Basics Of Auditing - Sample/practice exam, questions and answers PDF

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INTRODUCTION -AN OVERVIEW OF AUDITING: Definition: 

Spicer and Pegler:

"Auditing is such an examination of books of accounts and vouchers of business, as will enable the auditors to satisfy himself that the balance sheet is properly drawn up, so as to give a true and fair view of the state of affairs of the business and that the profit and loss account gives true and fair view of the profit/loss for the financial period, according to the best of information and explanation given to him and as shown by the books; and if not, in what respect he is not satisfied." 

Prof. L.R.Dicksee:

"Auditing is an examination of accounting records undertaken with a view to establish whether they correctly and completely reflect the transactions to which they relate. FEATURES OF AUDITING: a) Audit is a systematic and scientific examination of the books of accounts of a business; b) Audit is undertaken by an independent person or body of persons who are duly qualified for the job. c) Audit is a verification of the results shown by the profit and loss account and the state of affairs as shown by the balance sheet. d) Audit is a critical review of the system of accounting and internal control. e) Audit is done with the help of vouchers, documents, information and explanations received from the authorities. f) The auditor has to satisfy himself with the authenticity of the financial statements and report that they exhibit a true and fair view of the state of affairs of the concern. g) The auditor has to inspect, compare, check, review, scrutinize the vouchers supporting the transactions and examine correspondence, minute books of share-holders & directors, Memorandum of Association and Articles of association etc., in order to establish correctness of the books of accounts. TECHNIQUES OF AUDITING Following are the common techniques of auditing −        

Checking of posting and casting. Physical verification of assets. Verification and examination of transactions with available evidences. Scrutiny of the books of accounts, Checking of various calculations. Checking of carried forward balances in next year. Checking of Bank reconciliation statements. Auditor can get information from inside and outside sources of organization.

QUALITIES OF AN AUDITOR An Auditor must have the following qualifications and qualities –   

      

He should be a qualified Chartered Accountant or he should be a qualified member of The Institute of Cost & Works Accountants of India to do cost audit. He must have adequate skills and qualities to conduct his work efficiently. An Auditor must be honest, impartial and unbiased. He should also be hard-working, have adequate common sense, capacity to hear arguments of others, systematic and methodical. An Auditor should ask for clarification on matter on which he is unable to understand the information provided to him. His audit report should be correct and clear. In case where any suspicious situation arises, he should assume that he is dealing with dishonest and fraudulent peoples. He must have thorough knowledge of accounting principles and practices. He must have the know-how of all the domestic and international court case decisions. He must have thorough knowledge of financial management, industrial management and business organizations. He must have up-to-date knowledge of the Mercantile law and the Companies Act.

BASIC PRINCIPLES FOR CONDUCTING AN AUDIT

1. Principle of Integrity, Independence and Objectivity: The auditor has to be honest while auditing, he cannot be favoring the organization. He must remain objective throughout the whole process; his integrity must not allow any malpractice. Another important principle is independence. So, the auditor cannot have any interest in the organization he is auditing, which allows him to be independent and impartial at all times. 2. Principle of Confidentiality (Security of Information): The auditor has access to a lot of sensitive financial information of the organization. It is important that he respect the confidential nature of such information and documents. He cannot disclose any sensitive information to any third party unless it is a requirement by law. 3. Principle of Skill & Competence: The auditor must be experienced and trained in the procedures of auditing, i.e. must be qualified as an auditor. And as a professional, he must be up to date on recent changes, announcements, rules etc. 4. Responsibility of Work Performed by Others for you: The scope of audit at times can be very vast. So, an auditor has employees, delegates and other people who work under him. However, the auditor will continue to be fully responsible for the work done by these people working for him. 5. Principle of Documentation: In most cases the auditor maintains an audit notebook, an audit plan and auditing file. It is important the auditor keeps a record of important documents with respect to his audit work, as it is evidence of the work the auditor has done.

6. Principle of Planning: An audit plan allows the auditor to plan out his work and

enables him to be more efficient and timelier. Every audit plan is different as it has to be customized according to the type of organization, the kind of business they conduct, the scope of the audit, the efficiency of the internal controls etc. 7. Principle of Audit Evidence: The auditor must collect enough evidence to

support his final opinion. This collection of such evidence is done by compliance and substantive procedures. There are two sources of this evidence – internal and external. Also, external sources of evidence are always more reliable. 8. Accounting Systems and Internal Controls: The auditor has to assure that the

accounts of the organization are accurate and represent a true and fair picture of the financial status of the company. Also, the auditor must ensure that all material information has been recorded in the accounts. Testing the internal controls system is also important as it helps determine the same. 9. Audit Conclusions and Reporting: After the auditor collects all evidence he must

now form his opinion on the basis of the following criteria,  All relevant accounting standards were applied at all times.  Financial statements are in compliance with all regulations and statutory requirements.  All material information has been disclosed. Ref: https://www.toppr.com/guides/accounting-and-auditing/concept-ofauditing/basic-principles-governing-an-audit/ OBJECTIVES OF AUDITING: There are two main objectives of auditing. The primary objective and the secondary or incidental objective. a. Primary objective – as per Section 227 of the Companies Act 1956, the primary duty (objective) of the auditor is to report to the owners whether the balance sheet gives a true and fair view of the Company’s state of affairs and the profit and loss A/c gives a correct figure of profit of loss for the financial year. b. Secondary objective – it is also called the incidental objective as it is incidental to the satisfaction of the main objective. The incidental objectives of auditing are:  

Detection and prevention of Frauds, and Detection and prevention of Errors.

FRAUD The term fraud means the willful misrepresentation made with an intention of deceiving others. It is a deliberate mistake committed in the accounts with a view to get personal gain. The following are the three distinct types of fraud − a) Misappropriation of Cash b) Misappropriation of Goods c) Manipulation of Accounts

Misappropriation of Cash Misappropriation of cash is the easiest way of fraud especially in large business houses where there is limited or no communication between the owner of an organization and the cashier. Following are some of the ways through which embezzlement or misappropriation can be done −   

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Theft of cash receipts and petty cash and showing fictitious payment to workers, creditors, purchases, etc. Showing false payments or excess payments in cash book. By using the Teeming and Lading method, the money received from any customer can be pocketed and the money received from another customer can be shown as money received from the former. Cash sale can be shown as credit sale.

Strict internal control system should be followed in receipts and payments of cash so that the work done by one person should be automatically checked by another person. Misappropriation of Goods Misappropriation of goods can be done in the following ways −  

Goods may be stolen by employees or with the help of employees. By issuing false credit notes to customer on account of goods return.

Detection of misappropriation of goods is more difficult rather than detecting misappropriation of money, especially where management is not much vigilant and sound system of book-keeping, internal control and adequate system of securities are not available. To keep control on the physical verification of goods, reconciliation of physical stock with books and careful checking of sale and purchase is must. Manipulation of Accounts Two types of manipulation of accounts are mainly done by top management to mislead some parties for some specific purpose. Showing higher profits − Following are the reasons behind showing higher profit than actual −

a) To obtain credit or to enhance existing credit from financial institutions and also to show credit worthies to suppliers of the company. b) To maintain confidence of shareholders. c) To hike the market price of shares of the company and enable the sale of those at higher price, it may be done by declaring higher dividends on shares. d) To get more commission where commission is calculated on the basis of profit earned. e) To declare dividend at higher rate. Showing low profits − Following are the reasons behind showing lower profit than actual − a) To avoid or to reduce Direct Taxes of the company (Income Tax, Wealth Tax). b) To purchase shares at lower price. c) To give wrong impression to the other competitors of the business. Manner of Manipulation of Accounts Manipulation of accounts may be done in the following ways −

Window dressing is a manipulation or miss-representation of financial data in such a way that it seems better than what it actually is. Some of the method of window dressing is given as hereunder.     

Over valuation of closing stock Under valuation of Liabilities or Over-valuation of assets Purchases and expenses of current year may be deferred to next financial year Charging revenue expenses as capital expenditure Sale and other incomes of preceding year may be shown as income or sale of the current year.

Secret reserves of previous years may be used in the current financial year to inflate the profit or secret reserves may be created to suppress the profit of the current financial year. Stock may be under or overvalued. Income and sales may be suppressed or inflated. Expenses and purchases may be suppressed or inflated. ERRORS An accounting error is an error in an accounting entry that was not intentional. When spotted, the error or mistake is often immediately fixed. If there is no immediate resolution, an investigation into the error is conducted. Errors may be broadly classified as follows − a) b) c) d)

Error of Principle Errors of Omission Errors of Duplication Errors of Commission

e) Compensating Errors Error of Principle Where the recording of the items of transactions are not done according to the Principle of Accounting, it is known to be an error of principle. These errors are not traceable from trail balance; these errors may be committed unintentionally or for the purpose of manipulation of accounts to inflate or deflate profit. Errors of Omission There may be two types of omission of entry while recording the transactions in the books of accounts; Where transaction is totally omitted from the books of accounts, it will not affect the trial balance and the detection of such error is difficult. Following are the examples of such errors;  

Omission of purchase or sale from the purchase day book or the sale day book respectively. Omission of outstanding or unpaid expenses.

The transactions which are partially omitted from the books of accounts are −  

Where total of purchase day book or sale day book omitted to be posted in purchase or sale account respectively. Where payment or receipt transaction omitted to be recorded in ledger account from cash book.

Errors of Duplication The detection of error of duplication is very difficult. It might be detected with proper and minute observation of accounts; for example, purchase may be recorded twice with original and duplicate copy of purchase invoice, etc. It is also possible to post the total of any ledger account twice in the trial balance. Errors of Commission Error of commission occurs the entry made in the books of the original entry or the ledger account is wrong. Let us see the following examples −    

Purchase of goods for Rs. 25,000 wrongly entered as Rs. 2,500 in purchase book. Credit purchase from AB Company wrongly credited to BA Company’s account. Wrong totaling − total of purchase day book is totaled as Rs. 1,12,500 instead of 1,21,500. Purchase from AB Company wrongly debited to AB company account instead of crediting AB company account and debiting purchase account.

Compensating Errors When the effect of an error compensates with another error; it is known to be a compensating error. Such errors do not affect the trial balance; for example, total of a debit

account as well as credit account totaled short by Rs. 7,500. This type of error will compensate both. Prevention of Errors and Fraud After the completion of audit, the Auditor can suggest his client to make changes in the accounting systems and also to improve his internal control system as an Auditor cannot do anything directly to prevent errors and frauds. Auditors are expected to conduct audit as per professional standards expected from him. He cannot guarantee that no fraud exists. An Auditor should ensure and follow these standards −     

Internal control system While recording the business transaction whether accounting principle are being followed or not Policies of management are being followed or not Whether provisions laid in the Companies Act are being followed while preparing books of accounts Whether Balance-sheet and Profit & Loss account show true and fair view of state of affairs of concern

TYPES OF AUDIT:

1. Internal audit: Internal audits take place within your business. As the business owner, you initiate the audit while someone else in your business conducts it. Businesses that have shareholders or board members may use internal audits as a way to update them on their business’s finances. And, internal audits are a good way to check in on financial goals. Although there are many reasons you may conduct an internal audit, some common reasons include to:      

Propose improvements Monitor effectiveness Make sure your business is compliant with laws and regulations Review and verify financial information Evaluate risk management policies and procedure Examine operation processes

Payroll audit: A payroll audit examines your business’s payroll processes to ensure they are accurate. When conducting payroll audits, look at different payroll factors, such as pay rates, wages, tax withholdings, and employee information. Payroll audits are typically internal. Conducting internal payroll audits helps prevent possible external audits in the future. Businesses should conduct internal payroll audits annually to check for errors in their payroll processes and remain compliant.

2. External audit: An external audit is conducted by a third party, such as an accountant, the IRS, or a tax agency. The external auditor has no connection to your business (e.g., not an employee). And, external auditors must follow generally accepted auditing standards (GAAS). Like internal audits, the main objective of an external audit is to determine the accuracy of accounting records. Investors and lenders typically require external audits to ensure the business’s financial information and data is accurate and fair. a. IRS tax audit: IRS tax audits are used to assess the accuracy of your company’s filed tax returns. Auditors look for discrepancies in your business’s tax liabilities to make sure your company did not overpay or underpay taxes. And, tax auditors review possible errors on your small business tax return. Auditors usually conduct IRS audits randomly. IRS audits can be conducted via mail or through in-person interviews. b. Financial audit: A financial audit is one of the most common types of audit. Most types of financial audits are external. During a financial audit, the auditor analyzes the fairness and accuracy of a business’s financial statements. Auditors review transactions, procedures, and balances to conduct a financial audit. After the audit, the third party usually releases an audit opinion about your business to lenders, creditors, and investors. c. Operational audit: Operational audits are similar to internal audits. An operational audit analyzes your company’s goals, planning processes, procedures, and operation results. Generally, operational audits are conducted internally. However, an operational audit can be external. The goal of an operational audit is to fully evaluate your business’s operations and determine ways to improve them. d. Compliance audit: A compliance audit examines your business’s policies and procedures to see if they comply with internal or external standards. Compliance audits can help determine whether or not your business is compliant with paying workers’ compensation or shareholder distributions. And, they can help determine if your business is compliant with IRS regulations. e. Information system audit: Information systems audits mostly impact software and IT companies. Business owners use information system audits to detect issues relating to software development, data processing, and computer systems. This type of audit ensures the system provides accurate information to users and makes sure unauthorized parties do not have access to private data. Also, IT and non-software businesses should regularly conduct mini cybersecurity audits to ensure their systems are secure from fraud and hackers.

f. Pay audit: Pay audits allow you to identify pay discrepancies among your employees. A pay audit can help you spot unequal pay at your company. During a pay audit, analyze things like disparities due to race, religion, age, and gender. Pay audits can also help you ensure workers are paid fairly based on your business’s industry and location. SOME TERMS RELATED TO AUDITING: Internal Control System: It is the primary responsibility of a company to keep adequate internal control system in his organization. On the basis of such internal control system, an Auditor can determine the nature, timing and audit procedure to be applied to conduct his audit. Audit Evidence: An Auditor should adhere to substantive and compliance procedure for collecting audit evidences before conducting an audit. Through substantive procedures, an Auditor may collect evidences regarding accuracy, completeness and validity of data; and through compliance procedure, he may collect evidences regarding internal control system as used in the client’s organization. Audit reports: When your business is audited, external auditors usually give you an audit report. Audit reports include details of the audit process and what was found. And, the report includes whether your financial records are accurate, missing information, or inaccurate. Criteria: The audit criteria are the policies, procedures, or requirements used as a reference against which audit evidence is compared. Findings: Audit findings are the results of the evaluation of the collected audit evidence against audit criteria. Conclusi...