Q.1)
a) Why Window dressing is done
1. Mislead Investors & Lenders
A company may want to mislead investors into buying its shares by showing a better picture of its net worth. The banks may give larger loans based on the higher net worth shown in the accounts. The concern may be taken over by another concern for a higher price.
2. Hide Losses
Sometimes, the concern may suffer extraordinary losses. The concern may not like to show a huge loss in its books. A company may show fictitious profits through window dressing in order to be able to pay dividends to the shareholders.
3. Higher Commission
Many times, window dressing is done by the directors themselves so as to earn more commission based on the higher profits shown in the books of the company.
b) How secret reserve is created
Basically, secret reserves are created by understating the net worth of a concern. Since Net Worth of a concern is equal to Assets less Liabilities, secret reserves can be created by: (i) understatement of assets or (ii) overstatement of liabilities.
Understatement of Assets
- Recording new fixed assets purchased in the books at a lower cost.
- Omitting to record new fixed assets in the books.
- Providing excess depreciation on fixed assets, by changing method of depreciation.
- Showing lower quantity of closing stock in the books.
- Under-valuing closing stock by changing method of valuation.
- Making excess provision for bad debts, doubtful debts, discount etc.
- Writing off intangible assets like patents or goodwill.
- Treating capital expenditure (assets) as revenue expenses e.g. treating new machinery purchased as repairs of old machinery.
- Treating an item of income as capital receipt, e.g. treating a receipt of sale price from debtor as a deposit.
- Ignoring accrued income and pre-paid expenses.
Overstatement of Liabilities
1. Recording liabilities in the books at a higher amount.
2. Recording fictitious liabilities in the books.
3. Treating an item of income as a liability, e.g. treating rent received as receipt of loan.
4. Treating contingent liabilities as actual liabilities.
5. Recording Outstanding Expenses at a higher amount.
6. Showing reserves as current liabilities.
c) List any 4 types of substantive audit procedure
Substantive Procedures are the steps taken by the auditor to obtain evidence regarding (a) the transactions during the year and (b) the balances of the assets and liabilities as at the year end. Evidence obtained from compliance procedures determines the nature, timing and extent of the substantive procedures. Following are the main substantive procedures used in an audit: (1) Vouching (2) Posting Checking (3) Casting Checking (4) Ledger Scrutiny (5) Verification of assets and liabilities and (6) Grouping, disclosure and presentation in final accounts.
1. Vouching
Vouching is the audit procedure used in order to obtain evidence regarding the transactions during the accounting year. Vouching involves the steps taken by the auditor to obtain evidence to prove that
(i) the transactions actually occurred
(ii) all transactions that occurred have been recorded
(iii) transactions are recorded for the right amount and
(iv) transactions are accounted and disclosed properly.
2. Posting Checking
Posting Checking is the procedure to check that the entries from Journals and Registers are properly posted in the Ledgers. Auditor has to check whether the right amount is posted in the right account and on the right side of the account.
3. Casting Checking
Casting Checking is the procedure to check the totals of the books, ledgers etc. Auditor also checks whether the totals are carried forward correctly.
4. Ledger Scrutiny
Ledger Scrutiny is the procedure to check and review the accounts of parties, assets, liabilities, income and expenses in the Debtor's ledger, Creditors' ledger, and the General ledger.
5. Verification
Verification is the audit procedure to check the balances of various accounts as at the end of the year. Verification involves physical inspection, confirmation and valuation of assets and liabilities as at the end of the year. Verification means the steps taken by the auditor to ascertain whether -
Q.2
a) Define audit techniques, list any 4 audit techniques
Audit techniques mean the methods used to obtain audit evidence [SA 500]. These methods are used in both the compliance and substantive audit procedures. Audit techniques are of the following types - (1) Inspection (2) Observation (3) Inquiry (4) Confirmation (5) Computation (6) Analytical Review.
1. Inspection
Inspection consists of examining records, documents or tangible assets. Thus, the procedure of vouching may use the technique of inspection to examine vouchers and supportings. The procedure of verification may use this technique of inspection to physically verify a fixed asset.
Inspection consists of examining (i) records and documents, or (ii) tangible assets.
(i) Inspection of records and documents provides evidence of varying degrees of reliability depending on their (i) nature, (ii) source and (iii) the effectiveness of internal control over their processing. There are four major categories of documentary evidence, which provide different degrees of reliability to the auditor
2. Observation
Observation consists of observing a procedure being performed by others. Thus, auditor may observe the procedure of physical inventory being taken by the client's staff.
3. Inquiry
Inquiry consists of seeking information from others. Thus, auditor may seek information or explanation from employees of the client. He may also seek information from outsiders e.g. bankers, lawyers, customers, suppliers, consignees, Insurance Companies, Lenders of the client.
4.Confirmations
Confirmation is a formal inquiry from outsiders. Thus, auditor may seek confirmations from banks, suppliers, debtors etc. regarding their balances with the concern.
5. Computation
Computation consists of checking the arithmetical accuracy of vouchers, documents and accounting records by performing independent calculations.
6. Analytical Review
Analytical Review consists of study of various accounting ratios (e.g. Gross Profit to Sales, Input-Output Ratio, Debtors' Turnover Ratio). It also consists of comparison of figures of current year with those of past to ascertain unusual differences. Ledger scrutiny uses this technique to analyse accounts.
b) List any 4 difference between Investigation and auditing
| No. | Auditing | Investigation |
|---|---|---|
| 1. | Auditing is examination of accounts to report if they are true and fair. | Investigation is examination of accounts for specific purpose. |
| 2. | Audit is an annual recurring assignment. | Investigation is a specific non-recurring assignment. |
| 3. | Audit may be statutory or voluntary. It may be continuous, interim or final. | Investigation may be statutory under Companies Act, Income-tax Act or voluntary for valuation of shares, goodwill, fixing purchase consideration, detection of fraud etc. |
| 4. | Auditor is appointed by owners or shareholders. | Investigator may be appointed by outsider e.g., Income-tax Dept., Registrar of Companies, Investors, Lenders, purchaser of business/shares. |
| 5. | Audit covers the entire accounts. | Investigation may be limited to a particular item in accounts or may go much beyond accounts depending upon its purpose. |
| 6. | Audit does not involve re-audit. | Investigation may involve re-audit. |
| 7. | Audit is compulsory for companies. | Investigation is not compulsory. |
| 8. | Auditor of a company must be a practising chartered accountant. | No qualifications are prescribed by law for an investigator. |
c) What are the auditors responsibility for fraud and errors (any 5)
The Institute of Chartered Accountants of India has laid down the responsibility of an auditor for Errors and Frauds in SA 240 (The Auditor's Responsibilities Relating to Fraud in an Audit of Financial Statements) as follows:
1. Basic Responsibility of Management
Management is basically responsible for prevention and detection of errors and frauds. It is for the management to establish a good accounting and internal control system to prevent and detect errors and frauds.
2. Incidental Objective of Audit
Detection of errors and frauds is only an object of audit incidental to the basic object of reporting whether the accounts are true and fair. However, if the accounts are to be true and fair, they must be free from major errors and frauds. The Auditor should plan and perform audit in such a way as to ensure that the accounts are free from major errors and frauds.
3. Possibility of Non-detection
Due to inherent limitations of Auditing (see para 5.2 above), it is possible that some errors or frauds may remain undetected. This does not imply that the auditor has failed in his duty. So long as the auditor has taken reasonable care and followed the basic Principles of Auditing, the auditor is not to be held responsible for any error or fraud remaining undiscovered.
4. When Circumstances Indicate Error or Fraud
When circumstances indicate existence of errors or frauds (as explained in para 13 above), the auditor should take additional steps to detect them and to ensure that the
final accounts are free from errors and frauds. If the error is confirmed, he should that it is rectified. If a fraud is detected and is material, he should report it to owners or shareholders.
5. Report to Central Government
Further, if an auditor of a company, in the course of the performance of his duties auditor, has reason to believe that an offence involving fraud is being or has bee committed against the company by officers or employees of the company, he shal immediately report the matter to the Central Government within such time and suc manner as prescribed [S. 143(12) of the Companies Act, 2013].
6. CARO 2020
In the case of a Company, its auditor is required, under Companies Auditor Repor Order (CARO) 2020, to report whether any fraud on or by the company has bee noticed or reported during the year; if so, the nature and the amount involved is to b indicated.
Q.3 Explain basic principles of audit
1. Integrity, Objectivity and Independence
The auditor should be honest and sincere in his audit work. He must be fair and objective. He should also be independent.
2. Confidentiality
The auditor should keep the information obtained during audit, confidential. He should not disclose such information to any third party. He should, it is said, keep his eyes and ears open but his mouth shut.
3. Skill and Competence
The auditor should have adequate training, experience and competence in auditing. He should have a professional qualification (i.e. be a Chartered Accountant) and practical experience. He should be aware of recent developments in the field of auditing such as statements of ICAI, changes in company law, decisions of courts, etc.
4. Materiality
Auditor should consider materiality when conducting audit. Information is material it its misstatement could influence economic decisions of the user. Material matters are
important for the true and fair view.
5. Work Performed by Others
(a) The auditor should carefully direct, supervise and review the work of his
assistants.
(b) He should satisfy himself that work done by an internal auditor is reliable. (c) He should satisfy himself that work done by another auditor (e.g. a branch auditor)
is reliable.
(d) He should satisfy himself that work done by a joint auditor is reliable.
(e) He should satisfy himself that work done by an expert (lawyer, valuer, etc.) is
reliable.
6. Documentation
The auditor should document matters which are important in providing evidence that the audit was carried out in accordance with the basic principles.
Q.4 What are the types of audit (explain any 2 with advantages and disadvantages)
1.Statutory or Voluntary
The auditor should ascertain whether the audit is statutory or voluntary. If the audit is statutory, e.g. financial audit under the Companies Act, the audit must be conducted in accordance with the provisions of the Companies Act. If the audit is voluntary, e.g audit of a sole trader or a partnership firm, the auditor must know why the audit is being conducted e.g. for valuation of business at the time of sale, admission of partner and so on. This helps in defining the scope and procedure of audit.
2. Continuous or Final
The auditor should ascertain whether the audit is continuous or final. This enables the auditor to decide the extent of checking and the type of audit procedures to be adopted.
Q.5
a) What are essentials of good audit evidence
Audit evidence must be (1) sufficient, (2) relevant as well as (3) reliable.
1. Sufficient Evidence
Sufficient evidence means adequate evidence in terms of its quantity or extent. Audit evidence need not be obtained by 100% checking. Sufficient evidence can be obtained even by test checking.
2. Relevant Evidence
Audit evidence must be relevant to the matter being checked. Thus, if transactions in stock book for receipt and issue are being checked, relevant evidence would be Goods Received Notes, Delivery Challans etc. If balance of stock-in-hand at the year end is being checked, relevant evidence would be list of physical inventory taken at the year end.
3. Reliable Evidence
No evidence can be 100% reliable or conclusive. It is said that audit evidence is normally persuasive rather than conclusive in nature. Auditor must see whether the evidence obtained is reliable or not. Reliability of audit evidence depends upon-
(a) its source whether the evidence is internal (e.g. Pay Rolls prepared by the concern itself) or external (e.g. confirmation by debtors); and
(b) its nature-whether the evidence is verbal (e.g. explanations from client's staff), visual (e.g. physical verification of stock) or documentary (e.g. supporting documents such as bills attached to vouchers).
b) List the 4 steps to be taken by the auditor before commencement of an audit
Before commencing an audit, the auditor must take the following steps and procedures.
1. Ascertain the type of audit i.e. statutory, continuous etc.
2. Obtain necessary documents such as list of books, employees etc., and
3. Give instructions for preparations to be made by the client.
This will help the auditor to:
(1) develop the overall audit plan
(2) prepare the audit programme and
(3) identify areas of audit requiring special emphasis.
The actual audit should be started only after dealing with above "pre-commencement considerations".
Q.6 Define an audit programme, what are the types of audit programme?
Prof. Meigs defines an Audit Programme as "a detailed plan of the audit work to be performed, specifying the procedures to be followed in verification of each item in the financial statements, and giving the estimated time period. "
[Walter B. Meigs, Principles the audit staff, who is to do what work and within what time. It is a Time Table of what of Auditing, Irwin]. Audit programme is an outline of how the audit is to be conducted by work is to be done by whom, how and when.
Types
An Audit Programme may be (a) Fixed or (b) Flexible. A Fixed Audit Programme is fixed once and for all in the beginning and must be followed strictly throughout the audit. A Flexible Audit Programme, on the other hand, is reviewed constantly as the audit goes on. A Flexible Audit Programme is suitably modified in the light of actual audit work.
Q.7 What do you mean by the term Audit Note Book, list any 4 Contents of Audit Note Books?
Audit Note Book is a part of the current audit file. It contains the 'notes' made by the audit team for recording special points which have been observed during the course of audit.
Form
Audit Note Book is usually in the form of a bound book. However, loose sheets may be used for entering queries and notes which subsequently, on being punched, may be filed in a special file maintained for each client.
Contents
The Audit Note Book contains -
The Audit Programme.
Analysis of transactions and balances.
A record of the nature, timing and extent of auditing procedures performed (vouching, verification etc.), and the results of such procedures i.e. the points raised (queries), how the points were solved, the explanation or documents obtained while solving the queries and the conclusions drawn. This forms the major part of the Audit Note Book.
Evidence that the work performed by assistants was supervised and reviewed. Copies of letters or file notes concerning audit matters communicated to or discussed with the client.
Conclusions reached by the auditor concerning significant aspects of the audit, including the manner in which exceptions and unusual matters, if any, disclosed by the auditor's procedures (i.e. queries) were resolved or treated.
Q.8
a) What do you mean by the term audit working paper?
Audit Working Papers mean a record of (a) the audit plan (b) the audit procedures performed and (c) the conclusions drawn from the evidence obtained. This term denotes the file of analysis, summaries, comments and correspondence built up by the auditor during the course of audit or even, only the Queries and Explanation File kept by the audit assistants. Working Papers is the link between the client's records and the auditor's report.
b) Explain working paper ownership, custody and access.
Confidentiality
SA 200 (Basic principles Governing an Audit) states that the auditor should respect the confidentiality of information acquired in the course of his work and should not disclose any such information to a third party without specific authority or unless there is a legal or professional liability to disclose.
Property
SA 230 (Audit Documentation) states that, unless otherwise specified by law or regulation, audit documentation is the property of the auditor.
Access
Auditor may at his discretion, make portions or extracts from the audit working papers available to clients, provided such disclosure does not affect the validity of the audit work performed or the independence of the auditor.
Retention
The working papers should be preserved and retained by the auditor for future use.
(i) SA 230 (Audit Documentation) states that the auditor should retain the audit working papers for a period of time sufficient to meet the needs of his practice and satisfy any pertinent legal or professional requirements of record retention. SQC1 issued by the ICAI states that - "in the specific case of audit engagements, the retention period ordinarily is no shorter than seven years from the date of the auditor's report."
(ii) According to S. 128(5) of the Companies Act, 2013 the books of accounts relating to a period of not less than eight years immediately preceding the current year are to be preserved in good order by every company. Thus, it would be prudent to preserve the related audit working papers for such eight years too.
(iii) According to an opinion of the expert advisory committee of the ICAI, auditor should retain audit working papers for a minimum of ten years.
Q.9 What do you mean by an error Enumerate the different types of error.
1. Errors of Omission
An Error of Omission occurs when a transaction is omitted from books either wholly or partly. If a transaction is partially omitted, the trial balance would not tally and the error can be detected and rectified. If a transaction is wholly omitted, the trial balance would still tally and it would be difficult to detect such error. Let us clarify this through an example of a cheque payment to a creditor. If this payment is partially omitted i.e. only one account is entered (say Bank Account) and another (Creditor) account is omitted, the trial balance would not tally. The error can be detected by checking the posting of the Bank Book into the Creditors Ledger. However, if the entire transaction is omitted, the trial balance would tally and the error would not be noticed at first. Such error can be detected only through (1) Bank Reconciliation (2) Confirmation of Bank Accounts (3) Vouching Cheque Counter- foils (4) Scrutiny of Creditors Accounts (5) Confirmation of Creditors Balances and so on. Thus, the detection of errors of complete omission is more difficult.
2. Errors of Commission
An Error of Commission occurs when a transaction is entered in the books but wrongly. Such errors may be (1) Mathematical Errors (2) Casting Errors or (3) Posting errors. 1. Mathematical Errors
Mathematical Error of calculations may occur in voucher, books, ledger, trial balance and so on. Thus, in a Sales Bill, 100 No. x 10 may be calculated as 10,000 instead of 1,000. Since the original entry itself is of wrong amount, the trial balance will tally. Such error can be detected by checking the calculations on the voucher, scrutiny of party accounts (party would have paid only 1,000 in the above case), obtaining statement of accounts from parties, overall ratio analysis (Quantity of Sales x Standard Price, in above case would not tally with actual amount of Sales) and so on. 2. Casting Errors
Casting Errors, i.e. errors in totalling, carry-forward, extension etc. may occur in Day Books, Ledgers or the Trial Balance. Thus, in Sales Register, while totalling all bills for a month a bill of 1,000 may be taken as 10,000. Thus the amount posted to Sales Account (10,000) will be more by 9,000 as compared to the amount posted to the Debtors A/c. (1,000). This will lead to difference in the Trial balance and can be detected by checking the casting of the Sales Register.
3. Posting Errors
Posting Errors occur while posting amounts from Registers (Day Books/Journals) into the Ledgers. Thus, a Sales Bill of 1,000 on Mr. A may be (i) posted to Mr. A's A/c for 10,000, or (ii) posted on the Credit side instead of Debit side of Mr. A's A/c, or (iii) posted in Mr. B's A/c. Or, the Sales Bill of 1,000 may be (i) posted in Sales A/c for 10,000, or (ii) posted on the Debit side of Sales A/e instead of Credit, or (iii) posted in Purchase A/c instead of Sales A/c. The error of posting wrong amount (of 10,000 instead of 1,000) or of posting on the wrong side of account (debit instead of credit or vice versa) will affect Trial Balance and can be detected by checking the posting. The error of posting into wrong party a/c can be detected through ledger scrutiny, confirmations from parties etc. The error of posting sales into purchase a/c can be detected through reconciliations, ratio analysis, comparison with previous year's figures etc.
3. Compensating Errors
Compensating Errors occur when the effect of one error is compensated by another error. Thus one error cancels the effect of another error and there is no final net effect on the accounts. For example, one sales bill No. 12 for 1,000 on A is posted into account of B, and another sales bill No. 22 for 1,000 on B is posted into the account of A. The posting error in the first bill is compensated by the posting error in the second bill. These errors cancel each other and do not affect the trial balance. These errors, though difficult to trace, can be detected through vouching, obtaining statement of account or confirmations from parties, etc.
4. Errors of Duplication
Errors of Duplication occur when a transaction is recorded twice in the book of original entry. The posting is also done twice. Thus, a Sales Bill for 1,000 on A may be recorded twice in the Sales Register. Such an error would not affect the trial balance. An Error of Duplication can be detected by careful vouching, scrutiny of ledger account, confirmation from parties, ratio analysis, quantity reconciliations and so on.
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