Origin of Audit

From the time of ancient Egyptians, Greeks and Romans, the practice of auditing the
accounts of public institutions existed. Checking clerks were appointed in those days to
check the public accounts. To locate frauds as well as to find out whether the receipts
and payments are properly recorded by the person responsible was the main objective of
auditing of those days.
During the 18th century industrial revolution brought in large scale production, steam
power, improved facilities and better means of communication. This resulted in the
origin of joint stock form of organizations. Shareholders contribute capital of these
companies but do not have control over the day-to-day working of the organization. The
shareholders who have invested their money would naturally be interested in knowing
the financial position of the company. This originated the need of an independent person
who would check the accounts and report the shareholders on the accuracy of the
accounts and the safety of their investment.
The Indian Companies Act, 1913 defined the qualification, power, duties and procedure
of appointment of the Auditor. The audit of Joint Stock Company made compulsory by
this Act. Educational qualification certificate were issued by the Central and State
Governments to those who undergone the prescribed course. In the year 1949, Chartered
Accountants Act was passed. Companies Act, 1956 further elaborated the provisions
related to the auditing and accounts of the companies. Now a person to do the auditing
must be qualified as per the standards of the Institute of Chartered Accountants of India.

The word ‘Audit’ is originated from the Latin word ‘audire’ which means ‘to hear’. In
the earlier days, whenever there is suspected fraud in a business organization, the owner
of the business would appoint a person to check the accounts and hear the explanations
given by the person responsible for keeping the account and funds. In those days, the
audit is done to find out whether the payments and receipt are properly accounted or not.
The objective of modern day accounting is not only for the verification of cash but to
report the financial position of the undertaking as disclosed by its Balance sheet and
Profit and Loss Account.

Defining Audit

Audit may be defined as ‘an official inspection of an individual’s or organization’s

accounts, typically by an independent body’. A precise definition of the term ‘Auditing’ is
difficult to give. Some of the definitions given by different authors are as follows:

According to Montgomery, a well known author, “auditing is a systematic examination of

the books and records of a business or the organization in order to ascertain or verify and
to report upon the facts regarding the financial operation and the result thereof”.

Auditing is the systematic and scientific examination of the books of a accounts and
records of a business so as to enable the auditor to satisfy himself that the Balance Sheet
and the Profit and Loss Account are properly drawn up so as to exhibit a true and fair
view of the financial state of affairs of the business and profit or loss for the financial
period. The Auditor will have to go through various books and accounts and related
evidence to satisfy him about the accuracy and authenticity to report the financial health
of the business.
Auditing means the scrutiny of books of accounts and the relative documentary evidence
by an independent qualified person in order to ascertain the accuracy of the figures
appearing therein.
Scope of Audit
The scope of audit is extending day by day because of the changes in the economic
conditions of the country. “Today, most of the economic activities are largely conducted
through public finances. In a rapidly developing economy this has to be so. The
companies which are in the public sector have also public finances invested in them to a
very large extent. Whether these larger funds are properly used is the responsibility of the
trustees of the nation’s finances.” From these two statements, it is apparent that not only
the scope of auditing is widening but there is change in emphasis in audit objectives also.
As a result of that, the society expects more from the auditor. As mentioned by Schlosser,
“Auditing is a systematic examination of financial statements, records and related operations
to determine adherence to generally accepted accounting principles, management policies or
stated requirements.” This definition not only emphasises on the verification of accounting
statements but extends the scope of auditing by including in it a thorough examination of
allied operations. He further adds that audit now also covers cost audit, management audit,
internal audit and governmental audit etc. It is not confined only to business houses but
non-business organizations also avail services of qualified auditors to get their accounts
audited.
 RELATIONSHIP AMONG BOOK-KEEPING, 4. For
ACCOUNTANCY AND AUDITING obtaining
loan from
Book-keeping:
financial
Book-keeping is the art of recording day-to-day transactions systematically in institutions
the books of accounts. This part of work is performed by book-keeper. It includes like Banks,
journalizing, posting, totaling and balancing of the ledger accounts. The work of a LIC,
book-keeper is clerical in nature and it is performed under overall direction and HUDCO,
supervision of an accountant. HDFC,
IFCI etc.,
Accountancy: previous
years
“Accountancy begins where Book-keeping ends”. The job of accountant starts audited
when book keeper has finished his job. The work of accountant is to check accounts
arithmetical accuracy of the accounts prepared by the book keeper by preparing evaluated
the trial balance. If any omission or error arises it shall be rectified. Finally the for
accountant has to prepare Trading profit and loss account and the Balance Sheet, determining
incorporating necessary adjustments there in. the
capability
Auditing: of returning
“Auditing begins, where accountancy ends”. After the accountant has the loan.
completed his work an auditor is invited to verify the work done by accountant. 5. Regular
audit of
Auditing is concerned with making an analytical and Critical examination
account
of the books of account, checking and verification of the evidence is support of create fear
transactions appearing in the books of accounts and ascertaining the authenticity of among the
assertions made in the financial statements. employees
in the
Advantages of Auditing accounts
department
It is compulsory for all the organizations registered under the Companies Act and exercise
must be audited. There are advantages in auditing the accounts even when a great
there is no legal obligation for doing so. Some of the advantages are listed moral
below: influence on
1. Audited accounts are readily accepted in Government authorities like clients staff
Income-tax Dept., Sales Tax dept., Land Revenue departments, banks etc. thereby
restraining
2. By auditing the accounts errors and frauds can be detected and rectified in
them from
time.
commit
3. Audited accounts carry greater authority than the accounts which have not frauds and
been audited. errors.
6. Audited accounts facilitate settlement of claims on the retirement/death of a partner.

7. In the event of loss of property by fire or on happening of the event insured against, Audited
accounts help in the early settlement of claims from the insurance company.
8. In case of Joint Stock Company where ownership is separated from management, audit of accounts
ensure the shareholders that accounts have been properly maintained, funds are utilized for the right
purpose and the management have not taken any undue advantage of their position.
9. To determine the value of the business in the event of purchase or sales of the business, audited
account will be the treated as the base for the evaluation.
 10. The audit of accounts by a qualified auditor also help the management to understand the financial
position of the business and also it will help the management to take decision on various matters
like report in internal control system of the organization or setting up of an internal audit
department etc.
11. If the accounts have been audited by an independent person, disputes between the management and
labour unions on payment of bonus and higher wages can be settled amicably.
12. In the event of admission of a new partner, audited accounts will facilitate the formation of terms
and conditions for joining the new partner. Last 3 years audited accounts and balance sheet will give
a general idea about the growth and financial position of the business to the new partner.

Difference between Accounting and Auditing

Basis of
Accounting Auditing
distinction
1. Nature Accounting refers to preparation of Auditing refers to examination
Accounts. and checking of financial
records.
2. Objective The primary object of Accounting is to The primary object of Auditing is
find out the trading results of business to certify the correctness and
during a financial year and show the justification of the financial
financial position of the concern on a statements prepared by the
particular data. accountants.
3. Qualification The accountant need not be a The Auditor must be Chartered
Chartered Accountant. Accountant.
4. Appointment The accounting work is done by an The auditor is not an employee.
employee of the concern and works He is an independent person.
directly under the control of Professionally competent,
management. appointed by the proprietor with
specific purpose.
5. Status The accounting work is done by a The audit work is done by an
permanent employee of the concern. outsider.
6. Scope Its scope is restricted to preparation of It is determined by the
financial statements and their agreement between auditor and
interpretation. his client.
7. Commencement It starts where book-keeping ends. It starts where accountancy
ends.
8. Remuneration The accountant is paid monthly salary The Auditor gets a fixed amount
as per agreement with his client.
9. Knowledge The accountant may or may have any The auditor must have through
knowledge of auditing and its knowledge of Accountancy.
techniques.
10. Time Period Accounting work is undertaken Generally Auditing is taken up at
throughout the year the end of the year.
11. Regulations Accounting is governed by any Auditing is governed by the code
applicable professional regulations. of conduct and standards laid
down by the ICAI.
12. Submission of The accountant is not required to The auditor is required to submit
Report submit a report on the Financial a report to his client on truth and
Statements prepared by him. fairness of financial statements.
13. Compulsion Keeping of Accounts is a must to know Audit is not compulsory except
the exact financial position and where this is required by the
profitability of the business at the end of statute.
the financial year.
Objectives of Audit

For a better understanding we could classify the objective of audit as:

Primary Objectives

To determine and judge the reliability of the financial statement and the
supporting accounting records of a particular financial period is the
main purpose of the audit. As per the Indian Companies Act, 1956 it is
mandatory for the organizations to appoint a auditor who, after the
examination and verification of the books of account, disclose his
opinion that whether the audited books of accounts, Profit and Loss
Account and Balance Sheet are showing the true and fair view of the
state of affairs of the company’s business. To get a true and fair view of
the companies’ affairs and express his opinion, he has to thoroughly
check all the transactions and relevant documents of the company made
during the audited period which will help the auditor to report the
financial condition and working result of the organization. While
carrying out the process of audit, the auditor may come across certain
errors and frauds. But detection of fraud or errors is not the primary
objective of the audit. They come under the secondary objectives of
audit.

1.1.1 Secondary Objectives

In order to report the financial condition of the business, auditor has to

examine the books of accounts and the relevant documents. In that
process he may come across some errors and frauds. We may classify
these errors and frauds as below:
1. Detection and Prevention of Errors: Following types of errors
can be detected in the process of auditing:
(a) Clerical Errors: Due to wrong posting such errors may occur.
Money received from Microsoft credited to the Semens’
account is an example of clerical error. Even though the
account was posted wrongly, the trial balance will agree. We
can classify clerical errors as below:
(i) Errors of Commission: These errors are errors caused
due to wrong posting either wholly or partially of in the
books of original entry journal or ledger accounts or
wrong totaling, wrong calculations, wrong balancing
and wrong casting of subsidiary books.
 Example: 5000 is paid to Microsoft for the supply of windows
program and the same is recorded in the cash book. While posting the
ledger the Microsoft’s account is debited by 500. It may be due to the
carelessness of the accountant. Most of these errors of commission are
reflected in the trial balance and can be identified by routine checking
of the books.
(ii) Errors of Omission: When there is no record of
transactions in the books of original entry or omission of
posting in the ledger could lead to such errors. Sales not
recorded in the sales book or omission to enter invoices
in the purchase book is examples of Errors of Omission.
Errors due to entire omission will not affect the trial
balance. Errors due to partial omission will affect the
trial balance and can be detected.
(iii) Compensating Errors are errors committed in such a way that the net result of these
errors on the debit side and credit side would be nullifying the net effect of the error.

Example: Ram’s account which was to be debited for 5000 was credited for 5000
and similarly, Sita’s Account which was to be credited for 5000 was debited for 5000.
These two mistakes will nullify the effect of each other. Unless detailed investigation is
undertaken such errors are difficult to locate as both the sides of the trial balance are
equally affected.

These types of errors are said to occur when they offset the effect of each other either
wholly of partially.

(iv)Errors of Duplication: These types of errors occur when a particular transaction is

recorded twice in the books of account. Since they are also posted twice these do not affect
the trial balance.
(v)Errors of Principle: While recording a transaction, the fundamental principles of
accounting is not properly observed, these types of errors could occur. Overvaluation of
closing stock or incorrect allocation of expenditure or receipt between capital and revenue
are some of the examples of such errors. Such errors will not affect the trial balance but will
affect the Profit and Loss account. It may occur due to lack of knowledge of sound
principles of accounting or can be committed deliberately to falsify the accounts. To detect
such errors, the auditor has to do a careful examination of the books of account.
When accountings principles are violated in writing the books of account the error of
principal occurs. For example, when wrong account head is chosen to record a transaction,
error of principal occurs. When expenses of capital nature are debited to revenue or vice
versa it is said that error of principal has occurred.

2. Detection and Prevention of Frauds: To get money illegally from the organization or
from the proprietor frauds are committed intentionally and deliberately. If it remains
undetected, it could affect the opinion of the auditor on the financial condition and the
working results of the organization. Therefore, it is necessary for the auditor to exercise
utmost care to detect such frauds. It can be committed by the top management or by the
employees of the organization. Frauds could be of the following types:
(i)Misappropriation of Cash: Since the owner has very limited control over the receipt and
payments of cash, misappropriation or defalcation of cash is very common especially in big
business organizations. Cash can be misappropriated by various ways as mentioned below:
 Recording fictitious payments
 Recording more amount than the actual amount of payment
 Suppressing receipts
 Recording fewer amounts than the actual amount of payment.
There should be strict control over receipts and payments of cash known as “Internal check
system” to prevent such frauds. The auditor should check the Cash Book with original
records, bills register, invoices, vouchers, counterfoils or receipt books, wage sheets,
salesman’s diary, bank statements etc. in order to discover such frauds.
Misappropriation of Goods: Companies handling with high value goods
are prey to this kind of misappropriation. Without proper records of stock
inward and stock outward, it is difficult for the auditor to find out such
fraud. Periodical and surprise checking of stock and maintaining the proper
record of inward and outward movement of stock can reduce the
possibility of such fraud.
Falsification or Manipulation of Accounts: In order to achieve certain
specific objectives, accounts may be manipulated by those responsible
persons who are in the top management of the organization. They prepare
accounts such a manner that they disclosed only a fake picture not the true
picture. Some of the ways used in manipulating the accounts are as
follows:
 Inflating or deflating expenses and incomes.
 Writing off of excess or less bad debts.
 Over valuation or under valuation of closing stock.
 Charging excess or less depreciation.
 Charging capital expenditures to revenue and vice-versa.
 Providing for excess or less doubtful debts.
 Suppressing sales and purchase or showing fictitious sales and
purchases, etc.
Window Dressing is the way of presenting the financial data in a much
better position than the original position. It is known as window dressing.
Some of the reasons for doing window dressing are as follows:
 To win the confidence of shareholders.
 To obtain further credit.
 To raise the price of shares in the market by paying higher dividend
so that shares held may be sold.
 To attract prospective partners or shareholders.
(b) Secret Reserves: In secret reserves, accounts are prepared in
such a way that they disclose worse picture than actually what
they are? The objectives of preparing accounts in this way
are:
(i) To conceal the true position from the competitors.
(ii) To avoid or reduce the tax liability
To reduce the price of shares in the market by not paying dividend or
paying lower dividend so that the shares may be bought at a much lower
price.
It is very difficult to detect such frauds since these frauds are committed by
those persons in the organizations who are at the top positions like
directors, managers, financial controllers etc. To detect these kinds of
frauds, the auditor must be vigilant and should make searching inquiries to
arrive at the true position.