You are on page 1of 85


Chapter 1

Origin of Audit
The origin of audit may be traced to middle ages, but the audit in the present sense can be traced after the introduction of large-scale production, in consequence of Industrial Revolution, during the 18 th century. Before this ear, goods were produced by individuals, on small scale. There was not much capital. The individual, who invested the capital, usually himself maintained the accountants and, therefore, there was no necessity of checking them. But stabilized governments, expansion of banking facilities and new means of communication, have widened the scope of investment and business. The investor would naturally like to see that his investment is safe. For this purpose, the accountants must be checked and audited, especially in the case of joint-stock companies, where the share-holders are drawn from far-off-place, and who have hand in the actual running of the business. In such a case, therefore, it is essential to get the accounts audited, in order to assure them that their investment is safe and that the Directors and the Managing Directors etc., who handle the capital and accounts, have presented true and correct accountants. As it is not possible for the share-holders to check the accounts of the company, they appoint a person who would audit the accountants on their behalf. Formerly, such a person used to be one of the shareholders, who might not have technical knowledge of accountancy. To have an effective check, the custom to appoint professional accountants began to develop. Definition of Auditing The word "Audit" is derived from the latin word "Audire" which means "to hear". In older times, wherever the owners of a business suspected fraud, they appointed certain persons to check the accounts, such persons sent for the accountants, and "heard" whatever they had to say in connection with the accounts. Thus, the auditor or audit is burnt out, the opinions of different writers are. "An audit is the independent examination of financial statement or related interrogation of an artily, whether profit oriented not and irrespective of its size or legal form, when such an examination us conducted with a view to expressing an opinion thereon". -International standard of auditing. ``An audit is an examination of such records to establish their reliability and the reliability of statement down from them. A.W. Hanson ``Auditing is concerned with the verification. Of accounting data. With determining the accuracy and reliability of accounting statements and reports. R. K. Mautz "Auditing is a systematic examination of the books and record of a business or other organization in order to ascertain or verify and to report upon, the facts regarding the financial operating and results, there of. Montgomery From the above discussion, it is clear that the term audit generally empties audit of financial statement In such an audit, the expert opinions of auditor is given about the quality of such statement. Here it can be concluded that the audit means critical and intelligent examination of facts financial on other wise to give in the form of certificate or report an attestation, an expert opining or an expert advice

The objectives of audit:

It has been already been pointed out while dealing with the definition of audit, the main objective of audit is to find out after going through the books of account, whether the balance sheet and profit and loss account are properly drawn up according to companies act and whether they represent a true and fair view of the state of the affairs of the concern. This is possible when he verifies the accounts and statements while performing his duty; the auditor has also to discover errors and fraud. But it would not be possible for auditor to discover all errors and fraud, in the financial statements due to the limitations of his checking. The SAPZ of the Institute of Chartered Accountants of India, states that such discovery is not the main objective of audit. In this light, the objectives of audit can be categorized into three parts. These are (1) Main objectives (2) Secondary objectives (3) Specific objective The objectives of audit are shown in a diagram in the next page -

Objectives of audit

Main objectives Expression expert opinion Errors

Secondary objectives Detection or prevention

Specific objective


*Review of operation *Performance management policy *Cost records

Clerical errors

Errors of principle Errors of omission

Compensating errors Errors of commission

Errors of duplication

Embezzlement of cash Fraudulent of manipulation of accounts Errors Misappropriation of

Partial error

Complete error

Now, the various objectives of auditing are describes with examples in detains below 1.Main objectives : The main objective of audit is to express expert opinion or financial statements. An entity prepares balance sheet to portray its financial position. It also prepares P&L account to disclose the operating results of the period covered in the statement. These financial statements are submitted to the auditor for his checking and comment. The auditor checks them in a careful manner with outmost diligence and professional competence. He verifies that accounts are prepared within the framework of recognized accounting policies and practices and relevant statutory requirements if any he checks whether the facts as represented in the balance sheet and profit and loss account are true. Based on this checking in this respect, the auditor express his opinion about the quality of the financial statements concerning proper disclosure of facts in the financial statement and the truth and fairness of the financial position and operating results of the enterprise, as disclosed in the balance sheet and profit and loss account respectively. 1.Secondary objectives: a)Detection or prevention of errors : Errors are generally innocent but sometimes errors which might appear, at first sight, as innocent are ultimately found to be due to fraudulent manipulation and therefore an auditor must ay particular attention to every errors, however, innocent it may appear to be first sight. The following are the various types of errors.

Clerical errors : These errors are committed in posting, totaling and balancing. Such errors may again be sub divided into. a) Errors of omission; and b) Errors of commission 2 Errors of principle 3 Compensating errors or off-setting errors. 4 Errors of duplication Let us discuss these errors in details. 1(a)Errors of Omission : As the name indicates, the errors of omission are one where a transaction has not been recorded in the books of account either wholly or party. In the forms case it will not be easy to detect the errors and it will not affect the trail balance, but sometimes it is apparent from the balance of an account that an entry has been omitted. Example : The rent account may show that the rent for the 12 th month has not been paid. This type of error can be detected by careful observation. But there are many other cases where it may not be possible to detect the omission, e.g. purchases or sales have entirely been omitted to be entered and therefore there is neither a debit entry nor a credit entry. Such an error will not affect the trail balance and the omission will not even be apparent. 1(B)Errors of commission : When a transaction has been recorded but has been wrongly entered in the books of original entry or posted in the ledger, error of commission is said to have been made. Example: A purchase invoice for R.S. 1250 was entered in the purchase book as RS. 1520. Such an error may be intentional or un-intentional. The underlying idea may be to miss appropriate cash, in league with the seller of the goods. Therefore vouching should be done very carefully, in order to defect such an error or fraud. Other errors of commission are wrong costing, calculation, postings, extensions carry forwards, etc. Some of such errors will be detected by the non arrangement of the trail balance. On the other hand, if a mistake has been committed in the invoice for sale of goods; the error will not be detected as the mistake will appear both in the original books as well as in the ledger. 2.Error of Principle : Such error arise when the entries are not recorded according to the fundamental principal of accountancy, e.g. wrong allocation of expenditure between capital and revenue, ignoring the outstanding assets and liabilities, valuation of assets against the principles of book-keeping. Such error may be committed either intentionally; or unintentionally. If they are committed intentionally the object is false and manipulates the accounts either to show more profit or less profits than they actually are. Such errors ultimately affect the profit and loss account and the balance sheet. Therefore it is very important for an auditor to pay particular attention towards this type of error. It can be detected only by a searching inquiry and independent checking. 3.Compensating Errors or Off-setting Errors :A compensating error or off-setting error is counterbalanced by any other error or errors. Example: If As account was debited for Tk 100 but was debited for Tk 10 while Bs account was to be debited for Tk 10 was debited for Tk 100. Thus both the accounts have been debited for a total sum of 110 which amount ought to have been debited or a sale of tk10 to A is posted to the debit of B Tk 5 and the purchased book is over cost by Tk 5. Again an over costing of an account may be counter balanced by the under costing of another account to the same extent. These errors are most dangerous and are difficult to guard against. This type of error will not be detected easily. This error may or may not affect the profit and loss account. These errors are most dangerous and are difficult to guard against this. Error may or may not affect the profit and loss account. 3.Errors of Duplication:Such errors when an entry in a book of original entry has been made twice and have also been posted twice. b) Detection and Prevention of Fraud : Having deal with the detection and prevention of errors, let us now proceed to discuss the detection and prevention of fraud. Fraud means false representation or entry made intentionally or without belief in its truth with a view to defraud somebody. Detection of fraud is considered to be one of the important duties of an auditor, as a matter of fact; originally audit was conducted mainly with a view to detect fraud whenever it was suspected. The system of internal check aims at the prevention of fraud. If the auditor finds that the internal check system is defective and will not prevent the commission of frauds he should suggest a better system. The chief ways in which fraud may be perpetrated are as follows 1 Embezzlement of cash

2 Misappropriation of goods; and 3 Fraudulent of manipulation of accounts. 1.Embezzlement of Cash : There is a greater possibility of defalcation of money in a big business house than in the case of a small proprietary business where the proprietor has a direct control over the receipt and payments of cash. So it is clear to misappropriate cash and therefore, the author does well to pay particular attention towards cash transactions. Cash may be misappropriated by a) omitting to enter any cash which has been received; or b)entering less amount than what has been actually received; or c) making fictitious entries or the payment side of cash book; or d)entering more amount or the payment side of the cash book than has been actually paid. 2.Misappropriation of Goods : Again fraud may be in respect of goods, i.e. misappropriation of goods. This type of fraud is very difficult to detect especially when the goods are less bulky and are of higher value. Proper methods of keeping accounts in regard to purchases and sales, stock taking, periodical checking of stocks, comparing the percentages of gross profit to sales of two periods, necessity for cash will help to avoid misappropriation of goods. 3.Fraudulent of Manipulation of Accounts : This type of fraud is more difficult to discover as it is usually committed by directors or managers or other responsible officials with the object of showing more profits than what actually they are so that if they get commission on profits, they may get more commission. Showing less profit than what actually they are. Such fraud are difficult to detect as they are committed by the people of the help of affairs who are presumed to be trustworthy, honest and responsible, and therefore, no suspicious falls on them, position of auditor in regard to errors and frauds affecting financial statements. The auditors carrying out necessary checks before expressing his opinion on the truth and fairness of financial position and operating results of an entity as reflected in financial statements. The auditor seeks to ensure that there is no material misstatement of financial information arising from errors or frauds. However, there is possibility that some material misstatement of financial information resulting from errors of fraud may creep in financial statements. The misstatement may be subsequently found out. The auditor is an expert in his own field. He must have adequate expertise to testify the financial statements as to their truth and fairness. Definitely he must have at his disposal specialized skills to unravel the mess of errors and frauds. The audit may encompass such other areas like review of operations, performance management policy, cost records and so on. Accordingly, there will be specific objective in respect of each type of such specific audits. For example, in operational audit, the aim of audit is to evaluate the existing operations of the entity in order to give expert advice to improve their efficiency. 3. Specific Objectives : We have emphasized that the term audit should not be taken to imply financial audit alone, in the definition topic. The audit may encompass such other areas like review of operations, performance management policy, cost records and so on. Accordingly, there will be specific objective in respect of each type of such specific audits. For example, in operational audit, the aim of audit is to evaluate the existing operations of the entity in order to give expert advice to improve their efficiency. The cost audit is to check the cost records of the entity in order to make a report on the paper ascertainment of cash of production of goods or services.

Scope of Audit
Scope of Audit refers to its subject matter. It includes its area of operations, various aspects to be covered under the audit and the requirements of the relevant legislations. As per statement on Auditing and Assurance 2 (AAs2) the scope of Audit is mentioned belowThe scope of an Audit is determined by the auditor, having regard to: (a) The terms of the engagement (b) The requirements of the relevant legislation and (c) The pronouncements of the institute of chartered accountants of India. However, the terms of the engagement cannot restrict the scope of an audit in respect of matter. Which are prescribed by the relevant legislation and the pronouncements of the Institute? The audit should adequately cover all aspects of the enterprise, which are relevant to the financial statements under audit. The auditor should be reasonably stratified that the information contained in the accounting records etc. is reliable and sufficient for the preparation of financial statements in respect of which he is to form his opinion. He should also see that the disclosure of information is as per the legal requirements, if any. The reliability and sufficiency of the information with be assessed by

(a) Study and evaluation of the accounting systems and internal control which are to be relied upon so as to decide the nature, extent and timing of audit procedures, (b) Carrying out other necessary tests, enquires and verification procedures. Propriety of disclosure of information in the financial statements will be determined by (a) Examining whether the financial statements properly summarize the transactions and events recorded in the accounting records, etc. (b) Considering the managements judgments as regards preparation of financial statements which will involve an assessment of selection and application of accounting policies, the manner of classification of information and adequacy of disclosure. The audit is primarily concerned with the items, which, whether individually or as a group, are material in relation to the affairs of an enterprise. Material items are those which might influence the discussion of the user of the financial statements. However, in the absence of any definite standard to judge materiality. The auditor should make a decision about it on the basis of its professional experience and judgment. The auditor is not expected to perform duties. Which are outside the scope of his competence, such as determining physical condition of certain assets? If there are any constraints as regards the scope of audit. Which impair the auditors ability to express an unqualified opinion on financial statements, he should set them out in his report and render a qualified opinion or a disclaimer of opinion, as deemed appropriate.

Advantages of auditing.
Now-a- days Business people get their Accounts audited by Professional auditor with a -view to making the accounting information transparent and reliable. It has some advantages. i) Detection and Prevention of errors and fraud: Auditing helps a business to detect and prevent the fraud and errors. It can be located and rectified at an early and initial stage. (ii) Acceptability by the authorities:- Audited accounts are readily acceptability by the Income tax, sates tax and other authority. iii) Professional advice available:- Independent Auditors also reader service other than auditing. They do tax work, advice on internal control system in operation and prepare report required by govt agencies. iv) Speedy Processing on loan:-Financial institutions consider audited accounts genuine and authentic and list helps then in speedy processing of loan proposals. v) Settlement of disputes: The audited accounts of a trim by an independent person minimizes the dispute among the partners. Vi) Helps to provide net worth and goodwill:- In case of sale or take over of Business as a going concern by other party. Audited acuity carry greater reliability to deciding out of net worth and good will of Business. Vii) Settlement of insurance claims:- Audited accounts are likely to have more creditability and this helps in early and easy settlements on insurance claims in case on fire. Viii) Useful to compare the financial performance:Audited financial statements are considered more reliable to compare the financial to compare the financial performance of a business concern over the years. (ix) Keeps accounts department vigilant: A regular audit of accounts keeps the accounts department not only up-to-date but also careful and vigilant. x) Identify the weak areas: It helps to identify the weak areas which helps management to get over the weakness and achiever their good within stipulated time. So, we can say that, this are the advantage on auditing. It helps to run the business.

Disadvantages of Audit :
In spite of the advantages of auditing, there are certain drawbacks of such an audit, which are under: 1. Alternation of Figures: Dishonest clerk may alter figures in the books of account, which have already been checked by the auditor at his previous visit, and the frauds may thus be perpetrated. 2. Dislocation of Clients Work: The frequent visits by the auditor may dislocate the work of his client and causes inconvenience to the latter. 3. Expensive for Business Organization: It is a very expensive for business organization. Every year the business organization has to pay a huge amount of money behind these auditors. Although it is not sure that the result from them is accurate. 4. Queries May Remain Outstanding:

The audit clerk may lose the thread of his work and the queries, which he wanted to make, may remain outstanding, as there might be long interval between the two visits. 5. Information can not be Accurate: The accurate information may not be expressed by auditing in organization. After auditing if any errors or fraudulent has caught then the auditor could be accused for all time. After auditing with sincerity if the auditor fail find out the errors or fraudulent then also he will not be accused. Thats why it cannot be said that after auditing the information or result is accurate. 6. Illegibility of Real Information: Sometimes it seems that journal is not properly prepared or there is some illegibility of real information. Thats why auditor has to know the proper information from upper level officer. So if this officer dont give or deny giving proper information then the auditor could not come to know the real information of these opaque journals. 7. Inherent Limitations of Audit: Since the auditor seeks to obtain persuasive rather than conclusive evident and relies on test checks there is possibilities that some material misstatement resulting from fraud or error may not be detected by the auditor. 8. Disclaimers: In some cases the scope an audit might be so inadequate that auditors will not render any option on the financial statements. In other situation the uncertainty might have such a serious potential impact on the financial statements that auditors would refuse to give an opinion. The applicable report in this circumstances is one that disclaimers and option on the financial state and given the reasons for so doing. Disclaimers in an auditors report can have serious impact on readers and the viewers the company in financial statement. 9. Creates the opportunity of corruption: Auditing creates the field of corruption. Many auditors change the audit result by involving in corruption. So there has good chance for the auditors to get something and give something by changing the audit. 10. Insufficiency of expert Auditors: Now a day the business world becoming very critical land sophisticated. There are various types of transactions are occurred and business organizations different types of strategy to grow up its business. So here the expert and sufficient auditors are needed to audit the accounts of these organizations. But there is much lack of such kind of sufficient and expert audit 11. Lack of Unbiased of the Auditors: The auditor must be unbiased. But in reality in most of the time it seems that the auditors cannot keep themselves unbiased all time. Most time it seems that the auditors changed the audit result by involving in corruption. AUDIT TECHNIQUES: The techniques by which an auditor collects evidence are known as techniques of auditing. There are many techniques in auditing. On selection of particular audit techniques in a given situation depends on the size, scope account system, nature of document of an enterprise. Some of the more important techniques of auditing are briefly described below: 1. Physical Examination: Physical examination Technique is used where the item to be examined can be clearly identified and is capable of being measured in physical terms. Also the auditor must be capable of distinguishing the quality of what he is examining. Physical Examination Technique includes counting, identification and to a certain extent, evaluation of quality of the item. 2. Observation: Observation Technique is consisting of looking of a process or procedure what is being performed by others. 3. Re-computation: The auditor undertakes the same calculation for checking many figures, which was undertaken by the accountant in arriving of these figures. Repetition of competition for verifying the arithmetical accuracy of various propositions. 4. Re-tracing Book Keeping Procedures: In this technique an auditor follows the same technique which was followed by the accountant in order to discover errors in the same. Thus, posting from the books of prime entry are traced to the ledger, or fresh trail balances of various ledgers are prepared. 5. Confirmation: Written statements and certificates on certain matters may be obtained from competent independent parties. At the behind of the auditor, the enterprise under audit request such parties to communicate their confirmation of certificates directly to the auditor. Thus, a accountants receivable or accountants payable may confirm his balance with the enterprise under audit or a bank may confirm the investments, belonging to the enterprise which are in its possession. It is necessary for the auditor to maintain a strict control over such confirmation. 6. Scanning: The dictionary meaning of scanning is looking intently at all parts successively. An auditor after scans an account or a book of original entry or any other accounting record. In doing

so, an auditor must use his skill and experience to determine whether the transactions follow a logical pattern or whether something is unusual. By scanning the records an auditor can know whether transactions follow logical pattern or whether unusual. Scanning, though a valuable auditing technique, can be used only by an experienced and competent auditor. 7. Flow Charting: There are many techniques in auditing. Flow chart is one among them. An auditor may use flow charts in analyzing a system and in evaluating its effectiveness. They prepare flow chart to record accurate and comprehensive regarding systems. 8. Inquiry: This refers to asking questions in order to obtain information or examination. In many cases especially when evaluating systems the auditor uses pre-designed questionnaire. An auditor must be able to raise pertinent and intelligent questions and correlate the answer. 9. Examination of Subsidiary Records: Subsidiary records may be examined by an auditor to obtain corroboratory evidence in support of certain transactions. Thus, one of the evidences support the quantity of goods sold may be proved by examining the finished goods ledger. 10. Analytical Review: By correlating various sections of a statement, its harmony or consistency as whole can be examined. Thus, in an independent financial audit, an auditor often analyses financial statements by correlating various transactions or figure with each other. Thus harmony or consistency of the accountants as a whole can be checked by calculating rations which show the relationship between one accounting figure and another. Similarly an auditor reconciles a number of accounting figures with a related account or piece of information. Thus, the total fee received by a club may be verified by reconciling it with the fee received by a club may be verified by reconciling it with the fee that should have been received. AUDIT PROCEDURES : How to proceed with the work will depend up on the circumstances of each particular case. The method of works varies with the training, experience, and knowledge of the auditor. Some general points are given below: Kinds of Audit Procedures: Audit procedures are two kinds. These are 1. Compliance Procedures 2. Substantive Procedures 1.Compliance Procedures : Compliance procedures refer to audit tests which are designed to check the degree of compliance with prescribed internal controls. In other words, they indicate to the auditor whether or not the internal controls are effectively in operation. An auditor may choose to test whether an internal control system alterably each check is required to be sighed by two managers, is in operation or not. The audit tests designed to check this are called compliance tests. In performing compliance tests, the auditor it is operating effectively and whether it has so operated throughout the period under audit. 2.Substantive Procedures: On the other hand, substantive procedures are designed to obtain evidence as to the completeness, accuracy and validity of the data-base are tests performed on the data under audit. Auditing Procedures : An auditor needs sufficient appropriate evidence to form his opinion. This evidence is obtained through the performance of compliance and substantive procedures. These procedures are performed using a number of audit techniques. These are given below: 1.Ticking: Ticking indicates the placing of a mark against an entry in the book to donate that it has been explained by the auditor for a certain purpose. Variously shaped marks are used to donate checking of additions, posting, carry-forward, training, extraction of balances etc. To ensure consistency, most of the good auditors use a tick chart which is required to be learnt by heart by al the members of the audit staff. 1.Casting: Casting refers to the checking of additions of books of accountants and financial statements. It is essential that arithmetical accuracy be checked so that fraud or errors may be defected. This job is normally done by a junior member of audit staff. 2.Calling Over: A sizable part of the works of audit consists of the comparisons of entries in two or more books or of an entry in a book with its supporting evidence or voucher. Case should be used to see that the whole of the important details of each item is checked and not merely the amount. Special care in checking postings to personal ledgers is needed as to names and title of account; otherwise a wrong posting may remain undetected. Clarity in pronunciation is essential. There may be confusion between ninety and nineteen, sixty and sixteen etc. Thus it is advisable to pronounce ninety as ninetie, sixty as sixtie and so on.

3.Vouching : Vouching is a technical term which refers to the inspection by the auditor of documentary evidence which supports and substantiates a transaction. The function of the voucher is to authenticate an entry and the auditor must satisfy himself that it does exist. It must correspond in date and account to the entry in the books. It must be in respect of the client and the entry must be correctly passed in the books. The act of vouching consists of checking the documentary evidence like/such as invoices, cash memos, bills, receipts, vouchers, minutes, reference to legal documents etc. as should establish the accuracy and truthfulness of the entries appearing in the books of account otherwise the matters are noted for discussion and if the auditor still remains unsatisfied, the outstanding matters are reported to the client. 4.Verification: When an auditor has vouched the entries appearing in the books of account, his duty is not thereby fully discharged. If appointed for audit under the Act, he has to report whether or not the balance sheet exhibits a true and correct view of the state of affairs of the company. For this purpose, he should satisfy himself on the following points: A. That each asset and liability is correctly vouched and correctly stated in the balance sheet. B. That the assets actually existed at the date of the balance sheet. C. That they are property of the business. D. That they are not suffering from a change except that disclosed in the balance sheet. The technique of audit carried out to achieve the foregoing objectives is known as verification. 5.Reporting: After the above steps have been carried out, then the auditor will be required to submit his report. The form and the contents will depend upon several factors such as: the legal status of the appointing authority, the contact for the scope of work to be done, whether the audit is being conducted under the Company Act 1994, Banking Company Ordinance 1991, Insurance Act 1938 etc. The form of auditors report to be submitting after the annual audit of accountants of accompany has been prescribed as form 35-A annexed to the Company Act 1994. Modern trends follow the under noted sequences: a. Examination of the accounting system b. Evaluation of internal controls c. Sample checking of vouchers d. Verification of assets and liabilities Submission of auditors report Who is Auditor? In the ancient stage the transaction of business was few. So the owners of the business can record the transactions and supervise the accounts. If the size of the business is large or the owners do not have enough knowledge about recording the accounts. The owners have to appointe other person for keeping the account properly. The person who is appointed by owners of the firm is called auditor. "Auditor is a independent person who audits the companys accounts." P. H. collin (Dictionary of Business) :"An auditor is a person who reports on the accounts of an undertaking or enterprise. His principal task is to examine the accounts and underlying records of the undertaking and report where in his opinion they properly reflect the activities of the undertaking during the period under review and its assets and liabilities at the end of that period." (ICAB study manual on Audition) : So, we can say that a Auditor is a person who audits the account of a company accurately. Qualifications of Auditor: The progress of an organization mostly depends on the qualifications of auditor the qualifications of an auditor are given below. Personal Qualifications: It is vary impotent for an auditor to be well versed in the fundamental principles and theory of all branches of accounting. e.g. general accounting, cost accounting, management accounting, income tax etc. It is impossible for an auditor to audit the accounts unless he himself knows how to prepare them. There is an autonomous institution in Bangladesh called ICAB which provides CA degree. The CA degree holders are capable for auditing. According to company Act 1994, Section 212 it is mandatory to audit the accounts of public Ltd company by CA holder. In the case of sole trade or partnership it is not mandatory to audit the accounts by CA holder. If the concern is related to production, it is mandatory for this concern to audit the accounts by CMA degree holder. This degree is provided by ICMAB. General qualifications:

General qualification can be classified into two categories. General qualification be acquired and general characteristics. General qualification be acquired: (i) Knowledge all the branches of Accounting: It is very important for on auditor to be well versed in the fundamental principles and theory of all branches of accounting e.g. general accounting, cost accounting, income tax. 2) Knowledge in Economics: It is very important for an auditor to be well versed in the fundamental Principles and theory of all branches of Economics. Because business is related to economic events. (3) Knowledge in different laws: Auditor should be quite familiar with the company and mercantile Laws and must be a complete master of the principles of Auditing. (4) Knowledge in Business organization: An auditor has to know about business organization and business management. Because it is very important for auditor. (5) Knowledge in languages: After completing Audit the auditor has to submit report to the organization. So, it is very important for an auditor to know different language. (6) knowledge about mechanical methods: Now-a-days many countries prepare their accounts by using mechanical methods. So, an auditor should know about mechanical methods. General characteristics: 1. Honesty and intelligence: An auditor must be an honest and intelligent person. 2. Sharp Altitude: An auditor must be astute person. He must be a prudent, sagacious and careful person. 3) Impartial Attitude: Impartiality is another qualification of an auditor. (4) Realistic: An auditor must be a realistic person. Because his work is so tough. (5) Patient and jolly: the work of an auditor is complicated and time consuming- An auditor should be patient and jolly person. (6) Determination: An auditor must work the debit report in a clear, right and ere idle way. So, we can say that an auditor is no bound to be a detective, or to approach his work with suspicion or with the foregone conclusion that there is something wrong. He is a watch- dog but not a blood hound. Classification of Audit Different classes of Audit: The Audit may be classified into (a) On the basis of legislative control-statutory audit Government audit, private audit. (b) On the basis of relation of auditor vis a vis management-External audit, internal audit (c) On the basis of periodicity of audit continuousness audit interim audit, periodical audit, occasional audit. (d) On the basis of subject matter of audit- financial audit, operational audit, cost audit, management audit, (e) On the basis of coverage of audit complete audit partial audit. (f) On the basis of manner of checking standard audit, balance sheet audit, post and vouch audit. A. Legislative Control: Where the appointment of auditors manner of Audit, contents of audit report etc. are specifically mentioned in any enactment, the audit conducted with reference to them is called statutory audit. Statutory audit is a compulsory audit and is to be carried out each year by an auditor called statutory auditor. In India, the accounts of joint stock company banking company, insurance company, co-operative societies trust institutions are subject to compulsory audit. The audit of accounts of union of India. States, Government departments, undertakings, local bodies are done by government auditors. The appointment of auditor is as per the articles of the constitution of India. Under article 146 of the constitution, the president of India shall appoint the controller and prime authority in the audit hierarchy of government accounts. Each state has its auditor general. To audit the accounts of municipalities, universities and other government institutions. Local fund auditors are appointed. The C & AG submits the audit report of accidents under his jurisdiction to the president. The audit report of the C & AG is laid before the parliament for a debate on it. Similarly the state


legislature considers the audit report of the accounts laid before them. With regard to the audit of governments compares and public sector undertakings, the auditor is appointed by central government on the advice of C & AG. The C & AG shall have power to give directions to the company auditor; he can a conduct supplementary audit also. The auditor submits his report to C & AG who comments on it and cause it to be placed before parliament. In case of private audit, there is no statutory or constitution compulsion to get the accounts audited. For example, the sole proprietors partnership firms get their accounts audited without compulsion in view of advantages of having audit. B. Relation of Auditor vis a vis Management The audit is said to be external it the appointment of auditor is made by persons other than those whose performance is evaluated by auditor. For example, the directors of the company are responsible for the activities of the company. They present an account of companys account and Balance sheet. The statutory auditor is said to be external auditor because he is appointed not by the management but by the shareholders. The external auditor is an independent person. The scope of his audit can not be curtailed by the management the external auditor submits his report to the appointing authority, say, shareholders in case of joint stock companies. On the other hand, an audit is said to be internal when the auditor is appointed by persons who are responsible for the performance of the entity. An internal auditor is usually appointed by management of the company. In many cases, the internal Auditor is in regular employments of the entity. The internal auditor is no completely independent. The scope of his work can be controlled by the management. C. Periodicity of Audit Based on the frequency with which the audit is conducted, the audit is classified into continuous audit, periodical audit, interim audit, and occasional audit. A Continuous Audit or a detailed audit as it is some times called is an audit which involves a detailed examination of the books of account of regular intervals of, say, one month or three months. The auditor visits his clients at regular or irregular intervals during the financial year and checks each and every transactions. At the end of the year he checks the profit and loss account and the balance sheet. (II) Periodical Audit or final Audit or complete Audit Periodical is one which is taken up at the close of the financial or trading period when all the accounts have been balanced and a trading and profit and loss accounts and the Balance sheet have been prepared It may also commence before the final accounts are prepared and continue till the audit is completed even after the close of the financial the auditor visits his client only once a year and goes on checking the accounts until the audit work for the whole of the period is completed. (III) Interim Audit: Some writers opine that an audit which is conducted in between the two annual audits, with a view to finding out interim to enable to company to declare an Interim Dividend, should be called Interim Audit. It is a kind of audit which is conducted between the two periodical or Balance sheet Audit. (IV) Occasional Audit:As the name indicates their type of audit is conducted once a while when ever the need arises and the client designer it to be carried out. This is possible only in case of proprietor concerns such as a soletradens business or a partnership business. D. Subject matter of Audit: On the basis of subject matter of the audit, the audit may be classified into financial audit, cost audit, operational audit, and management audit. Financial Audit is examination of financial statements to express opinion on the truth. And fairness of financial condition and operating results of the entity. The statutory or external audit is generally financial audit. Cost audit is audit of cost records of the company. It is checking of cost accounts and costing techniques, methods, system followed by the entity. The cost audit seeks to verify the truth and fairness of cost of production of goods or rendering of service by an entity. Operational audit is review of operations of an entity. it is generally carried out by internal auditors. It involves intelligent examination of various operations of functional areas of the business viz production, marketing, stores etc. observing weakness, lapses, inefficiency in the operations and suggesting ways to strengthen the system, for averting lapses and for improving efficiency profitability of the operations.


Management audit is critical review of policy and practices of management. It involves review of various process of management. E. Coverage of Audit: On the basis of Coverage of Audit. The audit may be complete audit or partial audit. In completed audit, there is no restriction placed on auditor in the matter of coverage audit. The auditor checks up all books of accounts with corrected records to express opinion on the final statement. The client can not put any restriction with regard to coverage audit in case of statutory audit. Therefore it is an example of complete Audit. In case of partial audit, usually the areas to be covered in audit are delimited by specific agreement to their effect. F. Manner of Checking On the basis of manner of checking the audit may be classified into standard audit balance sheet audit and post and vouch audit. Standard Audit: Mr. Irish of Australia definer standard Audit in his book theory and practice of Auditing as ``His embraces a complete check and analysis of certain items and, confinement upon effective internal check, appropriate test checks on remaining items, the whole of the work being in accord with general auditing standards quite adequate to justify and unqualified opinion? Balance Sheet Audit: Balance sheet audit is of recent growth as compared to other types of audits which we have al ready deal with. This type of audit is more popular in U.S.A. than in England or other countries. The term ``Balance sheet audit Means verification of the values of assets, liabilities, the balance of reserves and provisions and the amount of profit earned, or loss suffered by a firm during the year. Vouch and post audit: Vouch and post audit is that where the auditor checks each and every transaction right form its origin in the books of prime entries till they are posted. This system of audit has become obsolete in case of large firms where the member of transactions run into millions and where a good internal check system is prevalent or where the mechanized system of accounting has been introduced. Advantages of Continuous Audit : (1) Easy and Quick Discovery of Errors: Errors and frauds can be easily discovered easily and quickly as the auditor checks the accounts at regular intervals and in detail. It he were to check the accounts after one year, it would be difficult to locate an error. (2) Knowledge of Technical Details :Since the auditor remains more in touch with the business, he is in position to know the technical details of it and hence it can be presented to the shareholders soon after the close of the financial year at the annual general meeting. (3) Quick Presentation of Accounts : Most of the checking works having been already performed during the course of the year; the final audited accounts can be presented to the shareholders soon after the close of the financial year at the annual general meeting. (4) Keeps the Clients Staff Regular : As the auditor visits the clients, at regular intervals, the clerks will be very regular in keeping the accounts up-to-date. They will see that there is no inaccuracy or frauds as it would be detected by the author at his nest visit. (5) Moral Cheek on the Clients Staff : If the auditor pays surprise visits, it will have a considerable moral check on the clerks preparing the accounts as they do not know when the auditor may pay a visit to check the accounts. (6) Efficient audit : The auditor, having more time at his disposal, can check the accounts with greater attention and in detail and his work will be more efficient. (7) Preparation of Interim Accounts : Where the directors of a company wish to declare an interim dividend, continuous audit will help in the preparation of the interim accounts without much delay. (8) Audit staff can be kept busy : The audit staff may be sent to other clients after having finished the work for one client. Thus whole of the staff can be kept busy throughout the year. Disadvantages of Continuous Audit: (1) Alternation of Figures : Figures in the books of account which have already been checked by the auditor at his previous visit, may be already by a dishonest clerk and the frauds may thus be perpetrated.


(2) (3) (4)

Dislocation of Clients Work : The frequent visits by the author may dislocate the work of his client and cause inconvenience to the latter. Expensive : It is an expensive system of audit. Queries may Remain Outstanding : The audit clerk may lose the thread of his work and the queries which he wanted to make may remain outstanding as there might be a long interval between the two visits, The staff of the client may depend upon the audit staff to help other out of difficulties in the course of their work. Extensive note taking may be necessary in order to avoid any alteration in the figures after the


(6) audit. Procedures to Conduct Balance Sheet Audit: The process of balance sheet audit are given below 1. Checking the Minute Book: The auditor should examine the minute book of the concern at first. 2. Examine Profit & Loss Accounts: The auditor should examine and compare the profit and loss account with that of the previous year to see whether here is any material difference between the two. 3. Comparing the Difference: He should also compare the difference of other accounts. 4. Valuation of Stocks: He also investigates the values of closing stock. 5. Depreciation Method: He also investigates the methods of depreciation if there any mistakes e.g. rate of Depreciation, method etc. 6. Non Recurring Account: He should investigates into the items of non-recurring nature e.g. profit mode or loss suffered on the sale of fixed assets. 7. Examine Assets Account: He should examine the current, fixed and intangible assets. 8. Material Alteration: If there is any material alteration I the pre-payment and accountants, he should pay alteration to such a variation. 9. Evaluation: If there is any sustentation, he can evaluate the assets and liabilities. This is the procedure of auditing a balance sheet. By following the above steps net and clear Balance Sheet audit is possible. c) Vouch and Post Audit : Vouch and post vouch audit is that where the auditors checks each and every transaction right from its origin in the books of prime entries till they are posted. The system of audit has become obsolete in the case of large firms where the number of transactions run into millions and where a good internal check system is prevalent or where the mechanized system of accounting has been introduced. The auditor relies on the examination of some of the transactions scientifically selected at random. Audit Programme Having fixed up the audit and gained knowledge over the business, accounting and internal control system, the auditor needs to draw up a plan of action. The plan of action is called audit programme. According to A. W. Holomes, "An audit programme is a flexibly planned procedure of examination." According to Howard. F. Settler, Audit programme is an outline of all procedure to be followed in order to arrive at an opinion concerning clientss financial statements. According to prof. W. B. Meigs. An audit programme is a detailed plan of the auditing work to be performed specifying the procedures to be followed in verification of each item in the financial statement and giving the estimated time required. To sum up, we earn say that an audit programme is a written scheme of the exact details of the work to be done by the auditor. Types of audit programme There are two types of audit programme. These are (ii) General audit programme and (iii) Special or specific audit programme Also we can divide the audit programme into two categories. Such as(i) Pre-determined audit programme


(ii) Progressive audit programme Advantages of Audit Programme : The advantages of such an audit programme may be outline as below: 1. It ensures that all necessary work has been done and nothing has been omitted. 2. The auditor is in a position to know about the programme of the work done by his assistant. 3. A uniformity of the work can be allowed as the same programme will be followed of subsequent audit. 4. Work of the audit can be divided amongst the different juniors who will be responsible for their work. 5. In care of change of negligence against the auditor for not having done some work, the auditor can defend himself that the work had been done by him or his assistant who had duly signed the audit programme. 6. Internal Check System: Internal check system should be considered when programme will make or proper. 7. Accounting Method: In case of programme the procedure of accounting systems should be considered. 8. Accounting Books: It also is considered. 9. Voucher: Different types of voucher in support of transactions should be considered. For preparing a well set programme the above points should be considered thoroughly. 7. It is a kind of guidance to the audit clerk for the work he has to perform. 8. It facilitates the final review before the report is signed. 9. For a new clerk the audit programme is a guide to his duty. 10. It is a useful basis for planning the programme for the subsequent year. Disadvantages of Audit Programme: In spite of many advantages the audit programme has some disadvantages also, such as: 1. Efficient Clerk Loses his Initiatives: An efficient clerk loses his initiatives because he adheres to the programme which has been fixed for him, he may not make any suggestion. 2. Not Cover Everything: Even if the audit programme is well drawn up, it may not cover everything that might come up during the course of audit. 3. Mechanical Method: Programme follows mechanical method. So it is not very suitable for all. 4. Not Necessary for all types of Business Concerns: Audit Programme is not suitable for small business concerns. Time Consuming for Clerk: Audit Programme is time consuming for clerk. Points to be noted preparing Audit programme For completing the audit programme properly various points should be considered. The explanation of this point is given below one by one(a) Scope and object of work:At first an auditor should consider the scope and area of auditing work. And also the auditor should consider the legal object of work. (b) Distribution of work:Then the work will be distributed among the clients according to their skill and competence. (c) Timing:The auditor has to know the time by which the audit programme will be completed. (d) Nature of the business:For preparing an audit programme nature of organization will be considered, because preparation of audit programme may be different according to the nature. (e) Accounting system in use:The auditor has to know that what type of accounting system do the organization use. (f) Internal check system:Internal check system must be exist in the organization when the audit programme will be made. Working Paper : Working Papers are the connecting link between the clients records and the audited accountants. These include all the evidence gathered by the auditor indicating what work has been done by him and the


procedure he has followed in verifying a particular asset or liability. These provide a permanent historical record logically arranged in order, in which each item appears in the balance sheet. Documentation is an important thing preferring working papers. Documentation refers to the working papers prepared or obtained by the audition and retained by him in connecting with the performance of his audit. Subject Matter of Working Papers: Working papers normally includes: 1. Information concerning the legal and organizational structure of the entity. 2. Extracts on copies of important legal documents, agreements and minutes. 3. Evidence of the planning process of the audit an audit programmes. 4. A record of the study and evaluation of the accounting system and related internal controls. 5. Analyses of transactions and balances. 6. Analyses of significant ratios and trends. 7. A record of the nature, timing and extent of auditing procedures performed and the results of such procedures. 8. Evidence that the work performed by assistant was supervised and reviewed. 9. An indication as to who performed the audit procedures and when they were performed. 10. Copies of communication with the auditors, experts and other third parties. 11. Copies of letters or notes connecting audit matters communicated to on discussed with the client. 12. Letters of representation received from the client. 13. Copies of the financial information being reported on and the related audit reports. 14. Conclusions reached by the auditor concerning significant aspects pf the audit, including how exceptions and unusual matters, if any, disclosed by the auditors procedures were resolved on treated. Ownership and custody of audit working papers Audit working papers are important document of auditor. The working papers must be kept in safe and secrete place. Working papers should not be shown to unauthorized person. Because it may be misused. If is very important question who will be owner of audit working papers auditor or organization. According to International Audit standard 9 of Para 12 "Working papers are the property of the auditor So, we can say that the auditor should adopt reasonable procedure for safe custody and confidently of his working papers and should retain them for a period of time sufficient to meet the needs of his practice and satisfy any pertinent legal or professional requirements of record retention. Audit Note Book During the course of an audit, an auditor has to make several queries which might not have been satisfactorily answered, he might have taken down the totals of different books of accounts, and certain other points which he would like to incorporate in his audit report. Lest he might forget these points, he notes them down in a book which is called an Audit note book. This book is some times called Memoranda Book. It may be a bound or loose leaf book. Contents of an Audit Note Book (i) A list of the books of account maintained by the client. (ii) The names of the principal officers, their powers, duties and responsibilities etc. (iii) The technical terms used in the business (iv) The points which require further explanation and clarification. (v) Points which must be incorporated in the audit Report. (vi) A record of the work done on each visit. (vii) Points which require discussion with the senior or the auditor. (viii) Particulars of missing vouchers, the duplicates of which have to be obtained. (ix) Date of commencement and completion of audit. It must be remembered that large number of notes must not be made in the Note Book. Definition of Routine Checking


Routine checking is a detailed and extensive method of checking applied for verification of each and every item of books of account. It is a basically process of verification on accuracy and propriety of financial statements routine checking is carried on by the auditor and includes checking of. (i) Castings, sub-Castings, Carry forward and other calculations in the books of original entry. (ii) Postings into the ledger accounts. (iii) Castings and balancing of various accounts. (iv) Transfer of balances from the ledger to the trial balance. So, we can say that routine checking is a sort of, simple checking and is mainly initiated correct. Postings have been comically made etc. Advantages of routine checking Routine checking is an important foots of auditing. It has some advantages. The advantages of routine checking are given below. i) Thorough checking of transitions:In a routine checking, the books of original entry can be checked thoroughly errors and fraud can be spotted easily. ii) Arithmetical accuracy. Routine checking does not only reveal and prevent fraud and errors but also it helps to verify the arithmetical accuracy of each entry. iii) Verify the financial statements:Another advantage of routine checking is verification of financial statements; it helps to verify the financial statements. iv) Easy to perform:Routine checking is a simple job, which can be performed easily by a person having ordinary knowledge of accountancy. It evolves the work on an elementary nature. Demerits of routine checking Actually routine checking is not free from limitations. It has some disadvantages and explains given below. i) Monotony: - Practically routine checking is a mechanical process. As a result is creating monitory among auditor and workers. ii) Failing to detect Special errors and fraud:Routine checking helps to discovery simple errors. But it fails to defect complex errors and fraud. iii) Expensive:- Routine checking is not economical as it takes more time and consumes higher cost. iv) Tends to be boring:It also tends to be quite boring because on its mechanical and monotonous nature. V) Redundant in certain Cases:Routine checking is considered redundant in certain cases. As for example a Business here in self-balancing accounting system exists. Routine checking is almost of no use. Definition of test checking Test checking as the expression implies is a method of examining a selected number of items. It is based on a selective examination of transactions with a view to avoiding definition of items of importance so for as the purpose of auditing is concerned. According to W. B. Meigs, Testing and test checking mean to select and examine a representative sample from a large number similar items According to R.A Imslc. A test check is really a check on a selections of entries, generally made at random or by scientific sampling to prove the reliabilities of accounting procedure and internal control. So, we can say that test checking means the relation and checking of representative number of entries of each class of transactions instead on going through every earthy. Audit planning: To finish any work or activity properly planning is very important. According to Newman- "Planning is deciding in advance what is to be done; that is, a plain is a projected course of action. In every organization audit is very important. Generally single person can not audit all types of work. So it is necessary to some subordinators to help the auditors. In this situation audit planning is very necessary before strafing audit. Audit planning is a plan that is used to finishing all activities properly of the audit.


Generally it should include the audit planning that are given below: i. Determining the scope of auditing ii. Assumption about accounting it system of auditing organization; iii. Assumption about internal control system of auditing organization; iv. Determine audit programme, time table, and nature of auditing v. Planning of manpower In the end we can say. That to finish auditing activities properly and timely the audition make plan which is called audit planning. Advantages of Audit planningIt goes without saying that planning is necessary to finish any activities property. Auditing is necessary to fruitful planning activities. Appropriate planning about auditing to help auditing activities. There are many advantages of audit planning that are given below. (i) Direction and control: Auditing planning help in direction and control of audit works. As auditor make plan about audit before auditing so it is easy to direction and control of auditing works. (ii) To help in attention to important matters of audit. (iv) To help in unedifying potential problem about planning works. (v) To help the audit work is completed expend busily. (vi) To help in utilizing the subordinators properly. (vii)To help in co-coordinating of other auditors and experts works. (viii) To help in minimization of cost and growth. (ix) To help in achieving affiance. In fine we can say that audit planning is important of auditing works properly. Auditors duties regarding capital & Revenue expenditure. Dividing capital expenditure and revenue expenditure is very important for any organization. If the expenditure is not classified properly it will be impossible to identify proper financial condition of an organization. So, It is very important duty for an auditor to examine the expenditure whether it is revenue or capital expenditure. The duties of an auditor regarding capital and revenue expenditure are given bellow. 1. It is very important to know about the nature and working system of on organization before analyzing the expenditure. 2. The duty of auditor is to determine the expenditure of an organization with regard to analyze the nature of an organization. 3. Auditor have to know the objectives of dividing the expenditure an organization. 4. Another duty of auditor is to know in what methods capital expenditure and revenue expenditure are divided. 5. It there are errors, when recording capital expenditure and revenue expenditure. It is the auditor duty to know the correction is made by proper authority of an organization. 6. At last the auditor will examine each transaction by his own skill and Judgment. So, It is very important for an auditor dividing capital expenditure and revenue expenditure. Auditing begins when accounting ends-explain Auditing begins when accounting ends : Auditing is an instrument of financial control. It acts as a safe guard on behalf of the proprietor again extravagance, carelessness, fraud, mistake or misrepresentation. Auditing begins when auditing ends : Accounting is an information system that identifies records and communicates the economic events of an organization to its interested users. At first accounting identifies or select economic events or activities relevant to a particular organization. After identifying the activities accounting records the events in a systematic way. At the end of the financial year or a particular period it calculates the profit earned or loss suffered by the organization. After completing the accounting system the owner of the organization can know the economic condition of the organization. If he suspects fraud or mistakes or misrepresentation or manipulation of data he appoints a certain person to check the accounts thoroughly and this process is called auditing. After the above discussion it is clear that, the auditing begins when accounting ends. This is normal process or system. "Accounting is a necessity while auditing is a luxury for a business enterprise." Do you support it? Justify your answer. "Accounting is necessary while auditing is luxury for a business enterprise. I do not support this concept. Because auditing is an important tool to the shareholders management, financing authors


and others for various advantages. Luxury means that which cost a lot but Provides unnecessary facilities but auditing is universal. The owners of the business or share holders are keen about security and profitable use of their investment specially in partnership and company organization as there is a question of interest of the owner or share holders. In this ease an audit by a neutral and experienced third party is necessary. Auditing is vital to management authorities Mangers use auditing to ensure the effectiveness of their plans and procedures and Programmers. To get more credit facilities from financing institutions. The enterprise should show the accounts or documents checked by auditor. After examine those documents financial institution can provide loan. The income tax authority generally accept the profit & loss account which has been audited by the auditor. So, to give income tax, auditing is necessary The labours or employees expected to know the actual financial position of the concern. They always want to see whether the enterprise is able to pay higher salaries or wages. In this case auditing gives proper satisfaction. From the above discussion it is established that auditing is not luxury for business enterprise like accounting, auditing is necessary for the business. Difference between Auditing and Investigation : There is a lot of difference between auditing and investigation that are shown below in a table. Auditing Investigation Audit is conducted to find out whether the balance sheet is properly drawn up and exhibits a true and fair view of the state of the affairs of a concern. Auditing relates to one year. Investigation is concerned with finding out the profit earning capacity or a financial position of a concern. Investigation covers several years, say, 3, 5 or 7 years. Investigation may be carried out on behalf of the outsiders or proprietors.

Audit is concerned on behalf of the proprietors.

Difference between bookkeeping, accountancy and auditing : Book keeping Accountancy Book keeping is an art of recording the business transactions in the books of original entry and the ledger. The spade work is done by book keeper. Book keeper prepares books of original entry and ledger. A book keeper primarily prepares the books of transaction. Accountancy means the complication of accounts in such a way to know the state affairs of the business. Accounting finishes the touch given by auditor. Usually accountants prepare profit and loss account. It may also be given to auditor. An accountant prepares profit and loss account and give to it to auditor.

Auditing Auditing means the verification of book entries and accounts to find out their accuracy. Where the work of accountants ends the work of an auditor begins. But ink auditing auditor simply signature on the prepared profit and loss account Auditor has to check and verify such transactions and accounts and sent a report to the persons who appointed him. Statutory audit

Difference between internal audit and statutory audit : Subject Internal audit


Appointment Qualification Status Conduct audit Object of

Internal auditor is appointed by the management. Internal auditor need to possess qualification. Internal auditor is an employee of the company. It is continuous audit. To detect fraud and mistake. Works of internal auditor can be reduced by management. Internal auditor works also watch dog of the directors. He has no right to stay at meeting.

Statutory auditor is appointed by shareholders. A statutory auditor must have these qualifications according to company act. Statutory auditor is an independent person. It is dine at the end of the financial year. To report on the balance sheet and profit and loss account. Here, there is no possibility of it. He is a watch dog of shareholders. Statutory auditor has such right.

Determination of duties Watch dog After done a meeting Removal

Internal auditor can be removed by the He is removed by the shareholders management. Distinction between continuous audit and periodical or annual audit: Continuous Audit Periodical audit Continuous audit is conducted during the financial Periodical audit is conducted at the end of the year at regular or irregular intervals. year. Detailed account can be audited in this audit. Detailed account can not be audited. Continuous audit is applicable for large concern. Periodical audit is applicable for small concern. Errors and fraud can be located easily. Errors and fraud can not be located easily. This audit keeps the clerk busy. Periodical audit can not keep the clerk busy. Owners and shareholders may get correct They do not get accounting information before information at the end of the fixed period. ending year. In this audit dishonest clerks may change the There is no scope of alteration of accounts. accounts. It is expensive. It is not so expensive. Difference between internal audit and interim audit : Internal audit Interim audit Independence of an auditor is limited in internal Independence of an interim auditor is limited. audit. Workers of a concern perform this audit. Skillful person who is not work or person of a concern perform such audit. This audit is conducted during the financial year. Interim audit is conducted at the end of specified year. The purpose of this audit is to locate errors. The purpose if interim audit is to publish interim evident. In this audit authority may be skillful or not. In interim audit authority must be a chartered accountant. It is expensive. It is not expensive. Difference between partial audit and complete audit: Partial audit Complete audit In partial audit all things are not audited. In complete audit all things are audited. It is not controlled by law. It is controlled by law. It is applicable to partnership and sole traders. Audit must be completed in a company. Its area is limited. It has a large area. All accounts are not audited so their may remain Errors can be locked in this audit. errors. Distinction between the continuous audit and interim audit: Continuous audit Interim audit The work of audit is carried on up to any date The work of audit is carried on up to a definite


according to any convenience of the auditor and his client. The verifications of assets and liabilities is done after the balance sheet has been prepared at the end of the accounting period. No trail balance is prepared at that time. There is no intention to know profit or loss.

date according to the instructions of the client. Assets and liabilities are verified when such an audit is conducted. In the case of interim audit the trail balance is to be prepared. Internal audit is conducted with the object of finding the profit and loss.

Chapter 2 ERRORS
The procedure of preparing a trial balance is relatively simple. However, id the trial balances does not balance. Locating an error in a manual system can be time-consuming tedious and frustration. Errors generally result from mathematical mistakes, incorrect postings or simply transcribing data incorrectly. How ever if the mechanical processes in the keeping of asset of books have been properly carried out, list of all the balances on the books on the given data, arranged in debit and credit order is known as a trial balance. if the trial balance totals fail to agree and it is itself taken out correctly(this should be the first thing checked) then there must have been some errors made in the work of posting or addition of the subsidiary books or ledgers. Definition of error An error represents an unintentional misstatement of the financial statement it may bematerial or immaterial e.g., omission of an amount or disclosure, mistake in gathering or processing financial data, oversight or misinterpretation of facts resulting in an incorrect amounting estimate or unintentional misapplication of accounting principles. Two authors definition are given below: According to kamal gpta,the error may be defined as inaccuracy or incompleteness on the measurement or presentation of a fact. According to onternational auditing practice committee(IAPC) Fr isa-11,the term error refers to unintentional mistakes in financial information. Such as: Mathematical or clerical mistakes in underlying records and accounting data. Oversight misinterpretation of facts. Misapplication of accounting policies. So it can be said that, at the time of recording mathematical mistakes, wrong classification of actual event and transactions are not recorded properly misapplication of accounting principles of called error. Types of errors The term error refers to unintentional mistakes in financial information. The following are the various types of errors:

Clerical errors Errors of omission
Error of principal

Compensating errors

Error of duplcation

Errors of commissiion


Now we discuss these types of errors. Clerical errors These errors are committed in posting, totaling and balancing. All errors except errors of principles are known as technical clerical errors. Clerical error may be aub divided into two categories: A errors of omission Errors of omission The error of omission is one where a transaction has not been recorded in the books of account either wholly or partly. It will not be easy to detect the error and it will not affect the trial balance. This type of error can be detected by careful observation. But there are many cases where it may not be entered and therefore there is neither a debit entry nor a credit entry. Errors of commission When a transaction has been recorded but has been wrongly entered in the books of original entry or posted on the ledger it is called error of commission. For example. A purchase invoice for R.S. 1250 was entered in the purchase book asR.S.1520. such an error may be intentional or unintentional. Other error of commission are wrong casting, calculation, postings, extensions, carry forwards etc. therefore vouching should be done very carefully to detect error of commission. Errors of principles When the entries are not recorded according to the fundamental principles of accountancy it ia called errors of principles. For example, wrong allocation of expenditure between capital and revenue, ignoring the outstanding assets and liabilities, valuation of assets against the principle of book keeping. It is very important for an auditor to pay particular attention towards this type of error. Such an error is not disclosed by the trial balance or by routine checking. It can ge detected by a searching inquiring and independent. Compensating errors for offsetting errors A compensating error or offsetting error is one which is counterbalanced by any other error or errors. For example: if as account was to be debited for Rs.100 but was debited for RS.10 while bs account which was to be debited for RS. 10 were debited for RS.100. thus both the accounts have been debited for a total sum of RS.110.these errors are most dangerous and are difficult to guard. This type of error will not be detected by the trial balance and such an error will not affect the trial balance. This error may or may not affect the profit and loss account. Errors of duplication Such error arises when an entry in a book of original entry has been made twice and has also been posted twice. Location of errors The question is how to locate an error if the trial balance does not agree and the auditor is called upon to locate the error although it is not his duty to do so. The followint steps are taken to find out or locate an error: Check the totals of the trial balance. Compare the names of the accounts in the ledger with the names of the accounts as have been recorded in the trial balance. It is possible that balance of some accounts might not have been transferred to the trial balance especially in the case of the balance of cash book, purchases and sales books. Bills books etc. Total the lists or debtors and creditors and compare them with the trial balance. If the books are maintained on the self balancing system; see that the total of different accounts as recorded on the trial balance. Compare the items of the trial balance with the items of the trial balance of the previous year to see if any item has been omitted. Whatever be the difference in the trial balance, halve it and see if there is any item of this value. This is done to avoid the putting of the debit balance of the credit side of the trial valance or vice versa.


It is possible that the totals of some subsidiary book might not have been transferred to the trial balance. Recheck the totals of these books. Of in spite of the above steps the error cannot be located the error may be due to the following causes: An error say of Rs.1 or 100, etc. i.e.a round sum may be due to wrong totaling. If the difference is in rupees and paisa, it may be due to wrong posting or extracting awrong balance. An error which is divisible by 9 may be due to misplacement or transposition of figures,e.g.32 for 23 for 23,52for25 and54for 45 and so on. It may be remembered that in spite of the trial balance has agreed, it does not mean that there are no errors. Definition of frauds An errors represents an intentional misstatement of the financial statement it may be material or immaterial. Definition of frauds is given below: According to B,n. tendon, fraud means false representation or entry made intentionally or without belief in its truth with a view to defraud somebody. According to international auditing practice committee (IAPC), the term fraud refers to intentional misrepresentation of financial information by one or more individuals among persons charged with governance, management, employees or third parties. Types of frauds Fraud means false representation or entry made intentionally or without belief in its truth with a view to defraud somebody. The ways of fraud are divided into three classes. These are 1. embezzlement of cash 2. misappropriation of goods 3. fraudulent manipulation of accounts now we discuss these three ways of frauds in detail: Embezzlement Of Cash There is a greater possibility of defalcation of money in a big business house than in the case of a small proprietary business where the proprietor has a direct control over the receipts and payments if cash. In a big business the system of receipt and payment of cash should be such that the work of one clerk is automatically checked by another clerk. It is easier to misappropriate cash and therefore the auditor will to pay particular attention towards cash transactions. Cash may be misappropriated by: omitting to enter any cash which has been received entering less amount than what has been actually received making fictitious entries on the payment side of the cash book entering more amounts on the payment side of the cash book than what has been actually paid. MISAPPRIPRIATION OF GOODS fraud may be in respect of goods ,Ie, misappropriation of goods. This type of fraud is very difficult to detect especially when the goods are less bulky and are of higher value. Proper methods of keeping accounts in regard to purchases and sales, stock taking, periodical checking of stocks, comparing the percentage of gross profit to sales of two periods etc. will help to avoid misappropriation of goods. FRAUDULENT MANIPULATION OD ACCOUNTS This type of fraud is more difficult to discover because it is usually omitted by director or manager or other responsible officials. Ways of fraudulent manipulation of accounts are as follows: by not providing any depreciation or providing more depreciation. By under valuation or over calculation of assets and liabilities. By showing fictitious sales or purchases or return in order to show more profits or less profits whatever the case may be. By the utilization of secret reserves during a period when the concern has made less or no profit, without disclosing that fact to the shareholders.


By sharing revenue expenditure to capital or vice versa. By crediting the revenue account with the income which will be received next year or not crediting the profit and loss account with the income which has accrued but which has not been received. The auditor must carry out the routine checking, vouching and verification, and make searching enquiries intelligently to detect such fraudulent manipulation. OBJECTS OF MANIPULATION OF ACCOUNTS By manipulation of accounts we mean to say that the accounts are prepared in such a way as to show more profits of fewer profit and loss when in fact there is no loss. It is usually committed by directors of managers with certain objects. The object of manipulation of accounts may be to show more profits than actually what they are. If the employees get commission profits of bonus they may get more commission of bonus. Their services may be retained by showing by showing to the shareholders that because of their efficiency they have show more profits and this maintain the confidence of the shareholders. If they hold shares, the may sell them at a high price by declaring higher dividends. To obtain further credit by showing that the position of the concern is better than what actually it is. To attract more subscribers for the sale of the shares of the shares of the company etc. The objects of manipulation of accounts may be to show fewer profits than actually it is In order to purchase share in the market at a lower price. To reduce or avoid the payment of income tax. To give a wrong impression about the success of the business to the competitions in order to ward off competition etc. POSITION OF AUDITOR IN REGARD TO ERRORS AND FRAUDS AFFECTING FINANCIAL STATEMENTS The auditor carries out necessary checks before expressing his opinion on the truth and fairness of financial position and operating results of an entity as reflected in financial statements. The auditor seeks to ensure that there is no material misstatement of financial information arising form errors or frauds. Are as follows : It is the responsibility of management to prevent errors and frauds. The auditor is not liable for any subsequent discovery of misstatement of financial information resulting from errors and frauds if he carried out his duty according to the generally accepted auditing practices. If he discovers any errors or frauds during his audit. He is property must also bring to the notice of the concerned the occurrence of fraud at the earliest time The auditor need not sniff for errors and frauds. But if he smells something about it, he should not leave them carelessly. He must enlarge his extent of checking and modify checking procedures to suit the occasion. DUTIES OR RESPONSIBILITY OF THE AUDITOR FOR DETECTION AND PREVENTION OF FRAUD AND ERROR: The auditor has to obtain reasonable assurance that financial information is properly stated in all material respects. This impels that the auditor seeks reasonable assurance that fraud of error which may be material to the financial information or the error is corrected. The auditor should detecting material misstatements in the financial information resulting from fraud and error. RESPONSIBILITY FOR THE DETECTION OF FRAUD AND ERROR The responsibility for the prevention and detection of fraud and error rests with management through the implementation and continued operation of an adequate system of internal control. such a system reduces but does not eliminate the possibility of fraud and error.


The objective of an audit of financial information is to enable an auditor to express an opinion on such financial information. In forming his opinion, the auditor carries out procedures designed to obtained evidence that will provide reasonable assurance that the financial information is properly stated in all material respects. Consequently, The auditor seeks reasonable assurance that fraud or error which may be material to the financial information has no occurred of that. It has occurred, the affect of fraud is properly reflected in the financial information or the error is corrected. The auditor, therefore, should plan his audit so that has a responsible expectation of detecting material misstatements in the financial information resulting from fraud and error.` INHERENT LEMITATIONS OF AN AUDIT Since the auditor seeks to obtain persuasive rather than conclusive evidence and relies on test checks, there is a possibility that some material misstatement resulting from fraud and error may not be detected by him. However. the risk of material misstatement of the financial information caused by fraud and error. CONDITIONS INCREASING THE RISK OF FRAUD ANS ERROR In addition to weaknesses in the design of the internal control system anal noncompliance with identified central precedence condition or events which increase the risk of fraud or error inculcate: Question with respect to the integrity or competence of management Unusual pressures within an entity Unusual transactions. Problems on obtaining sufficient appropriate evidence. PROCEDURES WHEN THERE IS AN INDICATION THAT FRAUD OR ERROR MAY EXIST It circumstances indicate the possible existence of fraud or error, the auditor should consider the potential effect on the financial information. It the auditor believes the suspected fraud or error could have a material effect on the financial information, he should perform such modified or additional procedures as he determines to be appropriate. The extent of such modifications of procedures depends on the auditors judgment as to: The type of fraud or error that could occur. The relative risk of their occurrence. The likelihood that a particular type of fraud or error could have a material effect on the financial information. Perfuming modified or additional procedures will normally enable the auditor to confirm of dispel a suspicion of fraud or error where confirmed, he should satisfy himself that the effect of fraud is properly reflected in the financial information or the error is corrected. Role of internal control system The implementation and continued operation of an adequate internal control system reduces the probability of occurrence of fraud or error. However, it should be recognized that any system of internal control may be in effective against certain types of frauds. DIFFERENCE BETWEEN FRAUDS AND ERRORS The term error refers to unintentional misstatement in financial statements including an omission of an amount or a disclosure. On the other hand fraud refers to intentional act by one or more individuals among persons these charged with governance. Employees or third parties. Subject Errors Frauds 1. Definition Error occur when account is Frauds occurred by written wrongly or totally not misappropriation of cash and written goods 2. Agreement In case of errors trial balance In case of frauds trial balance may be or may not be equal is always equal 3. object In case of errors intention is In case of frauds intention not present. and deception is present. 4. detection It is easy to detect. It is difficult to detect 5. hint It is occurred by a hint of It is occurred by a hint of nobody. directors, managers etc.


6. duty 7. Prevention

The duties of an auditor are to advice about detection and prevention of errors. Errors can be prevented by auditor.

It is the duty of an auditor is to detect frauds. Fraud can not be prevented.

Chapter 3 Introduction
Business activities has become increasingly complex as the economy of the country has expended, and this increase in complexity has required management to delegate more and more of its authority in order to discharge its responsibility effectively. This wider delegation of authority and responsibility and the necessity of greater reliance on accounting data have all combined to emphasize the internal control aspect of accounting operations. Internal control today is as vitally important to the public accountant as it is to the controller and the internal auditor. An internal auditor must be alert to recognize weakness in the system and to make constructive suggestions and improvements. Those are the matter of internal control the measurement of system efficiency which challenges the internal auditor in every phase of his work. The expression of internal control is used wide sense and includes internal check and internal audit besides other form of control. Internal control system assures the management that the information it receives, is both reliable and accurate. This is the term determines the nature intent and timing of substantive audit tests to do applied Definition of Internal Control Internal control is one of the basic factors in the management of on organization. It is a system which normally applied in the financial and organizational sector of a business. The production costs, developed of product, budget etc are also included in the internal control system. Spicer and Peglar, famous authorities on auditing literature, define the system of internal control as Internal control is best regarded as the whole system of controls, financial and otherwise, established by the management in the conduct of a business including internal check, internal audit and other forms of control. This definition implies the following things:(a) The internal control is a system of controls (b) Controls are established over financial and non financial areas (c) The mechanism of controls may manifest itself in the forms of internal check or internal audit or other forms. According to AICPA Internal control is the plan of organization and all of the co-ordinate methods measures adopted within a business to safeguard its assets, check the accuracy and reliability of its accounting data, promote operational efficiency and encourage adherence to prescribe managerial policies. Now after the discussion of those definitions we have found some common features of internal control system:(i) Controls are established over financial and non financial areas. (ii) Ensure adherence to management policies. (iii) Safe guards of assets. (iv) And accuracy of record. So, we can say that internal control is the whole system, which establish by the management and including internal check, internal audit and other forms of control.


Importance of Internal Control

Once upon a time most business was small form owner operated. Those owner managers were involved with most of the decision making. As business grew huge size and complexity, professional managers replaced the owner operators. At the present time the importance of internal control is described below:1. Professional managers do not have the same first hand knowledge of all aspects of business as did the owner operators. Consequently they relay heavily on the information supplied to them by the accounting and other information systems. 2. To ensure management that information it receives is both reliable and accurate as system of control is developed. 3. Internal control system also helps ensure that assets and secure and that management policy is being followed. 4. Both management and independent auditors heavily rely on the system of internal control in determining the timing nature and extent of their work. 5. The existence of a good internal system reduce to a large extant the work of an independent auditors.

Nature of Internal Control System

Internal control is an essential prerequisite for efficient and effective management of any organization. It is thus a primary responsibility of every management to establish and maintain and adequate system of internal control appropriate to the size and nature of the business of the entity. SAP 6 defines the system of internal control as the plan of organization and all the methods and procedures adopted by the management of an entity of assists in achieving management objective of ensuring as for 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 related directly to the functions of the accounting system.

Essential features of Internal Control System

There are some fundamental features in proper internal control system. Those features are dies-cussed below:1. Distribution of specific duties responsibilities: Specific duty should be distributed among different level according to the skill and fitness of the employees. Concerned employees to the duty can be responsible as a result of specific distribution of duty among the employees. 2. Division of labor and specialization: Duties and responsibilities are distributed according to division and specialization of labor in internal control system. As a result the interest of employees in the business firm increase as well as their skill and experience also magnify. In such a system skills and experience of the employees are valued very importantly. 3. Ability of staff: Necessary knowledge, skills and awareness required to perform duties imposed properly and beautifully are needed to be available in the organization.


4. Recording of each type of work: Recording and evaluating is another feature of internal control system. 5. Valuation of work: There must have the system of valuation of performance of employees. 6. Controlling over accounts: Controlling over accounts must be to show the truth and logic accounts of the organization. 7. Verification of assets with its accounts: Whether every assets of the business is recorded or not that must be verified. 8. Protection of assets: Duty and responsibility to prepare papers of buying and selling must be given on authorized and responsible employee. 9. Sound environment of work: It must be assured that the sound environment in every department of the organization. 10. Supervision by management authority: Management authority whether the internal control system properly followed or not. should supervise

The internal control system is says to be proper and efficient if the above features of internal control system are available in any organization

Basic Elements of Internal Control System

Council of institute of chartered accounts of England and Wales says theme is three elements of internal control system. (i) Specific direction amen the employee with organized planning. (ii) Integral check system as approval of transaction journalizes the entries and ledger system. (iii) Eternal audit with administrative management and criticism. Organized planning means the proceeds of distributions the works properly to the employee. In an astatine each works divided into different parts on give then to employee accordions to thin ability and skill ness. By distributing the works in this shorten any employee will be responsible for any spastic job. In the secondly steps of internal control system each transaction will be approval to the related authority. Proper journalize of each inundation and heap save the asset of an institute are an important thing of internal control.

The objective of Internal Control System

The objective of internal control system is determined by the management, keeping in view the specific circumstances of the organization. In case of large organization, it is not possible for a owner of governing bodies observe all activities of the workers. For this reason, different types of internal control system have been taken to ensure the discipline and efficiency in different position of the organization. Now the objectives of internal control system are discussed below:(1) Saving of assets: To save the assets from different types of unfavorable situation such as fraud or errors, firing or any other accident is an important objective of internal control system.


(2) Development of rules and regulations: Developments of accounting system of an organization is another objective of internal control system. (3) Maintenance of fixed assets: There are so many fixed assets in an organization internal control system also trying to maintain those fixed assets appropriately. (4) Implementation of rules and regulations: Internal control system also observes those rules and regulation which are following in accounting and management process of organization. (5) To ensure the correction of account: Sometimes different types of errors are account by the clerks. Internal control system tries to removes those errors by observing the duties of clerks appropriately. (6) To express real and reliable condition in financial statement: Internal control system tries to implement real and reliable condition in case of preparing financial statement. (7) Developing the adroitness of workers: Adroitness of workers is very important for every organization. Internal control system tries to measure the efficiency or adroitness of workers by division of labor. (8) Helps in administration and management process: Internal control system is also helps administrating and management process so that an organization performs their duties appropriately. (9) To stop fraud client work: Internal control system plays an import role in case of stop at fraudulent work by maintaining the accounts appropriately. Internal control system tries to stop different types of fraudulent works.

Scope of Internal Control

Control procedures are the policies and procedures that the management has established to achieve the entities specific objective. E.G, physical verification of assets, periodic review and reconciliation of accounts, specific controls on computer general data. The scope of internal control, according to the above definition means operational control such as quality control, work standard; budgetary control, periodic reporting, policy appraisals, quantitative controls etc are all parts of the internal control system. In an independent financial audit, the auditor concerned primarily with the accounting and internal control system which are relevant to the assertions underlying the financial statements. From this point of view internal control can be classified into tow broad categories (1) Accounting Control: Accounting control primarily relating to safeguarding of assets, prevention and detection of fraud and error, accuracy and completeness of accounting records and timely preparation of reliable financial in formation. (2) Administrative Control: Administrative control, on the other hand included all administrative and managerial controls concerned with the decision-making process. An example of administrative control is the maintenance of records giving details of customers contacted by the salesman on the procedure of getting the production managers approval of the samples of a manufactured product. The distinction between accounting controls and administrative controls is significant. An auditor of financial information is primarily concerned with the accounting controls since these have a direct and significant bearing on the reliability of financial information. Administrative controls, on the other hand, have only those administrative controls which have a bearing on the reliability of financial records. Thus, the auditor of financial information


may not normally be interested in evaluating the system of getting the production managers approvals of the samples of a manufactured products. Types of internal control The types of internal control are categorized in the appending to the operational auditing guideline on internal controls and this organization is Followed her. 1) Organization:An enterprise should have:(i) A plan of organization which should (ii) Define and allocate responsibilities 2) Segregation of duties:(i) Not a single person should be responsible for the recording and processing of a complete transaction. (ii) The involvement of several people reduces the risk of Intentional manipulation. 3) Physical:(i) This concerns physical custody of assets and involves procedure designed to limit assess to authorized personnel only. (ii) Assess can be direct e.g. being able to center the workhouse or indirect, that is by documentation. 4) Authorization and approval:Require at authorization or approval by an appropriate person. Examples:(i) All circle sales must be approved by the credit control department. (ii) All overtime must be approved by the works manager. (iii) All individual office stationary purchases may be approved by the office manager. 5) supervision:All actions by levels of stall should be supervised. The responsibility for supervision should be clearly land down and communicate to the person being supervised. 6) Arithmetical and Accounting:(i) Those are the controls in the recording function which check that the transactions. Have been authorized. (ii) Procedures include checking the arithmetical accuracy of the records. In this step the main inconstant think is apply of antennal prose. To think the nature scope and total condition of an instantly keep harmonium of external and antennal condole system. Need for Evaluating Of Internal Control The auditors are increasingly recognized the importance of evaluating internal controls before undertaking specific audit tests. Various professional accounting bodies now recognize the fact that the evaluation of internal control system helps in formulating a programmed of detailed verification. In the context of an audit of financial inform, SAP 1, Basic principles of governing an audit, states: The auditor should gain an understanding of the accounting system and related internal controls and should study and evaluate the operation of those internal controls and should study and evaluate the operation of those internal controls upon which he wishes to rely in determining the nature, timing and extent of other audit procedures. Where the auditor concludes that he can rely on certain internal controls, his substantive procedures would normally be less extensive that would otherwise be required and may also differ as to their nature end timing. If an audit finds that internal controls in certain areas are inadequate, he may decide to apply more effective substantive procedures, or change the timing of the tests to be applied, or extend his audit tests to carry out a, more detailed examination of the unsatisfactory aspects of the system. Internal control and Auditor The work of auditors depend much on a good internal control. Because, of good internal control auditor can be certain about protection of assets and transaction dependence. So, it depends on internal control of a company how much make wide auditor his works. Auditor can decrease his working criteria if he certain about that the control of the company is good. If auditor does not satisfied about the internal control he would examine transactions properly. So,


it can be said that, the internal control system and its apply is duty of the anchorites, auditor have not duty on it. But he can advise to eliminate the errors. At least it can be said that how much a auditors depends on internal control system is a matter of his personal decision, of course, according to how he can not be left from his selfcreated responsibility. Limitation of Internal control An auditor can depends on organizational internal control system for his works. But it should be remembered that in internal control can not provide surety in case of organizational process as well as accounting process. We can find those following limitation of internal control:1. The internal control may not adequately cover all areas in view of costs considerations. 2. It can not foresee control mechanism for transactions of unusual nature. 3. It can not stand against deliberate circumvention of control procedures by management. 4. False manipulation of transactions by the entity with tacit approval of management or ingenious breach of controls by stuff by collusion or controls may become obsolete in changed scenario. 5. It is costly so that many organizations do not take this system in their organizational process. 6. Some errors can be aroused in internal control system because of increasing the business transactions. 7. In spite of internal control system in different position of organization some frauds can be raised be dishonest communication of clerks or workers. INTERNAL CHECK Internal is one of those measures which are taken to conduct a business efficiently. It is a method of organizing the accounts-system of a business concern or a factory, where duties of different employees are arranged in such a way that the work of one person is automatically examined by another and thus the possibility of fraud or error or irregularity is minimized. Definition: Internal Check is an integral part of the current routine operations and provides the means by which automatic proof of accuracy is accomplished. The following definitions are the famous definitions of internal check. According to L.R.Dicksee:- Internal check Such an arrangement of book keeping routine that errors and frauds are likely to be prevented or discovered by the very operations of the book-keeping itself. According to F.R.M. De Paula:- Internal check means practically a continuous internal audit carried on by the staff itself, by means of which the work of each individual is independently checked by other members of the stuff. According to Spicer and Pegler:- A system of internal check is an arrangement of stuff duties where by no person is allowed to carry through and to record every aspect of a transaction so that: without collusion between tow or more persons, fraud is prevented and at the same time possibilities of errors are reduced to a minimum. After all we can say that, Internal Check is a system by which of business is divided among the employees in such a way, So that, the work is automatically checked and frauds and errors are detected and at the same fine prevented successfully. Basic principles of Internal Check There are two basic principles of internal check such as: (1) Checks and Balances (2) Fixing responsibilities There are described below:


(1) Checks and Balances: The relationship of Checks and Balances to ace Phases of internal procedures is extremely broad. Fundamentally it refers to any means by which the results of one type of action are checked, proved or controlled by another separate and independent action. Checks and Balances should exist in every level of authority. The way relate to a minor phase of procedures or to functional or departmental activities of major scope. This basic principle is based on some subsidiary principles. They are:(a) Transaction Recording System: The transaction recording system should be in such as way, so that one employee can not complete the work alone. Because the greater the number of persons who participate in a transacting or an important past of it the better assurance is obtained of effective operations. (b) Distinction of Cash and According Division: The point of this principle is that no person should establish the accountability over his on operations. If this were done accountabilities could be modified at will, and for purpose of fraud prevention, would constitute no effective protection against dishonesty. (c) Proof and Control Methods should be utilized: The emphasis of his subsidiary principle is on methods, devices and procedures as well as individuals. It may be applied to any phase of the accounting operation. If between the proof and control method can be done in an expected way them the utilization we can get. (2) Fixing Responsibilities: The significant of this major principle is that is an operation of any kind that is to be efficient responsibility must be clearly fixed. The same original responsibility may be delegated downward several or many times, but the chain must be continuous and the responsibility must be fixed at every stage or level of authority this responsibility at the same time must be independent in the sense that there should be no conflict of the interest between the various activities with which the employee or officer charged. The objects of Internal Check The internal check system is organized to achieve the following objects:(i) To prevent the commission of any error of fraud by a Clarke. (ii) To prevent the misappropriation of cash or goods by any person by keeping a check on the receipts and payment of cash and receipts and delivery of the goods. (iii) To throw responsibility on a particular Clarke when the fraud or mistake is detected. (iv) To detect a fraud or an error quickly and easily. (v) To have an accurate record of all business transactions. (vi) Giving moral lesson to the dishonest workers for the purpose of preventing frauds. (vii) To prepare flexible and correct final account. Special features of Internal Check System To build an effective internal check system, the following measures need to establish, and these measures are called features of internal check system. 1. Specify the duties and responsibilities: the duties and responsibilities are distributed among the employees in such a way that they are responsible for their particular work. 2. Transaction recording: The transactions recording system should be in such a way so that one employee can not complete alone.


3. To examine automatically: The system should be in such a way so that work

of one employee is examined automatically by another employee. Thus errors and frauds are prevented. 4. Transfer of employee: The system of transferring the employee from one department to another helps to improve the system. 5. Distinction and according division: Cash and accounting division should be separate so that closeness can not be made among the employees of two departments. Advantages of Internal Check System If the internal check system is effective it pulls different advantages. Those are:Even distribution of power and responsibility: As the duties and responsibilities distributed among employees according to their skill ness and experience, the work done effectively. 2. Detection and prevention of errors and frauds: In this system errors and frauds are detected easily and then prevented them successfully. 3. Timely work performance: Because of distributing work according to their skill ness and experience, the employee perform their work timely. 4. Advantages of preparing of final account: As this system detects errors and frauds and prevents them, it helps to create final account rapidly. 5. Free from doubt: As a result of using this system, the owner can be free from doubt about the accuracy of accounts. 6. Increase in profit: Because of increasing the employees skill ness, cost of business reduces. As a result profit in business increase. 7. Advantages of preparing of audit program: Because of using internal check system, the auditor can audit his program easily and carefully. 8. Taking quick steps: By this system the errors and frauds are detected easily, so the owner take steps to prevent this errors rapidly. Disadvantages of Internal Check System Though there are more advantages in internal check system, disadvantages of it is no less. We can find following disadvantages in internal check system:1. Costly: As this system is costly, it can not apply in small business. 2. Indiscipline in performance: If the system is not sufficient, it creates indiscipline in performance of the employees. 3. Slackness in work: Over dependence of this system creates slackness in performance of high official employees. 4. Detailed examined: If this system is defective, the auditor has to examine all transaction details. 5. Increase in auditors liability: If auditors makes mistake under this system, he has to be liable for this mistake. 6. Doubt in truth ness of account: Under this system all transaction of business are not examined wholly, as a result the truth ness of account is not sure. Internal Check System in particular cases (a) Cash Received: In case of cash received following measures should be taken:(i) All received check and money should be sent to the bank after recording. (ii) Bank deposit slip has to be written by a third person except cashier. (iii) All received have to be taken by serial number and printed slip and the serial number of the slip has to be written in cash book. (iv) The accuracy of bank deposit must be checked by preparing Bank Reconciliation every month. (b) Cash Payment: In case of cash payment following measures have to be taken: (i) To perform petty transactions in the organizations, petty cashier has to be managed.



(ii) (iii) (iv)

All expenses have to be taken by check without petty expenses. Divorce recording check, Voucher, Bills and other document have to be examined at best. At the time of recording and rejected check has to be enclosed by pin.

(c) Cash Sales: Everyday a lot of transactions occur so that there is a great scope of frauds
especially in the expended organization. So to conduct the cash sales the following internal check systems are taken: (i) (ii) (iii) To conduct selling activities separated employee must be appointed. Except selling activities the seller will not be participated any other activities. According to expansion of the organization every department should have to appoint a central cashier and he is liable for all received money. Every cash memo has to be prepared for three copies. Unused cash memos have to be kept to responsible workers. Rejected cash memos have to kept with original book. Two copies of cash memos have to send to the seller. The seller has to be deposited the collected money of the cash memos to the cash deposited counter. At the end of the day, collected money to the by the general cashier has to be deposited to the main cashier and deposited money to the banks as soon as possible.



(d) Credit Sales: Whenever an order is received it should be recording in the order received Books, giving details recording the data on which the order was received, the name of the customer the particulars about the goods, data of delivery mode of frauds etc. So regarding credit sales the following internal check system are taken: (i) (ii) (iii) (iv) The order of a copy of it should be sent to the Dispatch Department. Another clerk should check the goods ready to be placed with the order to see that only those goods which have been ordered are being packed. A responsible officer should fix rates at which the goods are to be charged. A Clark should taken make the extensions. (v) The invoice should be prepared in duplicate or triplicate by means of carbon paper one copy to be sent, to the buyer, another to the invoice clerk or the account department for debating the account of the customer and the third copy is sent to the get keeper who will record in the goods onwards, book that such and such goods have left the premises. INTENAL AUDIT The internal audit is a continuous review of operations and records undertaken within the business and is normally done by specially assigned staff. It should operate independently of all the internal check and in no case should divest one of the responsibilities placed upon him. According to Professor Walter B. Meigs of America says: Internal Auditing consists of a continuous, critical review of financial and operating activities by a staff of auditors functioning as full-time salaried employees.


According to The Institute of Internal Auditors USA, has defined Internal Audit as under: Internal auditing is an independent appraisal activity within an organization for the review of operations as a service to management. It is a managerial control which functions by measuring and evaluating the effectiveness of other controls. So we can say that Internal Audit is the independent appraisal of activity within an organization for the review of accounting, financial and other business practice as a protective and constructive arm of management. Objectives of Internal Audit The main and most important objective of internal audit is early detection of errors and frauds. Besides, it has other objective mentioned below:(i) Review operations as a service to management. (ii) Facilitating final audit. (iii) Ensuring systematic accounting and proper recording of transactions. (iv) Verification of authenticity and correctness of the financial information presented to the management. (v) Review of system of internal check from time to time. (vi) Reduce the possibility for manipulation of accounts or misuse of property of the business. (vii) Early financialization of annual accounts. (viii) Highlighting the weak areas of the organization and giving suggestions to strengthen then. Status of an Internal Auditor The internal auditor acts as an advisor. He has no right to get up procedure or make policies. He has no authority to direct any one as to what to do or not to do. He has simply advise the management. It is for the management to act or not to act upon his advice. Sometimes people think that an internal auditors function is to report against the inefficiency or shortcomings of the accountants. Such a notion is far from truth. His duty is to promote the efficiency of accounts department. In order to achieve his objective, the internal auditor should try to dispel this wrong notion from the minds of the accountants. If he is successful in doing so he will be able to win their co-operation. He should be firm and fair and should report both bad as well as their good points. To whom should he send the Report. There are different views on this point. Some people are of opinion that the internal auditor should report to the chief Accountant or the controller of accounts of the company. There are others who say that he should report directly to the treasurer or the finance director of the company so that the independence of the internal auditor be maintained. Whatever the procedure is adopted the main idea should be to maintain independence of the internal auditor. Using the work of Internal Audit by External Audit


The auditor can effectively make use of the work performed by internal auditor by planned coordinator of his work. The auditor must judiciously use his work to his advantage. As regards to accounting system of the enterprise, the internal audit covers almost all areas of checking concerned under external audit. However the internal auditor expresses his opinion on the truth fairness of financial statements. Therefore the auditor has to evaluate the internal audit and decide whether its coverage of checking can lessen the extent of checking can lessen the extent of checking. The auditor has to evaluate the efficiency of internal audit system by assessing the professional competence of internal auditor, their independence in the organization, audit coverage, actual work performed by them as evidence by their working files, reports etc. depending upon the degree of reliance that he could place on it, the auditor can devise his nature, extend and timing of audit work.

Difference between Internal Auditor and External Auditor

There are some similarities of work of an internal auditor. However, their some difference too. Those are tabulated below:Basic Point 1. Appointment Internal Auditor Appointed by the management External Auditor Appointed by the shareholders

2. Nature 3. Major concern 4. Basic job

He is an employee of company Serving the needs of management Review of operations and internal controls for developments, improvements and ensuring compliance of policies and procedures Determined by management Statutory Audit

He is an outsider Compliance of statutory requirements Expression of an independent opinion on financial statements.

5. Scope of work

Determined by status

We have seen the meaning of internal audit in the forgoing paragraphs. Let us now see what is meant by statutory audit. When an audit is conducted under the companies Act, it is called statutory audit, e.g. the audit of joint stock companies. Distinction between Internal Audit and Statutory Audit Let us see the points of distinction between the tow audits. 1. Appointments: Internal audit is appointed by the management while the statutory auditor is appointed by the share holders except in certain cases when he is appointed by the director of the company or the government. Appointment of internal auditor is optional while that of the statutory auditor is obligatory.


2. Qualification: Internal auditor needs not posses the qualifications as are laid down under section 226 of the companies Act while a statutory auditor must have that qualification. 3. Conduct of audit: An internal audit is a kind of continuous audit while a statutory audit is generally conducted after the preparation of financial accounts. 4. Scope of work: The scope of work by the internal auditor is determined by the management while the scope of the work by and the responsibilities of the statutory auditor are determined by Law. 5. Determination of Duty: The scope and duties of an internal auditor can be reduced while it is not so in the case of a statutory auditor. 6. Activities: The activities of an internal auditor are continuous while those of the statutory auditor are periodic, usually for a year. 7. Attendance at Meetings: Internal auditor has no right to attend a meeting of the shareholders while a statutory auditor has such a right. 8. Check of Transaction: Internal auditor has to check all the transaction while the statutory auditor may apply test checks. 9. Report: Internal has not to submit any report to the shareholders while a statutory auditor has to do so. 10. Remuneration: Remuneration of the internal auditor is fixed by the management while for the statutory auditor they are fixed by the shareholders. 11. Removal: Internal auditor can be removed by the management or the directors while a statutory auditor can be removed only by the shareholders and not by the management or the directors Internal Auditing a Staff functions It is important to understand that internal auditing is a stuff function rather than a liner operating functions. The internal auditor will of courses exercise line authority over his own group, but he does not exercise any direct authority and over other personal in the organization. The role of internal auditor is to present his findings to those who do have direct authority. This mode of operation is particularly important in that the internal auditor does not thereby in any way relive those persons with direct authority in the organization of their and primary responsibilities. This does not mean that the internal auditor has no responsibilities. He is especially qualified accounting and financial matter. But it does mean that any assumption of direct responsibility and any type of approach which would relieve the officials in charge of their responsibilities would create a chaotic organizational situation.

Chapter 4 Audit Sampling

Audit Sampling is the application of an audit procedure to less that 100 percent of the items within a class of transitions of account balance to enable the auditor to from certain conclusions about that class or balance as a whole. An auditor car apply sampling in carrying out both compliance procedures (to evaluate the effectiveness of the internal control system) and sampling in carrying out both compliance


procedures (to evaluate the effectiveness of the internal control system) and substantive procedures (to obtain evidence regarding the completeness, accuracy and validity of the data) According to ISA 19: audit Sampling means: The factors that and auditor should consider when designing and selection and audit sample and evaluation the results of audit procedures are identified. The ISA applies to both statistical and non-statistical sampling methods and provides fundamental yet practical guidance on such matters as sampling risk, stratification, selection, selection methods and protection of errors.

PURPOSE OF AUDIT SAMPLING Sampling is used in auditing to obtain and aggregate or population with which the auditor is concerned. For example, the accuracy of pricing and extension in a sample of account payable vouchers is studied in order to arrive at an opinion to the accuracy of all vouchers, not just the vouchers in the sample.
When the auditor uses sampling techniques, he is not trying to find all errors in the records. This could only to done by a complete, 100 per cent examination. Thus we are taking of degree of accuracy, not accuracy in the sense of mathematical balance. In accounting we have many instances where approximations are used to obtain a practical degree of accuracy; for example, estimates of depreciation, allowances for doubtful accounts, and similaritems. The reviewing the selected samples, the purpose of audit is not limit to finding the amount of errors I the sample. The auditor does not examine the amount errors, and then make such adjustment in the company records. The approach would only be considering a very small part of the and the significance of the much larger ensampled portion would be lost


Sampling is an important audit technique since it is enables the auditor to select some techniques out of some large mass of repetitive data in a manner that the can draw valid conclusions about the entire data after a through examination of the selected transactions. Let us discuss the need for Audit Sampling. The primary objective of is to formulate and express and overall opinion on financial or there information based on a examination of the record of transactions and other relevant information. However, the number of transaction, particularly in the case of large enterprise, is so enormous that it may be physical impossible for the auditor to check all of them. Further, in most cases, detailed checking serves no purpose at all. It becomes mechanical and the auditor is so tied down to the large number of individual transactions that he loses the overall view. A compliance method is used; information can be obtained about the entire field, within certain limits. The auditor can thus arrive at conclusions about the field without performing a 100% check, thereby obtaining savings. Audit sampling may provide greater accuracy than 100% test. When voluminous data are counted in their entirety, there is often the chance of clerical errors. However, when a small sample is taken, there may be fewer errors made. S it is clear that, audit sampling I most important in the audit practice. It is very useful for a large population, where all the population can be entered into the audit procedures.



Several principle of sampling, related to the principle of Audit & Evidence, can be sated. Using this as reference points, the auditor should be able to assure himself that the conclusion on his sample objective will provide meaningful evidence on hid primary audit objectives. 1. The auditor should always have an objective for sample, objectives are same three essential as do all audit objectives criteria, causes, and effects. The criteria are related to the materiality (precision) desired and should be related as the primary audit objective. The effect are related to the cause\ are the action of the auditor. 2. The auditor should always state that the materiality (precision) desired of the true value. As estimate derived from a simple obviously could nor be exactly the same s the true value of the universe. The sample value, however, should have a high probability of falling somewhere in an acceptable range above or below the true value, and this rage is the measure of precision the auditor uses as the standard or criteria of his audit objectives. The precision would show what the auditor could consider as being an immaterial amount from the true value. Any values beyond that range would material and would be acceptable as the criterial from the audit. The measure cab be stated either as an absolute figure or as percartage. 3. The auditor should know and stated the reliability he desired, or risk he is willing to take, in his complying for audit evidence. Confidence is a statement that the sample value will fall within the precision range a certain percentage of the time. 4. The auditor should assure himself the universe for his sample is homogeneous. Momogeneous pertain to the same of the information, and the source of information is related to the compliance of the evidence. Thus homogeneity would pertain to competency of evidence. 5. The auditor should assure himself that each item in the universe has the same chance of being selected as any other item when he takes a sample. Since the selection pertains to the source of the information, the proper selection of sample would be one means of determining the competency of the evidence. 6. The auditor should assure himself, through proper probability, techniques that his sample size is as small as possible but large enough to provide him the precision he desires and the confidence he expects, cost demand this. Also, sample size pertains to source and thus to competency of the evidence. 7. A performance auditor sample may types of universes. Most of this universes fall within the normal curve relationship. The techniq2ues of sampling and will be discussed.

Where an auditor examines documentary evidence, he or she is said to be performing detailed test work. Inspection is one aspect of audit test. An auditor performing audit test to determine the accuracy of the transactions or other components. Let us discuss about several types of Audit Test: Types of Audit Test: Audit procedures cab be classified as either (A) Compliance Test and (B) Substantive Test (C) Duel-purpose Test There are other types of audit test which is called by Dual Purpose Testing. Let us discuss different types if audit test: (A) Compliance Test: Test that ask whether employees are performing their duties as prescribed are compliance tests and provide support for relying on controls. Reliance on internal accounting control is an important kind of audit evidence, as it permits the reduction of substantive test work.


The main reason for performing compliance test is to reduce the amount of substantive tests that need to be performed. Therefore, the decision of whether to perform compliance tests should weight the possible compliance test against the possible substantive tests that could be performed to determine which test will be most efficient and effective. (B) Substantive Test: Substantive test are intended to obtain evidence of the validity and property of the accounting treatment of transactions and balances. These tests are used to determine the amount, usually the dollar amount, usally the dollar amount, of a specific group of items. If the auditor seeks to determine the of disallowed deductions, for instance, the result of the sample will be a dollar figure of disallowed deduction I that the same proportion of disallowed deductions will exists in the population. (c) Dual-Purpose Test: Although the substantive and compliance test procedures are usually descried as separable audit approaches, the result of a particular audit procedure often provides evidence relevant to the questions being addressed by each types of test. That means often samples cab be designed to serve both compliance and substantive test. When it is likely that records will be needed for both types of applications, the auditor should strive to pull one sample. This is called dural-purpose testing.


An auditor is not required to have evidence that all items in a set of accounts are 100 percent correct. His duty is to give an opinion of the truth and fairness of the accounts cab still give a true and fair view. This tolerable errors is audition materiality. This materiality is an erectile consideration in determining quit risk and the two have a close relationship. So are have to discuss first about audit Risk. Audit risk: Audit risk is the risk that the auditor gives n inappropriate audit opinion when the financial statements are materially misstated. Audit risk have several component. 1. Inherent Risk: Inherent risk is risk attached to any particular population became of factors life the type of industry a new manufacturing hi-tech industry is more prove to errors of all sorts than a stable like a brewery. Previous experience indicates that significant errors have occurred some population are always prove to error. E.g. stock calculation work-in progress. 2. Control Risk: This is the risk that intend controls will hot detect and prevent material error. It this risk is large the auditor may each eschew compliance tests al to gather and apply only substantive test. 3. Detection Risk: This is the risk that the auditing substantive pro0cedures and analytical review will not detect material errors. The assurance that an auditor seeks from Sampling procedures is related to the audit risk that he perceives. Audit Materiality: Audit materiality deals with the concept of materiality and its relationship with audit risk. According to standard, information is material it its misstatement (i.e omission or erroneous statement) could influence the economic decisions of users taken on the fairs of the financial information. An auditor plans and perform an audit to have a reasonable expectation of detecting misstatements that are material in the information of which he is reporting. For this purpose at the planning stage itself, the auditor sets the materiality level. Thus one may conclude that the materiality level provides a threshold or cut of point, primarily bored on the size of an time, for determining


whether its omission or misstatement could be material in the circumstances of the care. Let as discard the major principle include in the standard and determination of materiality level.

Determination of Materiality Level:

To determine the materiality level, one may identity the critical components of the financial statements under audit. It is generally accepted that the effects of misstatement of reported profit is critical to the users to the financial statements. Many auditor, there fore, determine the materiality level at 5 per cent of the normal per-tux profit. Many others argue that, it is mare appropriate to set the materiality level with reference to other critical components, Sometimes more than one materiality level is used. Determination of materiality may also influenced by other commiserations such as legal and regulatory requirement, non-compliance with which may have a significant bearing of the financial information. In his and it planning the auditor need to determine the amount of tolerable error in any given population. Consideration of Materiality level: Materiality level should be considered by the auditor when (a) Determining the nature, timing and extent of audit procedures, (b) And Evaluation the effect of misstatements.

Statistical sampling activities auditors are carried. Out under a number of different types of sampling plans. These sampling plans are applicable to special types exist in each case. We discus threes of these plans that are most often used by internal auditors. These are attribute sampling variable sampling and discovery sampling.

Attributes sampling plan

A type of sampling plan commonly used and evaluation of attributes this is qualitative evaluation of a particular group of items or trans actions based on how many times a particular attribute occurring. Normally the attribute. Being measured is an error or to her type of deficiency. Determines the seriousness of the situation and what the internal auditor will report in terms of conclusion and recommendations. The attributes or characteristics cab have to do with any physical item, any finical record, any internal procedure, or operation al activity, Its focus normally will be on compliance with designated policy, procedure, or established standard.

Variables sampling plan

A second type of sampling plan, referred to as variables sampling has to do with the size How much as opposed to the ho many of attribute sampling, the objective served is to be able to project aggregate quantity on the basis of a sample. Illustrative would be the desire perhaps to estimate the amount of obsolescence in that in that inventory. Still another practical application would be the determination of the estimated aggregate dollar amount of excessive items in a group of expense reports. Variables sampling is thus concerned with absolute as opposed to the number of a particular type of error. There are various types of variables samples: (1) single (2)stratified (3) multistage and (4)stratified multistage. The statistical problems involve in this type of sampling are closely related to attributes sampling, but include certain additional concepts and calculations. One of these additional complexities is the necessity to compute the standard deviation of the sample as a measure of the range of variability of the sample. Because of the more complicated nature of thus of thus approach, a step-by-step analysis of the method of application is given below for single-stage variables sampling. The example is based on a simplified manual method for estimating the standard deviation when computer developed or offer information on the standard deviation is not available.



In certain situations the concern of the internal auditor may be as to wheater a particular type of deficiency exists. The deficiency involved normally a very serious one and would be expected to have a very low occurrence rate. Illustrative of this kind of situation would be the possibility that there are fictitious employees on the payroll, or perhaps the failure to obtain collateral for loans which, under company policy, are supposed to be secured. In this case were concerned with a type of occurrence, and to that extent it is like attribute sampling. However, in this situation we know the size of the population, and we are endeavoring on the basis of a given sample to determine the probabilities that the particular kind of deficiency does or does not exist. Discorey sampling is used for a more limited or special purpose, but again is part of the kit provided by the statistical approach.


In designing an audit sample, the auditor applies judgment in considering: 1. audit objectives, 2. Population, 3. risk and assurance, 4. tolerable error, 5. expected error in the population and 6. stratification Audit objectives: The auditor should first consider the specific audit objectives to be achieved to enable him to determine the audit procedure for combination of procedures which is likely to beast achieve those the audit evidence sought and possible error in defining what constitutes an error and what population should be used for sampling.

The population is he entrire set of data from which the auditor wishes to sample in order to reach a conclusion. The auditor should determine that the population form which he draws the sample is appropriate for the specific audit objective. Risk and Assurance: In planning the audit, the auditor uses professional judgment to assess the level of and it risk that is appropriate Audit risk includes: 1. 2. the risk that material errors will occur (inherent risk), the risk that the cliens system of internal control will not prevent or correct such errors (control risk).

3. the risk that any remaining material errors will not be detected by the auditor (detection risk). Tolerable Error: Tolerable error is the maximum error in the population that the auditor would be willing to accept and skill conclude that the result from the sample has achieved his audit objective. Tolerable error is considered during the planning stage and is related to the auditors preliminary judgment about materiality. The smaller the tolerable error, the larger the sample size the auditor will require. Expected Error in the population: Stratification is the process of dividing a population into subpopulation, that is a group of sampling units, which have similar characteristics (often monetary value). The starta must, be explicitly sampling unit cab belong to only one stratum.


Selection of the Sample

Sample items should be selected in such a way that sample cab be expected to be, representative of the population. This requires that all items in the population have an opportunity of being selected. While there are a number of selection methods, three methods, three methods commonly used are: 1. 2. random selection. systematic selection, and

3. Haphazard selection. Random selection: Ensured that all items in the population or within each stratum have a known chance of selection, for example, be use of random number tables. Systematic selection: Involves selecting items using a constant interval between selections, the first interval having a random start. When using systematic selection, the auditor should determine that the population is not structured in such a manner that the sampling interval corresponds with a particular pattern in the population. Haphazard selection: May be an alternative to random selection provided that the auditor attempts to draw a representative sample form the entire population with no intention to either include of exclude specific unite.

Statistical vs. non-statistical sampling

There are broadly two methods of samplings; statistical sampling and non statistical ample. These tow methods differ in terms of the manner of determination of sample size and evaluation of sampling result; besides, the may also differ with regard to the manner of selection of sampling. In statistical sampling, the auditor applies statistical formula for determining the sampling size and for evaluation the sample results. These formula allow the auditor to measure in precise, quantitative terms the sampling risk that he is taking in deciding to se3lect the sample of a particular size and in evaluating the sample results. In non-tatistical sample result on a non statistical basis e.g., on the basis of his knowledge of the client and internal controls, he makes a judgment about the size of sample and interprets the result of the audit procedures performed on the selected items. The method of selecting the sample may also different under the two approaches. When statistical sampling is used the sample selection must be probabilistic, i.e., the sample should be selected in such a manner5 that each item in the population has a known and equal chance of being sample selection may be either probabilistic or non probabilistic. Non probabilistic sample selection involves the use of professional judgment by the auditor rather than the use of probabilistic methods in determining the items to be included in the sample. For example the auditor may include in the sample only those items that are most likely to contain misstatements. In fine, it cab be said that both statistical and non statistical methods can provide sufficient appropriate audit evidence if they are applied properly.

The auditor should document matters which are important in providing evidence that the audit was carried out in accordance with the basic principles. Maintenance of adequate documentation (working papers) help the auditor in proper planning, performance supervision and review audit. Adequate documentation also provides and evidence of audit work performed. In audit sampling process, all sampling plans should be documental in the working papers and include


1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13.

The testing objective A definition of population A definition of sampling unit. A definition of the sate when applicable. The means of ensuring that the from and the the sample selection techniques the types of sampling approach used The confidence level selected. The desired precision. Details of the pilot sample when applicable sample size sample evaluation the audit conclusions drawn

Evaluation of sample Results Analysis of errors in the sample:

In analyzing the errors detected in the sample, the auditor should determine that an item in question is in fact and error In designing the samople the auditor will have defined those conditions that constitute and error by reference to this audit objectives. For example, in substantive procedure relation to the recording of account receivables, a miss posting between customer accounts does not affect the total account receivable. Therefore, it may be inappropriate to consider this an error in evaluating the sample results of this particular procedure, even though it may have an impact on other areas of the audit, such as the assessment of the doubtful accounts. The auditor also should consider the qualitative aspects of errors. These include the nature and cause of the error and the possible impact of the error on other phases of the audit, for example, the amount of planned reliance on internal control procedures.

Projection of errors:
The auditor should project the error results of the population which the sample was selected. There are several acceptable methods of projecting the error results. However, in all cases the method of projection should be consistent with the method used to select the sampling unit. When projecting error results, the auditor should keep in mind the quantitative aspects of the errors found. When the population in derived in two or more sub-populations (satisfaction), the projection of errors in done separately for each sub-population and the results are added together.

Assessing sampling risk:

The auditor should consider whiter errors in the population error to the tolerable error and also then compare the sample result to the evidence obtained from other relevant audit procedures when forming his conclusion about and account balance, class of transactions or specific control. The projected population error used for this comparison should be need of adjustments made by the clien. As projected error approaches tolerable error the risk of incorrect acceptance or over reliance increases. The auditor should therefore reconsider the sampling risk and if he determines that the risk is unacceptable, he should consider extending this audit procedures or performing alternative audit procedures.

Having evaluated the sampling results, the auditor should conclude a to which he has sufficient appropriate audit evidence in support of the particular characteristic of the account balance or class of transaction with which


Chapter 5 Vouching:
One of the important functions of an auditor is the comparison of entries of the books of accounts. This process of comparison is generally called vouching. A voucher is documentary evidence in support of a transaction in the book of account. The act of establishing the accuracy and authenticity of entries in the account books is called vouching. According to Dicksee, vouching consists in comparing entries in books of account with document evidence in support of. According to R.B Bose, By vouching is meant the verification of the authority and authenticity of transaction recorded in the books of accounts. According to R.A Irish, vouching is the technical term which refers to the inspection by the auditor of documentary evidence supporting and substantiating a transaction. So, we can say that, vouching means testing the truth of items appearing in the books of original entry. Actually, it is carried out in connection with the subsidiary books of the business. It includes orders for good outwards i.e.; sales. Examination of the bought ledger with detailed creditors. Features of vouching: For proper auditing vouching is essential. By vouching auditor discovers the manipulation of accounts. There are some features the main features of vouching are as follow: 1. The first characteristic of vouching is, it helps to verify the recording of transactions. 2. It helps to judge the documents of the transactions of the organization. 3. It examines the accounts recorded in the primary book and final accounts. 4. it makes the accounts of the organization more reliable to others. 5. it makes the internal and external controlling system more efficient. So these are the main characteristics of vouching. Objectives of vouching: There are some objectives of vouching. Without vouching an organization can not achieve all these objectives. The objectives of vouching are as follow: To know that all receipts and payments have been recorded properly To verify the cash in hand and at bank. To avoid manipulation of accounts. To judge the correctness of transactions. To judge consistency. So, these are the main objectives of vouching. After above discussion, we can say that, for proper auditing vouching of transactions and achieving of its objectives are very important. Importance of vouching:


Vouching is very important for business organizations. It helps the organization. It helps the organization to verify the recording of transactions. It also helps to discover the manipulation of accounts. The main objectives of vouching are as follow: Verification of recording of transactions. Judgment of correctness of transactions. Discovery of manipulation of accounts. Judgment of fairness of transactions. Judgment consistency. Controlling manipulation. Creating faith. To verify the cash in hand and at bank. To associate with extirpation of true and fair view. So, vouching is very important to find out the accuracy of the entries in their books of accounts. For this reason it is the essence of auditing. Voucher: A voucher is a documentary evidence which proves the accuracy of a transaction appearing in the books of accounts. A voucher is a documentary evidence in support of a transaction in the books of account. It may be a receipt counterfoil of a receipt book, an agreement resolution passed by the board of directors or shareholders and as recorded in the minute books, an invoice, bank paying-in-slip, bought note, sold mote, correspondence, gate-keepers books, wages book, order book and so on. According to A.W holmis, a voucher is any documentary evidence in support of a transaction According to B.N tendon, voucher is evidence in support of a transaction in the books of account. According to profN.A khan,a piece of evidence or a written document serving a proof a paper which confirms the truth of anything. So, voucher is a business document uses in summering a transaction and. Approving it for recording and paym Types of Voucher: In business various types of vouchers are used. Different types of vouchers used for different purpose are as follows: 1. Cash Receipt: When cash is receipt it should be acknowledged by means of a printed receipt which should have a counterfoil. This is called cash receipt voucher. Example of cash receipt: Carbon copies for the receipts issued, cash memo, correspondence etc.


2. Cash paid: When the evidence cash payments are examined, the following points should be considered carefully. (a) That the name of client is stated as a payer. (b) That the payees name is correctly stated in the cash book. (c) That it bear proper revenue stamp. Examples of cash payments: Original receipts of the payees supported y relevant documents, invoices, wages book, contracts, correspondence. 3. Purchase: All credit purchases are entered in a particular column of the purchase book. This book carried out only goods purchased. Examples of purchase: Copies of the purchases order, original invoices, Goods received notes, Correspondence etc. 4. Sales: The auditor has to be more careful in case of vouching sales. He should maintain the day book or sales book which records only credit sales. Examples of sales: Orders received Carbon copies of the invoices, Copies of the goods out slips, Correspondence etc. 5. Purchase: When the goods are returned to the seller, being not according to the sample or of inferior quality, a credit note should be obtained if the price has already been paid, If the price has not been paid, a note should be sent to the cash department to send less amount to the seller. Then the auditor should compare the credit note with the purchase returns journal or returns outward book and the gatekeepers outwards book or the stores record. Examples of purchase return: Credit note received, Copies of the goods sent out slips, Correspondence etc. 6. Sales return: When the goods are returned from customers, being defective or any of other reason, they should be entered by the gatekeeper in the register known as Gatekeepers returns inward book and the Stock register. The goods returned should also be recorded in the sales return book and a credit note should be prepared to be sent to the customers. Examples of sales returns: Debit note received from customers, goods received notes and Correspondence etc. Journal Entry:


The accounts which can note be passed trough any other book of primary entry are passed trough the journal. The following transactions are usually passed through journal Opening entries, Forfeiture of shares Closing entries, Adjusting entries. et. While examining the voucher, following points must be borne in mind Different Between Vouching and Verification The act of establishing the accuracy and authenticity of entries in the account books is called vouching. On the other hand, Verification means proving the truth or conformation of the account. Some consider voucher and verification as same. But there are some differences between them. Some differences are as follow: Point of Distinction 1.Definition Vouching Vouching means testing the truth of items appearing in the books of original entry. 2.Nature Vouching is documentary evidence. Verification is not documentary evidence. 3.Scope The scope of vouching is smaller than verification. 4.Period Vouching is done for a period of time. 5.Beginning The work of vouching begins form the cash book. 6.Object The main object of vouching is to test the truth of the items appearing in the books of original entry. Important Points to be Considered During Vouching: Some points needs to be considered during vouching. Some of these points are as follow: All the vouchers are consecutively numbered and filed in order of the entries in the accounts. He should pay attention to the dated, which must correspond with the cash book, name of the party to whom the voucher is issued and the amount etc. Verification is done for a particular date. The work of verification begins form the cash balance. The main object of verification is to prove the truth of assets and liabilities. The scope of Verification is large. Verification Verification means proving the truth or conformation.


The voucher inspected should be cancelled by a stamp lest they may be produced again. Subsidiary documents such as statements invoi8ces etc. relating to such a voucher should also be cancelled.

Special attention should be paid to those vouchers which are in the personal name of o9ne of the partners, directors, manager or secretary etc. as such a voucher may not relate to the business.

He should see that every voucher is passed as in order by a responsible officer. The signature of he officer should be noted. He should also note, whether the voucher is stamped, if the amount of voucher is above 20 taka. He should also find out the nature of payment as to whether it relates to the business. He should see as to which account the payment is posted revenue or capital. this is important as wring posting will affect the profit and loss account and ultimately the balance sheet.

Attention should be paid to the amount both in words and figures. If they differ the matter should be investigated. Note should be made of any item whi8ch requires further elucidation or information or evidence which is available from partnership deed, contracts, article of association, minute book, leases etc.

If duplicate vouchers for a missing one is produced, it should be properly scrutinized to avoid any fraud. List of missing vouchers should be prepared and reason and explanation for their loss should be obtained from the client.

The audit clerk should not take the help of any members of the stuff of the client for an explanation while vouching receipts. Receipted invoice should be accepted as a voucher because there is a danger of the payment being made twice once as a credit purchase and again as a cash transaction against the receipted invoice.

Some times business houses issue there own printed receipts to be singed by the payee, which receipts are considered as vouchers. While examining the vouchers for insurance, rent rates and taxes etc. the audit clerk should not the period for which the payment has been made.

So, these points mentioned above should be considered with importance during vouching. Vouching of cash book Receipts side The techniques of vouching in respect of the important items which usually appear on the debit side of the cash book is discussed here: 1. Opening Balance:


It should be checked with the balance shown in the audited balance sheet of the previous year. References should be made to the audit working papers to see if the closing balance of the cash shown in the balances sheet is the result of many balances. 2. Cash Sales: Cash sales should be examined very carefully as they offer a vast scope for commission of various types of frauds. The required evidence for vouching the cash sales would depend upon the procedure for recording the cash sales in the book. Usually carbon copies of the cash memos or cash invoices would support such entries which should be checked. Where automatic tills are in use the entries in the cash book should be checked from the till records. If automatic cash register is maintained, resort should be made to the summaries. The auditor should compare the dates on the cash memos and the cash book. If cash discount has been allowed on sales, he should see that a uniform policy and rate of discount has been followed. The cancelled cash memo should not be detached from the book. :Receipts from Debtors .3 To vouch cash received from debtors to whom goods had been sold on credit in the past, the auditor should take following steps: 1) The carbon copy of the receipt or the counterfoil receipt, as the case may be, should be checked with the pay-in-slip. Special attention should be given to the amount banked, i.e., number of the cheque and corresponding amount. This is meant to ensure whether the cheques which were received had been deposited into the bank. 2) The management must follow as an inflexible guiding rule that all are immediately crossed Accounts Payee Only. 3) The acknowledgements against the receipt of money should provide for the disclosure of the facts whether the amount was received in cash or by cheque. In the case of payment by cheque, the cheque number must be stated on the carbon copy receipt or the counterfoil receipt. 4. Income from Interest: The evidence required to vouch the amount of interest will depend upon the nature of the interest. Interest received on account of fixed deposits in the bank should be checked with the bank advice and the arithmetical accuracy of its calculation should also be verified. Interest on savings bank account should be vouched with the bank advice. Interest on any loans granted should be vouched with reference to the agreement with the borrower. The terms of the agreement in respect of rate of interest, the date of payment, etc. should be carefully scrutinized. Interest received on securities should be checked with reference to the securities, correspondence exchanged, covering letter in respect of the receipt of the interest and counterfoil receipts issued and other documentary evidence. 5. Dividend Received:


Dividend received should be vouched with the counterfoil or the upper portion of the dividend warrant and with the letters with which the cheques for amount of the dividend had been received. Where shares have been purchased cum-dividend or sold ex-dividend, the auditor should check the brokers note to ensure that dividends due on those shares have in fact been received later on. 6. Rents Received: Rental income may be derived in respect of short-term rental or long-term leasing of real estates, plant and machinery, construction equipments, etc. To vouch such income lease deeds and agreements should be examined in respect of amounts of rent receivable, the due date; provision regarding repairs, etc., counterfoil of the receipts or carbon copies receipts should be checked. Rent received should also be checked with the rent rolls. If the rent is collected through an agent, agents statement of account and details therein must be carefully examined. Proper adjustments should also be made in respect of rental income accrued but not due. 7. Commission Received: Commission is a sort of allowance or remuneration for rendering service or labour in discharge of certain duties. Commission account should be checked with the amounts of the parties from whom commission has been received. Agreement with the parties regarding the rate of commission should be inspected. Counterfoils of the receipts should be checked with the amount in the cash book. To see the accuracy of the amount, calculation should be made. 8. Bills Receivable: To vouch bills receivable bills receivable books should be compared with cash book and the pass book to see that the amount has been received on the due date. Inquiries should be regarding the bills which have matured but the amount has not been received for them. 9. Subscriptions: A subscription is simply contribution towards a fund maintained by a society, club, etc. The entitlement of the receipt of the subscription must be checked with the by-laws of the association or club. Subscriptions received should be checked with the counterfoil receipt or the carbon copy receipt with the register of subscribers. Any unusual amount of subscription should be inquired into. 10. Sale of Investments: Sale of investments should be vouched with brokers advice. The fact that the sale is ex-dividend or cum-dividend should carefully be examined. In the case of cum-dividend sale, element of income in respect of dividend and amount attributable to investments should be apportioned. 11. Realization of Bad Debts: Received from debtors, who have become bankrupt, should be vouched with the dividend warrants received from the official receiver or assignee indicating the total debt and


the rate per rupee payable as dividend or any correspondence which might have passed between the debtor or the official receiver and the client in regard to the amount paid, the number of installment and the balance due 12. Insurance Claim: Insurance money received against a claim from an insurance company should be checked with correspondence passing between the client and insurance company, the account rendered by the insurance broker or company. 13. Share Capital: In the case of firms, the Partnership Deed should be examined to find out the amount of capital contributed by each partner. 14. Sale of Fixed Assets: Cash receipts from sale of fixed assets should be vouched with the correspondence, auction notes, agreement of sale, and any other evidence supporting the sales transaction. 15. Hire-purchase Agreement: The auditor should check that the whole amount of an installment is not credited to sales account and it has been bifurcated between sales and interest. 16. Miscellaneous Receipts: For vouching miscellaneous receipts, resort must be made to correspondence, contracts or any other documents, which will be produced for substantiating the support of transaction involved in respect of the miscellaneous receipts. Vouching of Cash Book- Payments Side After finishing the vouching of the receipts side, an auditor now should proceed to vouch the cash payments which means that he should satisfy himself that the payments have been actually made(a) to the right persons or parties; (b) to the business itself; (c) have been sanctioned by a person holding some authority; and (d) have been properly recorded in the books of account. Some of the important items which usually appear on the credit side of the cash book and the duties of an auditor thereto are given below; 1. Cash Purchases: Payments for cash purchase should be vouched with cash memos of the suppliers. To ensure that goods have actually been received, the available documentary evidence, such as goods received notes (GRN), goods inward book, should be examined. 2. Cash Paid to Creditors: Money paid to creditors on open account should be vouched with the receipts issued by the creditors acknowledging the receipt of money. Money due to them should by compared


with the accounts of the creditors and the actual invoices received from the suppliers of the goods. Statements of account of the creditors should be scrutinized. 3. Wages: Before vouching the amount of wages paid, an inquiry should be made in respect of the system of preparation of time-keeping and pay-roll records and the procedures of making payments, and the adequacy or other of the system of internal control. The following steps should be taken for vouching the wages paid: (a) Casts and cross casts of the wages sheets or pay role or wages book should be checked and the amount should be traced into the cash book. (b) Calculations of the amounts should be checked. (c) Time keeping records or piecework records should also be checked with the wages sheets or wages book. (d) Payee acknowledgements should be checked. In case of thumb impression the auditor should ensure that they were authenticated. (e) The basis of payments of payments (daily rates, or hourly rates or piecework rates) should be enquired into and it should be seen that the same has been followed in practice. (f) The total amount of wages payable should be checked with the amount of the cheque drawn. (g) All unpaid amounts should be traced into unpaid wages register and subsequent payment out of them should be verified with the said register. (h) The auditor should see that the wages sheets are properly initialed or signed by all the persons responsible for the preparation of the wages sheets. (i) A test check on surprise to ensure the physical existence of the wage earners is also suggested. (j) The total amount of wages of each department should be compared with the original estimate made by the Costing Department. (k) Wages sheets of the previous months should be compared with the current month and if there is any increase of the number of workers enquiry must be made. 4. Salaries: The salaries register should be carefully scrutinized and the steps to be followed are; (a) Casts and cross casts of salaries register should be checked and amount must be agreed with the cashbook. (b) Cheques drawn should be tailed with the salaries register.

(c) The recipients acknowledgement bearing a proper revenue stamp be checked.

(d) Deductions on account of provident fund, income tax, etc. should also be checked. (e) The auditor should see that the increment was actually due or it is a fictitious entry. (f) In case of new recruitments, letters of appointment or resolution of the board should be examined.


(g) It should be seen that the salaries register has been signed by an authorized official. 5. Capital Expenditure: Capital expenditure means money spent on acquiring fixed assets. The duty of an auditor in this connection is to see that the payment is in order, that is duly authorized and that the money spent has been properly capitalized. The procedure adopted in vouching various items is as follows(a) Freehold or leasehold property: The agreement for sale together with the title and conveyance deeds should be vouched for the real property. If the property has been purchased through a broker, brokers sold note or his statement of account should be seen that all legal charges incurred in connection with the acquisition of the property and brokerage paid have been capitalized, and payees acknowledgements should be seen. (b) Purchase of Plant and Machinery: The procedure for vouching will differ depending upon the nature of acquisition of the plant and machinery. If it was got constructed under a contract, the actual contract should be inspected and the certificate for the completion of construction and erection be seen. The amounts paid should be checked with the contract, bills rendered by the contractor and payees acknowledgement. (C) Furniture and Fixtures: The procedure for vouching will differ depending upon the nature of acquisition of the furniture and fixtures. If the furniture and fixtures have been bought or imported, invoices, payees acknowledgement, bank advice, letter of credit, asset receiving reporting etc. should be checked. (d) Motor Vehicles: Contract for purchase, invoice, brokers note, payees acknowledgement, asset receiving report and the registration book showing the ownership in the name of the client should be examined. (e) Patents: In case a patent has been purchased, the auditor should examine the patent and the receipt acknowledging the purchase consideration. If it was purchased through an agent, the statement of agents account should also be examined and his commission be capitalized. It should be seen that renewal fees are not capitalized. (f) Investments: Payments for the purchase of shares, securities, etc. should be vouched with the Brokers Bought Note. The original investments should also be physically examined to ensure their existence and for acquiring satisfaction that they stood in the name of the client. In case of a new issue, letter of allotment and the Bankers receipt for the installment paid should be examined. In case of cum-dividend purchase of investments, the auditor should see that the correct allocation between the capital and revenue is done and interest is subsequently received. g) Payments under Hire Purchase and Installment Agreements: Actual hire purchase) agreements or agreements to pay by installments should be examined. For every installment paid, the vouchers should be examined. Installments which have been paid include interest


also, and, therefore, it should see that such interest is not capitalized but is transferred to .revenue account 6. Traveling Allowances: The traveling allowance bill should be checked with the rules and regulations regarding the payment of traveling allowance. Payees acknowledgement should be checked. 7. Agents and Travelers Commission: The agreement with the travelers and the agents should be examined to ascertain the appointment regarding the rate of commission. Calculation should be made and the receipt given by the traveler or the agent should be examined and compared with the cash book. 8. Freight, Carriage and Custom Duties: The statements of account regarding the payment of freight and carriage, submitted by the shippers, clearing or forwarding agents, together with the receipts issued by them, should be examined to see that the payment has been duly made and accounted for. The auditor should also see that allowances in respect of rebates have been brought into account. 9. Insurance Premium: In case of a new policy, the cover note or the receipt from the insurance company and the policy itself should be examined. In case of a renewal, the renewal receipt for the premium should be examined. 10. Bank Charges: Bank charges such as commission, interest on overdraft and loan, etc. should be examined with the pass Bank. Calculation of interest should also be checked. 11. Postage: Casts of the postage book together with the drawing received from cash or petty cash book should be checked. Postal receipts should be counted against the registered letters. Bill and receipt received from the telephone department should be checked. 12. Dividend Paid: Casts, cross casts and carry forwards of the dividend be checked. The amounts appearing in the dividend book with the bank statements and reconcile with the bank account. Unpaid amount into the unpaid dividend register should be traced. Any subsequent payment out of the unpaid amount of dividend should be checked with reference to the said register. 13. Bills Payable: Returned bills duly cancelled should be checked. Payees acknowledgement should also be checked. 14. Directors Fees: The articles of Association and minutes of the meetings of the board should be examined for payment of directors fees. The amount paid must be checked with the attendance register and receipts of the payees. 15. Miscellaneous Expenses: Miscellaneous expenses such as rent, taxes, advertising, lighting, etc. should be vouched with the vouchers as usual and should see that the expenditure is properly appropriated between the periods where necessary. Vouching of Petty Cash Book Petty cash book usually kept on the imprest system. The auditor should ascertain that the system of petty cash is maintained on the imprest system and note the amount of imprest


should be consistent and in the line with the requirements of the company, although it should not necessarily be rigid. After examining the adequacy or otherwise of the system of internal check, the following procedure should be followed for vouching the petty cash book: (a) Check the amounts drawn for petty cash with reference to the cash book or bank statement. (b) Check the casts, cross casts and carry forwards of the petty cash book. (c) Test check exhaustively the petty cash vouchers with the supporting evidence. (d) It should be seen that cashier has signed the petty cashbook at the end of the month. (e) Posting should be checked into the general ledger. (f) A surprise count of the cash kept with the petty cashier is also suggested, as at the date of financial closing, the cash on hand must be physically counted. (g) Allocation of expenditure should be properly verified. (h) It should be seen that payment vouchers are properly authorized. Vouching of purchase book: It is essential that an efficient system of internal check be in force for placing an order, receipt of goods, or checking of invoice in order to prevent the errors and frauds and to ensure that liability is accounted for only in respect of such cases where goods were actually received. The auditor should take the following steps to vouch the purchases book. Purchase book: The auditor can vouched purchases book with the invoices bills of credit memos. And auditor can cancel the vouched document by a rubber stamp or any way, so that it may not be produced again in support entry. Purchase Invoices: While checking the Purchase invoices the auditor should pay attention to the following points: 1. All purchases are made out in the name of the client. 2. The name of the creditors as given on the purchase invoice agrees with the purchase book. 3. 5. The dates of the purchase invoices fall within the financial period under the audit. The trade discount (if any) is to be deducted and the net amount to the invoice is entered to the individual accounts. 6. Any private account passed through the purchases book should be charged to the individual accounts. 7. It has been properly initiated by those who had internally checked. 4. The goods mentioned in the invoice are of a nature in which the business is carried on.


Allocation: The allocation of expenditure should be checked to ensure that proper distinction is maintained between capital and revenue expenditure. Capital goods should not be carried to the purchase book. Receipt of Goods: Purchase invoice must be cheeked with documentary evidence like goods receipt notes, goods inward register etc. as will ensure the receipt of the goods by the company. Inspection Reports: Inspection reports by the responsible official should be checked to ensure that liability is being recorded for the right type of goods purchase. Tenders and Quotations: The purchase invoices should also be checked with the tenders or quotations and purchase orders. Purchase Contracts: In case of bulk purchase it must be checked to verify the accuracy of the terms and conditions. Authorization: All entries before being made in the purchase book must be properly authorized by a responsible official. Duplicate Invoice: While examining the invoice, if the auditor comes across invoices marked copy or duplicate, he should satisfy himself that they were obtained in respect of only those invoices which have been actually lost or mislaid and that they I have not already been entered any where else in purchases book. Provisional purchases Invoices: If any invoice is marked provisional, the auditor should see that the relevant adjustments are made through the final invoices and correct liability is reflected in the book. Casts and posting: The casts-cross costs and carry forwards of the purchases book should be checked. Posting to general ledger and account payable ledger should also be checked. Suppression of purchases: The auditor should compare the goods inward book and the sock sheets with the purchases book to ensure that all goods taken into stock have been entered in the purchases book. In order to inflate profits the management sometimes includes the goods in the closing stock while no entry is made in the purchases book. Imports: In case of import, supporting documents like letter of credit, foreign invoice, bills of exchange etc. should be examined. They also verify assets receiving reports. Duty of an auditor in connection with credit purchases: After having satisfied himself that this is a good internal check system regarding the purchases the auditor should now proceed to vouch the purchases book. While examining the invoice the auditor should pay attention to the following points: 1. Whether the invoice is in the name of his client as sometimes invoices have been produced for goods which have never been purchased for the business. 2. 3. The date of the invoice should relate to the period under review. Whether the check who has checked the invoice with the order book to see that only


those goods have been sent for which the order was placed. 4. The auditor should also see that the goods mentioned in the invoice are not capital goods. If they have capital goods they should not be carried to the purchase book but should be carried to the fixed asset account. 5. He should, as a lest check, compare some invoice with the goods inward book or the gatekeepers inward book in order to see that the goods have been actually received. 6. 7. The auditor should check the casts and cross casts of the purchases book. He should see whether trade discount has been deducted from the invoice before making the entry in the purchases books. 8. He should compare the goods inward book and the stock sheets with the purchases book to ensure that all goods taken into stock have been entered in the purchases book. 9. The auditor should stamp the invoice or cancel after he has compared if with the entries in the purchases book to prevent its being produced again. 10. Sometimes the officials of the company purchases goods through the company in order to take advantage of the trade discount. 11. In order to be sure that all the invoices are included, the auditor should ask his client to write to all the creditors to send their statement of account direct to the auditor who will compare them with ledger accounts. 12. If the invoice runs into several pages, the auditor should see that the ground total is

correct. Vouching of purchases returns book: The following steps should be carried out for vouching the purchases return book which is intended for recording entries in respect of goods returned as damaged or not up to sample and also relating to allowances claimed on account of shortage in weight over charges etc. 1. Purchases returns book It should be vouched with the debit notes issued to the creditors. Debit notes While checking the debit notes, special attention should be given to the following points: i. ii It is made out in the name of the client. The name of the creditor as given on the credit note agrees with the purchases returns books.



iii iv

The date of the debit note falls within the financial period under audit. It has been internally checked by some member of the staff or the client and it bears his initials in token of internal checking.


Allocation The credit to the revenue account should be given in the books of client to that head of account which was previously debited.


Goods sent out The entries for the goods returned should be checked with the goods outward book or with gate out passes.


Reason for return The general reason (e.g. goods not in accordance with samples or of inferior-quality et.) for the debit note should be enquired into. Correspondence on the subject should be carefully read. This should be done in the cases of exceptional nature or where the auditor feels doubtful about the accuracy of entries. Casts and postings Casts, cross-casts and carry-forwards of the purchases returns book should be checked. The postings to the general ledger and some of the postings in the creditors ledger should also be checked. Statement of accounts The entries in the purchases returns book for the early part of the next period should be examined carefully. There is a possibility of manipulation of accounts by including the fictitious purchases during the year under audit and showing them as returned after the end of the accounting period.




Statement of accounts A test check of amount in respect of debit notes sent to creditors into the statements (if

received regularly) should also be done. Credit Sales After purchase and purchases returns the auditor should now issue to vouch the pay book or the sales book. In this book only credit sales are recorded. In this case the auditor has to be more careful. Because, vouching sales as documentary evidence is not as conclusive as in case of purchase. He should enquire into the internal check system regarding the sales. Vouching of Sales Book Internal check for credit sales is very important. An auditor has to perform this duty perfectly. For this purpose the following things should be attained. 1. Whenever an order is received, it should be recorded in the order received book properly with details regarding the date on which the order was received, the name of the customer, deliverys date, mode of transport etc.


2. 3.

The order or a copy of it is sent to the Dispatch Department. When the Dispatch Department has packed the goods, another clerk should compare the goods so dispatched with the order to se that the whole of the order is complied with or another list is prepared showing the goods in the package which list is sent to the Counting House.

4. 5. 6. 7.

A responsible official will now mark the rate4 at which the goods are to be charged. A clerk will now make the extensions. The invoice will then be prepared in duplicate or triplicate by means of carbon papers. One copy of the invoice will be sent to the invoice clerk, another copy will be sent to the gatekeeper, the third copy will be retained for further reference.


If orders are received through the travelers, they should be given order books with triplicate copies, one copy to be handed over to the customer, the second to be sent to the head office for necessary compliance and the third one is to be retained be the traveler for his record. For the expertness of an auditor in internal cheek regarding credit sales above things are

very necessary. The Duties of an Auditor in Connection With Credit Sales An auditor has to perform the following duties perfectly: 1. He should see that the internal check system is efficient. If it is not so, he should disown his responsibility. If it is efficient, he should apply a few test cheeks. 2. 3. He should compare the data of the copy of the invoice with the data in the sales book. He should see that the sales are not omitted from being entered in the sales book. If it is done, it is possible that when the customer send cash or cheque in payment of the goods sold, such an amount may be misappropriated the fraud will not be detected because no entry was made, when the goods were sold and therefore if no entry is made when the payment is received. Fraud can be detected in such a care when comparison is made with original records, e.g. copies of invoices, order received book, goods outward book etc. 4. He should further see that the sale of an asset is not treated as ordinary sale, otherwise profit will be inflated. 05. With the permission of the client, the auditor should send statements of account to the customers to confirm the accuracy of the balance. This method will prove the accuracy


o9f the credit sales as well as the receipts from debtors and is very effective to check frauds 6. He should check the sales book for the last days or weeks of the financial period in order to see whether fictitious sales or returns had been recorded to inflate profits. 7. 8. 9. He should check the casts and cross casts of the sales book. The cancelled invoices should be checked with the duplicate copy of the invoice. Sales tax, insurance charges etc. which are recoverable from the customers should be debited to the customers account and credited to the appropriate accounts. 10. Sales to allied or sister concerns should be carefully examined as they may be fictitious entries with a view to inflate profits. 11. If there is a significant difference of trade discount allowance to two different purchasers,

he should inquire into the reason of such a distinction. Above are the main duties of a auditor. Vouching of Sales Return Book When the goods are turned from customers being defected or on account of any other reason, they should be entered by the gatekeeper in the register known as Gatekeepers Returns Book and the stock register. The goods returned should also recorded in the sales returns book and a credit note should be prepared to be sent to the customer, such as a credit note should be singed by a responsible officer. Vouching of Bills Receivable Book: The casts and carry forwards of the bills receivable book should be checked posting to the ledger account and to the individual customer account in the subsidiary ledger should also be traced. If any bills has been disbursed, it should be seen that amount has been debited to the respective customers. The proceeds of discounted and matured bills should be traced into cash book / bank book. If any bills have been sent to bank for collection, a certificate should be directly received and subsequent realizations noted. Any bills which become over due must be secrecfinised and fully discussed with the management. A note should be taken to show the amount but are discount as at the date of the balance sheet. Bills on hand should be physically checked and the balance on the bills receivable account in the ledger should agree with the total of the bills not matured on hand. Vouching of Bills Payable Book: Casts carry forwards and posting of the bills payable book should be checked. Bills paid during the year should be vouched with the cash book and the returned bills. The auditor


should see that the total of the bills not matured, as shown, by the bills payable book, is in agreement with the credit balance on the bills payable account in the ledger. Vouching of Journal: Where in a concern there is a network of several books of original entries, the journal is principally used for recording, opening, closing and adjusting entries and also those transactions as could not be recorded in any other book of original entry. The evidence to vouch the entries would be in the form of vouchers, correspondence, contracts, minutes etc. The several classes of journal entries would be vouched as follows: Opening Entries: These should be checked with reference to previous years audit working paper or audited balance sheet. Closing Entries: These should be checked with reference to the audited closing balance of the general ledger. Transfer Entries: Authority should be seen for the transfer from one ledger account to another ledger account. The auditor must see that direct transfers from one account to another is not made. Rectification Entries: The details of actual mistakes should be scrutinized and transactions must be thoroughly checked with reference to the available evidence. The necessary entries must be authorized by a responsible official. Adjusting Entries: The auditors should see that all outstanding liabilities in respect of expenses relating to period under audit; income received in advance and income earned and not received are duly made. Adjustments in respect of expenses prepaid should also be closely scrutinized. Transactions for which there is no other book of original entry. Reference must be made to correspondence minutes of board share and other relevant documentary evidence to vouch the transaction for which there is no other book of original entry e.g. bad debts, bills receivable dishonored, acquisition of different assets or liabilities taken over from the vendors. The auditor should also check the casts of the journal vouches and entries and then the posting to the respective ledger accounts should be checked. Audit of Purchases Ledger After the books of original entries have been vouched and postings there from fully checked, the following further steps should be taken in connection with the audit of the purchases ledger which is also called sundry creditors ledger or accounts payable ledger: Casts: The casts and carry-forwards of the purchases ledger should cheek. List of Balances: The list of closing balances of creditors should be checked with the purchases ledger and the control account of the above ledger in the general ledger should be tallied with the total of the list of balances. The cast of the schedule of creditors should also be cheeked.


Confirmations: The purchases ledger balances be compared with the confirmations or statement of accounts received. Any differences must be sorted out and reconciled. Old Balances: The amounts, which remained unclaimed for a long time, should be noted and those which do not represent payable, should be suggested for write-off. Dispute Cases: In the case of debit balances on any of the accounts, the auditor must satisfy that they are really recoverable. Scrutiny: Scrutiny should be made to make sure that no item is left unticked on any of the ledger accounts (expect for the month for which no posting has been checked by the auditor). Audit of Sales Ledger: Sales ledger is also called sundry debtors ledger or accounts receivable ledger. After the books of original entries have been vouched and posting checked, similar work as explained under the Audit of Purchases Ledgers should be carried out for the audit of the sales ledger. Further, the list of debtors must be thoroughly scrutinized. Any legally time-barred debt must be written off. Steps should be taken to ensure that adequate and proper provision for doubtful accounts. Audit of General Ledger: After the posting into general ledger have been checked, the following work should be to audit the general ledger. COSTS: Costs and carry forwards of the account of he general ledger should be checked. SCRUTINY: The general ledger should be scrutinized to ensure that no entry remains enticed. This word assists in uncovering the cases of entries which did not exist in any of the books of original entries. TRIAL BALANCE: The closing balances of the general ledger must be checked with trial balance Audit of Bank Statements The bank column of the cash book should be checked with the bank statements or bank pass book according to the following procedure: DEBIT SIDE OF CASH BOOK: The amount shown deposits into the bank should checked with credit side of the bank statement. The same entries in both the above records should be compared and it should be noted that they should not differ from each other, for understanding lodgments the corresponding entries which do not appear in the bank statement, pay-in-slips should be examined to ensure that the amounts in fact deposited into the bank. CREDIT SIDE OF CASH BOOK: All entries in respect of payments by cheques, dishonored cheques relating bank collections, interest and bank charges, on any other amount charged by the bank should be checked with the debit side of the bank statements. VOUCHING OF ASSETS AND LIABILITIES Outstanding memorandum book is maintained. This book should be certified by a responsible official, it must be singed by a responsible official, he must compare the expenses


of the closing month with the corresponding month, if there is a large variation between the two periods, and he should make inquiry. The procedure will not only ensure the correctness of the profit and loss account but also the total personal account as well, since one of the most common methods of concealing manipulations in personal accounts is to make a cores pounding fictitious entry in Impersonal Accounts. Now we propose to deal with the transactions in the Impersonal Ledger which relate to profit and loss account. These transactions will be recorded either from the cash book or the journal or the totals of the subsidiary books of prime entry. The Impersonal Ledger, therefore, will be vouched as follows: 1. The vouching cash transactions relating to profit and loss has already been dealt with in connection with the audit of cash transactions. The auditor should check the posting of such transactions to the impersonal ledger. 2. Many important transactions of impersonal nature such as transfer and adjustments from one impersonal account to another are passed through the journal. He should see that each entry is supported by sufficient evidence. Particular attention should be paid to such transactions as they materially affect the final accounts. Check the total of the subsidiary books. The balance in the Impersonal Ledger should be checked and verified with the trial balance. However, if no outstanding memorandum book maintained, adjusting entries should be passed through journal and a narration should be inserted. Let us deal with some of the outstanding assets and liabilities. OUTSTANDING ASSETS: Outstanding assets may be called as an intangible assets, it sometimes may be called. 1. INCOME RECEIVABLE: Income had accrued during the current year, it but fair that the profit and loss of the current year must be credited with the amount though it has not received at the date of the balance sheet with a view to arriving at the current profit. But the auditor in such a case should see that the accrued income is brought into account only when it is received. 2. PREPAID EXPENSES: In certain case expense are paid for definite period but a part or whole such expenditure may be for the subsequent period and which is not cover by the period under audit, the whole of the expenditure should not, therefore, he debited to profit and loss account of the current year but a part of it paid for the subsequent years should be deducted from the total expenditure. Examples for such expenditures are insurance premium, rent rate etc.



DEFERRED REVENUE EXPENDITURE: Expenditure which thought of revenue nature is spread over a number of year because its benefit is derived during those years. Such expenditure is called deferred revenue expenditure. The advantage of which will be derived in years e.g. A. Expenditure incurred in launching and advertisement campaign. B. Experimental expenditure. C. Exceptional repairs of non recurring nature, e.g. overhauling of the plant. D. E. F. G. Discount allowed on the issue of debentures, and so on. Research expenditure. Plant rearrangement and removing costs. Development expenditure in the case of mines and plantations.

OUTSTANDING LIABILATY: In order to arrive at the error profit or loss it is necessary that all known liability are brought into account. Some of the outstanding liabilities may be in respect of: 1. UNEARNED REVENUE: The auditor should examine the vouchers to find out how much amount is to be credit to the profit and loss account the current year and how much will be earned during the following period. 2. UNPAID EXPENSES: Expenses incurred during the year but for which payment has not been made and will have to be made next year are called unpaid expenses. The auditor should examine voucher, receipt, invoices, demand note etc. to ascertain whether the expenses ought to have been debited to the current year profit and loss account and that no payment has been made. Some of the common forms of outstanding liabilities are given bellow: A. Purchases B. Rent, rates, taxes, electricity, water etc. C. Wages and salaries D. Audit fee E. Freight and carriage F. Travelers and agent commission G. Commission to the sales manager H. Notes payable CAPITAL EXPENDITURE Capital expenditure is that expenditure which is incurred in purchasing new property. It will help the production of goods or increase the earning capacity of the business. It will also increasing the life of an asset. If the existing property is permanently improve or enlarged or


extended in order to increase the earning capacity of the business or it efficiency or reduce the normal expense of production or administration. Such expenditure will be classified as capital expenditure. Examples of capital expenditure are installation of fans and lights, designs etc. If the heavy expenditure is incurred or repairs which ultimately increase the efficiency of the plant or machinery such as expenditure is of capital nature. Some a wrong idea is formed that if a have expenditure is incurred it is capital expenditure and when a small expenditure is incurred it is revenue expenditure. It may or may not be it depends upon the circumstances of each particular case. REVENUE EXPENDITURE Revenue expenditure is the expenditure which is periodically incurred to maintain the revenue earning capacity of business, e.g. 1. Expenditure incurred to maintain the value of any existing assets e.g. ordering repairs, white washing of the building etc. 2. Expenditure incurred in the ordering conduct and administration of the business e.g.; rent, advertising, salaries, wages etc. 3. Expenditure incurred in connection with the administration and distribution of the goods manufacture or roll, e.g.; commission, traveling expenses and as on. 4. Expenditure incurred exclusively in earning the revenue of a particular accounting period, and wholly consumed and written off during that period, e.g.; the expenditure incurred for the purchase of goods fore resale. Distinction between Capital and Revenue Expenditure. The correct allocation of expenditure between capital and revenue is of great importance. It will affect the pro9fit and loss account and balance sheet of a concern. There are some differences between capital and revenue expenditure. They are as follows: Points of distinction 1. Fixed and circulating capital Capital Expenditure Expenditure incurred to acquire or install a fixed asset which produce or aids in production is a capital expenditure. 2. Purpose of expenditure Expenses incurred for the purpose of securing capital is a capital expenditure. 3. Nature of liability discharged A payment may be on assesses to free himself from a capital liability is a capital expenditure. Expenses incurred for rewarding such capital is revenue expenditure. A payment made by on assesses to free himself from the liability to make on annual revenue payment is revenue expenditure. Revenue expenditure If the expenditure incurred is for the purchase of goods for sale, is revenue expenditure.


4. Nature of expenditure

Expenditure incurred for improvement or addition to the fixed asset is a capital expenditure.

Expenditure incurred for replacement of the asset or for reporting the some revenue expenditure. Expenditure incurred for replacement of the asset or for reporting the so9me is revenue expenditure. But dividend or interest paid for such capital or loan is revenue expenditure.

5. Development or replacement expenditure.

Expenditure incurred for improvement or addition to the fixed asset is a capital expenditure.

6. Example

Underwriting commission for the issue of shares and debentures is capital expenditure. CONTINGENT LIABILITIES

The duty of an auditor is to see all known liabilities are brought into account at the date of the balance sheet. There must be certain liabilities which may be or may not arise after the preparation of the balance sheet. It is therefore necessary that provision should be made for such unknown liabilities are called contingent liabilities. According to prof. Walter B Meigs; Contingent liabilities may be defined as potentials obligation which may in the future develop into actual liabilities or may dissolve without necessitating any outlay. Kinds of contingent liabilities: Contingent liabilities may be of two types, such as 1. A liabilities involving an ultimate loss, e.g. a liability in a disputed case where damages may have to be paid; guarantee given by a company for loans or overdrafts granted to manage companies; speculative transactions on the stock exchange; forward contracts etc. 2. A liabilities which will be involve in the acquisition of an asset of corresponding value e.g. when goods have been purchased for future delivery or under an agreement of service. No note should be made in the balance sheet in respect of this type of contingent liability but if the amount involved is considerable, a should be inserted at the foot of then balance sheet. The amount of contingent liability may be definite or may not be so. Similarly a contingent liability may be certain or uncertain. The auditor should divide the contingent liabilities into two main categories according to part 1 of the schedule 5 of the companies Act. Viz. 1. The liabilities in respect of which a provision has been made in the balance sheet. 2. The liabilities in respect of which no provision has been made in the balance sheet but merely a note has been inserted at the foot of the balance sheet. CONTINGENT ASSETS


Usually no mention is made at the foot of the balance sheet on the assets side about contingent assets such as An option to apply for shares in another company no favorable terms. Refund of octrol paid for goods which have been sent on later on. Claim for money from a previous endorser of a bill receivable which had been discounted but which might be dishonored, uncalled share capital of a company. A legal action for infringement of a copyright etc. Although the company Act provides that contingent liabilities should be provided in the balance sheet of a company, it does not require the contingent assets to be disclosed.

Chapter 6 Verification Definition of verification:

The term verification implies proving the existence or confirmation cornering to verify means to ascertain whether the actual facts are in conformity with those reported on asserted. Verification in fact is the process through which an auditor substantiates his opinions as to the truth and Fairness of the Financial information by means of physical examination of items appearing in the balance sheet. According to B. N. Tandon verification means proving the truth or confirmation. According to Kingston cotton mills case that it is no part of an auditors duty to take stock. No one contends that it is. He must rely on other people for the details of the stock in trade in hand. We can say that verification is the process by which the auditor substantiates the accuracy of the value, existence and ownership recorded in the balance sheet. Objectives of verification: One of the important functions of the auditor is the verification of assets and liabilities. The objects of verification are as follows. i. ii. iii. iv. v. vi. To establish the existence of actual items of assets and liabilities. To examine the title on ownership of assets. To examine possession of assets. To establish proper classification of assets and liabilities. To facilitate valuation of assets and liabilities. To substantiate the expert opinion.

Definition of verification of assets: Verification of assets simply implies proving the truth or confirmation of assets as or date of balance sheet. According to B. N. Tandan The verification of assets is To see whether a particular assets as recorded in the balance sheet on the day of the closing of the books of account exists or not. According to Lancaster The verification of assets is a process by which the auditor substantiates the accuracy of the right hand side of the balance sheet and must be considered as having three distinct objects. i. The verification of the existence of assets.


ii. iii.

The valuation of assets. The authority of their acquisition.

The above definition indicates that verification is a process of physical examination of assets which involves the followings. i. ii. iii. iv. v. Verification of the existence of the assets or the balance sheet date. Examination of ownership and title of assets. Verification as to assets were acquired for the business. Enquiry into proper value of assets. Assurance as to assets are free from any change or mortgate.

The auditors objective in regard to verification of assets generally, is to certify that theyObjects of verification of assets: i. ii. iii. iv. v. vi. To ensure future development of a business. Belong to the client. Are in possession of the client or persons authorized by him. Are not subject to undisclosed encumbrares or line. Are stated in the balance sheet at proper amount in accordance with sound accounting principles. Are recorded in the accounts.

In briefly the objects of verification of assets can be identified by the can VET L. C checking the value existence and title of assets. Difference between vouching and verification: The act of establishing the accuracy and authenticity of entries in the account books is called vouching. Verification on the other hand is the process of physical examination of items appearing in the balance sheet. Some consider voucher and verification as same but there are some differences between them. These are Subjects Definition Vouching Vouching means testing the truth of items appearing in the books of original entry. Vouching evidence. is documentary Verification Verification means proving the truth or confirmation. Verification evidence. is not documentary

Nature Object

The main object of vouching is to test the truth of the items appearing in the books of original entry. The scope of vouching is smaller than verification. Vouching is done for a period of time. The work of vouching begins from

The main object of verification is to prove the truth of assets and liabilities. The scope of verification is large. Verification is done for a particular date. The work of verification begins from

Scope Period Beginning


the cash book.

the cash.

So these are the main differences between vouching and verification. Techniques for verification:

In our modest contention the technique of verification revolves the round the following five points.
i. ii. iii. iv. v. Satisfaction as to the existence of our assets or liabilities. Ensuring that the assets and liabilities are correctly valued. Ascertaining whether the question of owner ship is valid and true in respect of an assets or liabilities. Satisfaction in respect of the fact that item of assets and liability is being properly disclosed as legally required under the act. Finding out whether any of the assets of the company is suffering from a charge or not a disclosure to that effect.

Definition of valuation of assets: Valuation of assets is an integral part of their verification. Valuation means monetary or financial worth of an assets on the basis of some accepted accounting principle. Without proper valuation of assets balance sheet will not exihibit a true and fair view of financial position of the business and profit so computed can not be deemed to be accurate. Any error or mainpulation in the valuation of assets means that the financial information is not connect and the financial statements do not reveal the true picture of financial position of the business undertaking. According to B. K. BASU The term valuation may be defined as the ascertainment or measurement of the money value at which different assets of the business are shown in the books of account or in financial statement. Basis of valuation: The different criteria which must be kept in view of the time of valuation of assets, are given below(a) Cost price: It is the price at which the asset was onginally purchased and inclnedes all other charges incidental to put the asset into operation as freight of materials and labour used in installation, registration fees etc. Examples of directly attributable cost are i) ii) iii) Site preparation cost. Inifial delivery and handling costs. Installation cost, such as special foundation for plants.

(b) Market value: It is the price at which the asset may be sold. Market value or market price is also known as ret realizable value. (c) Cost of replacement: It is the price that would be required to be paid to purchase an asset similar to the evesting one. In other words the price at which the evicting asset can be purchased now is called cost of replacement. (d) Break up or scrap value: It is the price, which may be realized if the assets is sold as scrap when it becomes unserviceable. Therefore, the price expected to be realized after the completion of working of the asset is called its scrap value. In other words, the value of an asset after its working life is known as scrap value. (e) Book value: Book value means orginal cost of the asset less depreciation charged up to date. Also known as written down value.


This is the value of which the fined asset appears in books of account L. C in balance sheet. Classification of asset and Methods of their valuation: Assets can broadly be classified under five main categories: 1. Fixed assets; 2. Current assets; 3. Intangible assets; 4. Wasting assets and 5. Fictitious assets. (1) Fixed assets: Fixed assets are of a relatively permanent nature and are owned and used by an undertaking for carning profits. Actually fixed assets are those which are acquired for permanent equipment and not for resale in the ordinary course of business. They are not censumed in the very process of manufacture. They are more or less of permanent nature and are acquired by a concern for the purpose of carning profits. Fixed assets are normally valued in the following manner(i) Non-depreciable fixed asset like is valued at cost price. And the cost includes original cost of acquisition i.e., purchase price, commission paid to brokers, registration fees, legal expenses, cleaning. Depreciable fixed assets are valued of cost of purchase reduced by a reasonable amount of depreciation. Depreciation on fixed assets should be distributed over the useful working life of the asset in such a manner that the profit and loss account of each accounting year beans the proportionate loss in the value of asset for the period.

(ii) (iii)

(2) Current assets: Current assets are these which are acquired for reasle or produced for the propose of sale or converting them into cash e.g. stock, semi-manufactured goods, book debts, cash, bills receivable, bank balance, prepaid expense etc. These assets add to the liquidity of the organization. Current assets are valued at cost price on net realizable value which ever is lower on the date of balance sheet. For instance, if the cost of purchase of the unused raw material is Tk. 10,000 and the present market price or net realizable value of the same is Tk 11,000 the value of closing stock to be shown in the balance sheet will be Tk 10,000. This is because of conservation concept of accounting. (3) Intangible assets: Intangible assets are those assets, which do not have their form or physical existence. However, they are part of business and appear in the balance sheet, like any other assets by vintue of their utility to the business. Good will, patent rights, copy rights, trade marks are some of the examples of intangible assets. Intangible assets are valued in the following manner(i) (ii) A reasonable and proportionate amount should be debited against profit and loss account on account of intangible assets written off. Such assets should be carried forward in balance sheet at their actual value until written off completely.

(4) Washing assets: Wasting assets are those fixed assets which are depleted gradually on exhausted in the process of working. Such as a mine a quarry, an oil well etc. There is a difference between fixed assets and washing assets. Firstly, a fixed asset is replaceable, whereas a wasting asset is irreplaceable after its useful life is over. Secondary, the value of fixed assets differences due to while the value of wasting assets declines as a result of gradual exhaustion or reducing stock.


As a general, the value of the wasting assets in the balance sheet is reduced by the estimated amount of yearly depiction. In other words, a wasting asset appears in the balance sheet at its estimated diminished value. (5) Fictitious assets: Fictitious assets do not have any physical existence like intangible assets. But they are totally different from intangible assets in the manner that these are not realizable in cash whereas intangible assets have some realizable value. Examples of such assets are preliminary expense incurred at the time formation of the company, development expenses, debenture discount, amount spent or special advertisement campaign. From valuation point of view, fictitious assets are treated as deferred revenue expenditure, which means temporary capitalization or revenue expenditure with the ultimate object of spreading the amount over several future years to which benefit of such expenditure will be available. These assets are shown in the balance sheet at the amount of expenditure fees amount written off against the profit and loss account up-to-date. Verification and Valuation of Specific Assets: Verification and valuation of assets are almost interdependent and inter-related activities. Verification of assets is an important segment of auditing and valuation of assets is its integral part. Verification and valuation of assets in fact, is a combined consideration through which the position of different assets appearing in the balance sheet is examined. Every business requires various assets to manage it affairs. The size and variety of assets, however, depends upon the nature and size of the business organization. The verification and valuation of certain specific assets may be divided in the following categories. Goodwill is an intangible asset, which represents the earning capacity of the business. Since goodwill is not tangible, it does not call for physical verification. Goodwill is to be verified and valued in the following manner: (i) (ii) (iii) (iv) Ascertain that the company is justified in creating goodwill in its books of account. Ascertain the amount of goodwill from the purchase agreement or partnership agreement and verify the amount. Examine that the sum paid for goodwill doesnt exceed the difference between the total purchase consideration and the value of the net tangible assets acquired. Goodwill may appear in the balance sheet at cost less any amount written off. It is not legally obligatory to depreciate it, but it is thought to be a prudent financial policy to write off the value of the goodwill out of the profit. Where this is done, the auditor should see the boards resolution.

FREEHOLD PROPERTY A freehold property possesses two attributes, e.g., immobility and indeterminate duration. The auditor should take the following steps for verification and valuation of freehold property. (i) (ii) (iii) (iv) (v) (vi) (vii) Examine title deeds indicating the name of client as the owner. Note the area covered by it. Ensure that proper depreciation has been provided for the property. Verify the basis of valuation and see that it is valued at cost purchase reduced by reasonable amount of depreciation, if applicable. See that all acquisition expenses (legal charges, brokerage paid, stamp duty for registration, etc.) for the purchase of land have been capitalized. In case of any doubt in respect of title deeds, obtain a certificate from the company socilitor stating that the ownership is vesled in the client. It is suffers from a charge of mortgage against overdraft or loan facilities, obtain a direct bank confirmation stating that the bank as security held the title deeds.



Ensure that depreciation is charged on freehold building only, but not on freehold land.

LEASEHOLD PROPERTY It is not necessary that land and buildings are absolutely owned by the company, sometimes assets are acquired by the company on lease for a particular period. The a editor should take the following steps for verification and valuation of leasehold property. (i) Study the lease deed noting the date of commencement of lease, area covered, period of expiry, terms of termination provisions affecting additions, hiring out, ground rent etc. (ii) See that the provision for depreciation is made in account according to the life of the lease. (iii) Ensure that leasehold property appears in the balance sheet with the required details. PLANT AND MACHINERY A manufacturing concern often needs a set of plant and machinery for the production process. The auditor should take the following steps for verification and valuation of this item of balance sheet. (i) Obtain a schedule of closing balances. Check it with asset register or asset cards indicating the location of assets. (ii) Get a schedule of plant and machinery in existence at different sites. (iii) Verify the cost of the schedule. (iv) Check the valuation with invoices, import document acquisition charges etc. (v) Conduct spot inspections for the physical existence of plant and machinery on random basis. (vi) If manufactured by the client. See that the among of direct materials, direct labour and attributable portion of the overheads are properly capitalized. (vii) Also inspect architects certificate in proof of completion of work. (viii) See that if the work is still in progress, the expenditure upto the date of the balance sheet has been shown under work-in-progress in the asset side. (ix) See that all repairs to plant and machinery are charged to revenue and not capitalized. (x) See that depreciation is calculated adequately on a consistent basis. (xi) Vouch all additions to and deletion from the account with supporting evidence and examine authorizations in this respect. (xii) See that on sale of plant, adjustment of accumulated depreciation included in the depreciation reserve is also made. FURNITURE AND FIXTURE Chairs, table, desks, racks, almirah etc. the items of furniture whereas fixtures are the gadgets like fans air conditioners, coolers fridge, geysers etc. Which need proper installation. An auditor should take the following steps for verification and valuation of furniture and fixtures. (i) Verify with reference to the purchase invoice, in case the assets have been acquired during the current accounting period. (ii) Check that a stock register is maintained containing the details of the various items purchased. (iii) Ensure that the amount and rate of depreciation charged on different items is based on a fair estimate of their working life. (iv) Check that repire to furniture, if any, during the current year is debited to profit and loss account.


(v) See that payment made on account of purchase of any item of furniture and fixtures through the invoices of the suppliers. (vi) See that old and unserviceable furniture and fixtures are discarded by a responsible officer and proper record for such items in maintained. (vii) Ask the management of prepare an inventory and reconcile it with the stock register. PATENT (i) Obtain a list showing the description of each patent, the registered number, date and number years to run. (ii) Examine the actual certificates issued by the patent office in respect of patents granted. (iii) Where patents have been purchased from an individual or syndicate, inspect the agreement the purchase and note the age of various patents. (iv) See that all renewal fees have been paid or provided in accounts and the amount charged to revenue. (v) See that the patents, which have expired, are written off. The cost of patent should be written off in the coure of its life. (vi) At time a patent might become valueless due to obsolescence or failure to create a demand of the patened article. In such cases the auditor should see that its value is written off even before the expiry of the period covered by the patent. TRADE MARKS AND DESIGNS (i) Examine the certificates of registration issued by the register. (ii) If the trade mark has been acquired by assignment, vouch the amount paid for that with the assignment. (iii) All cost of registration of trademarks, e.g. registration fees, payments to artists and expenditure on account of salaries and overhead, attributable to the time spent in developing designs of trademark should be capitalized. (iv) See that renewal fee has been charged to revenue. Examine the last renewal fee receipt to ensure that the trademark has not been allowed to lapse. (v) Check the amount of provision for depreciation. COPYRIGHTS The verification of this item will be on the line similar to those described under patents. (i) If the copyright was acquired by the client, see the agreement under which it has been assigned. (ii) Look into the question of amortization of copyright it should be revalued at frequent intervals. (iii) See that copyrights, which have expired, are written off where any publication ceases to common sales, the copyright in respect there of loses its and therefore the cost of publication of such should be written off. VEHICLES (i) Obtain a certified inventory of all vehicles preferably indicating the following particulars: (a) Registration number (b) Description of vehicles (c) Engine number (d) Chassis number


(e) Amount. (ii) Examine registration books and see that road tax for the year has either been paid or provided in accounts. (iii) Inspect the insurance policies also. (iv) Check the logbooks to verify the existence and use of the vehicle. See that it is adequately depreciated on a consistent basis as compared to that of the previous year. ASSETS ACQUIRED UNDER HIRE-PURCHASE AGREEMENT The auditor should see that the asset is brough on the record at its present value, i.c., cash basis and the additional amount resulting on account of deferred payment is charged to interest account. The whole of the interest as represented by the difference between the total payments agreed to be made and present cash price of the first year, but account and a proportionate amount of interest applicable to each year should be written off to revenue in that year. The calculation of the annual deprecation should be based on the cash price of the asset and not on the total instatement value. VERIFICATION AND VALUATION OF INVESTMENT Investments refer to utilization of surplus resources. A company makes investments in securities, e.g., shares, debentures, bonds, etc. With a view to have some monetary return. The auditor is required to verify the existence of all such investment and to certify that they appear in the balance sheet at a correct value. The perform this major task effectively, he should take the following step. (i) Study the memorandum of association as an authority for investment. (ii) Where the number of investment is considerably large, obtain a certified schedule of all investments held by the company. Such a schedule of investments comprises information about the names of the securities/investments, date their acquisition, nominal/face value, cost price book value, paid up value, market value, rats of interest applicable, dates of interest dues tax deductions, etc. at the date of the balance sheet. (iii) Then compare the schedule of investment so obtained with relevant ledger accounts a view to SPOT any discrepancy. After completing these formalities, an auditor should carry out the following work for a proper verification and valucation of investment: PRINCIPAL As regards principal the auditor should check the following: (a) Face value and ownership: Examine the investments seeing that name of the client is stated as the owner and note the face value. If these are held by the bank, obtain a direct confirmation stating the object of holding it, i.e., for sate custody or as a cover against loan. (b) Book value: Compare it with the investment ledger and the previous years schedule. Vouch the purchases with brokers bought note and see the terms of purchase, i.e., ex-divident or cum-divident. And sales during the year should be verified with the brokers sold note. See board resolution for the authority of the above purchase and sale. A comparison of rates at which these were brought or sold with the published lists should also be done. (c) Market value: Check the market value with the quotation list at the date of the balance sheet. Any material loss resulting from the decline in the market value compared to cost should be provided in the accounts. For unquoted investment, examine latest available accounts. INTEREST AND DIVIDENT Interest and divident will be verified in the following manner: (i) Scrutinize each individual investment account ensure that all interests have either been received or accrued in books. (ii) In case of investment in shares see that dividends received on investments have been duly credited in respective ledger accounts and provisions have been made for dividend declared but not collected.


CONTINGENT LIABILITY Note any amount of uncalled capital relating to shares, held as investments and give a footnote of if in the balance sheet. SPECULATIVE TRANSACTIONS Enquire into the speculative transactions with particular reference to short-term purchases and sales. VERIFICATION AND VALUATION OF STOCKS (a) (b) Examine clients written instructions for pricing and indicate department/official (s) responsible for pricing. Prepare schedule showing basis of valuation of (i) (ii) (iii) (iv) (v) (vi) (vii) (c) (d) (e) Raw materials. Consumable store. Work in progress. Finished goods. Packages and containers. Loose tools and Other stock.

Note any change of basis as compared with the previous year and assets the effect of change on the current years profits. Verify from the purchase invoices the cost prices of stocks, stores, etc. Consider whether replacement cost of balance sheet date is less than stock sheet value and if so, whether reflected in the valuation of partly manufactured and finished stock. Work in progress. (i) (ii) (iii) (iv) (v) (vi) Test build-up of cost records (materials, labour, overheads). Examine reconciliation of cost and financing accounts. Test overhead rates and bases of allocation. Consider the volume of activity on which overhead rates have been based. Ascertain that overhead in stock valuation excludes selling overheads. Consider any provision is necessary against anticipated losses on uncompleted contracts.


(g) (h) (i) (j) (k) (l) (n)

Finished stockTest valuation with subsequent selling prices (after allowing for selling cost). Test the absolute, slow-moving, redundant or damaged stocks are written down to realisable values. Test check extensions. Additions of stock sheet. Prepare summaries of stocks classified according to the nature of business with comparative figures for preceding year. Note any pledge or line in connection with stocks. Compare values with previous year and account for significant variations.

(m) Note value of stocks of insurance purpose.



Consider forward commitment for the purchase of raw material, etc. in relation to spot prices at balance sheet date.

Verification of liabilities: Verification of liabilities is as important as the verification of assets. If the liabilities are overstated or under stated the balance sheet shall not represent a true and fair view of the state affairs the company. Similarly profit and loss accounts are incorrect. Besides the verifications of liabilities is much easier than their valuation. For example: If some expenses have been incurred they have not been entered in the books of account. The profit and loss account will be incorrect and show more profit and balance sheet does not show such a liability. Objects of verification of liabilities: Given below: 1. 2. 3. To verify liabilities related transactions are recorded properly, or not. Fictitious liabilities are not shown outer column of balance sheet. To stop forgery related liability.

Auditors duties in regard to verification of liabilities: Discussed below: 1. Auditors duty to collect a testimonial from any duty ness employer. 2. Auditors duty to verify the amount of liability is written right by or not. 3. Auditors duties to see the total liabilities of business are shown properly or net. Verification and valuation of liabilities: 1. Capital: Although

capital is not the liability of a company, still it should be verified to enable an auditor to give certificate in regarded to the correctness of the balance sheet.
If it is the first audit of a company the auditor should examine memorandum of Association and the articles of association of the company. He should examine the cash book. Pass book and minute book of the board of directors to find out the number and the difference classes of shares issued the amount received on case share and the balance due from the memorandum and articles of association and minute book of the board of directors should be examined. The auditor should see that the issue of capital is according to the memorandum and articles of, association. If any shares have been issue to the vendors the contract between the vendors and the company should be examined. Capital show in the balance sheet capital less. Drawings add, additional capital less goods drawing add profit, interest on capital and result given the outer column. 2. Reserve and fund: Reserve means the part of the profit which is set a side for any known or unknown contingency liability diminution in the values of asset etc. Reserve and that are shown balance sheet as liabilities. 3. Debentures and mortgages: When company collect money without share this process is debentures sales maximum. The mortgager under takes that if the sale. Proceeds of the property are in sufficient troopers the money due he will remain personally responsible for the payment of the debt. 4. Bills payable: The auditor should verity this item from the bills payable account. The bills payable already paid should be checked from the cash book and examine the returned bills payable. To see the genuineness of the bills payable in hand on the date of balance sheet, the auditor should cash book of


the seceding year. Incase suspicion he should ask for the confirmation from the drawers of the bill. If any charge has been created on any assets on the concern by accepting the bill. The fact should be disclosed in the balance sheet. 5. Loans: Reference may be made to the agreement and correspondence for getting the loan. It interest on the loan has not been period he should see that it is shown as a liability. It loon has been secured by mortgaging any property. It should be indicated in the party who has advanced the loan regarding the amount of loan. Interested due and security offered incase of bank draft the agreement with the bank and security offered should be examined. 6. Contingent Liabilities: All contingent liabilities viz. 1. 2. 3. Total of Bills discounted for your customer with resource. Details of any guarantees bonds, indemnities given to you by the customer in favour of the third parties. Details of any guarantees, bonds indemnities given by you on your customers behalf, starting where there is recourse to your customer to its holding parent or any other company with in the group. Total of acceptances. Total of forward exchange counteracts. Total of out standing is liabilities under documentary credits.

4. 5. 6.

7. Trade creditors:The auditor should see that all purchases during the year have been included in the purchases and especially purchases made at the close of the years. Trade creditor is a current liabilities. That are shown balance sheet and some closed in the year. 8. Outstanding Expense: The auditors should get a certificate from a responsible official to see that all expenses from the current year are included and that the payment for each expenses such as interest discounts, salaries, wages legal expenses etc. those are included profit and loss account to determine profit and balance sheet show this liabilities. So we can say that verification of liabilities and assets and valuation of assets and liabilities is most important in Auditing matter or subject.


Definition of depreciation The word depreciation is derived from a Latin word Depretium. If we analyze the word de means decline and premium means price. Thus it means decrease in the value of fixed or capital assets. Depreciation has been defined as the decrease in value of an asset on account of natural wear or tear or exclusion of time. mm So depreciation is the process of cost allocation, not a process of asset valuation. But land is not a depreciable asset. B.G. Vickery defines it permanent decrease in the value of an asset through wear and tear in use or passage of time. Cropper, Marsis and Fission define Depreciation is a term employed by accountants to indicate the gradual depreciation both in the value and the usefulness of these assets which, by reason of there nature and uses steadily decline in value. Spicer and Pegler- Depreciation may be defined as the measure of the exhaustion of the effective life of an asset from any cause during a given period. William Pickles- Depreciation may be defined as the permanent and continuing diminution in the quality, quantity and value of an asset. RG William depreciation may be defined as a gradual deterioration in the value due to use. Depreciation is the allocation of the cost of a plant asset to expense over its useful life in a rational and systematic manner. Cost allocation provides for the proper matching of the expenses with revenues in accordance with the matching principle. So Depreciation is the allocation of the depreciable amount of an asset over its estimated lives. Difference between depreciation and fluctuation Accountants have sometimes described depreciation as Internal depreciation and fluctuation as External depreciation 1. Depreciation means the decreasing its value for constant using of any asset. Changing the price of assets in the market is called Fluctuation. 2. Depreciation is charged against the profits of the year. Fluctuation is not charged against the profit. 3. Depreciation is in connection with fixed asset. Fluctuation is in connection with current assets. 4. Depreciation of an asset affects its earning capacity. Fluctuation does not affect the earning capacity of asset. 5. Depreciation always means the decrease in the value of an asset. Fluctuation may mean either increase or decrease in the value of an asset. 6. Depreciation is always a permanent decrease of an asset. Fluctuation is a temporary rise or fall in the market value of an asset. Methods of depreciation. Depreciation is generally computed using one of the following methods 1. Fixed Installment method: This method is known by different names such as straight line method, original cost method etc. Under this method a percentage of the original cost of the asset concerned less the residual value. If any is written off every year till the end of its estimate life. Formula of straight line method:

Chapter 7 Depreciation

2. Units of activity method: Under this method, useful life is expressed in terms of total
units of production or use expected from the asset, rather than as a time period. The units of activity method are ideally suited to factory machinery. The units of activity method are generally not suitable for building or furniture, because depreciation for this


asset is more a function of time than of use. To use this method, total units of activity for the entire useful life are estimated, and these units are divided into depreciable cost. The resulting number represents the depreciation cost per unit. The depreciation cost per unit is then applied to units of activity during the year to determine the annual depreciation expense. Formula of units of activity method: Depreciation= depreciable cost / total units of activity.

3. Decline balance method: The decline balance method produces a decreasing annual
depreciation expense over the assets useful life. The method is so named because the periodic depreciation is based on a decline book value (cost less accumulated depreciation) of the asset. The depreciation remains constant from year to year, but the book value to which the rate is applied declines each year. Formula of decline balance method: Annual depreciation expenses= book value of beginning of year X declining balance.

4. The depreciation fund method: This method is known by different names such as
redemption fund method, Amortization Fund method, Sinking fund method etc. Under this method an equal amount is written off every year and profit and loss account is debited while the depreciation fund account is credited during the estimated life of the asset. 5. The annuity method: This method of depreciation is provided where it is also desired to retain the money in the business. The annuity method of depreciation in practice is very seldom used. 6. Insurance policy system: According to this system an endowment insurance policy is taken on the life of the asset so that at the end of the definite period, the insurance company will pay the assured sum with the help of which the asset can be repurchased. 7. Revaluation: Where it is not possible to provide for depreciation on mathematical basis. The asset is revalued at the time of the balance sheet, e.g., in the case of loose, tools, livestock, jars, bottles, packages, patterns, jigs etc. i.e., assets which have short life. 8. The use of mileage method: The method is applied in the case of those assets the use of which can be measured in terms of miles and not in terms of time. e.g., a car, bus, a motor cycle etc. 9. Efficiency hours method: This method is exactly life the mileage method. Under this method, instead of counting the life of the asset in miles, it is estimated in terms of working hours. 10. Production unit method: Under this method the depreciation is provided according to the number of units of the goods manufactured. It is just like efficiency hours method 11. Global method: Under this method the depreciation is provided according to the rate of depreciation is charged the method is very unscientific and should not be adopted. It is not permissible under the companies Act because fixed assets are to be distinguished from one another. 12. Single charge method: Under this method a definite sum of money representing a proper proportion of the total amount of depreciation and repairs over the life of the asset is debited to revenue account and credited to a depreciation and repair reserve account. 13. Depletion unit method: This method is used in case of wasting assets such as mines, quarries oil, wells etc. The contents of the mine are estimated in terms of tons, gallons, etc. The objects and necessity for providing depreciation:


1. The depreciation is to be determined and provided in the accounts to find out the correct cost of production. 2. If depreciation is not provided the asset will appear in the balance sheet at a value higher than its worth. Hence the balance sheet will not show the true and fair view of the financial position of the company. 3. The real object of providing depreciation is to keep the capital intact. By charging depreciation in profit and loss account, the amount of distributable profit(i.e. net profit) is reduced. The amount of depreciation set apart, accumulate year after year. The accumulated amount can be used to replace the asset when the asset is scrapped. 4. Lastly, it is necessary to provide depreciation legally in case of company under section 250 of the Act defines dividend can be declared only after providing for depreciation. Factors should be taken into consideration for measuring the amount of depreciation: The following are the important factors that should be taken into consideration for measuring the amount of depreciation: a) Original cost of the assets. b) Expected useful life of the depreciable assets. c) Estimated residual value of the depreciable asset. d) Methods of providing depreciation. e) Requirements of statues. a) Original cost of the assets: The original cost of the asset means money spent for acquiring, installing, commissioning the asset and subsequent addition or improvement cost of the assets must be determine for measuring the amount of depreciation. b) Estimated residual value of the asset: After the asset ceases to be of use it is disposed of. But it may have some realizable value, even it is junk. The amount of scarp value is to be estimated at the time of acquisition of the asset. If only very negligible amount would be realized. The scarp value can be taken to be nil. c) Expected useful life of the assets: Having decided on the total amount of depreciation to be written off over several years, one must also set limit on periods within which the total amount is to be wiped off. It is for the reason; the commercial life of an asset is estimated. The estimation of useful life is a technical matter. Estimated useful life of an asset is expressed in terms of various units of measurement. It may be expresses in terms of number of years for which the asset may be commercially fit, or number of machine hours a machine may last, or number of production units that may be manufactured within useful life of the machine and so on. d) Methods of providing depreciation: There have different methods of depreciation to ascertain of depreciation. A particular method must be selected for determining depreciation. e) Requirements of statutes: If any of the enactments applicable to the entity stipulates rate of depreciation that should be applied in respect of various classes of the assets, then the entity should charge depreciation for an amount not below the amount specified in the act. The Indian companies Act states that no dividend can be declared by the company unless depreciation is fully provided for. Causes of depreciation Causes of depreciation can be mainly divided into two A. Internal causes B. External causes. A. Internal causes When the depreciation of any asset occurs for general or natural reason or internal usage of the asset than it will be called internal causes of depreciation. Internal causes of depreciation can be divided into four 1 Wear and tear 2. Exhaustion 3. Depletion 4. Deterioration


5 The effects of weather and other elements 1 Wear and tear Decrease in the value of fixed asset such as plant and machines by constant use of such an asset less the probable scrape or salvage value of the asset concerned is called depreciation. If a machine is used daily, naturally it will not be ot the same value after sometime. This difference in its utility value when it was purchased and its utility value after using it for sometime is called depreciation. An increased use of asset may result in more depreciation, e.g., furniture in a school as compared to furniture in the office of the executives. Working few hours also does not mean less depreciation as some depreciation is caused by lapses of time also. 1 Exhaustion By using an asset it is exhausted e.g., a mine, where the mineral is extracted out of it and ultimately the whole of the mine is exhausted. This reduction in its value is the depreciation. 2 Depletion Depletion is another internal cause of depreciation of an asset. Depletion means decreasing the value of any asset with passing the time. Such as depletion of good will, leasing asset, copy right, trade mark etc. 3 Deterioration: Deterioration is another internal cause of depreciation. 4 The effects of weather and other elements: Sometimes the effect of weather, rain, sunshine etc also reduces the life of an asset and more depreciation has to be provided on such assets. B. External causes of depreciation Without asset natural or normal causes, when price is decreased in any other causes than these causes is called the external causes of depreciation. 1 Effluction of time Decrease in the value of an asset by the effluction of time as in the case of a less concession or a patent is called depreciation. In the case of a lease at the end of the period it terminates and it becomes valueless. The premium paid for the lease in the capitalized value of rent paid in advance and therefore it should be written off during the period of lease. 2 Obsolescence This is a kind of less arising on account of new inventories which have into the market and the use of which make the goods capture better and in large quantity. Thus obsolescence is therefore due to a) Technological development b) Shortage of labor; and many other factors may render the machinery unprofitable. Obsolescence arise where a product or a production method or machine goes out of use owing to change in fashion of demand resulting in the product no longer required or the machine being superseded by a later invention producing the same output more efficiently more efficiently of economically. An example if change in public taste or inventions rendering reduced at large sectors of industries may be instanced the falling out of fashion of mens boater or straw hats, the substitution of the loudspeaker in wireless reception for the earphones used for broadcasting and the substitution of petrol driver, motor cars for house drawn vehicles, substitution of color TV for black and white TV. 3 Permanent fall in market value. Some writer say that the permanent fall in market value of any asset is called the cause of depreciation. Duties of an auditor in respect of depreciation: 1. The auditors should check that the costs of the assets are properly stated. He must check capitalization entries keeping in mind the relevant accounting conventions. He must vouch the entries with such records as minutes of directions, purchase bills, delivery notes, expense vouchers, commencement certificate etc. 2. The auditor must bear in mind that adequate amount of depreciation is to be provided for in accounts regardless of non-availability of profits, availability of assets in market at a cheaper rate (i.e. below book values), repair and renewal policy or non-user of asset during accounting year, the depreciation provided for. It is charge against profits of the


company each year. It is equally important that no excessive depreciation has been provided for in the accounts. 3. The auditor must ascertain the scrap value and useful life of the asset are fairly estimated. He must also check that the method of depreciation adopted is suited to the entity. He must ensure the rates applied are not below the rates specified in relevant enact-ments applicable to the entity. 4. When assets are disposed off, the auditor should vouch entries. He must check such evidences autliorisation of bound, sale invoice copy of gate pass, amount received from the buyer and so on. 5. The auditors should check that there are circumstances warranting change, if the entity desires to make change in method of providing for depreciation. 6. The auditor must devise checks to ensure the accuracy aspect of depreciation. He must get a schedule of fixed assets from the client. He must compare the opening balances with previous years figures, vouch additions, deletions and check the grouping of individual assets into such convenient classes of assets. 7. The auditor should check the depreciation is properly disclosed in financial statements. The provision of depreciation should be distinctly shown in profit and loss account and total depreciation provision should be disclosed as a deduction from the cost of assets in the balance sheet. Reserves Definition of reserves Generally one understands by the term reserves that something has been kept apart for future use for the emergency. This is the definition by an ordinary mean. But from the accountancy point of views reserves means that part of the profits which is set aside for any known or unknown contingency, liability, diminution in the values of assets etc. The American institutions of accountants defines the use of the term reserve be limited to indicate that an undivided portion of the asset is being held or retained for general or specific purposes. According to B.N Tandon Reserve means that part of profits which is set aside for any known and unknown contingency, liability, diminution in the values of assets etc. Regarding the use of the world reserve in the part this term was applied both to appropriations of profits which are free from distribution and for specific requirements such as depreciation, bad debts and other contingencies, which represent charges against earnings. Classification of reserves Generally there are two kinds of reserves. (1) A General Reserve which is not to meet any specific liability, and (2) A Specific Reserve which is to meet any specific liability or diminution in the value of an asset. But now the Reserves are classified as under: 1 General reserves, which is not to meet any specific liability and 2 Specific reserve, which is to meet any specific liability or diminution in the value of an asset. But now the reserves are classified as follows a) General reserve or revenue reserve b) Specific reserve c) Sinking fund d) Reserve for development fund e) Capital reserve f) Secret reserve These different types of reserves are describes in details below. a) General reserve or revenue reserve It is an amount that sets aside out of the profits or surplus of a business to provide additional working capital or to strengthen the liquid reserves of the business or that they may be available for any unknown contingency or to equalized dividend or for expansion of business etc. It is an appropriation of profits. It is usually treated as a revenue reserve. Such a reserve is also known as a free reserve. This kind of reserve is not created to meet any known liability, contingency or commitment. This may be considered as the undistributed profit. Binnie and manning have described the nature of a general reserve when the say: A general reserve, in effect, defers only in name from the carry forward or surplus as the balance


remaining at the credit of the profit and loss account( after deducting dividends) is commonly called. If there is a heavy loss in future, the general reserve can be utilized for the purpose of wiping off the debit balance of profit and loss account and the balance, if any, may be shown in the balance sheet. Nature of general reserve The nature of general reserves is as follows 1 The expression Reserve shall not, subject as aforesaid includes any amount written off or retained by way of providing for depreciation, renewals, or diminution in value of assets or retained by way of providing for any known liability. 2 The expression capital reserve shall not include any amount regarded as free for distribution through the profit and loss account; and the expression revenue reserves shall mean any reserve other than a capital reserve. Auditors duty in connection with the general reserve It is no part of the duty of an auditor to see the adequacy or inadequacy of such a reserve. If the directors do not wish to provide for such a reserve, the auditor need not insist upon its creation. However, he may be called upon to advise the directors on the desirability of creating such reserve or whether the reserve be invested inside or outside the business. b) Specific reserve The reserve which is c charge against revenue for the purpose of providing for losses and contingencies which may result in losses and which are known or expected at the date of making provision for such a contingency to occur at a future date, is known as Specific Reserve. Such a reserve must be created whether there is any profit or not and even it there is a loss, it is a must. The exact amount involved is not known. It is provided before the profits are distributed and is created for a definite object, e.g. a) To meet a known loss, e.g., deprecation, heavy repairs and renewals, etc. b) To meet an expected contingency e.g., doubtful debts, discount on sundry, liabilities for a disputed claim, contingency liability etc. c) To meet an outstanding liability for expenses already incurred, e.g., salary and wages, commission, income tax and other accrued expenses. Specific reserve is not a surplus. It is not represented by any asset and, therefore, is not available for distribution amongst the shareholders. The amount is an estimated only at the date of making a provision. If the provision is in excess of the need according to the directors, the excess amount should be treated as reserve. Specific reserve or provision is deducted from the asset as in the case of depreciation, reserves for bad and doubtful debts etc. while reserves for outstanding liabilities are shown on the liabilities side of the balance sheet. Auditors duty in connection with specific reserve The auditor should see that if no reserve for discount on debtors has been provided for in the past, it should not be done during the current year, as otherwise such step will affect the compensation of the profit and loss accounts of the two periods. Reserves for discount on creditors should not be provided unless discount on debtors has been provided. The rate of discount on creditors should be the same as in the case of discount on debtors. d) Sinking fund It is a kind of reserve by which a provision is made1 to reduce a liability e.g., redemption of debenture or repayment of a loan; or 2 to replace a wasting asset, e.g., a mine; or 3 to replace a depreciating asset; or 4 te renew a lease, etc. Binnie and Manning define, A sinking fund is a form of specific reserves set aside for the redemption of a long term debt or the replacement of a wasting or a depreciating asset. The main purpose of creating a sinking fund is to have a certain sum of money accumulated for a future date by setting aside a certain sum of money every year. It is a kind of specific reserve. How is sinking fund created? The sinking fund is created


By debiting the profit and loss account every year with a certain sum of money and investing it, at the same time, in gilt-edged securities to ensure the safety of capital and a regular rate of interest. In such as case the object is to provide against a loss which should naturally fall on revenue, e.g., in the case of depreciation sinking fund. This provision is a charge against profit. Whether there any profit or not, provision must be made for such fund. b) By debiting the profit and loss appropriation account every year with a certain sum of money and investing it at the same time gilt-edges securities. In this case the object is the reduction of a liability or payment of a liability. The fund is created by allocation of profits. c) Reserve for development fund Practically there is no difference between a general reserve fund, which has already been dealt with in the foregoing pages and a reserve fund. Both are created with the same object and are debited to profit and loss appropriation account. The only difference is that in the case of general reserve the surplus is retained in the business and is represented by the general assets of the company while in the case of the reserve fund, the surplus is invested outside the business in securities and is represented by such investment. Some accountants argue that the word Fund indicates that the money is invested outside the business, and, therefore, it is but appropriate that such a reserve should be named reserve fund in order to distinguish it from the general reserve. Some accountants are of opinion that Development Fund can not be utilized for payment of dividends as a reserve can be, because it has been created for a specific purpose. e) Capital reserve Capital reserve has been defines as Any reserve which can not legally be distributed among the shareholders. But this definition does not seem he quite correct. As we shall see later on, Capital reserve may be distributed amongst the shareholders under certain circumstances. Capital reserve is just like a general reserve except that it is generally not distributable amongst the shareholders and it is not crated by debiting the profit and loss appropriation account. F.R. M. de Paula A capital reserve represents capital items that are not free for distribution. How capital reserve is created? Capital reserve is created out of capital nature, e.g., 1 If there has been appreciation in the value of a fixed asset, the difference between the book value and the appreciated value is transferred to capital reserve provided other assets have been revalued and necessary adjustment has been made. 2 Selling a fixed asset at a higher price than its book value. As it is not regular profit it is not credit to the revenue account but is transferred to capital reserve account. 3 Premiums received on the issue of shares and debentures. 4 Profit made on the redemption of debentures in the market at a discount. 5 The balances standing to the credit of forfeited shares account after such shares have been re-issued. 6 Profits of as exception nature which have not been earned in the regular course of business. 7 Profit made in purchasing a business i.e., when the purchase price is less than the net asset acquired. 8 Profit earned prior to incorporation of a limited company. 9 Any profits including revenue profits, which are not represented by liquid asset or which can not be distributed amongst the shareholders. *Duties of an auditor in connection with the reserve There are many duties of auditors in connection with the reserves some are given below in short1) The auditor should see that those capital profits which have been transferred to capital reserve account are really surplus of capital over the assets and liabilities. 2) That the capital reserve is utilized according to the articles and law of a country. 3) Capital reserve must be shown distinctly in the balance sheet and must be distinguished from the revenue reserve account. Any additions and deductions since the last balance sheet should be clearly shown.



4) Capital reserve may be invested either in the business itself or may be invested outside the business in easily realizable securities. f) Secret reserve Secret reserve has been defined as Any reserve which is not apparent on the face of balance sheet. It is sometimes called Hidden Reserve or Internal Reserve or Inner Reserve. According to Simon & Karrenbrook Secret Reserves are understatements of assets or an overstatement of liabilities accompanied by a corresponding under statement of capital. Spicer & Pegler A secret reserve may be defined as a reserve, the existence and/or amount of which is not disclosed on the face of balance sheet. How Secret reserve is created? A secret reserve is created by the following methods-a) By writing down the assets much below their cost or market value, such as investment, stock-in-hand, plant and machinery and land and buildings etc. b) By not writing up the value of an asset, the price of which has permanently gone up. c) By providing more reserve than necessary for bad and doubtful debts or discount on sundry debtors. d) By providing excessive depreciation on fixed assets. e) By writing down the goodwill to a nominal value. f) By omitting some of the assets altogether from the balance sheet. g) By charging capital expenditure to revenue account and thus showing the value of the assets to be less than its actual value. h) By over valuing the liabilities. i) By inclusion of fictitious facilities. j) By showing contingent liabilities as real liabilities. k) By grouping dissimilar items on the liabilities side of the balance sheet, e.g., reserves, provisions and creditors, under a general heading, as Sundry Creditors and other credit balances. Capital reserve may be invested either in the business itself or may be invested outside the business in easily realizable securities. Provisions Definition of provisions Provision is a charge against revenue for the purpose of providing for losses and contingencies which may result is losses and which are known or expected at the date of making reserve for such a contingency to occur at a future date. According to Spicer and pegler The terms provision should be used to describe amounts set aside out of profits to meet specific liabilities the amount where of can not be estimated closely and also to meet any diminution in the values of assets existing at the date of balance sheet, the creation of a provision thus the reduces the net assets employed in the business. Necessity or objects or importance of making provisions 1 To meet any known or unknown loss A company may have uncertainty about its future revenue or loss. Again there are some known things which may bring loss to the company. Such as heavy repairs, renewals, bad and doubtful debts etc. to make reserve fund against the uncertainty or loss provision fund has to be created. 2 To determine real profit There may create bad and doubtful debt for the cause of sale on account. If the loss which is occurred for the cause bad and doubtful debts is not deducted from the profit, the real profit of the year can not be determined. But if any provision fund is created for bad and doubtful debt, a assumed amount can be deducted from the profit. So real profits can be determined for making the provision. 3 To meet an outstanding liability To meet outstanding liabilities for expenses such as salaries and wages, commission, income tax and other accrued expenses, the provision must be created to meet these outstanding liabilities of these expenses. *Classes of provisions 1 Provision for bad and doubtful debts This provision is created to meet any future loss if the debtors fail to pay the whole or part of the debt owing by them. When the amount of loss which will take place is known provision should


be made for the exact amount. The revenue account is debited and the accounts of the particular debtors are credited. 2 Provision for discount on debtors and creditors In some business houses it is the custom that when the debtors make payment within the prescribed period, a certain amount of discount is allowed to them. Similarly the business house, when making payments to creditors, earns discount at the date of closing the books, the book debts shown may not be worth the amount mentioned as some discount will have to be allowed to the debtors. Therefore, the debtors should not be shown at their book value but the annual amount realizable from them should be shown. if this is not done, the balance sheet will not show the correct position of the concern and, therefore, discount payable to the debtors should be deducted from the total debtors and need realizable figure should be shown in the balance sheet. 3 Provision for sinking fund It is a kind of provision by which a reserve is made b) to reduce a liability, e.g. redemption of debentures or repayment of a loan; or c) To replace a wasting asset, e.g. a mine; or d) To replace a depreciating asset; or e) To renew a lease etc. 4 Provision for development fund The provision which is created for the purpose of creating development fund of the company is called provision for development.