Auditing 2 Answer
Answer 1
1. (a) Bad Debts: The
following procedure may be adopted for verifying bad debts-
(i) The amount of bad debts
should be traced to the schedule of bad debts written off during the year.
(ii) Major amount of bad debts in the
schedule be taken for scrutiny.
(iii) Check that the amount
considered in write off had been overdue for long and scrutinize the
correspondence files.
(iv) Check the authority for
write off and the level of authority is sufficient higher than the executive
involved in collection.
(v) The bad debts should be
properly disclosed in Statement of Profit and Loss according to its
materiality.
(vi) If provision had
already been created for bad debts, see that to the extent of actual bad debts
written off, the provision is released.
(b) Cash at Bank: While testing the authenticity of cash at
bank, the following areas may be considered
by the auditor-
(i) Apart from comparing
the entries in the cash book with those in the Pass Book the auditor should
obtain a certificate from the bank confirming the balance at the close of the
year as shown in the Pass Book.
(ii) Examine the bank
reconciliation statement prepared as on the last day of the year and see
whether (a) cheques issued by the entity but not presented for payment, and (b)
cheques deposited for collection by the entity but not credited in the bank
account have been duly debited/credited in the subsequent period.
(iii) Pay special attention
to those items in the reconciliation statements which are outstanding for an
unduly long period. The auditor should ascertain the reasons for such
outstanding items from the management. He should also examine whether any such
items require an adjustment write-off.
(iv) Examine relevant
certificates in respect of fixed deposits or any type of deposits with banks
duly supported by bank advices.
(v) The auditor should
examine the possibility, that even though the balance in an apparently
inoperative account may have remained stagnant, transactions may have taken
place in that account during the year.
(vi) In relation to
balances/deposits with specific charge on them, or those held under the
requirements of any law, the auditor should examine that suitable disclosures
are made in the financial statements.
(vii) Remittances shown as
being in transit should be examined with reference to their credit in the bank
in the subsequent period. Where the auditor finds that such remittances have
not been credited in the subsequent period, he should ascertain the reasons for
the same. He should also examine whether the entity has reversed the relevant
entries in appropriate cases.
(viii) The auditor should
examine that suitable adjustments are made in respect of cheques which have
become stale as at the close of the year.
(ix) Where material amounts
are held in bank accounts which are blocked, e.g. in foreign banks with
exchange control restrictions or any banks which are under moratorium or
liquidation, the auditor should examine whether the relevant facts have been
suitably disclosed in the financial statements. He should also examine whether
suitable adjustments on this account have been made in the financial statements
in appropriate cases.
(x) Where the auditor finds
that the number of bank accounts maintained by the entity is disproportionately
large in relation to its size, the auditor should exercise greater care in
satisfying himself about the genuineness of banking transactions and balances.
(c) Lease Hold Property: Following are the main steps involved
in verification/vouching of lease hold property-
(i) Inspect the lease
agreement to ascertain the amount of premium, if any, for securing the lease
and terms and conditions. A lease exceeding the period of one year is not valid
unless it has been registered by an instrument. Hence this has to be ensured.
(ii) Ascertain that all the
conditions, the failure of which may result in cancellation of the lease have
been complied with, e.g. payment of ground rent, insurance premium, maintenance
of lease and property in satisfactory state etc.
(iii) Ensure that due
provisions for any claims that might arise under the dilapidation clause on the
expiry of the lease have been made. If such provision has not been made, the
auditor should draw the client’s
attention to it.
(iv) Ensure that the outlay
and legal expenses incurred to acquire lease property have been capitalised.
The property must be written off in such a way that it completely wipes off the
asset at the end of the lease period.
(v) He should ascertain that
the clause entitles the lessee to sub-let any part of the leased property and
ensure its proper compliance.
(d) Profit or Loss Arising
on Sale of Plots Held by Real Estate Dealer: The landholding in the case of
real estate dealer will be a current asset and not a fixed asset. The same
should, therefore, be valued at cost or market value, whichever is less.
Profit or loss arising on sale
of plots of land by Real Estate Dealer should be verified as follows-
(i) Each property account
should be examined from the beginning of the development with special reference
to the nature of charges so as to find out that only the appropriate cost and
charges have been debited to the account and the total cost of the property has
been set off against the price realised for it.
(ii) This basis of
distribution of the common charges between different plots of land developed
during the period, and basis for allocation of cost to individual properties
comprised in a particular piece of land should be scrutinized.
(iii) If land price lists
are available, these should be compared with actual selling prices obtained.
And it should be verified that contracts entered into in respect of sale have
been duly sanctioned by appropriate authorities.
(iv) Where part of the sale
price is intended to reimburse taxes or expenses, suitable provisions should be
maintained for the purpose.
(v) The prices obtained for
various plots of land sold should be checked with the plan map of the entire
tract and any discrepancy or unreasonable price variations should be inquired
into. The sale price of different plots of land should be verified on a
reference to certified copies of sale deeds executed.
(vi) Out of the sale
proceeds, provision should be made for the expenditure incurred on improvement
of land, which so far has been accounted for.
(e) Petty Cash
(i) Trace the amounts advanced to the
petty cashier for meeting petty office expenses from the Cash Book in the Petty Cash Book.
(ii) Vouch payments with docket
vouchers which must be supported, wherever possible, by external evidence e.g.,
payee’s receipted bill or invoices, cash memo, etc.
(iii) Trace payments made for the
purchase of postage stamps recorded in the Postage Book. The totals of the
Postage Book should be test checked. The amounts of postage stamps in hand, at
the end of the year, should be credited to Postage Account by debiting the
amounts to Postage in Hand Account. It should be seen that the amount paid for
postage stamps is not unduly large and the Postage Book is normally checked by
the petty cashier from time to time before the amount of imprest is reimbursed.
Confirm that the postage expenses for the year are reasonable as compared with
that in the postage expenses from month to month.
(iv) See where a columnar Petty Cash
Book is maintained, that the extension have been carried forward into
appropriate amount columns.
(v) Check the column totals and cross
totals.
(vi) Trace
posting of the various columns in which payments are classified to the respective
ledger accounts.
(vii) Verify the cash balance in hand.
(viii) Auditor should also verify
whether the amount of petty cash imprest is fixed. Is this amount reasonable
considering the total amount of petty cash payments made during a month or so?
(f) Borrowings
from a Bank: Borrowings from a bank may be either in the form of overdraft
limits; or short term or medium term or long term loans. The audit procedures
which an auditor may adopt are outlined below-
(i)
Ensure that balance as per books of the
client and the bank statement tally. In case of difference between the two
amounts, reconciliation statement prepared by the client should account for
reasons.
(ii)
Examine whether borrowings from the bank
have been duly authorized.
(iii)
Examine documents to ensure that statutory
requirements, if any, with regards to creation and registration charges have
been met.
(iv)
Examine the loan agreement and ensure that
the terms therein have been duly complied with.
(v)
Ascertain the purpose for which loan has
been raised and examine whether end use of the funds have been accordingly
made.
(g) Sale Proceeds of Junk Material
(i)
Review the internal control on junk material, as
regards its generations,
storage and
disposal & see whether it was properly followed at every stage.
(ii)
Ascertain whether the organisation is
maintaining reasonable records for the
sale and
disposal of junk material.
(iii)
Review the production and cost records for the
determination of the extent of
junk
material that may arise in a given period.
(iv)
Compare the income from the sale of junk
material with the corresponding
figures of
the preceding three years.
(v)
Check the rates at which different types of junk
material have been sold and compare the same with the rates that prevailed in
the preceding year.
(vi)
See that all junk material sold has been billed
and check the calculations on the invoices.
(vii)
Ensure that there exists a proper procedure to
identify the junk material and good quality material is not mixed up with it.
(viii)
Make an overall assessment of the value of the
realisation from the sale of junk material as to its reasonableness.
(h) Repayment of Amount of Foreign Loan for Purchase
of an Asset
(i) Check the
loan agreement, rate of interest, terms of security.
(ii) Check the
remittances made during the year towards installments of repayments made.
(iii) Check
the receipted voucher/account confirmation for the balance of outstanding.
(iv)The year end liability of foreign
loan should be translated to the rate of exchange prevalent as on the closing date.
(v)The gain or loss arising on exchange
conversion is to be credited or debited to Statement of Profit and Loss in
accordance with the Accounting Standard 11.
(vi) Check
banker exchange rate chart for correctness of the conversion.
(vii) Check
RBI or other agencies’ permission for remittances outside India.
Answer 2
Auditing an Account of
Bought Ledger: The structure of
every account in the Bought
Ledger is - opening balance, credits on account of goods purchased and
debits raised in
respect of returns, allowances and discount receivable, advances paid
against goods,
payments and transfers.
An account in the Bought Ledger may be in debit. The balance may
represent the amount receivable on account of goods returned, rebate allowed by
the supplier or advance paid against an order. The auditor should confirm that
the advance against the order had been paid in pursuance of a recognised trade
practice, also that subsequently goods have been received against the advance
or will be received, for such an advance may represent a disguised loan to
accommodate a business associate. The book balance also may represent the cost
of goods purchased wrongly debited to the account of the supplier, instead of
the Purchase Account.
In each such case, it should be ascertained that the book balance is good
and recoverable and if it is not considered recoverable, a provision against
the same has been made. The book balances should be appropriately classified
for purposes of disclosure in the Balance Sheet.
If the debit balance represents a loan to a director or officer of the
company, either jointly or severally with another person or it is a debit due
by a firm or a private company in which the director is a partner or a member,
the same should be separately disclosed in the Balance Sheet in accordance with
the provisions contained in Schedule III to the Companies Act, 2013. The
maximum account due from the directors or other officers of the company at any
time during the year and debts due from companies under the same management
should also be disclosed along with the names of companies (Part I, Schedule
III to the Companies Act, 2013)
Answer 3
Factors Which Increases the
Gross Profit:
(i)
Undervaluation of opening inventory: It may be either the effect of non-inclusion
of certain items of inventories or that of valuation of the inventory at a rate
lower than that warranted by the basis of valuation adopted or miscalculation
of the value of one or more items of inventory. In such a case, the increase in
the rate of gross profit would be preceded by a fall in the rate of gross
profit in the previous year.
(ii)
Overvaluation
of closing inventory, either by the inclusion therein of fictitious items of inventory
or over-statement of values of some of them.
(iii)
Alteration
of the basis of valuation of closing inventory, e.g., where the opening
inventory was valued at cost or market rate whichever was lower, valuing the
closing inventory at the market price which is higher than cost.
(iv)
Increase
in the value of some of the items included in the opening inventory above cost,
on account of which the unsold inventory of these items at the close of the
year is valued at cost.
(v)
Under-statement
of opening inventory or over-statement of closing inventory, due to adjustment
of the amount of sales, when goods sold but not delivered are included in the closing
inventory or when goods were delivered and taken out of inventory last year,
but sales invoices is raised in the current year.
(vi)
Entry
of fictitious purchases to boost up the profits, if such a practice has been
resorted to, it would have the effect of reducing the rate of gross profit in
the ensuing year.
(vii)
Inclusion
in the closing inventory of goods returned awaiting despatch to supplier, the cost
of which has been debited to them or goods returned by customers, the cost whereof
has not been credited to parties.
(viii)
Inclusion
in the closing inventory of goods received for the sale on approval or on a consignment
basis.
(ix)
Treatment
of goods sent out for sale on consignment basis as regular sales.
(x)
No
provision or under-provision in the expenses accounts included in the Trading Account.
For example, purchase may be understated; provision for outstanding wages or carriage
inward may not have been made.
(xi)
Wrong
allocations of expenses, e.g., carriage inwards either in whole or in part may
be wrongly taken to the Profit and Loss Account.
Answer 4
a) Confirmation
of Balances: Direct confirmation of
balances from trade receivables/trade payables in respect of balances standing
in their accounts at the year-end is, perhaps, the best method of ascertaining
whether the balances are genuine, accurately stated and undisputed particularly
where the internal control system is weak. The confirmation date, method of
requesting confirmation, etc. are to be determined by the auditor.
“Guidance Note on Audit of Debtors, Loans and Advances” issued by the
ICAI recommends that the trade receivables may be requested to confirm the
balance either:
(i)
As
at the date of the balance sheet; or
(ii)
As
at any other selected date which is reasonably close to the date of the balance
sheet.
The date should be settled by the auditor in
consultation with the entity. Where the auditor decides to confirm the trade
receivables at a date other than the balance sheet
date, he should examine the movements in
trade receivable balances which occur between the confirmation date and the
balance sheet date and obtain sufficient evidence to satisfy himself that trade
receivable balances stated in the balance sheet are not materially mis-stated.
Therefore, it is not necessary that balances
of trade receivables/ trade payables should necessarily be verified only at the
end of the year only. In fact, in order to incorporate an element of surprise,
the auditor may consider different confirmation dates periodically, i.e., Dec,
31 as a cut-off date in one year and June 30 in another year and so on.
Therefore, the statement that balance
confirmation from trade receivables/trade payables can only be obtained for
balances standing in their accounts at the year-end is not correct.
(b) Certificate from a
Management’s Expert: The computation
of gratuity liability payable to employees is dependent upon several factors
such as age of the employee, expected span of service in the organisation, life
expectancy of the employee, prevailing economic environment, etc. Thus, it
gives rise to uncertainty in the determination of provisions of liabilities.
Under such circumstances, the management is required to make an assessment and
estimate the amount of provision. In view of this, the management may engage an
expert in the field to assist them in arriving at fair estimation of the
liability. Therefore, it is an accepted auditing practice to use the work of a
management’s expert. SA 500 on “Audit Evidence” also states that the preparation
of an entity’s financial statements may require expertise in a field other than
accounting or auditing, such as actuarial calculations, valuations, or
engineering data. The entity may employ or engage experts in these fields to
obtain the needed expertise to prepare the financial statements. It further
requires the auditor to evaluate the competence, capabilities and objectivity
of that expert; obtain an understanding of the work of that expert; and evaluate
the appropriateness of that expert’s work as audit evidence for the relevant assertion,
to conclude whether or not to rely upon such a certificate obtained by the management
from the actuary. Therefore, the auditor must follow the requirements of SA 500
before relying upon the certificate obtained by the management from the
actuary.
(c) Revaluation of Fixed
Assets: The revaluation of fixed
assets is a normally accepted
Practice which involves writing up the book value of fixed assets. AS 10
on ‘Accounting for Fixed Assets’ requires that “an increase in net book value
arising on revaluation of fixed assets is normally credited directly to owner’s
interests under the heading of revaluation reserves and is regarded as not
available for distribution”. Thus, creation of revaluation reserves does not
result into any cash inflows and represents unrealized gains. However, brought
forward losses are in the nature of revenue losses. As a matter of prudence,
revenue losses can be adjusted against revenue reserves only and not the capital
reserves. Therefore, the accounting treatment followed by the entity is not
correct and the auditor should qualify the audit report by mentioning the above
fact.
Answer 5
As per SA 501 on “Audit Evidence- Specific Considerations
for Selected Items”, the following principles are laid down in this respect:
(i) When
inventory is material to the financial statements, the auditor shall obtain sufficient
appropriate audit evidence regarding the existence and condition of inventory
by:
(1) Attendance at physical inventory counting, unless
impracticable, to:
(i) Evaluate management’s instructions
and procedures for recording and controlling the results of the entity’s
physical inventory counting;
(ii) Observe the performance of
management’s count procedures;
(iii) Inspect the inventory; and
(iv) Perform test counts; and
(2) Performing audit procedures over the entity’s final inventory
records to determine whether they accurately reflect actual inventory count
results.
(ii) If
physical inventory counting is conducted at a date other than the date of the financial
statements, the auditor shall, in addition to the procedures as stated above,
perform audit procedures to obtain audit evidence about whether changes in
inventory between the count date and the date of the financial statements are
properly recorded.
(iii) If the
auditor is unable to attend physical inventory counting due to unforeseen
circumstances, the auditor shall make or observe some physical counts on an
alternative date, and perform audit procedures on intervening transactions.
(iv) If
attendance at physical inventory counting is impracticable, the auditor shall perform
alternative audit procedures to obtain sufficient appropriate audit evidence
regarding the existence and condition of inventory. If it is not possible to do
so, the auditor shall modify the opinion in the auditor’s report in accordance
with SA 705.
(v) When
inventory under the custody and control of a third party is material to the
financial statements, the auditor shall obtain sufficient appropriate audit evidence
regarding the existence and condition of that inventory by performing one or
both of the following:
(1) Request confirmation from the third
party as to the quantities and condition of inventory held on behalf of the
entity.
(2) Perform inspection or other audit procedures appropriate in the
circumstances.
Audit Conclusions and Reporting: As per Companies (Auditor’s Report)
Order, 2015 [CARO 2015], the auditor has to report on whether physical
verification of inventory has been conducted at reasonable intervals by the
management; are the procedures of physical verification of inventory followed
by the management reasonable and adequate in relation to the size of the
company and the nature of its business. If not, the inadequacies in such procedures
should be reported. It also requires the auditor to report on whether the
company is maintaining proper records of inventory and whether any material discrepancies
noticed on physical verification have been properly dealt with in the books of
account. If the auditor is unable to obtain sufficient appropriate audit
evidence concerning the existence of inventory or adequacy of procedures
adopted by the management in respect of physical inventory count the auditor
should make a reference to a scope limitation in his audit report. If the
inventory is not disclosed appropriately in the financial statements, the
auditor should issue a qualified opinion.
Answer 6
General Principles of
Verification of Assets: It is not
sufficient for the auditors only to verify
Correctness of the amount of assets shown in the balance sheet, he must
verify them by actual
Inspection or otherwise and establish the existence of assets.
Points requiring auditor’s attention for verification are as under:
(i) Cost - In regard to assets, verification procedure
need not generally be extended to determination of the correctness of costs and
authority to incur costs unless the items concerned were purchased during the
accounting period under review. In such cases the auditor should check the
correctness of costs through normal vouching method. He should ensure that
adequate distinction has been made between ‘revenue’ and ‘capital’ nature of
costs.
(ii) Ownership - Where ownership of assets is evidenced by documents
of title etc. as in the case of immovable property, a reference should be made
to such documents. If the documents are held by third person the auditor should
either obtain a certificate directly from that party or arrange to inspect them
at the third party’s place of business.
(iii) Valuation - It must be ascertained that all assets are
valued in accordance with appropriate accounting policy. For the valuation
made, the basis must be consistently applied, unless circumstances necessitated
a change. Even then a disclosure is required for the change and its monetary
effect.
(iv) Existence - Physical inspection should be done wherever
possible. Where physical inspection is not possible, the possibility of
obtaining indirect evidence be considered e.g. machinery imported held in
customs godown or materials sent to subcontractor for job work or fabrication.
In such circumstances certificating of such parties should be obtained and if
considered necessary even physical verification may be requested.
(v) Presentation in
accounts - Material assets must be
properly disclosed and correctly described in the accounts. It should be seen
that the description given to them is clear and complete and is not misleading
e.g. stating loans on the assets side of the balance sheet “as dependent upon
realization” is just misleading as was held in the case of London and General
Bank Ltd. care must be taken to see that disclosures required under the statute
or statement issued by ICAI are complied with.
Answer 7
Cheques Received on the Last
Day of Accounting Year: It is a quite normal that in any ongoing business
entity many a times cheques are received from the customers on the last day of
the accounting year. It is also quite likely, that cheques received on the last
day of the accounting year could not be deposited in the bank. Though normally
speaking, it is expected that all cheques should be deposited in the bank
daily. But there may be a possibility that such cheques which are received
particularly during the late hours could not be deposited in the bank.
Therefore, it is quite important to ensure that the system of internal control
is effective and such cheques should be properly accounted for to avoid any
frauds and that the financial statements reflect a true and fair view.
As far as internal control
system is concerned, it should be ensured that a list of such cheques is
prepared in duplicate and a copy of the same has been sent to person controlling
the trade receivables’ ledger and a second copy is handed over to cashier along
with the cheques received. The person who is controlling the trade receivables’
ledger should ensure that proper accounting entries have been passed by
crediting respective trade receivables’ accounts. The balance of
cheques-in-hand should also be disclosed along with the cash and bank balances
in the financial statements.
Organizational Business Process : These are the high-level processes that are typically specified in textual form by their inputs, their outputs, their expected results and their dependencies on other