Concept of Auditing

Auditing is derived from the Latin word “Audire” which means “Listen”. Traditionally, a businessman used to appoint a person and asked him/her to go to the accountant to look after any suspicious transactions. Such appointed person used to go to the accountant with the queries about the suspicious transaction and listen to the accountant. After listening to the accountant, the appointed person used to measure the truthfulness of the transaction. Thus, to find out the truthfulness of any suspicious transaction or doubt is the traditional concept of auditing.

But the scope of auditing has changed in modern accounting. Now auditing is the act of checking cash embezzlement, recording of transactions, following accounting principles to prepare financial statements, checking of supportive documents of transactions etc. It is also concerned with whether or not financial statements are correctly prepared and they show the true financial position of a business. Hence, it can be regarded as the act of verifying financial statements to the financial position of the business. The person conducting such activity of checking and examining is called ‘Auditor’.

Key Definitions

Defined By	Definition
Montgomery	“Auditing is a systematic examination of the book and record of a business or other organization, to ascertain or verify and to report upon the facts regarding its financial operation and the result thereof”
M.L. Shandilya	“Auditing may be defined as inspecting, comparing, checking, reviewing, vouching, ascertaining, scrutinizing, examining and verifying the books of accounts of a business concern to have a correct and the idea of its financial state of affairs”
A.W. Hanson	“An audit is an examination of records to establish their reliability and reliability of statement drawn from them”

From the above discussion and definitions:  

• Auditing  is the examination of documents of accounting based on generally accepted accounting principles
• It is looking after the correctness of accounting books maintained
• It is inspecting whether or not financial transactions are done within rules and rights
• It is examining overall accounting based on basic and advanced accounting principles
• It is verifying actual financial position to the financial details shown by prepared financial statements
• It is reporting the facts observed during inspecting, checking, examining and verifying truthfully

Objectives of Auditing

There are different objectives of auditing. These objectives are mentioned as under: 

1.    Primary Objective: The main objective of auditing is to examine the books and accounts prepared by a business. It also aims at checking the accuracy of Profit and Loss A/C and Balance Sheet concerning accounting principles and compliance with existing laws. Similarly, it focuses on verifying the actual financial position of the business with the financial position shown by its financial statements. Its objective is also to determine errors related to recording, accounting principles, accounting standards, legal compatibility etc.

2.    Secondary Objective: This objective is determined to facilitate the achievement of the primary objective. The types of the secondary objective are as follows:

A.    Detection and Prevention of Error: Normally, error occurs due to a lack of accounting knowledge or carelessness. But some errors might be conducted intentionally by violating accounting rules and principles to take benefit or advantage. Auditing aims to detect and prevent such errors; Such errors could be in the following forms;

i.     Errors of Principle: Accounting has its own rules and principles. These must be followed while maintaining accounting records and preparation of financial statements. Sometimes errors of principle are conducted to manipulate profit & loss or financial position of the business. Such error of principle could be in the following forms:

• Treatment of revenue expenditure as capital expenditure or showing capital expenditure as revenue expenditure
• Providing inadequate or excess amount of depreciation
• Under or overvaluation of the stock
• Making the wrong provision for outstanding expenses and doubtful debts

ii.    Error of Omission: Sometimes some transactions are fully omitted while recording. Such error of omission cannitis detected by preparation of trial balance. In such a case, full checking and examining of all documents in records are required. Sometimes such errors are conducted intentionally to misrepresent any financial information. These errors could be in the following forms:

• Omission of purchase to record in purchase book
• Omitting the entry for charging depreciation in the book
• Entry for sales is omitted to record only in debtors account

iii.   Error of Commission: Auditing aims at finding errors of commission conducted during accounting. This is a type of error in which the same but not the actual amount is recorded in both debit and credit aspects of a transaction; Such error is also not detected by the trial balance and could be in the following forms:

• A wrong amount was recorded in the book of original entry
• Overcasting or undercasting of subsidiary books
• Posting of the amount on the wrong side

iv.   Compensating Errors: These are the type of errors in which one error nullifies the effect of another error. The profit created due to one mistake is canceled out by loss created by another error. This is also not detected by a trial balance. Auditing aims at detecting and preventing this error too.

B.    Detection and Prevention of Fraud: Detection of fraud is more challenging than detection of error. Fraud is the intentional error conducted to misrepresent financial position. Fraud is conducted with the intention of tax evasion, managerial strength, influence share price etc. Noticeably, frauds could be in the following forms:

• Cash embezzlement by inflating bills received from suppliers or canceling the purchase return or misappropriating cash by entering dummy names of workers in wage sheets or recording fictitious purchases or omitting cash receipts etc.
• Misappropriation of goods by recording wrong quantities, hiding goods dispatch slip of supplier, treating as disposed of which exists in-store etc.
• Manipulation of accounts by showing loss to avoid tax or falsification of accounts to obtain further loan from banks or showing high profit to inflate the rate of dividend or false sales recording to earn more commission

C.    Other Objectives

• To provide information on income tax
• Ensure the satisfaction of the Company Act
• To have a moral effect

Importance of Auditing

Auditing is important either in different situations or for use of different stakeholders. In this context, some importance of auditing has been explained below:

• Detection of Errors:

Auditing finds out an error that is violating accounting principles or existing laws. Similarly, it is capable of detecting errors that are hard to identify by preparing a trial balance. Such errors could be an error of omission, error of commission, error of principle, compensating error etc. Auditing with the detection of such errors makes the accounting system free of errors.

• Detection of Frauds:

Frauds related to cash embezzlement, misappropriation of goods, manipulation of accounts etc. are conducted intentionally for some purpose. These are against the law and accounting norms. Auditing detects such frauds andensures financial transparency in any organization.

• Increases Shareholders’ Trust:

Timely auditing means timely detection and prevention of errors and frauds. This also means any company is transparent in its financial issues. This increases the trust of shareholders. This ultimately increases the goodwill of the company.

• Facilitates Merger and Amalgamation:

It is necessary to know the assets and liabilities status of a company at the time of merger or amalgamation. If proper auditing has been conducted and such status is known, it helps in the easy calculation of purchase consideration. Hence, auditing facilitates mergers and amalgamation.

• Proof in Court of Law:

Generally audited financial statements act as proof in a court of law. Such statements are authentic to solving financial disputes and cases in courts.

• Partners’ Faith:

Proper and timely auditing ensures and increases faith among partners in partnership firms. Mostly dispute among partners is due to financial transparency issues. But regular auditing means the right disclosure of the financial status of the firm. This maintains partners’ faith in each other.

• Partnership Decisions:

Different partnership decisions are to be taken by a partnership firm. These include decisions such as an admission of a partner, retirement of a partner, death of a partner and even dissolution of a partnership firm. In all such cases, different adjustments are to be made in different accounts. Such adjustments are facilitated by regular periodical auditing.

• Confidence in Dividend Declared:

Public or shareholders have confidence in dividends declared by a company undergoing proper auditing. This is because they believe the accounts are correctly maintained and checked and hence the company has declared the right amount of dividend from its profit. That’s why auditing ensures shareholders’ confidence in dividends declared.

• Tax Liabilities:

Auditing helps in determining the right amount of tax liabilities with the tax laws of the country. The government also trusts correctly disclosed reports after auditing. The government also trusts businesses with timely auditing regarding tax evasion, tax fraud and other financial crimes.

Types of Audit

Basically, audit is the act of examining, inspecting and checking books of accounts so as to detect, rectify and prevent errors and frauds. Though it is a function of identifying and controlling errors and frauds, it has different forms. Audit is of different types depending upon its nature and how it is performed. The different types os audit are explained as under:

1. Financial Audit: The act or process of auditing all the financial books and records. It covers different types of financial transactions maintained in such books or records. It is focused on examining whether or not business transactions are maintained correctly. It is concerned with past financial performance of a business and thus has historical nature. It reports the fair and actual status of business affairs on financial terms. It also examines financial transparency in any business in terms of its earnings and spendings.
2. Cost Audit: It is an audit that concentrates on verification of cost records and adoption of cost accounting techniques correctly. It is verifying cost of production derived from the cost of material, manpower, machine, management and money. It is a systematic and accurate verification of cost account records and fulfillment of cost accounting principles and objectives. It could be performed in forms of efficiency audit, propriety audit and statutory audit.  It is useful to different stakeholders including management, shareholder and government.
3. Management Audit: It is an emerging concept in audit that evaluates differrnt aspects of a business including production management, sales management, marketing management etc. It focuses on checking management status so as to ensure goals are achieved in time by the business. Management audit review the organizational structure and decides on goal obtaining capabibity of the organization. The main objectives of management audit is to formulate organizational goals, ensure the fulfillment of such goals, improve the activities and procedures to work for such goals, and ensure all the members of the organization can discharge their duties to achieve such goals.
4. Tax Audit: It is an audit performed from view point of tax. It is examining and reporting whether or nor a taxpayer had correctly assessed her/his income to determine tax liability. It is an examination of accounting and financial records as well as their supporting documents by a professional auditor like chartered accountant from tax determination perspective. Tax audit is the examination of accuracy of tax returns of an individual or coporation. It could be performed through correspondence, interview of taxpayer in tax office and field audit conducted at taxpayers’ site.
5. Internal Audit: It is an audit conducted by the internal auditor appointed by the management of the organization. Such an audit is performed as specified by the internal audit department in large business organizations. Such internal audit department conducts audit of accounting, financtila and operational aspects of the organization. Internal audit helps management to discharge its responsibilities effectively and highlights internal weaknesses of the organization. It is identifying errors and rectifying them before the external aaudit or final audit.
6. External Audit: External audit is the audit performed by auditors who are  outsiders to an organization. It is an audit performend  by independent professionals. Since, such professionals are outsiders to an organization, they provide opinions without partiality or bias. Due to this, the interest of the shareholders is protected and prevented.

Difference Between Internal and External Audit

Basis	Internal Audit	External Audit
Objective	It aims to serve the management and to prevent errors, fraud, and irregularities.	It aims for assuring the full follow of accounting standards and financial reporting standards or not
Scope	The scope of internal audit is laid down by the management of the organization.	The scope of external audit is defined by law.
Status	Internal audit is conducted by an internal auditor who is the paid employee of the organization.	It is performed by an external auditor who is an independent person.
Appointment of Auditor	The appointment of the internal auditor is optional and done by the management.	The external auditor is appointed by the shareholder or by the government.
Reporting	The report of the internal audit is submitted to the management.	The report of the external audit is submitted to the shareholders of the company.
Duration	It is carried out throughout the year.	It starts after the preparation of year end final account.