Internal Audit and Control

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Unit 1
Structure: 1.1 Introduction Objectives 1.2 Evolution of Auditing 1.3 Development of Auditing in India 1.4 Definitions 1.5 Objectives of Auditing 1.6 Scope of an Audit 1.7 Philosophy of Auditing 1.8 Qualifications of an Auditor 1.9 Qualities of an Auditor 1.10 Advantages of Audit 1.11 Limitations of Audit 1.12 Summary 1.13 Terminal Questions 1.14 Answers

Auditing Today

1.1 Introduction
Auditing is a specialized discipline having its own theory, postulates, principles, standards, procedure and techniques. It is said that Auditing begins where Accountancy ends. As a student of Finance, you know that every economic unit, with or without profit motive, maintains Books of Accounts to record the financial transactions and prepare financial statements. The International Accounting Standards committee has defined the term Financial Statements to cover Balance Sheets, Profit and Loss Accounts or income statements, statements of changes in financial position, notes and other statements and explanatory material which are identified as part of the financial statement. Financial Statements reflect the financial position and performance of any organization. Generally, users of accounting information through Financial Statement fall into two categories: (a) Internal managers who use the information for day-to-day operating decisions.

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(b) External parties, such as investors, banks, suppliers, and Government authorities etc, who use the information for making decisions about the company. Keeping in view, the significance of various accounting information and Financial Statements the reliability and authenticity of the Accounts must be ensured. Auditing plays an important role in ensuring the authenticity of accounting data. A person who conducts audit is called auditor. The Auditor expresses his opinion about truthfulness and fairness of the Financial Statements through an audit report. This report helps to establish the extent of credibility of the financial statements. Figure 1.1 depicts the significance of Auditing.

Fig. 1.1: Significance of Audit

On the basis of nature of work undertaken, audit may be classified as statutory audit, internal audit and private audit. An audit which is authorized, governed and made compulsory under any statute is called statutory audit. Audit of a limited company incorporated under the Companies Act, 1956 is an example of statutory audit. An audit carried out, by the employees,
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specially appointed for the purpose by an organization is called internal audit. All other audits are private audits, carried out on behalf of the clients by the auditor. Objectives: This introductory unit will help you to get familiar with the basic concepts of auditing. After studying this unit, you should be able to: Discover the evolution of Auditing Have a brief idea of development of Auditing in India Define Auditing Understand the objectives, scope and philosophy of Auditing Explain the requisite qualifications and qualities of an Auditor Describe the advantages and limitations of Audit.

1.2 Evolution of Auditing

Auditing is as old as Accounting itself. The word audit has been derived from the Latin word audire meaning to hear, listen or give credence to. In ancient times it was the practice to check the accounts of an estate by hearing the business records from accounting parties by the person authorized to check the accounts. There is historical evidence supporting that household accounts of early rulers were kept by at least two persons, independently of one another, to keep a check on mistakes and misappropriations. In the Mauryan, Greek and Roman empires, there was a fool proof system of control over public revenue and expenditure. The industrial revolution in the 18th century and also advent of joint stock companies increased the number and complexity of business transactions. There was an ever growing need to ensure an independent statutory review of the accuracy and reliability of the Books of Accounts. Independent firms of professional Accountants came into existence to audit the accounts. Auditing profession received statutory recognition with the passing of the British Companies Act in 1862, and detection of fraud became the primary objective of Auditing. In the United States, Auditing profession was introduced in 1900 and ascertaining of actual financial conditions and earning of an enterprise was set out as the main objective of Auditing.

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Self Assessment Questions 1. Financial Statements reflect the financial position and performance of any organization. (True/False) 2. The word audit has been derived from the Latin word audile. (True/False)

1.3 Development of Auditing in India

In India, the compulsory audit in case of companies was introduced by the Companies Act of 1913, with specific provisions as to maintenance of Books of Accounts, contents of the Balance Sheet etc. The qualifications of the Auditor, his powers and duties and the procedure for his appointment were laid down. Accordingly, only a person holding a certificate from the local Government or a member of an association or society duly recognized for this purpose, could act as an auditor. In 1930, the accounting profession was brought under the control of Central Government to ensure uniformity in standards throughout the country. The Central Government maintained a register of Accountants and also established the Indian Accountancy Board (IAB) to advise it on matters relating to the profession. As the Professional Accountants in the country grew in number and importance, the need for an autonomous body to regulate and control the profession was felt. Accordingly, in 1949, the Parliament enacted the Chartered Accountants Act and the Institute of Chartered Accountants of India (ICAI) was established. The affairs of the ICAI are managed and controlled by council comprising elected representatives of Chartered Accountants and nominees of the Central Government. The council lays down standards of education, training, professional conduct and discipline. The ICAI has issued a number of Accounting Standards (AS) and Standards on Auditing (SAs) for guidance of its members. In 1956, a new Companies Act replaced the Act of 1913. This Act and its subsequent amendments considerably enlarged the scope of the annual accounts and the audit report. The Act clearly states that only professional Accountants having requisite qualification can act as a Statutory Auditor of a company.

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The Companies Act, 1956 also prescribed a cost audit in the case of specified companies to be conducted by a Cost and Works Accountants within the meaning of the Cost and Works Accountants Act of 1959. In 1984, the Income Tax Act, 1961 was amended to provide for compulsory audit of accounts of certain assesses, which has further contributed to the growth of auditing profession in India. Self Assessment Questions 3. In India, the compulsory audit in case of companies was introduced by the Companies Act of 1913. (True/False) 4. The affairs of the ICAI are managed and controlled by Government of India. (True/False) 5. Only professional Accountants having requisite qualification can act as a Statutory Auditor of a company. (True /False)

1.4 Definitions
Different experts and association have defined Auditing varyingly. Let us discuss and understand some of the important definitions: The International Auditing Practices Committee defines Auditing as The independent examination of financial information of any entity, whether profit oriented or not and irrespective of its size, or legal form, when such an examination is conducted with a view to expressing an opinion thereon. Montgomery has defined Auditing as A systematic examination of the books and records of a business or other organizations in order to ascertain or verify and to report upon the facts regarding the financial operations and the result thereof. According to Ronald Irish Auditing in its modern concept, is a scientific and systematic examination of books, vouchers and other financial and legal records in order to verify and report upon the facts regarding the financial condition disclosed by the balance sheet and the net income revealed by the profit and loss account. In the abovementioned definitions, the focus is on the examination of the financial records and report thereon. But now-a-days, audit is not only concerned with checking of financial records but also costing records,

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operational records, performance records etc. Efficiency audit has become a buzzword in modern Auditing. A more comprehensive definition of Auditing has been given by the Institute of Chartered Accountants of India which is as follows: Auditing is a systematic and independent examination of data, statements, records, operations and performance (financial or otherwise) of an enterprise for a stated purpose. In any auditing situation, the auditor perceives and recognizes the propositions before him for examination, collects evidence, evaluates the same and on this basis, formulates his judgment which is communicated through his audit report. This definition has described Auditing in a broad sense and covers the following essential features: 1. Auditing is a systematic examination of data (financial or otherwise) by an independent expert called auditor. 2. The stated objective of auditor is to express an opinion as to the truthfulness and fairness of the financial statements. 3. Before expressing his opinion, auditor needs to collect the necessary evidence depending upon his proposition and evaluate it on the basis of his professional knowledge and skill. 4. The auditor expressed his opinion through a report called Auditor Report primarily addressed to shareholders or his client. Self Assessment Questions 6. Audit is only concerned with checking of financial records. (True/False) 7. __________ audit has become a buzzword in modern Auditing. 8. The stated objective of auditor is to express an opinion as to the __________ and __________ view of the financial statements.

1.5 Objectives of Auditing

According to De Paula, The main object of an audit is to ascertain that the Balance Sheet and Profit & Loss Account of an undertaking is showing true and fair view of its financial positions and earnings. The objectives of Auditing can be discussed under two broad heads: 1. Primary objective: The primary objective of Auditing is to examine the reliability and validity of the financial statements so as to render an
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opinion on the truthfulness and fairness of the presentations in those statements. This object has statutory recognition in India and has been clearly stated in Section 227 of the Companies Act, 1956. It requires the auditor of a company to state whether in his opinion, the accounts give a true and fair view in the case of Balance Sheet of the state of companys affairs as at the end of the financial year and in the case of the Profit & Loss Account, of the profit or loss for the financial year. According to SA 200A, issued by the Institute of Chartered Accountants of India, the objective of audit of financial statements is to enable the auditor to express his opinion as regards the truth and fairness of assertions made in those statements. The user should however, not assume that this opinion is an assurance as to the future viability of the enterprise or the efficiency or the effectiveness with which the management has conducted the affairs of the enterprise. 2. Secondary objective: The secondary objective of audit is to detect and prevent the errors and frauds. An error may be defined as any unintentional mistake or misdescription in the Books of Accounts or records whether by way of: (a) Mathematical or clerical mistakes in the records and data; (b) Oversight or misinterpretation of facts; or (c) Misapplication of accounting policies. An error is generally taken to be innocent and not deliberate. Where it appears to be willfully made, it assumes the character of a fraud. The term fraud refers to an intentional act by one or more individuals of management, employees or outsiders, severally or jointly, involving the use of deception to obtain an unjust or illegal advantage. The distinguishing factor between error and fraud is the underlying motive that is the unintentional action resulting in the misstatement in the financial statements or the intentional action to obtain an illegal benefit or concealment of facts. Examples of errors: 1. Goods purchased on credit may have been overseen and was not entered in the Journal. 2. A purchase of Rs. 20,000/- was entered in the purchase book as Rs. 2,000/-.
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3. Goods were sold to X for Rs. 50,000/-. This amount is posted to the debit of Y instead of X. Examples of frauds: 1. Fictitious purchases recorded by accountant to misappropriate cash. 2. Income of preceding year may be recorded in the current year and expenses of current year being shown as of next year in violation of the matching concept of accounting. 3. Evasion of income-tax may be accomplished by charging depreciation on non-existence fixed assets. Auditors duty with regard to detection and prevention of frauds and error: The perception of auditors duty with regard to detection and prevention of frauds and errors has undergone various changes in the last century. Initially, it was based on the decision given in Kingston Cotton Mills Co. (1896) case. The learned judge Lopse summed up auditors duty by stating Auditor is a watchdog, not a blood hound. This statement implies: 1. An auditor is appointed by the shareholders in case of a limited company. He is expected to play the role of a watchdog on their behalf and should look after their interests. 2. Unlike the bloodhound the duty of the auditor is verification and not detection. If he discovers something suspicious, during the course of audit, he should probe the matter thoroughly and apprise the shareholders about it. In the absence of such suspicious circumstances, he is fully, justified in believing and relying on representations made by the tried servants of the company. In short, in case of frauds and errors, the auditor has a duty of reasonable care only. In recent years, however, the scope of auditors duty has been considerably extended. SA 240 titled, The Auditors Responsibility to consider Fraud and Error in an Audit of Financial Statements issued by ICAI provides expanded guidance on auditors responsibility for identifying and reporting on fraud and error. The salient points are discussed below. It is a fact that the primary responsibility for the prevention and detection of fraud rests with the management of the entity as well as those charged with Governance. However, it would be wrong to conclude that the auditor is
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altogether free from liability as to fraud and errors in the Books of Accounts or the financial statements of the enterprise under audit. It should be remember that he is a professionally qualified person and, in that capacity, owes a duty of reasonable care and skill in the conduct of his examination. Duty of reasonable care requires the auditor: 1. To make an intensive study of the system of internal control and check and devise his audit and testing procedure accordingly. 2. To make all verifications personally or through an experienced representatives. 3. To ensure that the financial statements fully conform to the generally accepted accounting procedures and relevant legal requirements. 4. In case of financial statements disclose a situation even remotely hinting at a fraud to pursue the lead to its logical conclusion. 5. The auditor should conduct audit to provide reasonable assurance that no material misstatements resulting from fraud and error exist in the financial statements. 6. If suspicion of fraud is aroused, the auditor should inform the management, irrespective of the materiality of such frauds on financial statements. However, in case of errors, only material errors are to be communicated. 7. If the auditor is confirmed about any fraud or error and also certain of its material effect on financial statements, he should satisfy himself that it has been disclosed in financial statements. If, not so, he should disclose it in his report. 8. If auditor is unable to obtain sufficient audit evidence to confirm or dispel a suspicion of fraud and error then he should assess the impact of such fraud or error on financial statements as per accepted auditing standards and highlights its in his report. 9. For any subsequent discovery of undetected material misstatement, the auditor cannot be held liable provided he had adopted adequate procedures that are in conformity with auditing standards. In conclusion, we can say that the judgment in Kingston Cotton Mills, comparing the auditor to a watch dog and not a bloodhound, does not absolve the auditor of his responsibility to conduct a careful checking of
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business transactions. In fact, his responsibility in this regard also extends to areas in which he has no adequate competence, such as valuation of assets or legal matters, in the case of which he may take the assistance of experts who will be regarded as his agents for the purpose. Activity: Choose a company of your choice listed on National Stock Exchange (NSE) and go through The Auditors Report section from its Annual Report. What kind of financial information does it contain? How do they differ from The Directors Report? Prepare a report on how the auditors report acts as a catalyst towards ensuring a better quality of reporting on financial performance and position and discuss with your teacher. Refer companys website for Annual Report. Self Assessment Questions 9. The primary objective of Auditing is to examine the __________ and __________ of the financial statements. 10. After the completion of statutory audit of Bright Ltd., a fraud has been discovered in the books of account of the entity. Comment whether auditor can be held liable.

1.6 Scope of an Audit

The scope of an audit is decided by the terms of agreement between the auditor and the client. The scope of an audit is also dependent upon the nature or kind of audit viz. statutory audit, internal audit, cost audit, management audit, tax audit etc. However, some common elements in scope of all types of audit are as follows: 1. A depth study of accounting and internal control system. 2. A depth examination of Books and Accounts and other relevant records. 3. Ensuring compliance with the Generally Accepted Accounting Standards, Auditing Standards and applicable statutory regulations 4. Reporting to clients It may be important to mention here that the Auditor is not responsible for the preparation of financial accounts of the company. As observed by the Council of Chartered Accountants of England and Wales, the directors are
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ultimately responsible for maintaining adequate records and preparation of Annual Accounts showing a true and fair view required by the Law. Directors are also responsible for safeguarding the assets of the company and they should not depend upon the auditor to protect them from any deficiency in carrying out their responsibilities. The Research Committee of the ICAI has specifically stated that the duty of safeguarding the assets of a company is primarily that of the management and the auditor is entitled to rely upon the safeguards and internal controls instituted by the management. However, the fact remains that in forming and expressing professional opinion on Audi tees Books of Accounts, the auditor carries an independent responsibility in the eye of law, which cannot be shifted to directors of the company. Self Assessment Questions 11. Auditor is not responsible for the preparation of financial accounts of the company. (True/False) 12. Auditors are responsible for safeguarding the assets of the company. (True/False)

1.7 Philosophy of Auditing

According to Mautz and Sharaf, the philosophy of auditing is based on the following primary concepts: Evidence Due audit care Fair presentation Independence Ethical conduct According to SA 500, AUDIT EVIDENCE, issued by ICAI, the auditor should obtain sufficient appropriate evidence in support of his conclusions as described in his report. Sufficient appropriate evidence does not mean a conclusive proof. But, evidence should be such that any reasonably competent person will accept it as a base before forming any opinion. For example, for verifying transactions in the bank pass book, the auditor should examine counterfoils of pay-in-slips; details of cheques issued and bank statements. Due to fraud prone item, the auditor should not confine
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himself to test checking and hence, quantum of audit evidence required would be more. The concept of due audit care is concerned with the determination of reliability and adequacy of evidence in support of observations made in the audit report. For example, a Bank Reconciliation Statement (BRS) prepared by an internal auditor who is independent of the cashier and accountant has a greater degree of reliability and is more relevant for the external auditor than a BRS prepared by a cashier who is also an accountant. Presentation of financial statements is deemed to be fair when it complied with the recognized accounting principles, practices and standards. For example, accrual basis of accounting is a widely accepted practice compare to cash basis of accounting. Auditor should be independent in his approach and free from any biases and prejudices. He should not forget that due to his professional standing, he is a public servant. Though he has been appointed by his client, his responsibility is also to safeguard the interest of all other stakeholders who might make decisions based on his report. The auditor must take extra efforts to earn and preserve his reputation as a person of character and integrity. Recent example of Satyam episode has shaken the confidence of public at large on auditors integrity and ethical values. Undoubtedly, this case has violated the spirit and concept of philosophy of auditing. Self Assessment Questions 13. Sufficient appropriate evidence means a conclusive proof. (True/False) 14. There is no difference between accrual basis of accounting and cash basis of accounting. (True/False)

1.8 Qualifications of an Auditor

Section 226 of the Companies Act, 1956 lays down the prescribed qualifications of an auditor: 1. A person who is a Chartered Accountant within the meaning of the Chartered Accountants Act, 1949 and holds a certificate of practice.
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or 2. A partnership firm where all the partners are Chartered Accountants holding certificate of practice may also be appointed as an auditor of a company. or 3. A person holding a certificate under the Restricted Auditors certificate (Part B States) Rule, 1956 is also qualified to be appointed as an auditor.

1.9 Qualities of an Auditor

An auditor renders a professional service to his client. He should not only possess the prescribed statutory qualifications but also certain personal qualities. Some of those personal qualities are mentioned below: 1. Common sense: According to Spicer and Pegler, the auditor should have a full share of that most valuable commodity-commonsense. This is necessary to distinguish between important and not so important information. 2. Independence: Expression of opinion is a prime duty of an auditor. An influenced and biased person cannot form an independent opinion. Hence, independence in true sense is an utmost quality of an auditor. 3. Honesty and Integrity: Like any other professional viz. Doctors, Lawyers etc. auditor should possess a high moral character. In a way, he is a public servant. He must not knowingly, misinterpret any fact or sign any document under undue pressure. 4. Objectivity: Independence of an auditor depends on his ability to act with objectivity. For example, the auditor of XYZ Company believes that closing stock has not been properly valued but accepts a certificate from the management as to its valuation. In this case, the auditors judgment lacks objectivity. 5. Communication: He should be able to communicate effectively, both orally and in writing. Particularly in the matter of report writing, he should be able to convey his message clearly and unambiguously. 6. Tactfulness: He should be firm, yet diplomatic with his client and staff. He should be tactful enough to obtain necessary written as well as oral evidence from his client, so that he can form a reasonable opinion.
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7. Awareness of latest developments: An auditor should keep his knowledge up to date related to his audit work likes changes in laws, changes in professional standards, latest development in technical guidelines etc. Self Assessment Questions 15. A partnership firm where all the partners are __________ holding certificate of practice may also be appointed as an auditor of a company. 16. The auditor should have a full share of that most valuable commodity __________.

1.10 Advantages of Audit

We know that the prime objective of an audit is to make a critical review of, the system of book keeping, accounting, and internal control etc. and report to the members stating whether, in the opinion of the auditor, the accounts shows a true and fair view of the affairs of the company. This report lends credibility to the financial standards prepared by the companys management. Moreover, the companys management knows that the financial statements, prepared by them would be subject to an independent professional review. Hence, they remain very vigilant and alert in preparation of financial statements, result in less erroneous and/or fraudulent information dissemination. Apart from above some other important advantages of audit are as follows: 1. It facilitates the early detection and easy prevention of fraud and errors. 2. It helps in reducing wastages and chances of losses or damage to business property. 3. Banks, financial institutions and Government required audited accounts before granting any financial assistance to the enterprises. 4. Liability of the enterprise as to income tax, wealth tax, VAT, etc can easily be determined on the basis of audited accounts as these are readily believed by the tax authorities. The Income Tax Act also contains a provision for holding tax audit. 5. Audited accounts help in determining purchase consideration of enterprise in case of outright sale, merger and acquisition etc.
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Self Assessment Questions 17. Audit keeps management more alert and vigilant. (True/False) 18. The Income Tax Act does not contain a provision for holding tax audit. (True/False)

1.11 Limitations of Audit

As per SA 200A issued by The Institute of Chartered Accountants of India, on objective and scope of Audit, the objective of an audit is to express an opinion as to the true and fair view of the financial statements. The user, should, however, not assume that this opinion is as assurance as to the future viability of the enterprise or the efficiency or the effectiveness with which the management has conducted the affairs of the enterprise. Moreover, the user should also understand that audit of accounts do not guarantee the detection of all the errors and/or frauds. These conceptual restrictions arise due to following inherent limitations of Auditing: 1. Postmortem of accounts: Auditing begins where accounting ends. The job of an auditor starts where an accountant finishes his task of preparation of accounts. Naturally, the auditor has to rely on different information and explanations given to him by the Accountant. In the process many times, misstatement of facts remain undiscovered even after the accounts have been audited. 2. Test nature of audit: Due to time and cost factors, the auditor does not usually examine all the transactions. He applies test checks and/or statistical sampling techniques. The inherent weaknesses of such methods bring an uncertainty or risk element in Auditing. Thus, Auditing only reduces and does not eliminate the possibilities of errors and frauds in the Books of Accounts and Financial Statements. 3. Inherent limitations of internal control system: An auditor before expressing his opinion mostly relies on the internal control system of the enterprise. Internal control is the overall control environment established by Management of an enterprise for effective and efficient monitoring and control of its operation. Internal control goes beyond the accounting functions of the organization and incorporates both accounting and administrative controls. The inherent limitations of internal control are
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the major hurdles in achieving the objectives of audit. Some of the limitations of internal control are as follows: (a) Certain level of management may be in a position to override control. (b) Possible collusion between persons operating the internal control and employees of the client enterprise or outside parties may render the controls ineffective. (c) Chances of human error contribute its own share to weaken the internal controls. Self Assessment Questions 19. Ram and Rahim invested in shares of Sure Grow Ltd. They lost their investment. They sued the auditor on the plea that auditors had given a clean audit report for last few years for the said entity. Comment. 20. Auditing only reduces and does not eliminate the possibilities of errors and frauds in the Books of Accounts and financial statements. (True/False)

1.12 Summary
Auditing is a systematic and independent examination of data, statements, records, operations and performance (financial or otherwise) of an enterprise for a stated purpose. In any auditing situation, the auditor perceives and recognizes the propositions before him for examination, collects evidence, evaluates the same and on this basis, formulates his judgment which is communicated through his audit report. The primary objective of Auditing is to examine the reliability and validity of the financial statements so as to render an opinion on the truthfulness and fairness of the presentations in those statements. The secondary objective of audit is to detect and prevent the errors and frauds. The scope of an audit is dependent on the terms of agreement between the auditor and the client and the nature or kind of audit. The philosophy of auditing is based on certain primary concepts viz. evidence, due audit care, fair presentation, independence and ethical conduct.

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A person who is a Chartered Accountant within the meaning of the Chartered Accountants Act, 1949 and holds a certificate of practice can only be appointed as an auditor of a company as per section 226 of Companies Act, 1956. Apart from professional qualifications, an auditor must possess certain personal qualities like honesty and integrity, tactfulness, vigilant, good communication skill etc. The audit provides a number of advantages. It helps both external and internal users in taking logical and informed decisions by upgrading the reliability and truthfulness of financial data and statements. Audit of accounts do not guarantee the detection of all the errors and/or frauds. The users should understand this inherent limitation of auditing. Glossary Postulates: fundamental truths or assumptions of a theory. Principles: broad generalizations inferred from postulates. Standards: quality of performance criteria. Procedures: specific acts to be performed. Techniques: methods used for carrying out a procedure. Financial Statements: Balance sheet and Profit and Loss Accounts etc. Error: any unintentional mistake or mis-description in the Books of Accounts or records. Fraud: An intentional act by one or more individuals of management, employees or outsiders, severally or jointly, involving the use of deception to obtain an unjust or illegal advantage.

1.13 Terminal Questions

1. 2. 3. 4. Define and explain the term auditing. An auditor is a watchdog and not a bloodhound. Comments. What are the objectives of auditing? Personal qualities of an auditor are important for the successful conduct of audit. Comments. 5. Discuss, in brief, the advantages and limitations of auditing.
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1.14 Answers
Answers to Self Assessment Questions 1. True 2. False 3. True 4. False 5. True 6. False 7. Efficiency 8. True and fair 9. Reliability and validity 10. As per SA 240, The Auditors Responsibility to Consider Fraud and Error in an Audit of Financial Statements, subsequent discovery of undetected material misstatements of financial information resulting from errors and frauds does not necessarily mean that the auditor has been negligent in performing his duties. If he had adopted adequate audit procedures as per auditing standards. 11. True 12. False 13. False 14. False 15. Chartered Accountants 16. Common sense 17. True 18. False 19. According to SA 200A, Objective and Scope of an Audit of Financial Statements, issued by ICAI, the auditors opinion is no assurance on future viability of the business of the entity. In the given case, if the auditor has conducted audit as per requirements of SA 200, Basic Principles Governing an Audit and other statutory provisions, he cannot be held liable. 20. True Answers to Terminal Questions 1. Refer to Para 1.4 2. Refer to Para 1.5
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3. Refer to Para 1.5 4. Refer to Para 1.9 5. Refer to Para 1.10 and 1.11

Mini-case
Menon & Menon Industries Ltd. Menon & Menon Industries Limited is a small sized family company for which you are appointed as the auditor for the year ended 31st March 2009. The company has made rapid progress during the current financial year. Turnover has increased by almost 150 percent from Rs. 2.2 crores to Rs. 5.5 crores, net profit by 75 percent from Rs. 6,50,000 to Rs. 11,25,000 and net assets by 100 percent from Rs. 2.8 crores to Rs. 5.6 crores. The entire share capital is owned by Menon family with Mr. Rahul and his two sons managing the business on a day to day basis. Because of the increased business activities of the company during the current financial year, the accounting department of the company witnessed an expansion through the employment of three more members of which one is a qualified accountant who is now occupying the position of chief accountant and is reporting to Mr. Rahul. You have indicated to Mr. Rahul that an increase in the audit fees is inevitable because of the growth in the size of the company involving far more transactions than the previous year. Mr. Rahul considers this as unjustifiable and even suggests that being a family business an audit itself is not necessary. Questions 1. Explain to Mr. Rahul why an audit is necessary. 2. Mention in brief outline, the basis for determining your audit fees. 3. Explain briefly the benefits of an audit and give three specific uses of audited accounts.
Source: AUDITING by Shekhar & Shekhar published by Vikas Publishing House Private Ltd.

Answers 1. The Indian Companies Act, 1956 stipulates that every company shall appoint an auditor and that auditor shall report to the members of the company. Thus, getting the accounts of the company by a qualified
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auditor is an essential legal requirement in spite of the small size of the company or being a family business. In addition to the legal requirement, an independent audit of the accounts of the company would give credibility to its financial statements thus giving confidence to the concerned outside parties to deal with the company in whatever capacity. 2. The basis for determining the audit fees will be dependent on the particular skills involved, the extent of responsibility and the time taken to perform the audit procedures to express an opinion on the financial statements under consideration. In the case of Menon & Menon Industries Limited, it goes without saying that the substantial growth of its business and the expansion of the accounts department will necessarily result in a corresponding expansion in the nature and number of accounting transactions. Consequently, there will be an enlargement of the auditors responsibility in carrying out an examination of the companys accounts. Also, it will mean higher skills and more time as compared to the previous year. It is only justifiable that the auditor is suggesting an increase in the audit fees. 3. Refer 1.9 for benefits of an audit. Three specific uses of audited accounts are: 1. In the matter of negotiations with banks and other financial institutions for obtaining financial accommodation. 2. In the matter of negotiations with suppliers of raw materials and/ or finished goods for obtaining beneficial trade terms. 3. In the matter of ensuring the shareholders that the business of the entity is carried on in an efficient and orderly manner, especially since the shareholders will not generally be in a position to exercise proprietarily control over the day to day affairs of the entity concerned, even if it is a family business.

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