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Nitin Gupta
Chapter-1
Auditing- Nature and Basic Concepts
Auditing – Meaning
The word “Auditing” has been derived from Latin word “audire” which means “to
hear”.
Audit is an independent examination of financial information of any entity whether
profit making or not irrespective of its size & legal structure, when such an audit is
conducted with a view to express an opinion thereon.
The audit is not confined to financial audit alone. It may be extended to other areas
also such as management audit, operational audit, internal audit and environmental
audit etc.
The audit is conducted for a stated purpose, for example, the financial audit may be
conducted to ascertain whether they present a true and fair view of the financial
position and the operating result of the enterprise.
Every audit has to be based on some evidence.
The audit findings have to be communicated to those who have appointed the auditor.
For example, in case of a company the audit report is made to the shareholders.
Auditing – Features
5- Entity
His client can be any entity whatever is the legal form i.e., it proprietorship, partnership
trust or company etc.
The entity may be profit oriented or a charitable one (For Example- Trust, Section 25
Companies)
6- Opinion
His opinion is on 'true &fair view' of financial statements.
For this, it is necessary that
(i) Financial statement have been prepared using acceptable policies which are
consistently applied
(ii) Financial statements have" been prepared as per regulations, &
(iii) There is appropriate disclosure of all material items.
Concept of True & Fair [May 2005 8 Marks, Nov 2012 6 Marks]
What Constitutes "true and fair", however, has not been defined in any legislation.
The concept of true and fair is a fundamental concept in auditing.
The phrase “true and fair" in the auditor's report signifies his opinion as to whether the
state of affairs and the results are truly and fairly represented in the accounts under
audit.
Section 211(5) of the Companies Act provides that the accounts of a company shall be
deemed as not disclosing a true and fair view, if they do not disclose any matters are
required to be disclosed by virtue of provisions of Schedule VI of that Act, virtue of a
notification or an order of the Central Government modifying the disclosure
requirements.
It is a matter of an auditor’s judgment in the particular circumstances of a case. An
auditor has to see:
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Independent Audit
[RTP, Nov 89, May 92, May 93, Nov 91, May 97, May 01, May 07, May 05, May 08, Nov
09,May 10, May 2012 5-8 Marks]
The principal aspects to be covered in an audit concerning the final statements of accounts
are as follows
The auditor should review the system from time to time to ascertain its adequacy and
comprehensiveness.
4) Reporting
Once the audit is carried out, the audit findings need to be communicated to the
appropriate person/body.
An audit report states that the opinion of the auditor as to the true and fair view of the
financial position and operating results of the enterprise.
Objective of Audit
The objective of an audit may be classified into two categories
(a) Primary Objective and
(b) Secondary Objective.
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Compensating errors- when there are two or more errors, but they compensate the
effect of each other. These problems do not affect the trial balance.
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As per nature
Self revealing errors: The existence of these errors becomes apparent during
compilation of accounts. A few illustrations of such errors are given hereunder,
showing how they become apparent
Omission to post a part of a Trial Balance is thrown out of agreement
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journal entry to the ledger
A failure to record in the cash Bank reconciliation statement will show up
2 book paid into or withdrawn error
from the bank
A mistake in recording amount Statement of account parties will reveal the
3 received from X in the account of mistake
Y
Non Self revealing error: The existence of these errors is not revealed automatically
by routine accounting procedures. These can be revealed by detailed analysis and
normal audit procedures. Example- Revenue expenditure is charged as capital
expenditure.
Procedural errors- These are the errors in the implementation of procedures or frauds.
Example- Payment of a purchase invoice without sufficient purchase documents.
2- Confidentiality
5- Documentation
6- Planning
He should plan his work to conduct audit in effective and timely manner.
Plans should be based on knowledge of the clients business.
Plans should be further developed and revised during audit if circumstance requires so.
7- Audit Evidence
Auditor should obtain sufficient and appropriate audit evidence by performing
compliance and substantive procedures.
Evidences enable the auditor to draw reasonable conclusion.
Compliance procedures mean the tests designed to obtain reasonable assurance that
internal controls have been properly designed & operating effectively throughout the
year.
Substantive Procedures are performed to obtain evidence as to the completeness,
accuracy and validity of data produced by the accounting system.
8- Internal controls
Internal control system ensures that the accounting system is adequate and that all the
accounting information has been duly recorded.
The auditor should understand the accounting system and related internal controls
adopted by the management.
He should study and evaluate internal controls system to determine the nature, timing
and extent of other audit procedures.
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The auditor should review and assess the conclusions drawn from the audit evidences
obtained through performance of procedures.
The audit report should contain clear written expression of opinion on the financial
statements.
His report is on whether:
The financial information has been prepared using acceptable accounting policies
which have been consistently applied;
The financial information complies with relevant regulation and statutory
requirements; and
There is adequate disclosure of all material matters.
The report should be as per legal requirement. When other than opinion is given, the
audit report should state the reasons thereof.
a) Integrity Auditor should be honest, sincere and straightforward while performing his
professional duties.
b) Communication Skill During the conduct of audit, he has to interact with various
officers and staff of organization & third parties, thus he requires good oral & written
communication abilities.
f) Logical Skills He must be able to analyse & interpret problem so that he can
accordingly deal with the same.
Meaning
The limitations which cannot be overcome irrespective of the nature and extent of a
procedures. Followings are the inherent limitation:
I. Involvement of judgement
Auditor’s work involves exercise of judgment, for example, in deciding the extent of
audit procedures and in assessing the reasonableness of the judgment and estimates
made by the management in preparing the financial statements. The judgement by
auditor may not always be correct.
3. If internal controls are weak, auditor may not be in a position to obtain assurance.
Going Concern:
The enterprise is normally viewed as a going concern that is as continuing in operation for
the foreseeable future. It is assumed that the enterprise has neither the intention nor the
necessity of liquidation.
Consistency:
It is assumed that accounting policies are consistent from one period to another.
Accrual:
Revenues and costs are accrued, that is recognized as they are earned or incurred (and not
as money is received or paid) and recognized in the financial statements of the periods to
which they relate.
Meaning & Disclosure of Accounting Policies [May 1999, Nov 2002, 4 Marks]
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True- Auditor uses sampling during performance of audit. It is not possible for him to
conduct detailed checking due to time constraints and other practical problems. As he
does not check each & every items. It is impossible for him to detect all fraud & errors.
11) Auditor is not an insurer. [Nov 2008]
True- The auditor does not insures the interest of users of accounts but only states his
opinion after taking all reasonable care and skill that the statement show a true and fair
picture.
12) Procedural error arises as a result of transactions having been recorded in a
fundamentally in correct manner. [May 2008]
False- When transactions are recorded in fundamentally incorrect manner it is known
as error of Principle. For e.g. a distinction not being made between capital and revenue
income or expenditure.
13) When an auditor identifies a misstatement resulting from fraud, it is his
responsibility to communicate it to the regulatory and enforcement authorities apart
from those charges with governance. [May 2010]
True- According to SA-240 “The auditor Responsibilities Relating to Fraud in an Audit
of Financial Statement” an auditor identifies a misstatement resulting from the fraud or
error it is his responsibility to communicate the matter with those charged with
governance and, in some circumstances, when so required by laws or regulation, to
regulatory and enforcement authorities also.
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Chapter-2
Core Concept in Auditing
Materiality [Nov 86, Nov 96, May 2007, Nov 2007, 4 Marks, Nov 2009, May 2013]
According to AS-1 Material items are those items, the knowledge of which might
influence decisions of the user of financial statements.
SA 320 is applicable on “Planning and Performing an Audit”
Materiality is therefore, an important and relevant consideration for an auditor who
has constantly to judge whether a particular item or transaction is material or not.
Judgement of materiality is affected by circumstances and size of the business.
Material is a relative term and what may be material in one case may not be material in
another.
The concept of materiality recognizes that some matters, either individually or in
aggregate, are important for true and fair presentation of financial information in
confirmation with recognized accounting policies and practices. Both the amount and
nature i.e. quantity and quality should be considered.
Even insignificant items in terms of quality may also be material in special
circumstances.
Sometimes the materiality of an item in term of quantity is described in law itself. For
example, schedule VI requires separate disclosures of items of expenditures which are
in excess of one percent of revenue from operating activities or Rs. 1,00,000.
Performance Materiality: It means the amount or amounts set by the auditor at less
than materiality for the financial statements as a whole to reduce to an appropriately
low level the probability that the aggregate of uncorrected and undetected misstatement
exceeds materiality for the financial statements as a whole.
There is an inverse relationship between materiality and audit risk.
Materiality should be considered by the auditor when:
Determining the nature, timing and extent (NTE) of audit procedures.
Evaluating the effect of misstatement.
Materiality decided earlier may be revised during the performance of the audit.
Auditor should document the following:
Material level considered for financial statement as a whole
Performance material considered
Any revision made in material level considered earlier.
The information, which may be oral or written obtained for the purpose of audit, is
known as audit evidence.
Auditor needs evidences to obtain information for arriving at his judgement.
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"The auditor should obtain sufficient & appropriate audit evidence through the
performance of compliance and substantive procedures to enable him to draw
reasonable conclusion there from on which to base his opinion on the financial
information." SA-500
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The reliability of audit evidence is influenced by its source: internal or external and
by nature: visual, documentary or oral.
While the reliability of audit evidence is dependent on the circumstances under
which it obtained the following generalizations may be useful in assessing the
reliability of audit evidence:
1. External evidence (e.g., confirmation received from a third party) is more reliable
than internal evidence.
2. Internal evidence is more reliable when related internal control is satisfactory.
3. Evidence obtained by the auditor himself is more reliable than that obtained from
the entity.
4. Evidence in the form of documents and written representations is more reliable
than oral representation.
5. Evidence provided by original documents is more reliable than those provided by
photocopies of documents
Existence
An asset or liability exists at a given date.
Occurrence
A transaction or event took place which pertains to the entity
Completeness
There are no unrecorded assets, liabilities or transactions.
Valuation
An asset or liability is recorded at an appropriate carrying value.
Measurement
A transaction is recorded in the proper amount and revenue expense is allocated to the
proper period.
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Presentation
An item is disclosed, classified and described in accordance with acceptable accounting
policies and, when applicable, legal requirement.
Methods (Techniques) to obtain Audit Evidence
[Nov 1997, Nov 2001, May 2003, 4 Marks]
One or more of the following methods:
Inspection;
Observation;
Inquiry and confirmation;
Computation; and
Analytical review.
1-Inspection
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2-Observation
Sending
Receiving
Evaluating
Positive Form-
In positive form external party always responds whether they agree with auditors
understanding or not.
If auditor does not receive any reply, he may send an additional confirmation
request.
If still request is not replied then he has to do additional procedure alternate
procedure.
If alternate procedures do not provide sufficient evidence, he should determine its
effect on audit report (Qualify/Disclaimer)
Negative Form
In negative form external party responds only when they disagree with auditor
understanding.
This form is generally used when risk of misstatement is low because internal
controls are effective and low exception rate is expected.
Evaluation
If response indicating disagreement of third party, the auditor shall investigate exception
to determine whether these are indicative of misstatement.
If management request auditor not to seek external confirmation, auditor should ask
management for written presentation. Auditor should consider whether there are valid
ground for the same. If there are valid grounds then he may accept the management
request and adopt alternative procedure. If there are not valid grounds then he may not
accept the management request as it is a limitation on scope of his work.
4-Computation
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