AUDITING PRINCIPLES AND

PRACTICES - I

CHAPTER-I

AN OVERVIEW OF AUDITING

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 1.1 Definition and Nature of Auditing
 The term ‘audit’ is derived from the Latin word ‘audire’,
which literally means ‘to hear’.

 Initially, the aim of audit was to know whether any cash had
been embezzled and if so, who embezzled it and what
amount was involved.

 But as the business grew both in size and complexity, the

owners found it more difficult to maintain complete
knowledge of all aspects of their business.

 Consequently, there arose a demand for independent

auditors to examine business undertakings’ financial
statements and to report on their correctness.
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 The scope of audit, as it exists today, cannot be confined
to cash verification.

 The principal object of modern audit is to report on the

financial position of the business undertaking under audit
as depicted by the financial statements, i.e., the balance
sheet and the profit and the loss account.

 Detection of errors and frauds is an incidental object of

independent financial audit.

 Thus, over a period of time, the work of auditors switched

in emphasis from searching for fraud to judging the fair
presentation of financial statements.

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Definition of Audit:

“An audit is an examination of accounting

records undertaken with a view to establishing
whether they correctly and completely reflect
the transactions to which they purport to relate”.
- Lawrence R. Dicksee

“Auditing is a systematic examination of the

books and records of a business or other
organization, in order to ascertain or verify to
report upon the facts regarding its financial
operation and the result thereof”.
- Montgomery
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Essential Characteristics of Auditing:

 Audit is an independent, scientific, intelligent and

critical examination of the books of account or
accounting records of a business.

 Such examination enables the auditor to satisfy

himself that the balance sheet and the profit and
loss account are properly drawn up, and the account
exhibits a true and fair view of the financial state of
affairs of the business for the accounting period.

 Detection of errors and frauds is an integral part of

auditing.

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 The job of auditing is preferred by an independent
person or body of persons qualified for the job.

 In order to report on the financial health of the

business, the auditor has to go through vouchers
and other related documentary evidence (both
internal as well as external).

 The auditor has to satisfy himself about the

correctness, authenticity, and reliability of
accounting information and submit his report
accordingly.

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 Comparison between Auditing and
Accounting

1. Subject matter:
 Accounting is concerned with collection, classification and
summarization of economic events in a logical manner for
the purpose of providing financial information for decision
making.
 Auditing, on the other hand, is concerned with
examination or review of financial information so
furnished.

2. Object:
 The main object of accounting is to know the trading
results or state of affairs of a business during the
accounting period.
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 Whereas, the object of audit is to judge the correctness
and reliability of financial statements prepared by the
internal staff of the business enterprise.

3. Hierarchy:
 Auditing begins where Accounting ends. There can be no
auditing without the prior existence of accounting data.

4. Nature:
 Accounting is constructive in nature as it measures
business events in terms of profit or loss and
communicates the financial condition of the business as
depicted by financial statements.
 Auditing, on the other hand, is referred as a analytical and
critical aspect of accounting since it reviews the
measurement and communication of results and condition
of business.
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5. Expertise required:
 An accountant may not comfortable with audit
techniques and procedures.
 But an auditor must be well versed with the principles
and techniques of accounting.

6. Process:
 Accounting is a four-step process that involves collection
and record, classification, summarization and
communication of accounting information and results
thereof.
 Auditing, on the other hand, includes three principal
steps, viz., preliminary planning, performing the audit
work, and reporting the findings.

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 Objectives of Audit

The objectives of an audit may be categorized as:

1. Primary objective
2. Secondary objective
3. Specific objective

1. Primary Objective:

 The primary objective of an independent financial audit

is to determine whether the financial statements present
a factual and impartial view of the financial position and
working results of an enterprise.

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2. Secondary Objectives:

 During the process of examining the books of account and

relevant supporting documents with a view to express his
opinion, certain errors and frauds may be discovered. They
are:

a. Detection and prevention of errors and mistakes:

The term ‘error’ in accounting refers to an unintentional
misstatement of financial statements.
1. Clerical errors: These errors arise because of mistakes
committed by the clerical staff in the ordinary course of
accounting work.
i. Errors of omission (These occur on account of
transactions no being recorded in the books of account
either wholly or partially).

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ii. Errors of commission (These consists of incorrect
additions, wrong postings and entries).

iii. Compensating errors (These are the errors which

counter-balance each other in such a manner that there
remains no difference between two sides of the trail
balance).

iv. Errors of duplication (These arise when an entry in a

book of original record has been made twice, or/and due
to double posting of a journal entry in ledger accounts).

v. Trail balance errors (These may consist of casting

errors in the trail balance, omission of a balance while
extracting balance from the books of account, or entering
an amount incorrectly or on the wrong side).

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2. Errors of Principle: These errors are those
which result from misapplication of or fail to noticing
accounting principles. They are:

i. Incorrect allocation (These occur when the

distinction between revenue and capital is not strictly
maintained).

ii. Omission of outstanding assets and liabilities

(These arise when prepayments are ignored and the
amount charged from the profit and loss account and
outstanding expenses in respect of rent, salaries,
commission etc., are ignored and not accounted for).

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 iii. Incorrect valuation of assets (This occurs when,
for example, (a). Fixed assets are not valued at
cost less depreciation (b). Current assets are not
valued at cost or market price, whichever is lower
(c). Excess or inadequate provision of depreciation
(d). Excess or wrong provision for bad and doubtful
debts (e). Overvaluation or undervaluation of
closing stock).

b. Detection and prevention of frauds:

The term ‘fraud’ may be defined as internal
irregularities aimed at cheating or causing loss to
another. Frauds are often committed by two or
more persons, acting in collusion (agreement) with
one another.

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1. Misappropriations and defalcations:
i. Embezzlement of cash (It refers to falsification or
misappropriation of cash, which is very common
especially in case of big business concern, as the
proprietor has very little control over the receipts, and
payments of cash. Examples are: a. By omitting to
enter receipts, b. By entering fictitious payments).

ii. Misappropriation of goods (Further, fraud may also

be committed through misappropriation of goods. It is
very difficult to detect, which is very common
especially when goods are not bulky and are of high
value. Such detection is possible only if possible
records of stock inward and outward are maintained).

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2. Misrepresentation of accounts (It refers to
Fraudulent Manipulation or Falsification of
accounts. This type of fraud usually involves very
large amount and cannot be detected easily by the
auditors because it is committed by those
responsible persons who are in top management,
viz., directors, managers, etc., in order to achieve
certain specific objectives). Basically there are two
different objects behind the manipulation of
accounts. They are:

i. Window dressing (When accounts are prepared in

such a manner that they seem to indicate a much
better and sound financial position of the business
enterprise, it is known as window dressing). The
main objectives behind this are:
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 To attract potential investors to subscribe for the
shares in order to produce further capital,
 To obtain further credit,
 To enjoy better reputation in the market by showing
more sound financial position than in actual term,
 To win the confidence of shareholders,
 To raise the price of shares in the market by paying
higher dividends.

ii. Secret reserves (When accounts are prepared in such

a manner that they seem to disclose worse financial
position of the company than actual ones, it is
known as ‘Secret Reserves’. Thus, the real picture of
the business is concealed and a distorted picture is
revealed). The main objectives behind showing less
profit than actual ones are:
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 To avoid or reduce income tax liability.
 To buy back shares from the open market through
reducing the price of shares by paying less or no
dividend.
 To conceal the true position of company’s state of
affairs from the competitors.

From the analysis of various definitions given by

different authorities on the subject and latest
developments in the field of auditing, it should be
clear that the term audit should not be confined to
financial audit alone. The area of operation of audit
is quite wide and such other areas like review of
cost, operations, efficiency, management, and tax
liability etc., fall under the purview of audit.
Accordingly there would be specific objectives in
respect of each type of such specified audit.
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Qualifications and Qualities of an Auditor

An auditor must be professionally qualified. Without such

qualification, he cannot be appointed as an auditor of a
joint stock company. Several organizations and
authoritative bodies influence audit practice today,
including:

a. The American Institute of Certified Public

Accountants (AICPA) is professional trade association
with over 400,000 members. The institute actively
lobbies Congress on legislation relevant to its
membership, and publishes authoritative
pronouncements about accounting, auditing, attestation,
professional ethics, management advisory services, and
taxes.
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b. The Securities and Exchange Commission (SEC)
Created by Congress in 1934, the SEC regulates the
registration and exchange of securities under the
Securities Act of 1933 and the Securities Exchange Act of
1934. Currently, the SEC issues two types of releases that
affect independent auditors: Financial Reporting Releases,
which announce accounting and auditing matters of
general interest, and Accounting and Auditing
Enforcement Releases, which announce accounting and
auditing matters related to the SEC’s enforcement
activities.

c. The Auditing Standard Board and the Accounting

and Review Services Committee: In 1978, the AICPA’s
independent commission on Auditor’s Responsibilities (the
Cohen Commission) issued a 195 page report about the
responsibilities of independent auditors. The Auditing
Standard Board consists of
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fifteen members who are appointed for rotating terms
with the consent of the AICPA’s directors. Although the
most influenced body in the audit and attestation
standard setting process, the ASB, like the Financial
Accounting Standards Board, does not issue
pronouncements without due process, including public
meetings and public hearings.

d. The Public Oversight Board : Like the legal and

medical professions, the public accounting profession is
self regulated. Practitioners abide by professional
standards (chapter 2) and by a Code of Professional
Conduct (Chapter 19), and sanctions for violations are
levied by the AICPA, by state societies of CPAs, and by
state boards of accountancy. POB is an autonomous
body that monitors the performance of the 1,260 public
accounting firms that audit more than 15,800 U.S
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publicly traded corporations. The five member POB
meets about eight times per year, overseas the peer
reviews (chapter 2) of some firms, and issues status
reports that recommend improvements in the self
regulation process.

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 Qualities of an Auditor

1. Knowledge of accountancy: It would be practically

difficult for a person to carry out a critical examination of the
accounts furnished by others unless he understands exactly
how the accounts have been prepared.

2. Knowledge of theory and practice of auditing and

relevant laws: He should possess thorough knowledge of
theory and practice of auditing. Besides, he should be familiar
with various relevant laws of the country governing a
business such as tax laws, corporate laws, and economic
laws, etc.,

3. Intelligence and tactfulness: He must be capable of

making intelligent and exhaustive inquiries till he ascertains
the information required to understand the state of affairs of
client’s business.
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4. Responsible and Prudent: An auditor should be prudent
enough. When asked by the client to offer suggestions or
advice on matters relating to financial policy, accounting
system, and internal controls prevailing in the organizations,
an auditor must be prudent.

5. Familiarity with the latest developments /

amendments affecting audit: An auditor should be
familiar with the latest developments / amendments as to
techniques of auditing / accounting and laws affecting him
and his work.

6. Integrity: An auditor should be honest and possess high

moral standards. Lord Justice Lindley describes that “……he
must not certify what he does not believe to be true and he
must take reasonable care and skill before he believes what
he certifies is true”.

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7. Objectivity, independency and transparency: An
auditor should maintain objectivity and be free of conflicts
of interest in discharging professional responsibilities. He
should carry out his duties cheerfully, conscientiously, and
independently. He should prove himself to be an
independent person and must show transperancy in his
work.

8. Vigilance: An auditor should be vigilant and cautious. He

should be able to detect errors and frauds.

9. Positive attitude and reliance upon client’s staff: In

the words of Lord Justice Lopes, “An auditor is not bound
to be a detective or to approach his work with suspicion or
with foregone conclusion that there is something wrong. He
is a watchdog and not a bloodhound. He entitles to rely
upon their representations provided he takes reasonable
care”.
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10. Diligence: Auditing job is analytical and critical in nature
and requires auditor’s time, energy, attention, and
patience.

11. Confidentiality and loyalty: Maintaining confidentiality

is an integral part of professional ethics. An auditor should
maintain complete secrecy of the business of his client
and should not disclose any confidential information
gathered during the course of his work to any outsider
unless there is a legal or professional duty contrary to it.

12. Communication skill: It is quite essential for an auditor

that he could communicate well with all the concerned. He
should be able to write audit report properly and without
ambiguity. He should be competent to convey his
message in a clear, concise and precise manner.

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Advantages of Audit

1. Detection and Prevention of errors and frauds become

easier.

2. Audited accounting information has greater reliability and

authenticity

3. Acceptability by the authorities such as income tax, sales

tax, and other authorities.

4. Professional advices on internal control system in operation,

tax work, management consultancy, preparation of reports
required by government agencies and so on are available
through auditing.

5. Speedy processing of loan.

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6. Settlement of disputes among the partners in case of
partnership firm.

7. Facilitates calculations of net worth and goodwill of

business in case of sale or take over of business as a
going concern by other party.

8. Settlement of insurance claims in case of losses by fire,

misappropriation, embezzlement or any other reason.

9. A regular audit keeps accounts department vigilant.

10. Audited financial statements are useful to compare the

financial performance. And, audit reviews the internal
control system of the auditee and identifies the weak
areas.
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 Classification of Audits

An audit examination can broadly be classified on

the following three basis:

I. Classification on the basis of Organizational

Structure

II. Classification based on Timing and Scope of Audit

Procedure.

III. Classification on the basis of Specific Objectives

behind audit.

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I. Classification Based on Organizational Structure:

A. Statutory Audit
Where undertakings are formed under the statute or laws,
audits for such undertakings is made compulsory under the
statutes that govern them. Audit is compulsory under
statute in the following cases:

1. Joint stock companies incorporated under the companies

Act
2. Cooperative societies registered under the cooperative
societies act.
3. Public charitable trusts registered under various concerned
acts.
4. Banking companies governed by the banking companies
regulation act.
5. Insurance companies governed by the insurance act.
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6. Public sector undertakings (PSUs), local authorities, and
government financial institutions established under special
act or law, if any.

B. Private Audit
Private audit is the one that is not mandatory under any
statute or law. Various types are:

1. Audit of accounts of Sole Proprietary is optional.

2. The Partnership act does not require a partnership firm to

get their financial statements audited. Still many firms
provide for audit of their books of account to present their
books of account fairly, easy settlement of accounts at the
time of admission, retirement or death of a partner, to
access loan from outside etc.,

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3. Audit of accounts of other entities such as clubs, libraries,
hospitals, schools, colleges, other educational institutions
are not required to be audited by an independent auditor
under ant statute of law. They may, however, get their
books of account audited so as to present a clear picture
of state of affairs of the business transacted.

C. Government Audit
The government offices, departments, under-takings
registered as companies, are also subject to independent
financial audit. Usually a statutory auditor appointed by
the Central Government on the advice of the Comptroller
and Auditor General audits accounts of government
companies.

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II. Classification Based on Timing and Scope of Audit
Procedures:

A. Continuous Audit
“A continuous audit is one where the Auditor’s staff is
occupied continuously on the accounts the whole year
round, or where the auditor attends at regular intervals say
weekly, fortnightly, quarterly, or as per the requirement of
the management and quantum of work. It is also known as
‘running audit’.

B. Internal Audit
Internal audit as the term implies is an audit conducted
within the organization by an internal auditor appointed by
the management of an enterprise.

Normally all large business organizations often set up an

audit department to exercise an independent appraisal
function within the organization.
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This department Normally all large business organizations often
set up an audit department to exercise an independent
appraisal function within the organization.

This department undertakes examination and evaluation of

various accounting, financial, and operating activities of the
business enterprise.

Internal audit is conducted to ascertain whether all prescribed

rules, regulations, policies, procedures and principles have been
followed or not.

To check whether existing internal controls are adequate and

effective and how well does it fit the size of the organization?

To ensure that all the assets of the organization are

safeguarded against any probable misuse.

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 To highlight the weak areas of the organization and give suggestions to
strengthen them.

To check whether working of the organization is smooth, effective, efficient

and economical.

C. Interim Audit
Interim audit is one that relates to an interim period and not to the full
accounting period.
It is conducted between two regular audits. It lies between final audit and
continuous audit.
It is initiated in order to know the reliability and accuracy of financial
statements of a business for a part of the year.
It is necessitated, if the directors of the company desire to pay the interim
dividend – and the profit for the period can be ascertained through interim
audit up to date.

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D. Final Audit or Periodical Audit

A final audit is one where the auditor undertakes the audit work
only at the end of the financial year.

In such a case, the audit work commences after all the

accounts are closed and balance sheet and income statement
are prepared.

The auditor visits his client only once a year and completes the
entire work in one session. It is useful in case of small concern.

The auditor is supplied with the full facts relating to the year
under review.

It is less expensive and very useful particularly for small-scale

business concerns, as they may not afford continuous audit.

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E. Balance Sheet Audit

Balance sheet audit originated in United States implies a

critical review of a Balance sheet.

It is a procedure in which the figures, as stated in the

Balance sheet are taken as a base and their authenticity is
verified from the records.

Just opposite to normal audit procedures, a balance sheet

audit commences with the detailed examination of the items
appearing in the balance sheet and works back to the
supporting evidence and related documents.

It involves the checking of values of fixed assets, current

assets, liabilities, balance of reserves and provisions, surplus
etc., and as well as income statement since profit or loss is
one of the balance sheet items.
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III. Classification of Audit Based on Specific
Objectives:

A. Cost Audit
Cost audit is an audit of cost accounting record. According
to Smith and Day “The term ‘cost audit’ means the detailed
checking of the costing system, techniques and accounts to
verify their correctness and to ensure adherence to the
objectives of cost accountancy”.

B. Special Audit

The Central Govt. has the power to direct special audit in

the following cases:

1. If the affairs of any company are not being managed in

accordance with sound business principles or prudent
commercial purposes.
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 2. Where any company is being managed in a manner likely to
cause serious injury or damage to the interests of the trade,
industry or business to which it pertains.

3. Where the financial position of any company is such as to

endanger its solvency.

C. Tax Audit
The Income Tax Act, provides for compulsory tax audit of the
books of account of every person carrying on business or
profession with turnover or gross receipt in respect of such
business, exceeding ETB______, and in case of profession,
exceeding ETB______ in any previous year.

The objective of such audit is to assist the income tax

assessment of the assessee concerned.

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D. Management Audit
Management audit refers to critical and analytical
examination of the performance of different managerial
functions in an organization.

It involves a critical review of all aspects of the process of

management.

It analyses the effectiveness of policies, procedures, and

operations of an enterprise. Management audit, in fact, is
an appraisal of both policies and actions.

It is very helpful to trace out the weak areas of function

and performance.

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E. Operational Audit
The concept of operational audit is a recent development. To
conduct operational audit normally an independent internal auditor is
appointed.

It refers to a review of any part of an audit to assess organization’s

operating procedures and methods for the purpose of evaluating
efficiency and effectiveness.

It helps to improve the profitability of the business organization.

Also helps to develop recommendations for improvement or further

action.

It aims to achieve the other organizational objectives other than the

profitability, i.e., social, environmental, developing human resources
and public interest.

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F. Marketing Audit
It refers to audit of marketing situation of a business
undertaking. Such type of audit is conducted in order to
evaluate and control marketing performance of a business
enterprise.

Marketing audit is very popular in American and European

countries.

According to Philip Kotler: “A marketing audit is a

comprehensive, systematic, independent and periodic
examination of a company’s or business unit’s marketing
environment, objectives, strategies, and activities with a
view to determining problem areas and opportunities and
recommending a plan of action to improve the company’s
marketing performance”.

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G. Environmental Audit
Environmental auditing originated in the United States in
the 1970s as a way of checking whether a company was
complying with a multitude of new environmental laws and
regulations.

An environmental audit is an assessment of the nature and

extent of harm (or risk of harm) to the environment posed
by an industrial process or activity, waste, substance or
noise.

The Confederation of British Industry has defined

environmental auditing as the systematic examination of
the interactions between any business operation and its
surroundings. This includes all emissions to air, land and
water, legal constraints; the effects on the neighboring
community, landscape and ecology; the public’s perception
of the operating company in the local area.
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H. Social Audit
Social auditing is a process that enables an organization to
assess and demonstrate its social, economic, and
environmental benefits and limitations.

In simple words, social audit attempts to assess the social

performance of an enterprise.

Social auditing provides an assessment of the impact of an

organization’s non-financial objectives through
systematically and regularly monitoring its performance and
the views of its stakeholders.

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I. Human Resource (HR) Audit
A HR audit reviews an organization’s policies, procedures, and
practices concerning human resource.

Its purpose is to examine the technical and practical dimensions of

the HR function and to create a comprehensive system that adds
value to the organization.

It identifies the HR programs that are most important to achieving

organization’s objectives.

This helps to benchmark HR work to ensure continuous

improvement.

It promotes change and creativity.

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J. Energy Audit
The term energy audit implies a critical review of utility
energy data for all fuels, including electricity, natural gas,
fuel oil, and any other delivered fuels.

Effective management of energy-consuming systems can

lead to significant cost and energy savings as well as
increased comfort, lower maintenance costs, and extended
equipment life.

A successful energy management program begins with a

thorough energy audit.

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