AUDITING PRINCIPLES AND TECHNIQUES This page is intentionally left blank. AUDITING PRINCIPLES AND TECHNIQUES S. K. Basu Senior Lecturer St. Xavier’s College, Kolkata, India Copyright © 2006 Dorling Kindersley (India) Pvt. Ltd. Licensees of Pearson Education in South Asia No part of this eBook may be used or reproduced in any manner whatsoever without the publisher’s prior written consent. This eBook may or may not include all assets that were part of the print version. The publisher reserves the right to remove any material present in this eBook at any time. ISBN 9788177581782 eISBN 9788131798676 Head Office: A-8(A), Sector 62, Knowledge Boulevard, 7th Floor, NOIDA 201 309, India Registered Office: 11 Local Shopping Centre, Panchsheel Park, New Delhi 110 017, India PREFACE The development of modern accountancy and the growth of auditing profession in India and, indeed, in the world as a whole must be seen in the context of the enormous expansion of industry, trade and commerce which has taken place in the last decade. The auditing profession is now going beyond the duties prescribed by the Companies Act. It is initiating its own accounting standards, and auditing regulations and guidelines. At present, it has sought to standardise the accounting procedure by issuing mandatory accounting standards and also issuing standardised auditing guidelines for conducting audit work. In addition to that, auditing in its modern form has adopted a multidimensional approach. At present, the scope of auditing is not restricted to only financial audit under the Companies Act but has been extended to cost accounts, managerial policies, operational efficiencies, system applications, social implications of business organisations and environmental aspects too. In the light of the above changes, Auditing: Principles and Techniques has been written in order to describe the modern tools and techniques of auditing. Written in a student-friendly manner, this book is intended for commerce students of all the universities in India as well as for different profes- sional examinations. This book aims to assist the readers to develop, in a systematic way, a thorough understanding of the concepts and techniques underlying auditing. Simplicity and brevity are the twin characteristics of this book. The contents of the syllabus have been lucidly explained point-wise with charts, examples and illustrations, where necessary, and the subject matter has been summarised at the end of each chapter for quick reference. The book has 20 chapters covering all the important and latest aspects of auditing including bank and insurance audit, audit in a computerised environment, new areas of auditing etc. A separate annexure has been added at the end of the book discussing some important case decisions. Two other annexures include model answers to questions, both subjective and objective. My endeavour has been to make this book strictly syllabus oriented. I hope my sincere efforts to present the text of the syllabus analytically and methodically is appreciated by students as well as teachers. I express my deep gratitude to the renowned authors on this subject from whom references have been taken in writing this book. I am also grateful to Pearson Education for publishing this book. If my work is appreciated by the readers, I will consider it as my best reward. S. K. BASU This page is intentionally left blank. CONTENTS Preface v 2.2 Classification of Audit 24 2.3 Classification on the Basis of Organisation 26 1 2.4 Classification on the Basis of Function 28 2.5 Classification on the Basis of Practical Nature of Auditing 1 Approach 30 1.1 Introduction 2 2.6 Classification on the Basis of Audit 1.2 Origin of the Word ‘Audit’ 2 Dimension 38 1.3 Early History of Audit 2 Points to Ponder 41 1.4 Auditing Defined 3 Review Questions 42 1.5 Essential Features of Auditing 4 1.6 Why Is There a Need for an Audit? 5 3 1.7 Objective of an Audit 5 1.8 Errors and Frauds in Accounting 7 1.9 Role of Auditors in Detecting Errors and Techniques and Procedu- Frauds 9 res of Auditing 43 1.10 Relation between Book-keeping, 3.1 Introduction 44 Accountancy and Auditing 9 3.2 Preparatory Steps before Commence- 1.11 Basic Principles Governing an Audit 10 ment of Audit 44 1.12 Postulates of Auditng 12 3.3 Preparation by the Auditor 46 1.13 Scope and Procedures of Audit 13 1.14 Changes in the Concept of Auditing 14 3.4 Principles and Techniques of Audit- ing 56 1.15 Social Objectives of Audit 15 1.16 Advantages of Auditing 16 3.5 Procedures Followed in Course of Audit 57 1.17 Limitations of Auditing 17 1.18 Qualities of an Auditor 18 Points to Ponder 67 1.19 Auditing and Other Services 19 Review Questions 69 Points to Ponder 20 4 Review Questions 21 2 Internal Control, Internal Check and Internal Audit 71 Classification of Audit- ing 23 4.1 Introduction 72 2.1 Introduction 24 4.2 Internal Control 72 ¿ Contents viii 4.3 Internal Check 84 6.6 Importance of Valuation of Assets 139 4.4 Internal Audit 94 6.7 General Principles for Verification and Valuation of Assets 140 4.5 Auditor’s Independence 102 6.8 Problems in Verification 141 4.6 Distinction between Internal Control and Internal Audit 103 6.9 Problems in Valuation 141 4.7 Distinction between Internal Check, 6.10 Window Dressing—A Challenge to Internal Audit and Internal Verification 142 Control 104 6.11 Verification and Valuation of Points to Ponder 106 Assets 142 Review Questions 108 6.12 Verification and Valuation of Intangible Assets 143 6.13 Verification and Valuation of Fixed 5 Assets 146 6.14 Verification and Valuation of Investments 150 Vouching 109 6.15 Verification and Valuation of Current Assets 152 5.1 Introduction 110 6.16 Verification and Valuation of Fictitious 5.2 Concept of Vouching 112 Assets 157 5.3 Objectives of Vouching 112 6.17 Verification and Valuation of Contingent 5.4 Importance of Vouching 113 Assets 158 5.5 Vouching and Verification 113 6.18 Verification and Valuation of 5.6 Vouching and Routine Checking 114 Liabilities 158 5.7 Concept of Voucher 115 6.19 Verification and Valuation of Fixed or 5.8 Internal and External Evidence 116 Long Term Liabilities 159 5.9 General Principles of Vouching 116 6.20 Verification and Valuation of Current 5.10 Teeming and Lading: A Challenge to Liabilities 160 Vouching 117 6.21 Verification and Valuation of Contin- 5.11 Vouching of Different Types of gent Liabilities 163 Transactions 118 6.22 Events Occurring after the Balance Sheet Points to Ponder 133 Date 164 Review Questions 134 6.23 Prior Period and Extraordinary Items and Changes in Accounting 6 Policies 165 Points to Ponder 165 Review Questions 166 Verification and Valuation of Assets and Liabilities 137 7 6.1 Introduction 138 6.2 Meaning of Verification of Assets 138 6.3 Meaning of Valuation of Assets 138 Depreciation 169 6.4 Difference between Verification and 7.1 Definition of Depreciation 170 Valuation 138 7.2 Purposes of Providing 6.5 Importance of Verification of Assets 139 Depreciation 170 ¿ Contents ix 7.3 Causes of Depreciation 171 7.4 Basis of Charging Depreciation 171 9 7.5 Quantum of Depreciation 172 7.6 Distinction between Depreciation and Company Audit 199 Amortisation 174 7.7 Different Methods of Depreciation 174 9.1 Introduction 200 7.8 Depreciation Accounting as per 9.2 Preliminaries before Commencement of Company Audit 200 AS-6 177 9.3 Audit of Share Capital 7.9 Accounting Disclosure Transactions 202 Requirement 179 9.4 Audit of Debentures 215 7.10 Legal Necessity of Provision for 9.5 Audit of Holding Company 218 Depreciation 179 9.6 Audit of Pre-incorporation Profit 221 7.11 Provision for Depreciation for Past 9.7 Specific Provisions for Accounts in the Years 180 Companies Act 222 7.12 Depreciation on Low Value Items 181 9.8 Payment of Interest Out of Capital 223 7.13 Depreciation on Wasting Assets 181 9.9 Special Requirements of Company Audit 224 7.14 Change in the Method of 9.10 Company Auditor 226 Depreciation 181 9.11 Special Auditor 242 7.15 Auditor’s Duty as Regards 9.12 Branch Auditor 242 Depreciation 182 9.13 Joint Auditor 243 7.16 Legal Views as Regards 9.14 Legal Views on Auditor’s Liability 244 Depreciation 183 Points to Ponder 248 Points to Ponder 184 Review Questions 250 Review Questions 185 Annexure 252 8 10 Reserves and Divisible Profits and Provisions 186 Dividends 267 8.1 Concept of Reserves 187 10.1 Meaning of Divisible Profit 268 8.2 Concept of Provisions 187 10.2 Meaning of Dividend 268 8.3 Difference between Reserves and 10.3 Concept of Profit 268 Provisions 187 10.4 Profit vs Divisible Profit 269 8.4 Classification of Reserves 187 10.5 Principal Determinants of Divisible Profit 269 Points to Ponder 197 10.6 Companies Act Relating to Payment of Review Questions 197 Dividend 272