualifications vary by jurisdiction but may include
registration with regulatory bodies. Personal qualifications include integrity, analytical
skills, attention to detail, and ethical conduct. Companies need auditors to ensure
financial transparency, compliance with regulations, and accurate reporting. Hiring a
company auditor provides benefits such as independent assessment, risk
management, and enhanced credibility. However, auditors must also meet specific
qualifications and avoid disqualifications, ensuring their appointment is in line with
regulatory guidelines.
Self Assessment
1. State down the educational qualification of auditor?
2. Describe the qualification of auditor: professional certifications?
3. What are the various Statutory Qualification of Auditor?
4. What is the procedure for Appointment of the First Auditor?

17.13 Glossary
Body corporate u/s 2(11) includes a company as per the Companies Act, 2013 and
a foreign company which is incorporated outside India.

17.14 Answers: Self Assessment

1). Please check section 17.3 2). Please check section 17.4
3). Please check section 17.5 4). Please check section 17.11
17.15 Terminal Questions
1. What are the essential qualities or skills required to become an auditor?And also
What are the typical educational requirements for individuals aspiring to become
auditors?
2. What are the advantages of hiring a professional auditor for a company's financial
statements?
3. What circumstances or conditions might disqualify an individual from serving as
an auditor?
4. What is the process for appointing an auditor for a company?
17.16 Answers: Terminal Questions:
1). Please check section 17.2 and 17.3 2). Please check section 17.8
3). Please check section 17.10 4). Please check section 17.11
17.17 Suggested Readings
1. Dalal, Chetan. (2015). Novel & Conventional Methods of Audit, Investigation
and Fraud Detection. Wolters Kluwer India Pvt. Ltd.
2. Gupta, Sanjeev (2016). Corporate Frauds and their Regulation in India.
Bharat Law House Pvt. Ltd
3. Kaul, Vivek (2013). Easy Money. Sage Publications, New Delhi.
4. Manning, George A. (2010). Financial Investigation and Forensic Accounting.
CRC Press: Taylor & Francis Group.
5. Sharma, B. R. (2014). Bank Frauds. Universal Law Publishing, New Delhi
 Lesson – 18
Company Auditor-II
Structure:
18.0 Learning Objectives
18.1 Introduction
18.2 Status of the auditor
18.3 Role of internal and external auditors
18.4 Advantages of internal auditor
18.5 Role of internal auditors detect fraud
18.6 Objectives of internal and external auditors
18.7 Differences in skills and capabilities
18.8 Rights and powers of an auditor
18.9 Duties of an auditor
18.10 Removal of an auditor
18.11 Summary
18.12 Glossary
18.13 Answers: Self Assessment
18.14 Terminal Questions
18.15 Answers: Terminal Questions:
18.16 Suggested Readings
18.0 Learning Objectives
After studying the lesson, you should be able to:-
1. Status of the auditor
2. Role of internal and external auditors
3. Rights and powers of an auditor
4. Removal of an auditor

18.1 INTRODUCTION

The company auditor plays a critical role in ensuring the accuracy and integrity of
financial statements, providing stakeholders with confidence in the company's
financial health and transparency. As an independent and impartial professional, the
auditor conducts thorough examinations of financial records, assesses internal
controls, and verifies compliance with accounting standards and regulations. This
introduction explores the significance of the company auditor's role, highlighting their
responsibilities, qualifications, and the importance of maintaining their independence
and ethical standards. Additionally, it underscores the trust placed in auditors by
shareholders, regulators, and other stakeholders, emphasizing the vital role they
play in upholding corporate governance and financial accountability.

18.2 STATUS OF THE AUDITOR

The status of the auditor within a company is akin to that of an agent
entrusted with a crucial responsibility. As an independent evaluator of
financial statements, the auditor assumes a fiduciary role, safeguarding the
interests of stakeholders by ensuring the accuracy and reliability of financial
information. Much like an agent, the auditor operates with a duty of care and
loyalty, upholding professional standards and ethical principles in the
performance of their duties.

1. Agent of Shareholders: Auditors serve as agents of the shareholders by

independently examining the company's financial statements and providing
assurance on their accuracy and fairness. Shareholders rely on audited
financial statements to make informed decisions about their investments and
assess the company's performance.
2. Agent of Management: While auditors are engaged by the company's board
of directors or audit committee, they maintain independence from
management. However, auditors work closely with management to obtain
necessary information and ensure cooperation during the audit process. As
agents of management, auditors help identify areas for improvement in
internal controls and financial reporting processes.
3. Agent of Regulatory Authorities: Auditors also act as agents of regulatory
authorities by ensuring compliance with applicable laws, regulations, and
accounting standards. Regulatory bodies rely on auditors to provide
assurance that financial statements accurately reflect the company's financial
position and comply with legal requirements.
4. Agent of Public Interest: Auditors serve as agents of the public interest by
promoting transparency and accountability in financial reporting. They play a
vital role in maintaining public confidence in the reliability of financial
information disclosed by companies. Auditors owe a duty to the broader
community to conduct audits with integrity and objectivity.
5. Agent of the Board of Directors/Audit Committee: Auditors are appointed
by the board of directors or audit committee to provide independent oversight
of the company's financial reporting process. They report directly to these
 governing bodies and are responsible for communicating audit findings and
recommendations for improvement.
18.3 Role of Internal and External Auditors
Internal and external auditors are like financial detectives who help make sure
companies are honest and secure. Internal auditors are like inside detectives; they
check the company’s own systems to prevent problems. On the other hand, external
auditors are like outside detectives; they double-check a company’s financial reports
to make sure everything adds up. In this conversation, we’ll explore what each type
of auditor does and how they work together to keep companies honest and maintain
trust in the world of money and business.

1. Internal Auditors
An internal auditor is a key figure in a company who ensures financial accuracy,
operational efficiency, and data security. They examine financial statements,
improve operational processes, and assess data security. Their role includes risk
assessment to prevent fraud. They often work within specific departments, reporting
to top executives or committees and providing essential insights and assurance.
In addition to financial oversight, internal auditors delve into the company’s everyday
operations, identifying areas for improvement and potential risks. They act as a
safeguard, examining the organization’s computer systems for security and ensuring
that everything functions smoothly. By doing so, they help maintain trust, prevent
issues, and support the company’s overall growth and stability.
internal and external auditors play crucial roles in ensuring the integrity and reliability
of financial information within organizations. Let's delve deeper into the
responsibilities and functions of each type of auditor and how they collaborate to
uphold transparency and trust in the realm of finance and business.

Internal Auditors: Internal auditors serve as the "inside detectives" of a company,

focusing on assessing and improving internal controls, risk management processes,
and operational efficiencies. Their primary objectives include:
1. Evaluating the effectiveness of internal controls: Internal auditors examine the
company's policies, procedures, and processes to identify weaknesses and
vulnerabilities that could lead to errors, fraud, or non-compliance with
regulations.
2. Conducting operational audits: They review various operational areas of the
organization, such as procurement, inventory management, and human
 resources, to ensure efficiency, effectiveness, and adherence to company
policies.
3. Assessing compliance: Internal auditors verify compliance with laws,
regulations, and internal policies to mitigate legal and regulatory risks.
4. Providing recommendations for improvement: Based on their findings, internal
auditors offer recommendations to management for enhancing internal
controls, streamlining processes, and mitigating risks to achieve
organizational objectives more effectively.
2. External Auditors: External auditors act as the "outside detectives" of a
company, providing independent assurance on the accuracy and fairness of its
financial statements. Their key responsibilities include:
1. Auditing financial statements: External auditors examine the company's
financial records, transactions, and disclosures to assess whether they
present a true and fair view of its financial position and performance.
2. Testing internal controls: While external auditors do not focus on the detailed
testing of internal controls like internal auditors, they do assess the
effectiveness of key controls relevant to financial reporting to determine the
extent of substantive testing required.
3. Reporting findings to stakeholders: External auditors issue an audit opinion
expressing their professional judgment on the fairness of the financial
statements. This opinion provides assurance to investors, lenders, regulators,
and other stakeholders regarding the reliability of the company's financial
information.
4. Providing insights and recommendations: In addition to their audit opinion,
external auditors may offer insights and recommendations to management
based on their observations during the audit process, although their primary
focus remains on providing assurance on the financial statements.

18.4 ADVANTAGES OF INTERNAL AUDITOR

Internal auditors play a crucial role in ensuring the integrity, efficiency, and
security of a company's operations. They are tasked with a range of
responsibilities aimed at safeguarding assets, identifying areas for
improvement, and mitigating risks. Here's an overview of the key functions
and significance of internal auditors:
1. Financial Accuracy: Internal auditors examine financial statements,
transactions, and accounting practices to verify their accuracy and compliance
with applicable standards and regulations. By conducting thorough reviews
and analyses, they help detect errors, irregularities, or discrepancies that
could impact the reliability of financial reporting.
 2. Operational Efficiency: Internal auditors assess the efficiency and
effectiveness of operational processes and procedures across various
departments within the organization. They identify opportunities to streamline
workflows, eliminate inefficiencies, and optimize resource allocation to
enhance productivity and performance.
3. Data Security: In today's digital age, data security is paramount. Internal
auditors play a crucial role in evaluating the adequacy and effectiveness of
the organization's information security controls. They assess the integrity,
confidentiality, and availability of data, identify vulnerabilities, and recommend
measures to mitigate cybersecurity risks and safeguard sensitive information.
4. Risk Assessment: Internal auditors conduct risk assessments to identify and
prioritize potential risks that could impact the organization's objectives. They
evaluate internal controls, business processes, and compliance with
regulatory requirements to prevent and detect fraud, errors, or misconduct. By
proactively addressing risks, internal auditors help protect the organization
from financial losses and reputational damage.
5. Departmental Oversight: Internal auditors often work closely with specific
departments or business units within the organization, providing independent
and objective assurance to management and executives. They report their
findings and recommendations to senior leadership or audit committees,
helping them make informed decisions and take corrective actions as needed.
6. Continuous Improvement: Internal auditors play a proactive role in driving
continuous improvement initiatives within the organization. They identify
opportunities for process enhancements, cost savings, and performance
optimization, contributing to the company's overall growth, innovation, and
sustainability.
18.5 Role of internal Auditors Detect Fraud
internal auditors play a critical role in detecting and investigating incidents of fraud
within an organization. Here's how they typically handle fraud detection and
investigation:
1. Reviewing Processes and Internal Controls: Internal auditors regularly
review the company's processes and assess the effectiveness of its internal
controls. This proactive approach helps identify potential vulnerabilities and
weaknesses that could be exploited for fraudulent activities.
2. Authority to Investigate Fraud: Internal auditors are empowered to
investigate incidents of fraud within the organization. They have the authority
to collect evidence, interview relevant individuals, and examine financial
records and other relevant documentation to uncover fraudulent activities.
3. Careful Planning and Resource Allocation: When investigating fraud,
internal auditors plan the investigation process meticulously. They allocate
experienced resources to the case and ensure that the investigation is
conducted thoroughly and impartially.
 4. Interviewing Individuals Involved in Fraud: As part of the investigation
process, internal auditors may conduct interviews with individuals suspected
of being involved in fraudulent activities. These interviews help gather
additional information and evidence to support the investigation.
5. Preparing Investigation Reports: Upon completing the investigation, internal
auditors prepare a detailed report summarizing their findings, including
evidence of fraud, the extent of the wrongdoing, and recommendations for
corrective actions.
6. Sharing Findings with Management and Oversight Committees: The
fraud investigation report is typically shared with the company's fraud
management committee and the Board of Audit and Compliance (BAC) for
their review and feedback. This ensures transparency and accountability in
addressing incidents of fraud within the organization.
By actively detecting and investigating fraud, internal auditors help safeguard the
company's assets, protect its reputation, and maintain trust among stakeholders.
Their thorough and systematic approach to fraud detection and investigation
contributes to the overall integrity and reliability of the organization's operations.

18.6 Objectives of Internal and External Auditors

Objectives of Internal vs External Auditors:
Internal Auditors:
1. Company Focus: The primary objective of internal auditors is to ensure the
accuracy and integrity of the company's financial statements and reports.
They focus on verifying the reliability of financial information generated
internally within the organization.
2. Collaboration: Internal auditors closely collaborate with the company's
management and internal stakeholders. They work as part of the internal
team, aiming to ensure compliance with Generally Accepted Accounting
Principles (GAAP) and other relevant standards. Internal auditors act as a
quality control function, ensuring that financial reporting processes are
effective and reliable.
3. Internal Controls: In addition to financial reporting, internal auditors assess
and improve internal controls and operational processes within the
organization. They aim to enhance operational efficiency, identify
inefficiencies, and mitigate risks. Internal auditors focus on strengthening the
company's internal workings and processes to achieve organizational
objectives effectively.
External Auditors:
1. Stakeholder Focus: External auditors serve external stakeholders, such as
shareholders, investors, creditors, and regulatory bodies. Their primary
 objective is to provide an independent and unbiased assessment of the
company's financial position and performance. External auditors act as an
external check and balance on the company's financial reporting, ensuring
transparency and reliability for stakeholders.
2. Certification: The main goal of external auditors is to certify the reliability and
accuracy of the financial information presented by the company. They verify
that the financial statements present a true and fair view of the company's
financial health and performance. External auditors' certification provides
assurance to stakeholders, especially investors, who rely on financial
statements for making investment decisions.
3. Independence: External auditors maintain independence from the company
they audit to ensure impartiality and objectivity in their assessment. They are
not part of the company's internal team and operate with autonomy to provide
an unbiased opinion on financial statements and related matters.
Independence is crucial for maintaining the credibility and integrity of external
audit reports.

18.7 Differences in Skills and Capabilities between Internal and External

Auditors:
1. Employment Relationship:
 Internal auditors are company insiders, employed by the organization
they audit.
 External auditors are outside experts, independent of the organization
they audit.
2. Knowledge Depth:
 Internal auditors possess in-depth knowledge of the company's internal
systems, processes, and operations.
 External auditors are well-versed in auditing standards, practices, and
techniques, with a broad understanding of financial auditing.
3. Focus Areas:
 Internal auditors primarily focus on operational effectiveness,
compliance with rules and regulations, and identifying operational and
compliance risks within the company.
 External auditors concentrate on financial matters, such as verifying
the accuracy of financial statements, assessing financial risks, and
ensuring compliance with accounting standards.
4. Reporting Lines:
  Internal auditors report their findings and recommendations to the
company's management, acting as internal watchdogs to improve
internal controls and operations.
 External auditors provide their reports to the company's shareholders,
regulatory authorities, or other external stakeholders, serving as an
external check and balance on the company's financial reporting.

18.8 RIGHTS AND POWERS OF AN AUDITOR

Rights and Powers of an Auditor:
1. Right to Inspect Books of Accounts (Section 227(1)):
 The auditor has the right to inspect the company's books of accounts
and vouchers, including statutory, statistical, and costing books.
 This right includes access to branch books and vouchers, ensuring a
comprehensive audit.
2. Right to Ask for Information and Clarifications (Section 227(1)):
 The auditor can request information and explanations from the
company's directors and officers necessary for auditing duties.
 This ensures transparency and facilitates the auditor's understanding of
financial transactions.
3. Right to Receive Notice of General Meetings and Attend (Section 231):
 The auditor has the right to receive notice of general meetings and
attend them, even if the company's accounts are not on the agenda.
 This allows the auditor to stay informed about company affairs and
address any concerns directly with shareholders.
4. Right to Make a Statement in the Meeting:
 The auditor can make a statement at shareholder meetings regarding
the company's accounts.
 However, the auditor is not obligated to make a statement unless
requested by the meeting chairman, and statements should be limited
to accounting matters.
5. Right to be Indemnified (Section 633):
 The auditor is entitled to be indemnified from the company's assets for
legitimate expenses incurred while defending against civil or criminal
proceedings.
  This protects auditors from financial liabilities arising from legal actions
related to their audit activities.
6. Right to Visit Branches:
 The auditor has the right to visit each branch of the company as part of
the audit process, provided those branches do not have separate
auditors and are not exempt from audit by the Central Government.
7. Right to Take Legal and Technical Advice:
 The auditor can seek legal and technical advice as needed to fulfill
audit responsibilities effectively.
 This ensures auditors have access to necessary expertise to address
complex audit issues and comply with regulatory requirements.

8. Right to Take Legal, Expert, or Technical Advice:

 The auditor has the right to seek legal, expert, or technical advice to
enhance the quality of their audit work.
 However, the auditor is responsible for forming and expressing their
own opinion in the audit report, distinct from any opinions provided by
external experts.
9. Right to Ask for Remuneration:
 The auditor has the right to request remuneration for completing the
audit work.
 Even in cases where the auditor is dismissed after appointment, they
are entitled to receive their fees for the work done.
10. Right to Sign the Audit Report (Section 229):
 The auditor has the right to sign the audit report, providing assurance
on the accuracy and fairness of the company's financial statements.
 In the case of an audit firm, a practicing Chartered Accountant partner
is authorized to sign the report and other relevant documents required
by law.
11. Right to Correction of Wrong Statements:
 The auditor has the right to correct any incorrect statements made by
directors during general meetings, particularly if those statements
relate to the audited accounts of the company.

18.9 Duties of an Auditor

 Duties of an auditor can be classified under two categories: A. Duties under the
Companies Act; and B. Duties as per Legal Decisions. Let's explore the duties under
the Companies Act:
A. Duties under the Companies Act:
1. Special Enquiries and Investigations (Section 227(IA)):
 The auditor is duty-bound to conduct special inquiries and
investigations related to various matters, including the proper security
of loans and advances, transactions represented by book entries, and
the sale of company assets.
(i) Ensuring loans and advances are properly secured and terms are not prejudicial
to the company's interests.
(ii) Verifying transactions represented by book entries are not prejudicial to the
company's interests.
(iii) Assessing the sale of shares, debentures, and securities to ensure they were not
sold at a price less than their purchase price.
(iv) whether loans and advances made by the company have been shown as
deposits;
(v) whether personal expenses have been charged to revenue accounts;
(vi) whether it is stated in the books and papers of the company that any shares
have been allotted for cash, whether cash has been received in respect of such
allotment, and if no cash has been so received, whether the position as stated in the
account books and the balance sheet is correct, regular and not misleading.
2. To Make Report to Shareholders (Section 227(2, 3 & 4)):
 The auditor must report to the members of the company on the
accounts examined by them and on every balance sheet and profit and
loss account presented at the general meeting.
 The audit report must address specific points, including whether the
accounts provide required information, present a true and fair view, and
whether proper books of account have been maintained.
3. Duty to State the Reasons for Negative Answers:
 If any of the points in the audit report receive negative answers, the
auditor must provide reasons for the negative response.
4. Duty to Include Matters Directed by Central Government (Section
227(4A)):
 The Central Government can direct auditors to include specific matters
in their report, and auditors must comply with such directions.
5. Duty to Sign the Audit Report (Section 229):
  Auditors must sign the audit report before sending it to the company
secretary.
6. Duty to Give a Report upon the Prospectus (Section 56(1)):
 Auditors must provide a report on the prospectus issued by an existing
company, including an assessment of assets, liabilities, and profit and
loss.
7. Duty to Certify the Statutory Report (Section 165(4)):
 Auditors must certify the correctness of the statutory report regarding
shares allotted, cash received, and payments made.
8. Duty to Declare the Solvency of Directors (Section 488(2)(b)):
 In voluntary liquidation, auditors must declare the solvency of directors.
9. Duty to Give a Report upon Profit and Loss Account and Balance Sheet
(Section 488(2)(b)):
 Auditors must provide a report on the profit and loss account and
balance sheet enclosed with the declaration of solvency.
10. Duty to Assist Investigators (Section 240(v)(b)):
 Auditors must assist investigators by providing necessary assistance
and producing audit working papers.
B. Duties According to Legal Decisions: Certain duties have been established by
legal decisions, including:
 Duty to inform members and shareholders about contraventions of company
law.
 Duty to enroll with the Institute of Chartered Accountants of India and obtain a
certificate.
 Duty to acquaint oneself with company law provisions and inquire from
predecessors.
 Duty not to canvass for appointment as auditor.
 Duty to verify cash in hand and not to be negligent in work.
 Duty to inspect securities personally and ensure safe custody.
 Duty to perform tasks with ability, care, and skill, including verifying
inventories and ledger accounts.
Non-performance of these duties has led to penalties in court, emphasizing the
importance of compliance for auditors.

18.10 REMOVAL OF AN AUDITOR

An auditor of a company can be removed from office before the expiry of their term
in several ways:
MANDATORY REQUIREMENTS
1. Approval of Central Government is required for removal of auditor.
2. The concerned auditor shall be given an opportunity of being heard.
3. Company has to take Shareholders’ approval within 60 days of receipt of
approval of Regional Director.
FOLLOWING PROCEDURE IS TO BE FOLLOWED
1. Approval for Removal from the Audit Committee
Where a Company is required to constitute an Audit Committee under section
177 then the proposal to remove the auditor shall be approved by the Audit
committee in a duly convened meeting of Committee. [For convening
meeting of Audit Committee, Refer the Procedure for Conducting Audit
Committee Meeting].
2. Convene a Meeting of Board of Directors [As per Section 173 &
Secretarial Standard-1 (SS-1)]
a. Fix the date of Board Meeting for removal of auditor in consultation with
the Chairman or the Managing Director of the Company.
b. Issue Notice of Board Meeting to all the Directors of Company at their
addresses registered with the Company, at least 7 days before the
date of Board Meeting. A shorter notice can be issued in case of urgent
business.
c. Attach Agenda, Notes to Agenda and Draft Resolution with the Notice.
d. Intimate the concerned auditor about the date of Board Meeting at
which resolution for his removal shall be passed in order to give him an
opportunity of being heard.
e. Hold a meeting of Board of Directors and pass the following Board
Resolution
 to consider the removal of the auditor before expiry of his
tenure.
 to authorize CS or CFO or any director of the Company to file
the application with Regional Director (RD).
 to authorize practicing CA/CS/CMA/Advocate to appear before
RD and execute a Vakalatnama or Memorandum of
appearance.
f. Listed Company shall submit the disclosure to the Stock Exchange
about the decision to file application for removal of Auditor as soon as
reasonably possible but not later than 30 minutes from the date of the
 Board Meeting and post the same on the website of the Company
within 2 working days. [Regulation 30 & 46(3) of the SEBI (LODR)
Regulations, 2015]
g. Prepare and Circulate Draft Minutes within 15 days from the conclusion
of the Board Meeting, by Hand/Speed Post/Registered Post/Courier/E-
mail to all the Directors for their comments. [Refer the Procedure for
Preparation and Signing of Minutes of Board Meeting]
3. File an Application to the Regional Director
Company shall file an application to the Regional Director for removal of
Auditor within 30 days of the resolution passed in the Board Meeting in Form
ADT-2 along with the details of the grounds for seeking removal of auditor.
4. Hearing and Order by Regional Director
 On receiving the application, Regional Director shall give a date for the
hearing.
 After hearing, RD may give approval for removal of the Auditor.
5. Intimation to the Stock Exchange about the Order [Regulation 30 and
46(3) of SEBI (LODR) Regulations, 2015]
Listed Companies shall submit the disclosure about the order of RD to the
Stock Exchange as soon as reasonably possible but not later than the
following:
i. within twelve hours from the occurrence of the event or information, in
case the event or information is emanating from within the listed entity
ii. twenty four hours from the occurrence of the event or information, in
case the event or information is not emanating from within the listed
entity, from the date of hearing and post the same on the website of the
company within 2 working days.
6. File Certified Copy of Order with ROC
Company shall file certified copy of order with ROC in Form INC-28 within 30
days from the date of issue of certified copy of order.
7. Convene a Meeting of Board of Directors [As per section 173 & SS-1]
a. Issue Notice of Board Meeting to all the Directors of Company at their
addresses registered with the Company, at least 7 days before the
date of Board Meeting. A shorter notice can be issued in case of urgent
business.
b. Attach Agenda, Notes to Agenda and Draft Resolution with the Notice.
c. Hold a meeting of Board of Directors of the Company and pass the
necessary Board Resolution
i. to take note of the order of Regional Director.
 ii. to fix day, date, time and venue for holding General Meeting of
the Company.
iii. to approve the draft notice of General Meeting along with
explanatory statement annexed to the notice as per requirement
of the Section 102 of the Companies Act, 2013.
iv. to authorize the Director or Company Secretary to sign and
issue notice of the General Meeting and to do such acts, deeds
and things as may be necessary to give effect to the Board’s
decision.
d. Prepare and Circulate Draft Minutes within 15 days from the conclusion
of the Board Meeting, by Hand/Speed Post/Registered Post/Courier/E-
mail to all the Directors for their comments. [Refer the Procedure for
Preparation and Signing of Minutes of Board Meeting]
8. Convene General Meeting [Section 96, 100 and SS-2]
a. Notice of General Meeting shall be given at least clear 21 days before
the actual date of a General Meeting in writing, by hand or by ordinary
post or by speed post or by registered post or by courier or by facsimile
or by e-mail or by any other electronic means or a Shorter Notice can
be issued with the consent of at least majority in number and ninety
five percent of such part of the paid up share capital of the company
giving a right to vote at such a meeting in accordance with Section
101.
b. Notice will be sent to all the Directors, Members, Auditors of Company,
Secretarial Auditor, Debenture Trustees and to others who are entitled
to receive the notice of the General Meeting.
c. Notice shall specify the day, date, time and full address of the venue of
the Meeting and contain a statement on the business to be transacted
at the Meeting.
d. Hold the General Meeting within 60 days from the date of receipt of
approval of Central Government and pass Special Resolution for
removal of auditor before expiry of his tenure.
e. Listed Companies shall disclose the proceedings of General Meeting to
the Stock Exchange within 24 hours from the conclusion of General
Meeting and same shall be posted on the website of the company
within 2 working days. [Regulation 30 and 46(3) of the SEBI (LODR)
Regulations, 2015]
f. Listed Companies shall submit to the stock exchange the details of the
voting results within two working days from the conclusion of the
meeting and post the same on the website of the
Company. [Regulation 44 of the SEBI (LODR) Regulations, 2015]
 g. Prepare the minutes of General Meeting, get them signed and compile
accordingly. [Refer the Procedure for Preparation and Signing of
Minutes of General Meeting].
9. File Form MGT-14 with ROC
File Form MGT-14 with the ROC within 30 days of passing Special Resolution
in General Meeting along with fee as specified in the Companies (Registration
offices and fees) Rules, 2014 and with the following attachments
a. Certified True Copies of the Special Resolution passed along with
Explanatory Statement
b. Certified Copy of Order of RD
c. Copy of the Notice of meeting sent to members along with all the
annexure
d. Shorter Notice Consent Letters from the members in case the General
Meeting was convened at shorter notice
e. Copy of Attendance Sheet of General Meeting
f. Any other attachment as may be applicable.

Self Assessment
1. Identify the key differences in skills and capabilities required for internal and
external auditing roles.?
2. Discuss the primary duties and responsibilities of an auditor.
3. What rights and powers does an auditor typically have during the audit
process?
4. Explain the role of internal auditors in detecting and preventing fraud within an
organization.

18.11 Summary
Auditors hold a critical status within organizations, tasked with ensuring financial
integrity and regulatory compliance. Internal auditors focus on internal controls, risk
management, and process improvement, providing valuable insights for management.
Their advantages include real-time monitoring and customized solutions. Detecting
fraud falls within their purview, aligning with their objective of safeguarding assets.
External auditors, meanwhile, independently verify financial statements for accuracy
and adherence to standards. The differences in their skills lie in internal auditors' deep
understanding of company operations versus external auditors' expertise in
accounting standards. Auditors possess rights and powers to access records, gather
evidence, and report findings accurately. Their duties include thorough examination,
reporting irregularities, and maintaining professional skepticism. Removal of an
auditor typically follows due process outlined in regulations, ensuring transparency
and accountability.
18.12 Glossary
1. Internal Auditors: An internal auditor is a key figure in a company who ensures
financial accuracy, operational efficiency, and data security. They examine
financial statements, improve operational processes, and assess data security.
Their role includes risk assessment to prevent fraud. They often work within
specific departments, reporting to top executives or committees and providing
essential insights and assurance.
2. External Auditors: External auditors act as the "outside detectives" of a
company, providing independent assurance on the accuracy and fairness of its
financial statements.
18.13 Answers: Self Assessment
1). Please check section 18.7 2). Please check section 18.9
3). Please check section 18.8 4). Please check section 18.5
18.14 Terminal Questions
1. What is the status of an auditor within an organization's governance
structure?
2. Compare and contrast the roles of internal and external auditors.
3. Discuss the advantages of having an internal auditor within an organization
4. Explain the role of internal auditors in detecting and preventing fraud within an
organization.
18.15 Answers: Terminal Questions:
1). Please check section 18.2 2). Please check section 18.3
3). Please check section 18.4 4). Please check section 18.5
18.16 Suggested Readings
1. Dalal, Chetan. (2015). Novel & Conventional Methods of Audit, Investigation
and Fraud Detection. Wolters Kluwer India Pvt. Ltd.
2. Gupta, Sanjeev (2016). Corporate Frauds and their Regulation in India.
Bharat Law House Pvt. Ltd
3. Kaul, Vivek (2013). Easy Money. Sage Publications, New Delhi.
4. Manning, George A. (2010). Financial Investigation and Forensic Accounting.
CRC Press: Taylor & Francis Group.
5. Sharma, B. R. (2014). Bank Frauds. Universal Law Publishing, New Delhi
 Lesson – 19
AUDIT COMMITTEE
Structure:
19.0 Learning Objectives
19.1 Introduction
19.2 Responsibilities of an audit committee
19.3 Composition of audit committee
19.4 Roles and responsibilities of an audit committee
19.5 Functions of audit committee
19.6 Powers of audit committee
19.7 Vigil mechanism
19.8 Penalties for violating audit committee provisions
19.9 Advantages of audit committee
19.11 Summary
19.12 Glossary
19.13 Answers: Self Assessment
19.14 Terminal Questions
19.15 Answers: Terminal Questions:
19.16 Suggested Readings
19.0 Learning Objectives
After studying the lesson, you should be able to:-
1. Responsibilities of an audit committee
2. Functions of audit committee
3. Vigil mechanism
4. Advantages of audit committee
19.1 INTRODUCTION
An Audit Committee is a vital component of corporate governance, especially in
publicly traded companies. Composed of independent members of the board of
directors, the Audit Committee oversees financial reporting processes, internal
controls, and audit functions to ensure transparency and integrity. Its primary
responsibilities include reviewing financial statements for accuracy and compliance
with accounting standards, assessing the effectiveness of internal control systems to
mitigate risks, and selecting and overseeing the external audit firm. The committee
also monitors compliance with legal and regulatory requirements, including
whistleblower protection mechanisms. By maintaining independence from
management, the Audit Committee provides an objective assessment of the
company's financial health, enhancing investor confidence and trust. Moreover, it
acts as a liaison between stakeholders and management, facilitating transparent
communication on financial matters. In summary, the Audit Committee serves as a
safeguard against financial mismanagement and fraud, promoting accountability and
ethical conduct within the organization.

19.2 RESPONSIBILITIES OF AN AUDIT COMMITTEE

The responsibilities of an Audit Committee may include:

1. Financial Reporting Oversight: The Audit Committee ensures the accuracy,

completeness, and reliability of financial statements. It reviews financial
reports to verify compliance with accounting standards and regulatory
requirements.
2. Internal Control Evaluation: Assessing the effectiveness of internal control
systems is a crucial responsibility. The committee evaluates controls to
safeguard assets, prevent fraud, and ensure compliance with laws and
regulations.
3. External Audit Oversight: The committee selects and appoints external
auditors, approves their fees, and reviews their independence and
performance. It oversees the audit process and evaluates audit findings and
recommendations.
4. Risk Management: Identifying and managing risks is vital. The Audit
Committee assesses the company's risk management processes, including
financial, operational, and compliance risks, to ensure they are adequately
addressed.
5. Compliance Monitoring: The committee monitors compliance with laws,
regulations, and corporate governance standards. It ensures that the
company adheres to relevant legal and regulatory requirements, including
codes of conduct and ethics policies.
6. Whistleblower Protection: Establishing procedures for whistleblowers is
essential. The Audit Committee implements mechanisms for employees to
report concerns about accounting, internal controls, or auditing matters
anonymously and ensures proper investigation and resolution.
7. Stakeholder Communication: Maintaining communication with stakeholders
is critical. The committee communicates with shareholders, regulators, and
external auditors to address any concerns related to financial reporting and
audit processes.
 8. Financial Expertise: Having financial expertise is important. Audit Committee
members possess financial literacy and expertise to understand complex
financial matters and effectively fulfill their oversight responsibilities.
9. Ethical Oversight: Ensuring ethical conduct is a key aspect. The committee
promotes a culture of integrity and ethical behavior within the organization,
setting the tone from the top and holding management accountable for ethical
lapses.
10. Continuous Improvement: Striving for continuous improvement is
necessary. The Audit Committee regularly evaluates its own performance,
practices, and processes to enhance effectiveness and meet evolving
regulatory requirements and best practices.
19.3 COMPOSITION OF AUDIT COMMITTEE
The composition of an Audit Committee, as per the Companies Act 2013 rules,
mandates the following criteria:
1. Minimum Three Directors: The committee must consist of at least three
directors. This ensures adequate representation and diverse perspectives in
overseeing financial matters.
2. Majority Independent Directors: A majority of the members of the Audit
Committee must be independent directors. Independent directors bring
objectivity and impartiality to the committee's deliberations, reducing potential
conflicts of interest.
3. Financial Literacy: All members of the Audit Committee, including the
Chairperson, should possess the ability to read and understand financial
statements. This requirement ensures that committee members are equipped
to effectively evaluate financial reports and disclosures.
4. Right to Be Heard: The company's auditors and Key Managerial Personnel
(KMP) have the right to be heard in Audit Committee meetings, particularly
when the committee considers the auditor's report. This provision allows
auditors and KMPs to provide relevant insights and clarifications but does not
grant them voting rights.
By adhering to these composition requirements, Audit Committees can fulfill their
responsibilities effectively, promoting transparency, accountability, and integrity in
financial reporting and corporate governance practices.
19.4 ROLES AND RESPONSIBILITIES OF AN AUDIT COMMITTEE
The roles and responsibilities of an Audit Committee encompass various critical
aspects of financial oversight and corporate governance:
1. Assessment of Financial Reports: The committee analyzes important
issues and judgments made by management in financial reports, ensuring
accuracy and compliance with accounting standards and regulatory
requirements.
 2. Fraud Prevention and Detection: Ensuring that appropriate policies and
processes are in place to prevent and identify fraud, including asset
misappropriation, corruption, and financial statement fraud. The committee
collaborates with management to address fraud detection measures.
3. Compliance with Anti-Corruption Laws: Understanding management's
responsibilities regarding anti-corruption laws and assessing the effectiveness
of policies and controls for detecting and mitigating corruption risks, such as
those outlined in the U.S. Foreign Corrupt Practices Act (FCPA).
4. Financial Statements Review: Reviewing quarterly and annual financial
statements, as well as news releases on earnings, to ensure accuracy,
completeness, and compliance with disclosure requirements. This includes
discussions with management and independent auditors.
5. Risk Oversight: While not responsible for day-to-day risk management, the
committee discusses and reviews risk-related policies and may be tasked with
cyber risk oversight in some organizations.
6. Mergers and Acquisitions (M&A): Providing insights on financials, internal
controls, and risk analysis in M&A transactions to ensure accuracy and
completeness of financial information. The committee oversees post-merger
integration of financial reporting controls and disclosure controls.
7. Appointment and Oversight of Auditors: Appointing, overseeing, and
compensating independent auditors, including holding regular meetings to
discuss financial reporting, internal controls, and audit processes.
8. Internal Audit Oversight: Some exchanges may require the audit committee
to oversee internal auditors, evaluate their performance, and address any
performance-related issues.
9. Compliance Administration: Ensuring compliance with rules and legislation,
including the company's code of conduct and ethics policies.
10. Coordination with Other Committees: Collaborating with other committees
to understand risks and responsibilities affecting financial reporting and
addressing the impact of non-GAAP metrics used for compensation on risk
assessment.
By fulfilling these roles and responsibilities, the Audit Committee plays a crucial role
in promoting transparency, integrity, and accountability in financial reporting and
corporate governance.
19.5 FUNCTIONS OF AUDIT COMMITTEE
The functions and powers of an Audit Committee, as outlined in the Companies Act
2013 rules, are essential for ensuring effective oversight of financial reporting and
internal controls within a company:
Functions of Audit Committee:
 1. Appointment and Remuneration of Auditor: The committee is responsible
for appointing the company's auditor and fixing their remuneration, ensuring
independence and adequacy of audit services.
2. Valuation of Undertakings or Assets: The committee evaluates the
valuation of company undertakings or assets to ensure accuracy and
compliance with accounting standards.
3. Review of Related Party Transactions: Evaluation of any related party
transactions, including granting omnibus approval as per Rule 6A, to prevent
conflicts of interest and ensure fairness.
4. Assessment of Internal Financial Control and Risk Management: The
committee evaluates the effectiveness of internal financial controls and risk
management systems to safeguard company assets and ensure compliance
with regulations.
5. Examination of Financial Statements: The committee scrutinizes the
financial statements to ensure accuracy, completeness, and compliance with
accounting standards and regulatory requirements.
6. Scrutiny of Inter-corporate Loans and Investments: Review of inter-
corporate loans and investments to assess risks and ensure proper utilization
of company funds.
7. Evaluation of Fund Utilization from Public Offers: Assessment of the use
of funds raised through public offers to ensure alignment with stated
objectives and transparency in fund utilization.

19.6 POWERS OF AUDIT COMMITTEE:

1. Call for Auditor Comments on Internal Control Systems: The committee
has the power to request comments from the auditor regarding the
effectiveness of internal control systems in place.
2. Review of Financial Statements: The committee can review financial
statements before their submission to the board, ensuring accuracy and
completeness.
3. Discussion with Auditors and Management: The committee has the power
to discuss any issues with the statutory and internal auditors, as well as
management, relating to matters contained in the financial statements.
4. Obtain Professional Advice: The committee can obtain professional advice
from external sources to enhance its understanding of complex financial
matters and ensure informed decision-making.
5. Access to Information: The committee has full access to information
contained in company records, facilitating thorough examination and
oversight.
These functions and powers empower the Audit Committee to fulfill its
responsibilities effectively, promoting transparency, accountability, and integrity in
financial reporting and corporate governance.

19.7 VIGIL MECHANISM

The Vigil Mechanism, as mandated by Rule 7 of the Companies (Meetings of Board
and its Powers) Rules, 2014, serves as an important safeguard against victimization
and provides a platform for directors and employees to report grievances and
concerns. Key points regarding the establishment and functioning of the Vigil
Mechanism include:
1. Applicability: The Vigil Mechanism is required to be established by every
listed company and companies meeting specific criteria, such as those
accepting deposits from the public or having borrowed money in excess of Rs.
50 Crores from banks and public financial institutions.
2. Role of Audit Committee: The Board of Directors is responsible for
nominating a director to oversee the Vigil Mechanism, typically from the Audit
Committee. This nominated director serves as the point of contact for
aggrieved persons to report their concerns directly.
3. Access to Chairperson/Nominated Director: Aggrieved persons have direct
access to the Chairperson or the nominated director of the Audit Committee to
report their grievances or concerns.
4. Action Against Frivolous Complaints: In cases of repeated frivolous
complaints, the Audit Committee or the nominated director has the authority to
take suitable action against the concerned director or employee, including
reprimand.
5. Disclosure Requirements: Details regarding the establishment and
functioning of the Vigil Mechanism, including its accessibility and procedures
for reporting, must be disclosed on the company's website and in the Board's
report. This ensures transparency and accountability in the implementation of
the mechanism.
By establishing a Vigil Mechanism, companies aim to create a conducive
environment for the reporting of grievances and concerns, thereby fostering
transparency, integrity, and ethical conduct within the organization.

19.8 PENALTIES FOR VIOLATING AUDIT COMMITTEE PROVISIONS

Penalties for violating audit committee provisions under the Companies Act 2013
and related rules can vary depending on the severity of the violation and the
discretion of regulatory authorities. Some potential penalties for non-compliance with
audit committee provisions may include:
 1. Fines: Companies and their officers responsible for the violation may be
subject to monetary fines imposed by regulatory authorities.
2. Prosecution: In cases of serious non-compliance, regulatory authorities may
initiate prosecution against the company and its officers, which could lead to
legal proceedings and potential criminal charges.
3. Disqualification: Officers of the company, including directors, may face
disqualification from serving on the board of directors of any company for a
certain period if found guilty of violating audit committee provisions.
4. Revocation of Listing: For listed companies, non-compliance with audit
committee provisions may result in penalties imposed by stock exchanges,
including delisting of the company's securities from trading.
5. Civil Liability: The company and its officers may also face civil liability,
including lawsuits from shareholders or other stakeholders for damages
resulting from non-compliance with audit committee provisions.
It's important for companies to adhere to audit committee provisions and ensure
compliance with relevant regulations to avoid these penalties and maintain good
corporate governance practices. Regular review of audit committee responsibilities,
proper documentation, and proactive measures to address any deficiencies can help
mitigate the risk of non-compliance.

19.9 ADVANTAGES OF AUDIT COMMITTE

The Audit Committee serves as a vital component of corporate governance, offering
numerous advantages to companies and stakeholders alike:
1. Enhanced Financial Reporting: By overseeing financial reporting processes,
the Audit Committee helps ensure the accuracy, reliability, and transparency
of financial statements, enhancing investor confidence.
2. Independent Oversight: Comprised of independent directors, the Audit
Committee provides objective oversight of financial matters, mitigating the risk
of conflicts of interest and ensuring impartial decision-making.
3. Risk Management: The Committee plays a crucial role in identifying,
assessing, and managing risks related to financial reporting, internal controls,
and compliance, helping the company anticipate and mitigate potential
threats.
4. Compliance Assurance: By monitoring regulatory compliance and
adherence to accounting standards, the Audit Committee helps the company
avoid legal and regulatory violations, safeguarding its reputation and integrity.
5. Internal Control Enhancement: Through regular evaluation of internal
control systems, the Committee helps strengthen controls, minimize fraud and
errors, and improve operational efficiency.
 6. Stakeholder Protection: The Committee's oversight functions protect the
interests of various stakeholders, including shareholders, employees,
creditors, and the public, by ensuring responsible financial management and
accountability.
7. Board Accountability: The Audit Committee holds the board accountable for
its fiduciary responsibilities related to financial oversight, promoting board
effectiveness and accountability to shareholders.
8. Credibility and Trust: Effective governance facilitated by the Audit
Committee fosters credibility and trust in the company's financial reporting and
management practices, enhancing its reputation in the marketplace.
9. Confidence Building: The Committee's activities, including transparent
reporting and communication with stakeholders, build confidence in the
company's operations, management, and long-term sustainability.
10. Continuous Improvement: Through regular assessments and
recommendations, the Audit Committee promotes continuous improvement in
financial reporting processes, internal controls, and corporate governance
practices, driving long-term value creation for the company and its
stakeholders.
Self Assessment.
1. What penalties or consequences may be imposed for violating audit
committee provisions?
2. Explain the concept of a vigil mechanism within the context of an audit
committee.
3. Outline the key functions performed by an audit committee.
4. What is Audit Committee?

19.11 Summary
An audit committee plays a crucial role in ensuring transparency, accountability, and
effective governance within an organization. Comprising independent directors, it
oversees financial reporting, internal controls, and compliance with regulations.
Responsibilities include reviewing financial statements, assessing internal and
external audit processes, and monitoring risk management. The committee functions
as a safeguard against fraud and misconduct, empowering it to investigate concerns
raised through a vigil mechanism. With the authority to recommend corrective
actions, the audit committee enhances investor confidence and promotes ethical
practices. Violations of audit committee provisions may result in penalties,
underscoring its importance in upholding integrity and mitigating corporate risks.
19.12 Glossary
1. Audit Committee: Audit Committee is a vital component of corporate
governance, especially in publicly traded companies. Composed of
 independent members of the board of directors, the Audit Committee
oversees financial reporting processes, internal controls, and audit functions
to ensure transparency and integrity. Its primary responsibilities include
reviewing financial statements for accuracy and compliance with accounting
standards, assessing the effectiveness of internal control systems to mitigate
risks, and selecting and overseeing the external audit firm
2. VIGIL MECHANISM: The Vigil Mechanism, as mandated by Rule 7 of the
Companies (Meetings of Board and its Powers) Rules, 2014, serves as an
important safeguard against victimization and provides a platform for directors
and employees to report grievances and concerns.
19.13 Answers: Self Assessment
1). Please check section 19.8 2). Please check section 19.7
3). Please check section 19.5 4). Please check section 19.11
19.14 Terminal Questions
1. What are the primary responsibilities of an audit committee within an
organization?
2. Describe the typical composition of an audit committee.
3. What powers does an audit committee typically possess within an
organization?
4. Discuss the advantages of having an audit committee within an organization.
19.15 Answers: Terminal Questions:
1). Please check section 19.2 2). Please check section 19.3
3). Please check section 19.6 4). Please check section 19.9
19.16 Suggested Readings
1. Dalal, Chetan. (2015). Novel & Conventional Methods of Audit, Investigation
and Fraud Detection. Wolters Kluwer India Pvt. Ltd.
2. Gupta, Sanjeev (2016). Corporate Frauds and their Regulation in India.
Bharat Law House Pvt. Ltd
3. Kaul, Vivek (2013). Easy Money. Sage Publications, New Delhi.
4. Manning, George A. (2010). Financial Investigation and Forensic Accounting.
CRC Press: Taylor & Francis Group.
5. Sharma, B. R. (2014). Bank Frauds. Universal Law Publishing, New Delhi
 Lesson – 20
AUDIT REPORT
Structure:
20.0 Learning Objectives
20.1 Introduction
20.2 Contents of an audit report
20.3 General provisions regarding auditor’s report
20.4 The applicability of the order
20.5 Opinion in an audit report
20.6 Signing of the audit report
20.7 Auditor's lien
20.8 Joint audit
20.10 Disadvantages20.11 special audit
20.12 Cost audit
20.13 Advantages of audit report
20.14 Audit certificate
20.15 Summary
20.16 Glossary
20.17 Answers: Self Assessment
20.18 Terminal Questions
20.19 Answers: Terminal Questions:
20.20 Suggested Readings
20.0 Learning Objectives
After studying the lesson, you should be able to:-
1. Contents of an audit report
2. Opinion in an audit report
3. Auditor's lien
4. Cost audit
20.1 Introduction
The auditor should review and assess the conclusions drawn from the audit
evidence obtained as the basis for the expression of an opinion on the financial
statements. This review and assessment involves considering whether the financial
statements have been prepared in accordance with an acceptable financial reporting
framework applicable to the entity under audit. It is also necessary to consider
whether the financial statements comply with the relevant statutory requirements.
The auditor’s report should contain a clear written expression of opinion on the
financial statements taken as a whole.

The basic elements of the auditor's report, typically presented in the following layout,
include:
(a) Title: "Independent Auditor's Report" or similar, indicating the independence of
the auditor.
(b) Addressee: The report is addressed to the shareholders, board of directors, or
other relevant parties.
(c) Opening or introductory paragraph: (i) Identification of the financial statements
audited. (ii) A statement of the responsibility of the entity’s management for the
preparation and fair presentation of the financial statements and the responsibility of
the auditor to express an opinion on the financial statements.
(d) Scope paragraph (describing the nature of the audit): (i) A reference to the
auditing standards generally accepted in India. (ii) A description of the work
performed by the auditor, including the procedures conducted and the evidence
obtained.
(e) Opinion paragraph containing: (i) A reference to the financial reporting
framework used to prepare the financial statements (e.g., Indian Accounting
Standards). (ii) An expression of opinion on the financial statements, indicating
whether they present fairly, in all material respects, the financial position, financial
performance, and cash flows of the entity in accordance with the applicable financial
reporting framework.
(f) Date of the report: The date when the auditor's report is issued.
(g) Place of signature: The location where the auditor's report is signed.
It's important to note that these elements are typically presented in a standardized
format to ensure clarity and consistency in communicating the auditor's opinion on
the financial statements. Additionally, the auditor's report may also include other
relevant information depending on the specific circumstances of the audit
engagement and applicable regulatory requirements.
(d) evaluating the overall presentation of the financial statements.
(e) Opinion Paragraph: The auditor's report should include an opinion on the
financial statements. This opinion should be based on the audit evidence obtained
and should express whether the financial statements present fairly, in all material
respects, the financial position, financial performance, and cash flows of the entity in
accordance with the applicable financial reporting framework.
An illustration of an opinion paragraph is: "In our opinion, the financial statements
present fairly, in all material respects, the financial position of [Name of the Entity] as
at 31st March 2XXX, and the results of its operations and its cash flows for the year
then ended in accordance with the Indian Accounting Standards, and comply with
the Accounting Standards generally accepted in India."
(f) Date of the Report: The date when the auditor's report is issued should be
included to provide clarity on the timing of the audit.
(g) Place of Signature: The location where the auditor's report is signed should be
indicated.
(h) Auditor's Signature: The auditor's report should be signed by the auditor or
auditing firm responsible for the audit engagement.
The uniformity in the form and content of the auditor's report helps ensure clarity and
consistency in communication, facilitating readers' understanding of the report and
identification of any unusual circumstances. Compliance with applicable laws,
regulations, and standards is essential, and the auditor should incorporate any
required matters or prescribed forms into the report accordingly.
(a) Title: The auditor's report should have an appropriate title. It may be suitable to
use the term "Auditor's Report" to distinguish it from other reports issued by
individuals such as officers of the entity or the board of directors.
(b) Addressee: The auditor's report should be addressed appropriately based on the
circumstances of the engagement and relevant laws and regulations. Typically, the
auditor's report is addressed to the authority appointing the auditor.
(c) Opening or Introductory Paragraph: The introductory paragraph of the auditor's
report should identify the financial statements of the entity that have been audited,
including the date and period covered by the financial statements. Additionally, it
should include a statement indicating that the financial statements are the
responsibility of the entity's management and that the auditor's responsibility is to
express an opinion on the financial statements based on the audit conducted.
(d) Scope Paragraph: This section outlines the scope of the audit, stating that it was
conducted in accordance with auditing standards generally accepted in India. It
describes the procedures performed by the auditor, including examining evidence,
assessing accounting principles and significant estimates, and evaluating the overall
financial statement presentation. The paragraph concludes by stating that the audit
provides a reasonable basis for the auditor's opinion.
(e) Opinion Paragraph: The opinion paragraph expresses the auditor's opinion on
whether the financial statements give a true and fair view in conformity with the
accounting principles generally accepted in India. The opinion also addresses
compliance with statutory requirements. The auditor uses the term "give a true and
fair view" to indicate that only material matters are considered.
(f) Date of Report: This is the date when the auditor signs the report expressing an
opinion on the financial statements. It indicates that the auditor considered events
and transactions up to that date. The report should not be dated earlier than the date
when the financial statements are signed or approved by management.
(g) Place of Signature: The report should specify the city where it is signed.
(h) Auditor’s Signature: The report should be signed by the auditor in their personal
name. If the audit firm is appointed as the auditor, the report should be signed by the
auditor and in the name of the audit firm. The signing auditor should also mention
their designation, such as "Chartered Accountant," after their signature.

20.2 Contents of an Audit Report

Based on the structure you provided, here's a breakdown of the contents of an audit
report:
1. Title: Clearly states that it is an "Independent Auditor's Report."
2. Addressee: Specifies to whom the report is being given, such as the
Members of the company, Board of Directors, or other relevant parties.
3. Management’s Responsibility for Financial Statements: Indicates that it is
the management's responsibility to prepare the financial statements.
4. Auditor’s Responsibility: States that the auditor's responsibility is to express
an unbiased opinion on the financial statements and issue an audit report.
5. Opinion: Expresses the overall impression obtained from the audit of financial
statements. This could be a Modified Opinion (qualified, adverse, or
disclaimer) or an Unmodified Opinion (clean).
6. Basis of the Opinion: Explains the basis on which the opinion has been
formed, providing relevant facts or explanations.
7. Other Reporting Responsibility: If there are any additional reporting
responsibilities, such as reporting on legal or regulatory requirements, they
should be mentioned here.
8. Signature of the Auditor: The engagement partner (auditor) signs the audit
report to signify their responsibility for the report's contents.
9. Place of Signature: Specifies the city where the audit report is signed.
10. Date of Audit Report: Indicates the date on which the audit report is signed,
providing clarity on the timing of the audit.
20.3 General Provisions Regarding Auditor’s Report
The passage discusses the provisions and distinctions between the Order and
Section 227 of the Companies Act, as well as the status of the Order in relation to
directions from the Comptroller and Auditor General of India (CAG) under Section
619 of the Act. key points summarized:
1. Applicability: The Order supplements the existing provisions of Section 227
of the Companies Act. However, certain distinctions exist:
 The Order exempts certain classes of companies, whereas Section
227 applies to all companies.
 Section 227(1A) requires specific inquiries by the auditor, but reporting
on these matters is only necessary if the auditor has special
comments. The Order, however, mandates a statement on each
specified matter, regardless of whether the auditor has comments.
 The Order aligns more closely with Section 227(2), (3), and (4), where
reporting duties are similar.
2. Relation to CAG Directions: The Order supplements directions given by the
CAG under Section 619, especially concerning government companies. The
CAG's directions remain in force, and matters specified in the Order form part
of the auditor's report for government companies.
3. Intent of the Order: The Order doesn't limit auditors' duties but requires
statements on specified matters in the audit report. For example, while the
Order focuses on internal controls related to certain areas like purchases of
inventories, fixed assets, and sale of goods, it doesn't imply that examination
of internal controls in other areas isn't important.
20.4 The applicability of the Order
The applicability of the Order to various categories of companies, including foreign
companies and branches of companies. Here's a summary:
1. Companies Covered: The Order applies to all companies except those
specifically exempted. This includes both domestic companies and foreign
companies.
2. Foreign Companies: The Order applies to foreign companies as defined in
Section 591 of the Companies Act. Foreign companies fall into two classes:
 Companies incorporated outside India that establish a place of
business within India after the commencement of the Act.
 Companies incorporated outside India that had established a place of
business within India before the commencement of the Act and
continue to have such a place of business at the commencement of the
Act. This includes liaison offices.
3. Branch Audits: The Order is also applicable to audits of branches of
companies under the Act. This is because Section 228(3)(a) specifies that a
branch auditor has the same duties in respect of audit as the company's
auditor. Therefore, the branch auditor's report must contain statements on all
 matters specified in the Order, unless the company is exempt from its
applicability. This enables the company's auditor to consider these matters
while complying with the provisions of the Order.

20.5 Opinion in an Audit Report

There are primarily two kinds of opinions issued by an auditor in his / her audit
report:
 Unmodified Opinion (also called Unqualified report)
 Modified Opinion (also called Qualified report)

1. Unqualified Report:
An unqualified opinion is issued when the auditor concludes that the financial
statements: (a) Present a true and fair view in accordance with the financial reporting
framework used. (b) Have been prepared using generally accepted accounting
principles, consistently applied. (c) Comply with relevant statutory requirements and
regulations. (d) Provide adequate disclosure of all material matters relevant to the
proper presentation of financial information, subject to statutory requirements where
applicable.
2. Modified Reports:
An auditor's report is considered modified when it includes: (a) Matters That Do Not
Affect the Auditor's Opinion:
 Emphasis of matter: This draws attention to a matter already disclosed in the
financial statements that is of importance to users. (b) Matters That Do
Affect the Auditor's Opinion:
 Qualified opinion: This is issued when the auditor concludes that, except for
specific issues identified, the financial statements present a true and fair view.
 Disclaimer of opinion: This occurs when the auditor is unable to express an
opinion on the financial statements due to significant limitations on the scope
of the audit.
 Adverse opinion: This is issued when the auditor concludes that the financial
statements do not present a true and fair view due to pervasive
misstatements or departures from the financial reporting framework.
Circumstances That May Result in Other Than an Unqualified Opinion
1. Limitation on Scope:
 Imposed by Entity: Limitation on the scope of the auditor's work may
be imposed by the entity, such as when the terms of engagement
 specify exclusions from audit procedures deemed necessary by the
auditor.
 Statutory Duties: Auditors should not accept engagements with
limitations that infringe on their statutory duties.
 Examples: Limitations can arise from timing issues, inadequate
accounting records, or inability to conduct desired audit procedures,
like observing physical inventories.
 Response: Auditors should attempt reasonable alternative procedures
to obtain sufficient audit evidence for an unqualified opinion. If a
limitation requires a qualified or disclaimer of opinion, the auditor's
report should describe the limitation and indicate potential adjustments
to the financial statements if the limitation didn't exist.
2. Disagreement with Management:
 Nature of Disagreements: Auditors may disagree with management
regarding accounting policies, their application, or the adequacy of
disclosures.
 Materiality: If disagreements are material to the financial statements,
the auditor should express a qualified or adverse opinion.

20.6 SIGNING OF THE AUDIT REPORT

The signing of the audit report is governed by Section 229 of the Companies Act,
1956, which stipulates the following:
1. Signatory Requirement:
 Only the individual appointed as the auditor of the company, or if a firm
is appointed, only a partner in the firm practicing in India, may sign the
auditor's report or authenticate any other document required by law to
be signed by the auditor.
2. Clarification from Department of Company Affairs:
 The Department of Company Affairs, Government of India, has clarified
that when a single chartered accountant is practicing, there is no firm
name involved.
 The partner in the firm must sign in their own hand for and on behalf of
the firm appointed to audit the company's accounts.
 Merely affixing the firm name without the signature of the partner is not
considered correct in the eyes of the law.
3. Penalty for Non-compliance:
  If the auditor's report or any company document is signed or
authenticated in a manner not in conformity with Section 229, and if the
default is willful, the auditor and any other person signing or
authenticating the document may be subject to a fine of up to Rs.
10,000.
4. Reading and Inspection of Auditor's Report:
 The auditor's report must be read before the shareholders of the
company in a general meeting and should be available for inspection
by every member of the company.
 However, it is not the duty of the auditor to individually send a copy of
the report to each member or to ensure that the report is read before
the company in the general meeting.
5. Penalty for Non-compliance with Sections 225 to 231:
 Non-compliance with any of the requirements of Sections 225 to 231
may result in the company and every officer of the company who is in
default being liable to a fine of up to Rs. 5,000.

20.7 AUDITOR'S LIEN

The concept of the auditor's lien, outlining the conditions under which an auditor may
exercise a lien on books and documents for non-payment of fees. Here are the key
points summarized:
1. General Principles of Law:
 Any person with lawful possession of someone else's property, on
which they have worked, may retain the property for non-payment of
dues for the work done.
2. Conditions for Auditor's Lien (as per the Institute of Chartered
Accountants in England and Wales):
 Documents retained must belong to the client who owes money.
 Documents must have come into the auditor's possession with the
client's authority, not through irregular or illegal means.
 The auditor can retain documents only if work has been done on the
assigned documents.
 Retention is allowed for documents connected with work for which fees
have not been paid.
3. Section 209 of the Companies Act:
 Books of account of a company are generally required to be kept at the
registered office, making it impractical for the auditor to possess them.
  Provisions allow books to be kept at a different place with a Board
resolution and notification to the Registrar of Companies.
 In such cases, the auditor may exercise the right of lien for non-
payment of fees.
4. Practical Constraints on Auditor's Lien:
 While legally possible, it may be impractical due to legal and
operational constraints.
 Working papers, being the auditor's property, do not fall under the lien.
5. AAS 3 on Documentation (ICAI):
 Working papers are the property of the auditor.
 The auditor may, at their discretion, make portions of or extracts from
working papers available to clients.
 The auditor should adopt reasonable procedures for custody and
confidentiality of working papers and retain them as needed for the
practice's requirements and legal or professional record retention.

20.8 JOINT AUDIT

Joint audits, where multiple firms of auditors collaborate on an audit engagement,
offer several advantages and disadvantages:
Advantages:
1. Sharing of Expertise:
 Pooling together the e0078pertise of multiple firms can lead to a more
comprehensive and thorough audit.
2. Advantage of Mutual Consultation:
 Auditors can consult with each other, benefiting from diverse
perspectives and experiences.
3. Lower Workload:
 Distributing the workload among multiple firms can alleviate the burden
on individual auditors.
4. Better Quality of Performance:
 With combined resources and expertise, joint audits may result in
higher-quality audit work.
5. Improved Service to the Client:
 Clients may benefit from a broader range of skills and insights brought
by multiple audit firms.
 6. Displacement of the Auditor in Takeovers:
 In takeover scenarios, the presence of joint auditors may prevent the
displacement of the incumbent auditor.
7. Expertise in Local Laws and Regulations:
 In the case of multinational companies, local firms can contribute their
knowledge of local laws and regulations, enhancing the audit process.
8. Lower Staff Development Costs:
 Joint audits may reduce the need for extensive staff development as
resources are shared.
9. Lower Costs:
 Sharing resources and expertise can lead to cost efficiencies in
conducting the audit.
10. Healthy Competition:
 Joint audits can foster a sense of healthy competition among audit
firms, driving them towards better performance.
20.10 Disadvantages:
1. Shared Fees:
 Fees for the audit are divided among the participating firms, potentially
reducing individual earnings.
2. Psychological Issues:
 There may be psychological challenges when firms of different
standing collaborate on joint audits.
3. Superiority Complexes:
 Some auditors may exhibit superiority complexes, leading to conflicts
or communication issues.
4. Coordination Challenges:
 Coordinating the work of multiple audit firms can be complex and may
lead to inefficiencies.
5. Neglected Areas:
 Areas of common concern may be neglected if there is a lack of clear
delineation of responsibilities among the joint auditors.
6. Uncertainty about Liability:
 Uncertainty may arise regarding the allocation of liability for the audit
work performed by different firms.
20.11 SPECIAL AUDIT
Special audits, as empowered by Section 233 A of the Companies Act, allow the
Central Government to call for an audit under specific circumstances:
1. Reasons for Special Audit:
 The Central Government may order a special audit if it believes:
 The company's affairs are not managed on sound business
principles or prudent commercial practices.
 The company's management poses a risk of serious injury to
trade, industry, or business interests.
 The company's financial position could endanger its solvency.
2. Objective of Special Audit:
 The special audit aims to provide the Government with a critical
assessment of the company and its financial position.
3. Appointment of Auditor:
 The special audit may be conducted by the company's statutory auditor
or another chartered accountant appointed by the Central Government.
 The appointed auditor has the same powers and duties as the statutory
auditor, reporting to the Central Government instead of the company's
members.
4. Contents of Special Auditor's Report:
 The special auditor's report should include all matters required in a
regular auditor's report under Section 227.
 Additionally, if directed by the Central Government, the report should
cover any specific matters referred by the Government.
5. Access to Information:
 The Central Government may order the company to provide the special
auditor with necessary information.
 Non-compliance with such orders may result in fines.
6. Action by the Central Government:
 Upon receiving the special auditor's report, the Central Government
may take appropriate action as per the Act or other applicable laws.
 If no action is taken within four months, the report must be circulated
among the company's members or presented at the next general
meeting.
 7. Expenses of Special Audit:
 The company is responsible for the expenses of the special audit,
including the auditor's remuneration.
 If the company fails to pay, the amount can be recovered as arrears of
land revenue.
20.12 COST AUDIT
Cost audit is a specialized audit process aimed at verifying the cost of manufacturing
or producing an article, based on the company's accounts regarding the utilization of
materials, labor, and other cost items. Here are some key points regarding cost
audit:
1. Appointment of Cost Auditor:
 The Board of Directors of the company appoints a cost auditor with the
previous approval of the Central Government, as per Section
233(B)(2).
 Before the appointment, the board must obtain a written certificate from
the proposed cost auditor confirming compliance with the relevant
provisions.
2. Inclusion in Books of Account:
 Companies subject to cost audit, as per Section 209(1)(d) of the Act,
must include specific particulars related to cost in their books of
account.
3. Independence from Financial Audit:
 Cost audit is conducted separately and independently from the regular
financial audit conducted under Section 224 of the Act.
 The cost auditor possesses the same powers and duties as prescribed
for auditors appointed under Section 224.
4. Qualifications of Cost Auditor:
 A cost audit must be conducted by a Cost Accountant as defined in the
Cost and Works Accountants Act, 1959.
5. Disqualifications for Cost Auditor:
 Disqualifications outlined in Sections 226(3) and 226(4) of the Act
apply to cost auditors.
 A person holding the appointment as the statutory auditor under
Section 224 is disqualified from acting as a cost auditor.
 If a person becomes subject to any disqualifications after appointment
as a cost auditor, they are disqualified from continuing in that role.
20.13 ADVANTAGES OF AUDIT REPORT
Audit reports offer several advantages, both to the stakeholders of the audited entity
and to the wider public. Some of the key advantages include:
1. Assurance of Financial Statements: Audit reports provide assurance to
stakeholders, including investors, creditors, and regulators, that the financial
statements present a true and fair view of the company's financial position,
performance, and cash flows.
2. Enhanced Credibility: An independent audit conducted by a qualified auditor
enhances the credibility of the financial statements. It demonstrates that an
objective and impartial examination has been performed, increasing trust in
the company's financial reporting.
3. Risk Identification and Management: Auditors assess the internal controls
and risk management processes of the audited entity. Their findings help
identify weaknesses or deficiencies, allowing management to take corrective
actions to mitigate risks and improve operations.
4. Compliance Verification: Audit reports verify whether the company has
complied with relevant accounting standards, laws, regulations, and
contractual agreements. This ensures transparency and accountability in
financial reporting and helps prevent fraud and non-compliance.
5. Improved Decision-Making: Stakeholders, such as investors, lenders, and
management, rely on audit reports to make informed decisions. The audited
financial statements provide reliable information for assessing the company's
financial health, performance, and future prospects.
6. Facilitation of Capital Acquisition: A favorable audit report can facilitate
capital acquisition efforts by providing assurance to potential investors and
lenders. It may increase confidence in the company's financial stability and
reduce the perceived risk associated with investing or lending capital.
7. Legal and Regulatory Compliance: Audit reports fulfill legal and regulatory
requirements imposed by government authorities, stock exchanges, and other
regulatory bodies. They ensure that companies adhere to reporting standards
and fulfill their obligations to stakeholders and the public.
8. Prevention and Detection of Fraud: Auditors are trained to detect signs of
fraud or financial irregularities during the audit process. Their findings can
help uncover fraudulent activities, deter misconduct, and protect the interests
of shareholders and other stakeholders.
9. Stakeholder Communication: Audit reports serve as a means of
communication between the audited entity and its stakeholders. They provide
transparent and reliable information about the company's financial
performance, enabling stakeholders to assess its current status and future
prospects.
 10. Continuous Improvement: Audit reports often include recommendations for
improving internal controls, operational efficiency, and financial reporting
processes. These recommendations can help management implement best
practices and achieve continuous improvement in corporate governance and
financial management.

20.14 AUDIT CERTIFICATE

An audit certificate is a written confirmation provided by a professional accountant
regarding the accuracy of a specific matter stated therein. Unlike an audit report,
which provides an opinion on the financial statements as a whole, an audit certificate
focuses on verifying particular facts or figures requested by the client.
Here are some key points to understand about audit certificates:
1. Specific Purpose: Audit certificates are issued for a specific purpose
identified by the client. They confirm the accuracy of particular information or
transactions, rather than providing a comprehensive assessment of the entire
financial statements.
2. Written Affirmation: An audit certificate affirms the truth of the facts
mentioned in the document, without including any estimates or opinions. It is a
written statement of assurance provided by the auditor.
3. Issuance on Auditor's Letterhead: To ensure credibility and authenticity,
audit certificates should be issued on the auditor's official letterhead or
stationary, which includes the auditor's name and address.
4. Restricted Use: The auditor should specify in the certificate that it is issued in
accordance with the company's request and is intended for submission to a
specific authority or for a particular purpose. It should not be used for any
other purpose without prior written permission.
5. Basic Assumptions and Explanations: The auditor may include any basic
assumptions made during the verification process and provide explanations
for the facts stated in the certificate. This helps to ensure clarity and
transparency.
6. Clear Title: The certificate should have a clear title that distinguishes it from
an audit report. This helps to avoid confusion and clearly indicates the nature
of the document to the reader.

DIFFERENCES BETWEEN AN AUDIT REPORT AND AN AUDIT CERTIFICATE

Basis of
Difference Audit Report Audit Certificate

A summary of information gathered A documented assurance of the

and reviewed to provide insight correctness of specific
Meaning into the company's affairs. information stated therein.

Includes the auditor's opinion on Does not express an opinion but

the fairness of financial validates specific facts and
Opinion statements. figures.

Based on information gathered and

verified from the entire set of Created based on specific data
Use of Data financial records. that can be verified for accuracy.

Guarantees the absolute

Extent of Cannot guarantee the absolute accuracy of the data and
Guarantee accuracy of financial statements. information contained within.

Covers the entire accounts of the Very specific, covering only a

business and all transactions made particular part of the accounts of
Coverage during the year. the concern.

Does not hold the auditor Holds the auditor liable if any
accountable for irregularities but information indicated is
requires reporting of any identified subsequently found to be
Responsibility issues. incorrect.

Self Assessment
1. Explain the concept of a cost audit and its significance for organizations?
2. What is a special audit, and when might it be necessary?
3. Explain the concept of a joint audit and its purpose?
4. Define the audit certificate?
20.15 Summary
udit reports serve as crucial documents summarizing the findings and opinions of
auditors regarding an entity's financial statements. Contents typically include an
introduction, scope of audit, opinion on financial statements' accuracy and
compliance, and disclosures of significant findings. These reports adhere to general
provisions ensuring transparency, accuracy, and compliance with auditing standards.
Auditors sign reports to authenticate their findings, and may exercise a lien for
unpaid fees. Joint audits and specialized audits like cost audits offer enhanced
scrutiny in complex scenarios. While audit reports provide assurance, they may also
bear disadvantages, yet their benefits lie in ensuring financial transparency,
accountability, and regulatory compliance through detailed examination and
certification of financial statements.
20.16 Glossary
1. Opinion Paragraph: The opinion paragraph expresses the auditor's opinion on
whether the financial statements give a true and fair view in conformity with the
accounting principles generally accepted in India. The opinion also addresses
compliance with statutory requirements. The auditor uses the term "give a true
and fair view" to indicate that only material matters are considered
2. Branch Audits: The Order is also applicable to audits of branches of companies
under the Act. This is because Section 228(3)(a) specifies that a branch auditor
has the same duties in respect of audit as the company's auditor. Therefore, the
branch auditor's report must contain statements on all matters specified in the
Order, unless the company is exempt from its applicability. This enables the
company's auditor to consider these matters while complying with the provisions
of the Order.
3. Branch Audits: The Order is also applicable to audits of branches of companies
under the Act. This is because Section 228(3)(a) specifies that a branch auditor
has the same duties in respect of audit as the company's auditor. Therefore, the
branch auditor's report must contain statements on all matters specified in the
Order, unless the company is exempt from its applicability. This enables the
company's auditor to consider these matters while complying with the provisions
of the Order.
4. Unqualified Report: An unqualified opinion is issued when the auditor concludes
that the financial statements: (a) Present a true and fair view in accordance with
the financial reporting framework used.
20.17 Answers: Self Assessment
1). Please check section 20.12 2). Please check section 20.11
3). Please check section 20.8 4). Please check section 20.14
20.18 Terminal Questions
1. What are the key components typically included in an audit report?
2. Outline the general provisions that auditors must adhere to when preparing
audit reports.
3. Discuss the potential disadvantages or limitations of audit reports.
4. What is an audit certificate, and what information does it typically contain?
And different between the audit report and the audit certificate?
20.19 Answers: Terminal Questions:
1). Please check section 20.2 2). Please check section 20.3
3). Please check section 20.10 4). Please check section 20.14
20.20 Suggested Readings
1. Dalal, Chetan. (2015). Novel & Conventional Methods of Audit, Investigation
and Fraud Detection. Wolters Kluwer India Pvt. Ltd.
2. Gupta, Sanjeev (2016). Corporate Frauds and their Regulation in India.
Bharat Law House Pvt. Ltd
3. Kaul, Vivek (2013). Easy Money. Sage Publications, New Delhi.
4. Manning, George A. (2010). Financial Investigation and Forensic Accounting.
CRC Press: Taylor & Francis Group.
5. Sharma, B. R. (2014). Bank Frauds. Universal Law Publishing, New Delhi