Studdy Note 5

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STUDY NOTE – 5

AUDITING BASICS – I

This study note includes -

● Evolution of Auditing

● Definitions● Major Influences of Auditing

● Nature of Auditing

● Scope of Auditing● Role of Evidence in Auditing

● Auditing Techniques and Practices● Generally Accepted Auditing Standards

● Concept of Materiality in Auditing

5.1. EVOLUTION OF AUDITING

In the early days of commerce and business there was no existence of the concept of auditing.This was, may be due to the small nature of business and day to day personal control of theproprietor.

Audit can be traced back in the period 3600-3200 B.C. Initially, the audit was mainly done thatof public accounts only. From historical records it appears that the ancient Egyptians, Greeksand Romans were used to the government accounts audit.

The accounts of the corporation of the city of London were audited in 12th Century. Later inShakespeare’s “Timon of Athens” the steward Flavins makes the remark “If you suspect myhusbandry or falsehood, call me before the exactest auditor, and set me on the proof” whichindicates the existence of an audit in the 14th century also.

In 1314, auditors were officially appointed to check the public accounts in England.

In 1494, Luca Pacioli, a French celebrated mathematician, brought the concept of Double Entrybook-keeping and auditing in practice. Gradually and especially after the Industrial Revolu-tion in the 18th century, the nature, type and size of business organizations changed. The largescale business came into existence causing dilution in the regular and direct control of theproprietor. This made it necessary to get the transactions made by the staff and representativesof owners, checked and verified by an independent person and this has given rise to concept ofauditing.

In 1866, the England’s Exchequer and Audit Department was created by Act of Parliament. In

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1870, The Institute of Accountants in the form of a society was formed in England. It got aRoyal Charter in 1880 and was turned into The Institute of Chartered Accountants in Englandand Wales, but before that in 1854, with a Royal Charter, The Institute of Accountants andActuaries in Glasgow.

In India, the auditing can be traced long back in Ramayana, Mahabharata and even in theVedas. Lord Ram asked Bharat about whether his income was more than his expenditure andvice versa. Likewise, King Yudhisthira ordered Nakula to look after the army’s accounts. Thesystem of land revenue, currency, trade and control etc. can be traced in Vedas and even inManu Smruti. This indicates that the roots of auditing in India were rooted long back in Satya-Yuga. The sophisticated system of accounting and auditing can be found in the reign of Mauryas,Guptas and Moughals too. This first legislation relating to companies in India that is the JointStock Companies Act, 1857 introduced the provisions of annual audit but was made optional.Latter, The Companies Act, 1913, made it compulsory. This Act was replaced in 1956 by theIndian Companies Act, 1956, the act and the subsequent amendments not only made thee au-dit compulsory but sought to ensure that only the independent professionals with requisitesqualifications are appointed as statutory auditors of Companies. In 1965, the amendment inthe Act took place and concept of Cost Audit was introduced, while the amendment in theIncome Tax Act, 1961, took place in 1984 introduced the concept of Tax Audit, Sales Tax (VAT),Trust Act, Co-op Societies Act etc. brought the concept of different audits into practice.

A number of technological, economic changes, social events, globalization, liberalization,privatization etc. have influenced auditing to a great extent in the course of development ofauditing and caused considerable changes and improvements in the techniques, principles,standards, reporting, professional ethics and responsibilities of auditor.

5.2. DEFINITIONS

The term “audit” has been derived from the Latin words “audire” which means to listen. Inthose ancient days, the person appointed to check the accounts, used to hear the explanationsrequired from responsible officers and that’s why, the person who heard the explanations wascalled as an “auditor”. However, now a days, due to drastic changes in business, accountingsystems, size and the provisions of different laws, this “hearing” concept of auditing is consid-erably changed and become more exhaustive and therefore, different authors have defined“auditing” differently, few of the important definitions are as under-

(a) Taylor and Perry - “Audit is defined as an investigation of some statements offigures involving examination of certain evidence, so as to enable an auditor tomake a report on the statement.

(b) F.R.M De Paula- “An audit denotes the examination of Balance Sheet and Profit andLoss Account prepared by others together with the books of accounts and vouchers relat-ing there to in such a manner that the auditor may be able to satisfy himself and honestlyreport that, in his opinion, such Balance Sheet is properly drawn up so as to exhibit a trueand correct view of the state of affairs of the particular concern according to the infomationand explanations given to him and as shown by the books”.

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(c) Prof. Montgomerly- “Auditing is a systematic examination of the books and records ofbusiness or other organization, in order to ascertain or verify and to report upon the factsregarding its financial operations and the result thereof.

(d) M.L.Shandilya- “Auditing may be defined as inspecting, comparing, checking,reviewing, vouching, ascertaining, scrutinizing, examining and verifying the books ofaccounts of a business concern with a view to have a correct and true idea of its financialstate of affairs.

(e) Spicer & Pegler- “Audit such an examination of the books of accounts and vouchers of abusiness, as will enable the auditor to satisfy himself that the Balance Sheet is properlydrawn up, so as to give a true and fair view of the state affairs of the business, and whetherthe profit and loss account gives a true and fair view of the profit or loss for the financialperiod according to the best of his information and explanations given to him and asshown by the books, and if not, in what respect he is not satisfied”.

In the close scrutiny of the different definitions we found that there are different ways ofexpressing the concept auditing but having lot of similarity therein.

The meaning of an Audit contains

(i) An intelligent and critical examination of the books of accounts of business.

(ii) It is done by an independent qualified person.

(iii) It is done with the help of vouchers, documents, information and explanationsreceived from the clients.

(iv) The auditor satisfies himself with the authenticity of the financial accounts prepared fora particular period.

(v) The auditor reports that-

(a) The Balance Sheet exhibits a true and fair view of the state of affairs of the concern.

b) The profit and loss account reveals the true and fair view of the profit or loss for thefinancial period.

c) The accounts have been prepared in conformity with the concerned law.

d) If he is not satisfied then reports in what respect he is not satisfied.

5.3. MAJOR INFLUENCES OF AUDITING

Now a days the techniques & process of audit ethical & professional responsibilities of anauditor, reporting method & standard, legal & statutory status of an auditor have been drasti-cally changed compared to that of ancient days, due to the influence of different things likeevents, laws, revolutions etc. Some of them are—

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(a) Industrial Revolution(b) Ownership(c) Professional Management(d) Statutory Provisions(e) Case Laws(f) Information Technology

5.4. NATURE OF AUDITING

An audit is a dynamic concept where accountancy ends and auditing begins. An auditor has toverify the entries passed by the accountant and the final accounts prepared by him. Auditingis, therefore, the scrutiny of the accounts of business with the help of the vouchers, documentsand the information given to him.

In the olden days audit was voluntary act of few businessmen having very limited scope, how-ever the change in the form of organizations after industrial revolution had increased the scopeof audit considerably.

Auditor acts according to the instructions of his client and in case of statutory audits to a cer-tain extent regulated by the concerned law, the words “certain extent” are meant as the actualmethod of performing an audit is not prescribed, and never can be prescribed, and althoughprofessional auditors act on certain well defined lines can be indicated only in a general way.

A very eminent English Judge once described an auditor as a “watchdog” and not a bloodhound’ which expression has been frequently quoted by others equally well informed as to thenature of an auditor’s work and of the very short period occupied by him, in the performanceof his duties. An erroneous description could not be applied to an auditor, as a watchdog is adog kept on premises for the purpose of guarding them from the damages from theft. Anauditor on the other hand only appears on the scene after the damage or theft, if any, has beenperpetrated, and the most he can do is to find out the amount of theft or extent of damages andalso, if possible, the proprietor.

The nature of auditing is such that, the auditor will later on appear in his capacity as a critic ofa book-keeper’s work, may have a great morale effect and thus prevent a cashier or book keeperfrom embezzling money. This morale effect has prevented theft in many more cases and is amore powerful point in favor of auditing.

5.5. SCOPE OF AUDITING

Development in the last two decades have extended the scope of auditing. Therefore, a morecomprehensive definition of auditing given by Schlosser may also be considered. According tohim, auditing is a ‘’systematic exmination of financial statements, records and related operationto determine adherence to generally accepted accounting principles, management policies ofstated requirements’. The earlier definition of auditing by Mautz emphasizes the verificationof accounting statements. While retaining that emphasis, Scholsser’s definition extends thescope of auditing by including in it an examination of allied operations. Similarly the purpose

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of auditing has been extended to examination of allied operations to ‘management policies orstated requirements”. This, whereas the previous definition mainly covers Mautz independentprofessional audit, Schlosser’s definition also covers cost audit, internal audit, Goverment audit,management Audit oparational audit and the like.

The auditor is not supposed to perform the duties which are beyond the scope of his compe-tence. Accounting is concerned with the recording of the transaction and preparation of state-ments of account but auditing involves a detailed and critical examination of accounts pre-pared by others. In fact, auditing begins where accounting ends.

Constraints on the scope of the audit of financial statements that impair the auditor’s ability toexpress an unqualified opinion on such financial statement should be set out in the report.Qualified opinion or disclaimer of opinion should be expressed as appropriate.

According to Schlosser, audit now also covers cost audit, management audit, internal audit,energy audit, excise audit, VAT audit and government audit too. Today audit is not confinedto the business houses only, but also to non-business organizations. Auditor is in the nature ofa watch-dog and a trustee of the nation’s finances.

According to AAS-2 (Auditing Assurance Standard No. - 2) issued by the Institute of CharteredAccountants of India, also, the scope of an audit of financial statements will be determined bythe auditor having regard to the terms of the engagement, the requirements of relevantlegislations and the pronouncements of the institute. Of course the terms of engagement cannotrestrict the scope of an audit in relation to matters which are prescribed by legislation or by thepronouncement of the institute. The auditor’s work involves exercise of judgment for example,in deciding the extent of audit procedures and in assessing the reasonableness of the judgmentsand estimates made by the management in preparing the financial statements. Further more,much of the evidence available to the auditor can enable him to draw only reasonable conclusiontherefrom. Because of these factors, absolute certainty in auditing is rarely attainable.

Hence, it becomes quite clear that the scope of audit is widening and there is a change inemphasis in audit objectives too.

5.6. ROLE OF EVIDENCE IN AUDITING

Meaning and Importance

The concept of evidence is fundamental to auditing. All auditing techniques and proceduresare derived from it. It helps the auditor in perceiving the types of evidence available in an auditsituation, collecting it through the various audit techniques and evaluating its sufficiency andcompetency to support accounting data. Development of this concept is therefore, basic to theunderstanding of the audit process.Mautz and Sharaf list the following five stepts in the process of Judgment formation in auditing.1. Recognition of the propositions to be proved.

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2. Evaluation of the proposition in terms of materiality or significance.3. Collection of evidence with in given limits of time and costs.4. Evaluation of evidence obtained as valid or not valid.5. Formation of judgment as to the propositions at issue.

Indian Accounting Standards(AS) and their interpretations(ASI)

According to AAS-1, the auditor is required to obtain sufficient appropriate audit evidencethrough the performance of compliance and substantive procedures to enable him to drawreasonable conclusions there from on which his opinion on financial statements be based. AAS-5 has elaborated the nature and procedure of audit evidence.

Types of Audit Evidence

The audit evidence influences the judgment of an auditor. The evidence need not be onlydocumentary. Arons and Luobecke have given types of audit evidence- Physical examination,confirmation, documentation, observation, inquiries of the client, mechanical accounting, andanalytical tests. While Prof.Mautz gives nine types of audit evidence –1) physical examinationby the auditor of the thing represented in the accounts. 2) Written or oral statement byindependent third parties. 3) Authoritative documents- prepared inside or outside the enterprise4) Formal or informal statement by officers and employees of the enterprise. 5) Calculationsperformed by the auditor. 6) Satisfactory internal control procedure. 7) Subsequent actions bythe enterprise and by others. 8) Subsidiary or detailed records with no significant indicationsof irregularities. 9) Interrelationship within the data examined. The types of audit evidence canbe grouped under the following two heads—

(a) Analytical evidence— These evidences consist of journals, subsidiary books, allocationsheets, reconciliation statements, or any other records which supports the data appearingin the books of accounts.

(b) Corroborative Evidence— This evidence consists of invoices, confirmations, cancelledcheques or similar documents.

Obtaining Audit Evidence:

Before obtaining audit evidence the auditor should give consideration to what types of evi-dence available and how to obtain them. What amount of evidence to be collected dependsupon the nature and circumstances & the types of evidence to be collected depends upon thetransaction and relevance of the evidence.

As per AAS-5, auditor obtains evidence in performing compliance and substantive proceduresby any one or more of the following methods-(a) Inspection(b) Observation(c) Inquiry and Confirmation(d) Computation(e) Analytical Review

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5.7. AUDIT TECHNIQUES AND PRACTICES

Effective auditing is the outcome of systematic audit procedures applied to trade and examineaudit evidence with the help of audit techniques.

According to Moyer, audit techniques are the devices or methods available to the auditor forobtaining competent evidential matter. While according to statement on audit standards, auditprocedure is the act to be performed, such as reviewing, inspecting and confirming. Practicerefers to the application of principles and techniques in various situations to get the expectedresults, on the same line auditing practice means the use of auditing principles, as were alreadyestablished and notified by professional pronouncements from time to time, in different audit-ing situations.

Audit Techniques:

As explained above, audit techniques are the tools used to get reliable evidence while conduct-ing an audit. According to Prof. Mautz, basically there are following ten techniques avail-able—

(i) Physical Examination(ii) Confirmation(iii) Comparing Documents With The Records (Vouching)(iv) Computation(v) Re-tracking Book-keeping(vi) Scanning(vii) Inquiry(viii) Examining Subsidiary Records(ix) Co-relation With The Related Information(x) Observation of Pertinent Activities

Professional Pronouncements

Professional pronouncements issued by professional bodies like ICAI, ICWAI, in variouscountries on generally accepted auditing standards regulate the auditing practice. Thesestandards are not related only to financial and cost audit but also to other items like compilationof financial statements. Compilation with the auditing standards is a must in normal situation,and hence an auditor is expected to observe it while expressing his opinion in audit report andso he has to mention in his report whether the audit is carried out in accordance with the GAAS(Generally Accepted Auditing Standards) or not, if not the reasons thereof. As per the provisionsof the Chartered Accountants Act, 1949, auditor is charged for professional misconduct if hefails to mention any material departure from the Generally Accepted Audit Procedure. TheInstitute of Chartered Accountants of India has issued number of pronouncements from time

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to time, which contain (i) Auditing and assurance standards- uptil now 32 standards arepronounced (ii) Accounting standards and accounting standards interpretation- uptil now 29accounting standards are pronounced. (iii) Other statements on accounting and auditing- uptilnow 55 such statements are issued. (iv) Guidance notes (v) Opinions (vi) Research studies/monographs. The Institute of Cost and Works Accountants of India has also issued numberof pronouncements from time to time, which includes- (i) Cost Accounting Record Rules andCost Audit (Report) Rule- uptil now 47 Record Rules and Report Rules have been issued. (ii)Guidance Notes- uptil now about 26 such guidance notes have been issued. (iii) ResearchPublications- uptil now 20 such research publications are issued. (iv) Research Bulletin- Bi-annual. (v) Cost Accounting Standards- uptil now 5 such standards have been pronounced.The International Federation of Accountants pronounced – (i) International Standards onAuditing- uptil now 28 such auditing standards have been issued. (ii) International AccountingStandards- uptil now about 41 such standards have been issued. (iii) International FinancialReporting Standards- uptil now about 8 such standards have been issued.

Auditing and Assurance Standards [Originally The Statement on Standard Auditing Prac-tices

The Auditing and Assurance Standards Board (auditing practices committee, as it was namedearlier in 1982) of the ICA of India, had pronounced following 32 Auditing and AssuranceStandards (AASs)—

AAS 1- Basic principles governing audit.AAS 2- Objective and scope of the audit of financial statements.AAS 3- Documentation.AAS 4- The auditor’s responsibility to consider fraud and error in an audit of financial

statement.AAS 5- Audit Evidence.AAS 6- Risk assessment internal control.AAS 7- Relying upon the work of an internal auditor.AAS 8- Audit planning.AAS 9- Using the work of an expert.AAS 10-Using the work of another auditor.AAS 11- Representation by manager.AAS 12- Responsibility of joint auditorsAAS 13- Audit materialityAAS 14- Analytical procedureAAS 15- Audit samplingAAS 16- Going concernAAS 17- Quality control for audit workAAS 18- Audit of accounting estimatesAAS 19- Subsequent events

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AAS 20- Knowledge of businessAAS 21- Consideration of laws and regulations in an audit of financial statements.AAS 22- Initial engagements- opening balanceAAS 23- Related partiesAAS 24- Audit considerations relating to entities using service organizations.AAS 25- ComparativesAAS 26- Terms of audit engagementAAS 27- Communication of audit matters with those charged with governance.AAS 28- The auditor’s report on financial statement.AAS 29- Auditing in a computer information systems environment.AAS 30- External confirmationsAAS 31- Engagements to compile financial informationAAS 32- Engagement to perform agreed upon procedures regarding financial information

These standards are mandatory and auditor is required to mention in his report, whether hehas followed these standards while conducting audit or not and if not give the reasons thereof.

Accounting Standards and Accounting Standards Interpretation

The ICA of India’s Accounting Standard Board has uptil now issued following 29 accountingstandards. These standards are based on the International Accounting Standards. These stan-dards are mandatory and, according to Sec 227(3) of the Companies Act, the auditor is requiredto state whether accounting standards have been complied with or not; also in case of TaxAudit u/s 44 AB, of I. Tax Act, 1961, these standards are mandatory. The SEBI also requires thelisted companies to comply with these Accounting Standards. If any company does not followthese standards, it should be disclosed in financial statements along with (i) The deviationfrom accounting standards. (ii) The reasons of such deviation and (iii) The financial effect, ifany, arising from such deviation.

These standards are applicable to all types of organizations whether business oriented or notexcept activities like collecting donations and expending on earth quake relief etc. Some enter-prises whose turnover in the immediately preceding financial year exceeds Rs.40 lakhs butdoes not exceed Rs.50 crores or whose borrowings include public deposits exceeds Rs.1 crorebut do not exceed Rs.10 crores and those enterprises whose turnover does not exceed Rs.40lakhs and borrowings do not exceed Rs. 1 crore are exempted from the applicability of account-ing standards nos. 3, 17, 18, 21, 23, 24, 25 and 27.

AS 1- Disclosure of Accounting PoliciesAS 2- Valuation of InventoriesAS 3- Cash Flow StatementsAS 4- Contingencies and events occurring after the balance sheet dateAS 5- Net profit or loss for the period, prior period items and changes in accounting policiesAS 6- Depreciation Accounting

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AS 7- Construction ContractsAS 8- Accounting for research and development (withdrawn)AS 9- Revenue recognitionAS 10- Accounting for fixed assetsAS 11- The effects of changes in foreign exchange ratesAS 12- Accounting for government grantsAS 13- Accounting for investmentsAS 14- Accounting for amalgamationsAS 15- Accounting for retirement benefits in the financial statements of employeesAS 16- Borrowing costsAS 17- Segment reportingAS 18- Related party disclosuresAS 19- LeasesAS 20- Earning per shareAS 21- Consolidated financial statementsAS 22- Accounting for taxes on incomeAS 23- Accounting for investments in associates in consolidated financial statementsAS 24- Discontinuing operationsAS 25- Interim financial reportingAS 26- Intangible assetsAS 27- Financial reporting of interest in joint ventureAS 28- Impairment of assetsAS 29- Provisions, contingent liabilities and contingent assets.

Other Statements on Accounting and Auditing

The ICA of India had issued following seven statements on accounting and auditing. Out ofthese almost all are mandatory. According to these statements auditor is required to verifywhether these statements are complied with or if there is any deviation, he is required to makedisclosure in his report and he should ensure to follow these statements while auditing.

Statement on continuing professional education compels the chartered accountant to undergostipulated hours professional education on on going basis. While the peers view provides amechanism to ascertain, while carrying out attestation engagements, whether the charteredaccountant has complied with the technical standards as prescribed by the ICAI.(i) Statement on auditing practices (many chapters, now transferred to guidance note)(ii) Statement on payment to auditors for other services(iii) Statement on the companies (auditors report) order 2003(iv) Statement on auditor’s qualifications in auditor’s report(v) Statement on the amendments to schedule VI to the Companies Act, 1956(vi) Statement on the continuing professional education(vii) Statement on peer-view

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Cost Accounting Record Rules and Cost Audit Report Rules

The ICWA of India had issued following 47 Cost Accounting Record Rules and Cost AuditReport Rules and these rules are mandatory as were made by the Central Government andcame into force from the date of publication.

(1) Cost Accounting Record Rules and Cost Audit Report Rules (cement) of 1997(2) Cost Accounting Record Rules and Cost Audit Report Rules (cycles) of 1967(3) Cost Accounting Record Rules and Cost Audit Report Rules (tyres and tubes) of 1967(4) Cost Accounting Record Rules and Cost Audit Report Rules (caustic soda) of 1967(5) Cost Accounting Record Rules and Cost Audit Report Rules (air conditioners) of 1967(6) Cost Accounting Record Rules and Cost Audit Report Rules (refrigerators) of 1967(7) Cost Accounting Record Rules and Cost Audit Report Rules (batteries) of 1967(8) Cost Accounting Record Rules and Cost Audit Report Rules (Electric lamps) of 1967(9) Cost Accounting Record Rules and Cost Audit Report Rules (Electric fans) of 1969(10) Cost Accounting Record Rules and Cost Audit Report Rules (motor vehicles) of 1997(11) Cost Accounting Record Rules and Cost Audit Report Rules (electric motors) of 1969(12) Cost Accounting Record Rules and Cost Audit Report Rules (aluminium) of 1972(13) Cost Accounting Record Rules and Cost Audit Report Rules (vanaspati) of 1972(14) Cost Accounting Record Rules and Cost Audit Report Rules (bulk drugs) of 1974(15) Cost Accounting Record Rules and Cost Audit Report Rules (sugar) of 1974(16) Cost Accounting Record Rules and Cost Audit Report Rules (milk food) of 2001(17) Cost Accounting Record Rules and Cost Audit Report Rules (jute goods) of 1975(18) Cost Accounting Record Rules and Cost Audit Report Rules (industrial alcohol) of 1975(19) Cost Accounting Record Rules and Cost Audit Report Rules (paper) of 1975(20) Cost Accounting Record Rules and Cost Audit Report Rules (rayon) of 1976(21) Cost Accounting Record Rules and Cost Audit Report Rules (dyes) of 1976(22) Cost Accounting Record Rules and Cost Audit Report Rules (soda ash) of 1976(23) Cost Accounting Record Rules and Cost Audit Report Rules (polyester) of 1977(24) Cost Accounting Record Rules and Cost Audit Report Rules (nylon) of 1977(25) Cost Accounting Record Rules and Cost Audit Report Rules (textiles) of 1977(26) Cost Accounting Record Rules and Cost Audit Report Rules (Dry battery cell) of 1979(27) Cost Accounting Record Rules and Cost Audit Report Rules (sulphuric acid) of 1980(28) Cost Accounting Record Rules and Cost Audit Report Rules (steel tubes and pipes) of

1984(29) Cost Accounting Record Rules and Cost Audit Report Rules (engineering industries) of

1984(30) Cost Accounting Record Rules and Cost Audit Report Rules (electric cables and conduc-

tors) of 1984

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(31) Cost Accounting Record Rules and Cost Audit Report Rules (bearings) of 1985(32) Cost Accounting Record Rules and Cost Audit Report Rules (chemical industries) of 1987(33) Cost Accounting Record Rules and Cost Audit Report Rules (formulations) of 1985(34) Cost Accounting Record Rules and Cost Audit Report Rules (steel plant) of 1990(35) Cost Accounting Record Rules and Cost Audit Report Rules (insecticides) of 1993(36) Cost Accounting Record Rules and Cost Audit Report Rules (fertilizers) of 1993(37) Cost Accounting Record Rules and Cost Audit Report Rules (scraps and detergents) of

1993(38) Cost Accounting Record Rules and Cost Audit Report Rules (cosmetics and toiletries) of

1993(39) Cost Accounting Record Rules and Cost Audit Report Rules (footwear) of 1996(40) Cost Accounting Record Rules and Cost Audit Report Rules (shaving systems) of 1996(41) Cost Accounting Record Rules and Cost Audit Report Rules (industrial gases) of 1996(42) Cost Accounting Record Rules and Cost Audit Report Rules (mining and metallurgy) of

2001(43) Cost Accounting Record Rules and Cost Audit Report Rules (electronic products) of 2001(44) Cost Accounting Record Rules and Cost Audit Report Rules (electricity) of 2001(45) Cost Accounting Record Rules and Cost Audit Report Rules (plantation products) of

2002(46) Cost Accounting Record Rules and Cost Audit Report Rules (petroleum industries) of

2002(47) Cost Accounting Record Rules and Cost Audit Report Rules (telecommunications) of

2002

These cost accounting record rules are not applicable to a company though it falls under any ofthe above (i) if the aggregate value of the machinery and plant installed where in, as on the lastdate of the preceding financial year, does not exceed the limits as specified for a small scaleindustrial undertaking under the provisions of the Industries (Development and RegulationAct), 1951 and (ii) the aggregate value of the turnover made by the company from sale orsupply of all of its products during the preceding year does not exceed ten crore rupees. Theauditor has to make mention in his report about whether the enterprise has maintained propercost accounting records as prescribed u/s 209(1)(d).

Cost Accounting Standards (CAS)

The ICWA of India had pronounced following five cost accounting standards, though thesestandards are not mandatory but the cost accountants are required to make a standard ap-proach towards maintenance of cost accounting record and undertaking cost audit u/s 209(1)dand sec.233(B) of the Companies Act, 1956. These standards equip the cost accountants withbetter guidelines on standard cost audit practice.

CAS 1- Classification of costs

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CAS 2- Capacity determination

CAS 3- Overheads

CAS 4- Cost of production for captive consumption

CAS 5- Determination of average (equalized) transportation cost.

International Accounting Standards (IAS)

The International Federation of Accountants had issued the following 41 accounting standards,though these standards are not mandatory, these provide a basis for development of accountingstandards in individual country. The Indian Accounting Standards issued by ICAI are largelybased on these international accounting standards—

IAS 1- Presentation of financial statements

IAS 2- Inventories

IAS 3- Consolidated financial statements (superceded by IAS 27 & IAS 28 in 1989)

IAS 4- Depreciation accounting (replaced by IAS 16, 22 & 38 in 1998)

IAS 5- Information to be disclosed in financial statements (superceded by IAS 1 in 1997)

IAS 6- Accounting responses to changing prices (superceded by IAS 15, which was withdrawnin 2003)

IAS 7- Cash flow statements

IAS 8- Accounting policies, changes in accounting estimates and errors

IAS 9- Accounting for research and development activities (superceded by IAS 38 in 1999)

IAS 10- Events after the balance sheet date

IAS 11- Construction contracts

IAS 12- Income taxes

IAS 13- Presentation of current assets and current liabilities (superceded by IAS 1)

IAS 14- Segment reporting

IAS 15- Information reflecting the effects of changing prices (withdrawn in 2003)

IAS 16- Property, plant and equipments

IAS 17- Lease

IAS 18- Revenue

IAS 19- Employee Benefits

IAS 20- Accounting for government grants and disclosure of government assistance

IAS 21- The effects of changes in foreign exchange rates

IAS 22- Business combinations (superceded by IFRS3 in 2004)

IAS 23- Borrowing cost

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IAS 24- Related party disclosure

IAS 25- Accounting for investments (superceded by IAS 39 & 40 in 2001)

IAS 26- Accounting and reporting of retirement benefit plans

IAS 27- Consolidated and separated financial statements

IAS 28- Investments in associates

IAS 29- Financial reporting in hyper inflationary economics

IAS 30- Disclosures in the financial statements of banks and similar financial institutions(superceded by IFRS7 in 2007)

IAS 31- Interest in joint ventures

IAS 32- Financial instruments presentation disclosure provision (superceded by IFRS7 in 2007)

IAS 33- Earning per share

IAS 34- Interim financial reporting

IAS 35- Discontinuing operations (superceded by IFRS5 in 2005)

IAS 36- Impairment of assets

IAS 37- Provisions, contingent liabilities and contingent assets

IAS 38- Intangible assets

IAS 39- Financial instruments

IAS 40- Investment property

IAS 41- Agriculture

International Financial Reporting Standards (IFRS)

The international federation of accountants had issued following international financialreporting standards. Actually these standards are pronounced by the International AccountingStandard Board (IASB) constituted in place of old International Accounting StandardsCommittee (IASC) in 2001, this pronunciation has amended certain IAS by IFRS. These IFRSapply to the general purpose of financial statements and other financial reporting by profitoriented entities. These IFRS apply to individual company and consolidated financial statements.The ICA of India has decided to fully converge with IFRS from the accounting periodcommencing on or after 1st April 2011—

IFRS 1- First time adoption of International Financial Reporting Standard

IFRS 2- Share based payments

IFRS 3- Business combinations

IFRS 4- Insurance contracts

IFRS 5- Non current assets held for sale and discontinued operations

IFRS 6- Exploration for and evaluation of mineral assets

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IFRS 7- Financial instruments disclosures

IFRS 8- Operating segments

Guidance Note

The ICA of India issued a number of guidance notes on matters raised by its members relatingto auditing. These notes are recommendatory in nature, cost accountant should ordinarily followrecommendations to an auditing matter but this guidance notes will be superceded by theaccounting standard coming in force (after guidance note).

The ICWA of India issued no. of guidance notes as for the benefit of cost accounts, whichincludes (i) guidance note on valuation audit under central excise law (ii) guidelines oncentral excise – MODVAT audit (iii) guidelines on cost audit (iv) guidelines oninventory valuation (v) total cost management in the manufacturing process (vi) guidelines ontransfer pricing (vii) guidelines on CenVAT audit under central excise. (viii) Environmentalaudit.

5.8. GENERALLY ACCEPTED AUDITING STANDARDS PRINCIPLES (GAAS/GAAP)

GAAS/GAAP means the norms of auditing as per the provisions of law, accounting standards,auditing and assurance standard, pronunciations, guidance notes, research monograms etc. tobe followed by the auditor while conducting an audit and reporting the findings. The expressionwas first coined by the American Institute of Certified Public Accountants (AICPA) in 1963.The generally accepted auditing standards for comprehensive audit performance approved byAICPA are really like a light house.

According to AICPA the auditor along with his training, knowledge and experience must beaware of and understand new authoritative pronouncements on accounting and auditing: He/she should be intellectually honest, free from any obligation to be recognized as independent.He should observe the standards in field work and reporting.(I) General Standards-

(i) Independence- The auditor, in all matters relating to the assignments, should followan independent attitude.

(ii) Due Care- In exercising the work of audit, the auditor should exercise due care.(II) Field Work Standards-

(iii) Planning and Supervision- Before the beginning of an audit, the audit work shouldbe properly planned and the work assigned to assistants be carefully supervised.

(iv) Internal Control- The internal controls existing in the enterprise be studied andevaluated before hand.

(v) Evidential Matter- While auditing, auditor should collect the evidential documentsto afford a reasonable basis for forming an opinion on the financial statements.

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(III) Reporting Standards-

(vi) Financial Statements- Auditor should make a mention whether the financialstatements are prepared according to the Generally Accepted Auditing Standards/Principles or not.

(vii) Consistency- He should make a mention whether these Principles/Standards areconsistently followed including current year.

(viii)Disclosure- If auditor does not make any adverse comment in his report; the financialstatements are taken as reasonably adequate.

(ix) Obligation- Auditor should submit his report, when the work is finished, statingclearly his opinion or if not possible make a mention there in that “opinion cannotbe expressed” and in such a case support it with reasons.

These formal standards/principles are framed in the context of statutory auditing but the AICPAsuggest that while following these GAAP/GAAS, due consideration be given to “materiality”and “audit risk”.

The International Federation of Accountants had issued following nine broad GAAP i.e. Ba-sic Principles governing an audit :

1. Integrity, Objective and Independence2. Confidentiality3. Skills and Competence4. Work Performed by Others5. Documentation6. Planning7. Audit Evidence8. Accounting System and Internal Control9. Audit Conclusions and Reporting

US -GAAP:

The features of US-GAAP and Indian Accounting Standards are clear from ther differences.They are as follows. :-

INDIA’S GAAP VERSUS THE US GAAP

India USA

1. Financial Statement 1. Financial StatementsPrepared in accordance with the Not required to be prepared underpresentation requirements of any specific format as long a theySchedule VI to the Companies Act, comply with the disclosure1956 (Scdedule VI). requirements of US Accounting

Standards.

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2. Fixed Assets & Depreciation 2. Fixed Assets & DepreciationRevaluation of assets permitted. Revaluation of assets not permitted exceptDepreciation is based (usually) on in cases of quasi-re-organisations.rates set out in Schedule XIV to the Depreciation is over the useful economicCompanies Act, 1956. lives of assets. Depreciation and profit/loss

on sale is based on historic cost.

3. Investment in own shares 3. Investment in own sharesExpressly prohibited except in cases Permitted, and is shown as a reductionof buy back of own securities. form shareholder’s equity.

4. R & D 4. R & DCosts can be capitalized subject to Costs are expenses as incurred except forthe conditions of the criteria of plant and equipment which are capitaliza-technical feasibility of the production tion and depreciation if they haveresource availability and existence altemative future uses or expenses asof market, etc. (AS-8, Research & incurred if they have no altemativeDevelopment, issued by the Institute future uses.of Chartered Accountants of India)

5. Goodwill 5. GoodwillPurchased goodwill is capitalized and Treated as any other intangible asset,amortised over the expected period of and is caspitalized and amortised. Thebenefit or charged against available maximum carry forward period is 40 years.capital reserves.No standard except for brief references isAS-10, Fixed Assets and AS-14, Accoun-ting for Amalgamations Goodwill arisingfrom amalgamations can be written offover 5 years.6. Pre-operative Expenses 6. Pre-operative ExpensesAll direct and indirect expenses Concept does not exist. They are expensesincurred prior to commencement of unless they are capital is nature.business are treated as pre-operativeexpenses and capitalized to the costof fixed cost of assets. There are alsoallowed to be deferred and written offover a period of 3-5 years or 10 years.

7. Assets and Liabilities 7. Assets and LiabilitiesNo mandatory disclosure of current Mandatory disclosures about current andand long term components. long term components separately. Current

component normally refers to one year ofthe operatin cycle.

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8. Foreign Currency Transactions 8. Foreign Currency TransactionsExchange fluctuations on liabilities Exchange gain/loss is taken to the incomeIncurre for fixed assets can be statement. The concept of capitalization ofcapitalized. exchange fluctuations arising from foreign

currency liabilities incurred for acquiringfixed assets does not exist.

9. Foreign Currency Transactions 9. Foreign Currency TransactionsGains and losses resulting from the Gains and losses resulting from thetranslation of financial statements translation of Financial Statementsinto a reporting currency should be into a reporting currency are reportedrecognized as income or expense for of a separate component of Shareholders’the period. equity in the balance sheet.

10. Related Party Transactions 10. Related Party TransactionsNo specific disclosures required. Disclosures are stringent and requireAuditors have a duty to report certain descriptions of nature of relations andtransactions entered into by related control, transactions, amounts involved,parties as defined under the companies and amounts due.Act, 1956 : AS-18 is issuedw.e.f. 01.04.2001

5.9. CONCEPT OF MATERIALITY IN AUDITING

The concept of materiality is fundamental to the process of aggregation, classification and pre-sentation of accounting information. It is an important and relevant consideration for an audi-tor who has to constantly judge whether a particular item of transaction is material or not.Obviously an auditor requires more reliable evidence in support of material items. He also hasto ensure that such items are properly and distinctly disclosed in the financial statements.According to AS 1, materiality means, the knowledge of the items disclosed in the financialstatement, which might influence, the decision of the user of the financial statement.

According to AAS 13, “information is material if its misstatement (i.e. omission or erroneousstatement) could influence the economic decision of user taken on the basic of the financialinformation. Materiality depends on the size and nature of the item, judged in the particularcircumstances of its misstatement.

The following are some of the specific requirements in the form of Balance Sheet based materi-ality cousideration implicit in the very process of prescribing the format in Part I of scheduleVI.

1. Loans from directors to be shown separately.2. Nature of interest if any, of any director with the bankers or other officers of the com-

pany at any time during the year should be disclosed by way of a note.

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3. The maximum due by directors or other officers of the company at any time during theyear should be disclosed by way of a note.

Further whenever there is any change in the basis of accounting, the effect thereof must bedisclosed.

AAS 13 on ‘Audit Materiality’ requires that hthe auditor should consider materiality and itsrelationship with audit risk when conducting an Audit.

Circumstances of Materiality

According to the ICFAI the circumstances of materiality are as under—

(i) Mistake discovered like valuation of stock, calculation of depreciation, calculation of in-terest, estimation of liability etc.

(ii) Non-disclosure of abnormal and unusual items or non-recurring income or expenditureetc.

(iii) Non-disclosure of items violating the statutory provisions etc.

Materiality and Audit Risk

A risk occurring due to insufficient or incompetent evidence collected by the auditor to expresshis opinion on the financial statement is called as an “audit risk”. In case of debtors appearingon balance sheets, auditor has to express whether the figure is materially correct or not and forthat he should collect the reliable confirmations from almost all debtors.

According to International Federation of Accountants, audit risk includes:

(i) Internal Risk- Risk that material error will remain(ii) Control risk- Risk that client’s internal control system cannot prevent or make up for

such error.(iii) Detection risk- Risk that material errors though they are there, will not be detected.

According to AAS 6, “audit risk” means, the risk that the auditor gives an inappropriate auditopinion when the financial statements are materially misstated. This audit risk had threecomponents as stated above by IFA.

According to AAS 13, there is an inverse relationship between materiality and the degree ofaudit risk i.e. the higher the materiality level, the lower the audit risk and lower the materialitylevel, the higher the audit risk e.g. the risk that a particular account balance or class of transactionscould be misstated by an extremely large amount might be very less, but the risk that could bemisstated by an extremely small amount might be very high. The auditor takes the inverserelationship between materiality and audit risk into account when determining the nature,timing and extent of audit procedure e.g. if after planning for specific audit procedures, theauditor determines that the acceptable materiality level is lower, audit risk is increased. Theauditor compensates for this by-

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(i) Reducing the assessed degree of control risk, where this is possible and supporting thereduced degree by carrying out extended or additional test of control. OR (ii) Reducing detectionrisk by modifying the nature, timings and extent of planned substantive procedures.

If the aggregate of the uncorrected misstatements, that the auditor has identified, approachesthe materiality level or if auditor determines that the aggregate of uncorrected statements causethe financial information to be materially misstated, he could consider requesting themanagement to adjust the financial information or extending his audit procedures. In any event,the management may want to adjust the financial information for known misstatements. Theadjustment of financial information may involve application of appropriate accountingprinciples, other adjustments in amounts or the addition of appropriate disclosures ofinadequately disclosed matters. If the management refuses to adjust the financial informationand the results of extended audit procedures do not enable the auditor to conclude that theaggregate of uncorrected misstatements is not material, the auditor should express a qualifiedor adverse opinion, an appropriate.

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ACID TEST

Q1. State with reasons, whether following statements are true or false:

(i) The concept of evidence is fundamental to all auditing situations as an auditor basi-cally seeks to obtain sufficient appropriate evidence to form his opinion.

(ii) In all auditing situations, the only evidence available to the auditor is books of ac-counts and vouchers.

(iii) Not only statutory provisions but also technology and economic changes have in-fluenced auditing to a great extent.

(iv) The decisions given by Hon. Courts in different cases do not affect the GenerallyAccepted Accounting and Auditing Practices and Standards.

(v) Auditing is generally associated with only accounting and financial records.(vi) The scope of audit depends upon the nature of appointment.(vii) The statutory audit provides the best means of enhancing the credibility of the ac-

counts.(viii) Auditor cannot gather sufficient appropriate audit evidence without performance

of compliance and substantive tests.(ix) Inspection and observation are not only the ways to obtain audit evidence.(x) US-GAAP are not different than that of INDIA-GAAP.(xi) Percentage test and past trends are the only criteria to establish the materiality of an

item in financial statements.(xii) The risk that the auditor gives an inappropriate audit opinion when the financial

statements are materially misstated is called as an “audit risk”.

Q2. What is Auditing? Explain the evolution on auditing.

Q3. Define “audit”. What are the factors which drastically changed the present day auditingpractice and auditor’s responsibilities?

Q4. Write short notes on:

(a) Nature of auditing(b) Change in scope of auditing(c) Auditing and Assurance Standard no. 1(d) Compliance Procedure(e) Substantive Procedure

Q5. What is audit evidence? Explain the different types of audit evidence and different meth-ods of obtaining them.

Q6. “Audit Technique is the device available to the auditor for obtaining competent eviden-tial matter”. Explain.

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Q7. Write short notes on:(a) Audit procedure(b) Audit practices(c) IFRS(d) GAAS(e) Concept of materiality in auditing(f) Materiality and Audit Risk

Q8. “Audit practices demands the thorough knowledge of different legal provisions and dif-ferent pronouncements”- Discuss.

Q9. Explain the important contents of US-GAAP.

Q10. Explain the important contents of INDIA-GAAP.