Objects of an Audit
The main object of audit is to verify the accounts and to report whether the Balance Sheet and the Profit and Loss Account have been drawn up properly according to the companies Act and whether they exhibits a true and fair view of the state of affairs of the concern. For this, an auditor has to discover errors and frauds.
As such the subsidiary objects of audit are :
(i) Detection and Prevention of errors,
(ii) Detection and Prevention of frauds.
The difference between an error and fraud is that error generally arises out of the innocence or
carelessness on the part of those responsible for the preparation of accounts, while fraud involves some
intention to gain out of manipulating records.
Types of Errors
A. Clerical Errors : Clerical errors are those which result on account of wrong posting that is posting an item to a wrong account, totalling and balancing. Such errors may again be subdivided into:
(i) Errors of Omission : An error of omission takes place when a transaction is completely or partially not recorded in books of account. For example, goods purchased from Narendra Kumar were not recorded any where in account books. This error will not affect the agreement of Trial Balance. But if posting is not done in one of the accounts, this will affect the agreement of Trial Balance.
(ii) Errors of Commission : Errors of commission take place when some transaction in incorrectly recorded in books of account. Following are the examples of such errors :
(i) Error in the books of Original Entry.
(ii) Debiting or crediting one account instead of the other. These two errors do not affect the agreement of Trial Balance,
(iii) Wrong balancing of an account.
(iv) Error in writing amount in an account. For example, debiting Prem Chand’ s Account with Rs. 107- instead of Rs. 100/-.
(v) Casting of the same amount to two accounts.
(vi) Posting of an amount on the wrong side.
(vii) Posting in one account and omitting of posting in the other account.
(viii) Error in carrying forward the total of a subsidiary book or an account from one page
to the other.
These errors affect the agreement of Trial Balance.
B. Errors of principle : Errors of Principle take place when a transaction is recorded without having regard to the fundamental principles of book-keeping and accountancy. For example a capital expenditure, say expenses incurred in constructing a godown, may be treated as a revenue expenditure or vice versa, Sometimes adjustments are not taken into consideration while preparing Final Accounts. These are errors of principle. These errors, however, do not affect the agreement of the Trial Balance.
C. Compensating Errors :- Compensating errors arise when an error is counter balanced or compensated by any other error so that the adverse effect of one on debit (or credit) side is neutralised by that of another on credit (or debit) side. For example Rani’s account was to be debited with Rs.10, but it was debited with Rs. 100 similarly Shyam’s account was debited with Rs. 10 instead of Rs.100. Both these errors compensate each other’s deficiency and will not affect the agreement of the Trial Balance.
Detection of Errors :- Although it is not the duty of the auditor to trace and locate errors in the books which he is required to check and audit as this is the work of an accountant but in many cases the auditor is frequently asked to discover the errors, specially so, when the accountant is unable to locate such errors. While locating errors, the auditor should take note of following devices :-
1. Check the totals of the trial balance.
2. Compare the names of the accounts in the ledger with the names of the accounts as have been recorded in the trial balance.
3. Total the list of debtors and creditors and compare them with the trial balance.
4. I f the books are maintained on the self-balancing system, see that the total of different accounts agrees with the total of these accounts with the balance of accounts as recorded in the1 trial balance.
5. Compare the items of the trial balance with the items of the trial balance of the previous year to see if any item have been omitted.
6. Whatever the difference is in the trial balance, see if there is any item of this amount. This
is done to avoid the putting of the debit balance on the credit side of the trial balance or vice versa.
7. It is possible that the totals of some subsidiary books, e.g. Cash book, Sales book etc. might not have been transferred to the trial balance. Recheck the totals of these books.
Detection and Prevention of Fraud
Fraud means false representation or entry made intentionally or without being in its truth with a view to defraud somebody. Detection of fraud is considered to be one of the important duties of an auditor.
Fraud may be of three types
1. Misappropriation of Cash : It is easier to misappropriate cash, therefore the auditor will have to pay particular attention towards cash transaction. Cash may be misappropriated by,
(a) Omitting to enter any cash which has been received; or
(b) Entering less account than what has been actually received; or
(c) making fictitious entries on the payment side of the cash book; or
(d) entering more amount on the payment side of the Cash Book than what has been actually paid.
In order to discover fraud under (a) and (b) above, the auditor should check the debit side of the cash book with rough cash book, salesmen’s reports, counterfoils of the receipt books, agent’s returns and other original records while the fraud under (c) and (d) can be discovered by reference to the vouchers, wage sheets, salary book invoices, etc.
2. Misappropriation of Goods :- This type of fraud is very difficult to detect especially when the goods are less bulky and are of higher value. Proper methods of keeping accounts in regard to purchases and sales, stock, taking, periodical checking of stocks, comparing the percentage of gross profit to sales of two periods, necessity for collusion will help to avoid misappropriation of goods.
3. Fraudulent Manipulation of Accounts : This type of fraud is more difficult to discover as it is usually committed by directors or managers or other responsible officials. That is why the auditor should be very careful in detecting such frauds. He should carry out the routine checking and vouching most carefully and make searching, tactful and intelligent enquiries. Such a fraud is committed with the following two objects :-
(a) Showing more profits than what actually they are so as to increase the commission payable on the basis of profits, borrow money by showing a better position, to attract more subscribers for the sale of the shares of the company etc. or
(b) Showing less profits than what actually they are so as to purchase shares in the market at a lower price ; or to reduce or avoid the payment of income tax or to mislead aprospective buyer of the business etc.
The accounts may be manipulated in a number of ways which are as follows:
1. by not providing any depreciation or less depreciation or more depreciation; or
2. by under valuation or over-valuation of assets and liabilities; or
3. by showing fictitious sales or purchases or returns in order to show more profits or less
profits whatever the case may be ; or
4. by showing revenue expenditure to capital account or vice versa.
5. by the utilization of secret reserves during a period when the concern has made less or no profit without disclosing that fact to the shareholders etc.
Auditor’s duty with regard to detection and prevention of frauds and errors.
The legal perception of auditor’s duty with regard to detection and prevention of frauds and errors has undergone various charges. Initially, it was based on the decision given in kingston cotton mills co.[1896] case. The learned. Judge Lopse summed up auditor’s duty by stating, “Auditor is a watchdog, not a blood hound. This statement implies.
1. In case of a limited company, an auditor is appointed by the shareholders. Thus, he is expected to play the role of a watch do on their behalf and should look after their interests.
2. Unlike a blood bound the duty of the auditor is verification and not detection. If he finds out something suspicious during the course of audit, he should enquire the matter in detail and inform the shareholders about it. But if he does not discover any such suspicious matter, he is fully justified in trusting and relying an representations made by the employees of the company. In briefly, in case of errors and frauds, the auditor has a duty of reasonable care only.
In recent years, auditor’s duty has been extended in some cases, besides shareholders, to third parties. But the condition is that his negligence is proved. This is in recognition of public pressure on auditors to take more responsibility for detection of fraud in pursuance of their role of lending credibility to financial statements. The judgement in ‘Headly Byrne and Co. Ltd. V. Heller and partners Ltd. Co.(1963) recognised for the first time the liability of professionals including company auditors towards third parties.
