Following points, You must revise before examinationcmahelp.weebly.com/uploads/1/5/6/3/15633668/aud.scanner_eng.pdf in association with DIVYJYOTI TUTORIAL Following points, You must

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Following points, You must revise before examination : Sec 209 : Books of accounts to be kept by the company.

.According to section 209(1)(d) of the Companies Act 1956, the Central Government has powers to

direct any class of company to maintain proper books of account in respect of utilisation of resources for

production or manufacture of a particular product.

The audit of companies directed under section 209(1)(d) may be ordered under section 233-B of the

Act.

Sec 210 : At every GM, the BOD of the company shall lay a balance sheet and profit and loss a/c.

Sec 211 : The forms and contents of balance sheet and profit and loss a/c shall be in accordance with

section 211. Section 211 of the Companies Act 1956 makes it compulsory for the companies to follow

AS-1. As per section 227, the auditor's report shall state, whether in auditor's opinion, the profit and loss

account and balance sheet complied with the accounting standards referred in section 211. Obviously

the auditor has to make a qualified report if accounting standards (AS-1) are not followed.

Sec 212 to Sec 214 relate to accounts of holding companies.

Sec 215 : Balance sheet and profit and loss a/c should be authenticated by Secretary (or manager) and

by two directors.

Sec 216 : The profit and loss a/c shall be annexed to balance sheet and Auditor's report shall contain

profit and loss a/c and balance sheet.

Sec 217 : The Director's report shall be attached with the balance sheet.

Sec 224 : Appointment of Company auditor

Sec 224 A: Appointment by Special Resolution

Section 224-A of the Companies Act 1956 provides :

A company in which not less than 25% of the subscribed capital is held by :

a public financial institution or a government company or the Central Govt. or any State Govt. or

any financial or other institution established by any Provincial or State or any State Act in which a State

Govt, holds not less than 51% of the subscribed capital, or

a nationalised bank or an insurance company carrying on general insurance business; or

any combination of the above categories,

shall appoint or re-appoint an auditor in the annual general meeting only by passing a special resolution.

If the company fails to pass a special resolution, it shall be deemed that, no auditor is appointed by the

company.

Section 224 (3) and Section 224 (4) : The CG may appoint a person to the casual vacancy in the office

of the auditor.

Section 224(5) of the Companies Act 1956, the first auditor of the company should be appointed by the

Board of Directors within one month from the date of registration of the company

Section 224(6) of the Companies Act 1956, states that the BOD can fill the vacancy caused by any

reason other than resignation.

Sec 225 : Removal of auditor. Sec 224 also deals with it.

Sec 619 : The auditors of Govt. Companies shall be appointed by the CG on the advice of CAG of

India. Section 224 and Section 233 are NOT applicable to such appointments of Govt. auditors.

Section 226 : Prescribes the qualifications and disqualification of auditors.

Sec 227 : Rights, Duties and liabilities of the auditor.

Sec 228 : Where a company has a branch office, the accounts of that office shall be audited either by the

company's auditor as appointed u/s 224 or by any other auditor possessing qualification prescribed u/s

226.

Sec 229 : Signature of Audit Report : Only the person or partner of the firm of Chartered Accountants

appointed as Auditor may sign the auditor's report or any other document of the company required by

law to be signed by the auditor.


Sec 230 : The auditor's report shall be read before the company in GM.

Sec 231 : Right of Auditor to attend GM.

Sec 232 : Penalty for non compliance with Sec 225 to Sec 231.

Sec 233 : Penalty for non-compliance by Auditor with Section 227 and Sec 229. If the auditor's report is

signed by any person other than as prescribed in law, the auditor concerned and the person be

punishable with fine.

Sec 233 A : Power of CG to direct special audit in certain cases.

Sec 233 B : The Cost Auditor shall be a Cost Accountant to audit the cost records of the company.

Section 233 B : Audit of Cost accounts in certain cases.

Chapter 1 : Auditing Techniques and Practices Write Short Notes On : 2001 Dec (5) Audit Risk [Repeated in 2003 June (8) and 2003 Dec (6)]

Answer : The audit risk implies and involves risks associated with process of auditing as well as performance of auditor. These risks arise on account of many causes; some of them are as below:

1. The auditor himself is human being tied on all fronts on this account. His performance, capacity and capability are limited to his physiological factors.

2. Time available and task allotted do not match in general. 3. Cost of audit, limits the scope giving rise to risks. 4. Due to sampling techniques, some transactions go unchecked. They may be

having material impact. The above mentioned points assert that there is unavoidable risk due to the test check and other inherent limitations of internal control system. It is evident that the auditor should be aware of risk which is inherent in any audit with reference to materiality of transactions and he should accordingly test and evaluate the internal control system so as to assess the extent of risk. Auditor should take into account the risk of material misstatement of the financial information caused by fraud and error, because the fraud usually involves actions designed to conceal it. Audit risk is the risk that the opinion of the auditor on the affairs of the company, may be inappropriate because the information on which he has based his opinion may be misstated. Audit risks may be categorised as :

Inherent risk, the risk that material errors and mist-statement will occur,

Control risk, risk that the auditee's system of internal control will not be able to prevent or rectify such errors,

Detection risk, the risk that any remaining material errors may go undetected during audit process.

Low risk areas are those which necessitate the application of conventional audit procedures of vouching, checking etc of transactions in a routine way. Low risk areas constitute major portion of any audit work. High risk areas are those which should be the primary concern of high level management, and will inter-alia include such matters as :

a) Computation of tax and compliance with taxation legislation;


b) accounting of contingencies and events which take place after the date of balance sheet;

c) adequacy of provisions; d) disclosure of accounting policies; e) disclosure of all liabilities including contingent liabilities; f) compliance with accounting standards and auditing standards; g) detection of overstatement of assets and liabilities;

2002 June (5) : (c) Matching Concept Answer : The matching concept is an essential part of accrual accounting, the two are often used interchangeably. The matching concept requires that the expenses relating to a period should match with the revenue income of that period. This concept requires proper allocation of costs into appropriate period so that relevant incomes and expenses are matched. The profit of an accounting period is the revenues from transactions less expenses incurred in producing those revenues. If expenses cannot be traced to specific items of revenues, they are generally written off in the year in which they are incurred. If the costs incurred so far have yet to produce revenue, they

should be carried forward. Similarly, if against revenue received, costs still have to be incurred, the revenue should be carried forward. 2002 Dec (8) : (a) Fundamental accounting assumptions Answer : The preparation and presentation of financial statements is based on certain accounting assumptions. Their acceptance is universal and thus they are not specifically mentioned. Disclosure is necessary if they are not followed. The following have been generally accepted as fundamental accounting assumptions:

(i) Going Concern : It is normally assumed that the concern will exist for a sufficient length of time in a foreseeable future. There is neither the intention nor the necessity of liquidation.

(ii) Consistency : It is assumed that the concern is consistent in its policies and procedures. It follows the same accounting principles from one period to another period.

(iii) Accrual : This is associated with the going concern concept of accounting. It is assumed that the revenues and costs are accrued i.e. they are recognised as they are earned or incurred and represented in financial statements.

If the fundamental accounting assumptions, viz., Going concern, Consistency and Accrual are followed while preparation and presentation of financial statements, specific disclosures are not required. However, if they are not followed, specific disclosure will become necessary.

2003 June (8) (b) Audit risk (d) Continuous Audit Answer : (b) For Audit Risk see above; (d) Continuous Audit:

When the work volume is considerable, audit once in a year would not suffice. Auditing should be matching and corresponding with the volume of work of the organization. A continuous audit is the audit in which the auditors keep on auditing throughout the year or for the concerned accounting period at fixed or irregular intervals. The distinctive character of continuous auditing is the short time lapse between the facts to be audited and the collection of evidence and audit reporting. Some of the drivers of continuous audit are:

1. all the aspects of auditing can be looked into in more specified manner;


2. it captures the internal control problems as they occur thus preventing negative effects.

3. greater and better assistance in detection of frauds, errors and omissions and in consequent application for their rectification and remedy.

4. stress on maintenance of up-to-date records of transactions; 5. superior performance in and presentation of final audit report at the close of

financial year; 6. use of updated information prevents financial fiascos and scandals. Disadvantages and Cautions:

1) Possibility exists for alteration of already audited figures either knowingly or unknowingly or fraudulently. Mechanism should be devised and applied to prevent any alternation in already audited figures. The audited figures should be maintained separately by the auditors.

2) It has to be efficiently built into the system of current operations. 3) The auditing layers and rules may need continuous adjustments and

updating. 2003 Dec (8) Disclosure of accounting policies Answer : Accounting standard-1 (AS-1) on '' Disclosure of Accounting policies'' issued by Institute of Chartered Accountants of India has been make mandatory for all companies. According to AS – 1, the accounting policies refer to specific accounting principles and the method of applying those principles adopted by the enterprises in preparation and presentation of the financial statements. At the time of preparation of financial statements i.e. Balance sheet, profit and loss account, there are many areas, which have more than one method of accounting treatment such as :

Method of depreciation viz. SLM or WDVM

Treatment of expenditure during construction : Written off, capitalization, deferment

Valuation of inventories : FIFO, Weighted average, Standard cost, LIFO

Valuation of investment

Valuation of fixed assets

Treatment of current liabilities

Treatment of Goodwill. and many more than above. The accounting policies declare the method adopted in preparation of financial statements; AS -1 requires all important accounting policies to be disclosed in one place and as a part of the financial statements. If the fundamental accounting assumptions viz. Going concern, Consistency and Accrual are followed in financial statements specific disclosure is not required. If a fundamental accounting assumption is not followed, the fact should be disclosed. AS-1 also states that if there is any change in accounting policies in preparation of financial statements from one period to subsequent period and such change affects the state of affairs of balance sheet and profit and loss account of current period or the financial statement of later period, then such change must be disclosed in financial statement. The amount, by which the financial statement is affected, should be disclosed to the extent ascertainable.


The view obtainable in the financial statements can be extensively affected by the accounting policies pursued. The accounting policies differ and diverge from one organization to other. For a proper understanding of financial statements, disclosure of accounting policies is obligatory. Such disclosure also assists in meaningful comparison of financial parameters between different organizations. Section 211 of the Companies Act 1956 makes it compulsory for the companies to follow AS-1. As per section 227, the auditor's report shall state, whether in auditor's opinion, the profit and loss account and balance sheet complied with the accounting standards referred in section 211. Obviously the auditor has to make a qualified report if accounting standards (AS-1) are not followed. 2003 Dec (6) Audit Risk Answer : Same as above. 2008 June (5) Generally Accepted Auditing Standards (GAAS) Distinguish Between : 2003 June (2) (b) [repeat 2001 Dec(5)(d)] State the main points of distinction between :Test Checking and Routine

Checking Answer :Main points of distinction between : Test Checking and Routine Checking Routine checking generally applies checking of all transactions in a routine manner. It stresses on checking and vouching of all the entries. As the volume of work grows, the option and practicability of routine checking fall. Existence of effective internal controls also reduces the meaningfulness of routine checking and it is seldom expected to reveal anything material. There is a growing realisation that the traditional approach to audit is economically wasteful because all efforts are directed to check all transactions without exception. This invariably leads to less emphasis on routine checking which often is not necessary in view of the time and the cost involved. Large volume of work requires sample checking of transactions as it is impracticable to check the entire gamut of transactions. Test checking is adopted on selected transactions. The selection is based on statistical sampling techniques. The auditor draws a sampling plan and judges the nature, size and significance of transactions. The entries relating to material accounts are seen in detail while less significant ones are proportionally checked. Some sampling assumptions are adopted for the conduct of checking viz. checking of a particular period of year under audit, checking of entries of transactions of more than a particular amount, checking of entries on some random basis. If the transactions so checked are ok, it leads to conclusion that all other transactions are also ok. If the test checking reveals any irregularity the extension and expansion of checking are taken up in more areas and entries. Descriptive Questions : 2002 June (1) As an auditor of a company, state your views on the following : (d) A limited company selling goods mostly on credit wants to maintain its books of account on cash basis: Answer : The company wants to contravene the provisions of Section 209 of the

Companies Act, 1956. The section 209 requires that the books should be kept on accrual basis and according to double entry system. It is statutory requirement to keep proper books in a manner and on matters as prescribed in the Act. The company can be prosecuted for contravening the provisions of Act if it maintains the books on cash


basis. The auditor has to give qualified report indicating the maintenance of books on cash basis. 2002 June (4)(a) : Discuss the requirements of accounting standards in respect of contingencies and events occurring after the balance sheet date. Answer : The AS-4 prescribes the accounting of contingencies and events which take

place after the date of balance sheet but before approval of balance sheet by Board of directors. According to AS-4, Contingency refers to :

Existing conditions and situations,

Results of which is not known on the balance sheet date

Results of which would be known only on happening or non-happening of certain events in future

Results may be either a gain or loss. As per AS-4, company should make the provision for bad and doubtful debts, as situation of non-recovery from the debtors is existing on the balance sheet date result of which will be known in future. The amount of provision for bad and doubtful debts should be shown as deduction from total debtors in balance sheet. Provision for loss is estimated on the basis of information available up to the date of approval of accounts by competent authority. But the contingency must exist at the date of balance sheet. If contingency does not exist on balance sheet date no provision or note to accounts is required. Events after balance sheet date : Events occurring after the balance sheet date are as follows :

Events, which occur between the balance sheet date and date on which financial statements are approved by competent authority.

These events are significant events and may be favourable or unfavourable Adjusting and non adjusting events :

1. Adjusting Events : Insolvency of a customer occurs after the balance sheet date usually , provides additional information on the condition that existed at the balance sheet date. Therefore, the carrying amount receivables should be adjusted for the event assumptions are made as follows:

The condition of insolvency existed at the balance sheet date.

The entity could not collect the complete information about the collectibility of the receivables because of the unreasonable effort and cost required to collect information.

Therefore, it could not estimate the insolvency of the customer. 2. Non adjusting events : however, insolvency caused by a major casualty

occurring after the balance sheet date is not an adjusting event. For example, insolvency caused by a major fire in the factory and the warehouse is a non-adjusting event. Accordingly, the carrying amount of the receivables should not be adjusted for the event. Similarly decline in the market value of investment is also non-adjusting event.

Event affecting going concern : Event occurring after the balance sheet date may indicate that the enterprise ceases to be a going concern (e.g. destruction of a major production plant by fire or earthquake after the balance sheet date) and a need to consider whether it is proper to use the fundamental accounting assumption of going concern in the preparation of the financial statements.


Proposed Dividend : Dividends in respect of the period covered by the financial statements, which are proposed or declared after the balance sheet date but before approval of the financial statements, should be adjusted in accounts. Events occurring after the approval of accounts : Events occurring after balance sheet date and also after the approval of accounts by board of directors of a company should be disclosed in the director's report, if material. Disclosure : If material contingent loss is not provided for, its nature and an estimate of financial effect should be disclosed by way of note. If estimate of financial effect cannot be made, the fact should be disclosed. 2002 Dec (2) Explain the following relationships with reference to the relevant SAPs. (b) Audit risk and materiality [repeated in 2004 Dec (7)] Answer : According to standard audit practices, (SAP), the audit risk implies and involves risks associated with process of auditing as well as performance of auditor. These risks

arise on account of many causes; some of them are as below: 1) The auditor himself is human being tied on all fronts on this account. His

performance, capacity and capability are limited to his physiological factors.

2) Time available and task allotted do not match in general. 3) Cost of audit limits the scope giving rise to risks. 4) Due to sampling techniques, some transactions go unchecked. They may

be having material impact. The above mentioned points assert that there is unavoidable risk due to the test check and other inherent limitations of internal control system. It is evident that the auditor should be aware of risk which is inherent in any audit with reference to materiality of transactions and he should accordingly test and evaluate the internal control system so as to assess the extent of risk. Auditor should take into account the risk of material misstatement of the financial information caused by fraud and error, because the fraud usually involves actions designed to conceal it. Audit risk is the risk that the opinion of the auditor on the affairs of the company, may be inappropriate because the information on which he has based his opinion may be misstated. Audit risks may be categorised as :




Low risk areas are those which necessitate the application of conventional audit procedures of vouching, checking etc of transactions in a routine way. Low risk areas constitute major portion of any audit work. High risk areas are those which should be the primary concern of high level management, and will inter-alia include such matters as:

a) Computation of tax and compliance with taxation legislation;


b) accounting of contingencies and events which take place after the date of balance sheet

c) adequacy of provisions; d) disclosure of accounting policies; e) disclosure of all liabilities including contingent liabilities; f) compliance with accounting standards and auditing standards; g) detection of overstatement of assets and liabilities;

Materiality and Audit Risk : Answer : AAS- 13 on ''Audit Materiality'' requires that the auditor should consider materiality and its relationship with audit risk when conducting and concluding an audit. According to this standard, information is material if its misstatement could influence the economic decisions of users taken on the basis of financial information. Materiality depends on the size and nature of the item and its assessment is a matter of professional judgement. The concept of materiality recognises that some matters either individually or collectively are relatively more important for a 'true and fair view' presentation of financial statements in conformity with the recognised accounting

policies, procedures and practices. The concept of materiality is subjective in nature, an item may be material for an enterprise while it may be ignored as immaterial for some other organization. There is inverse relationship between the degree of audit risk and materiality i.e. the higher the materiality lower the audit risk and vice-versa. The auditor takes the inverse relationship between audit risk and materiality into consideration while planning the nature, timing and extent of audit procedures. The assessment of auditor may undergo change during the conduct the audit, if during the audit he feels that his prior assessment needs to be revised in the light of new facts. More extensive tests of controls and modifying the substantive test procedures may be adopted if during audit some facts surface demanding the same. 2003 June (4) (b) Is it true that the overall objective and scope of an audit does change in computerized environment ? (8 marks) Answer : No it is not true. The basic objectives of audit remain same whether the environment is manual or computerized. The principal objective of an audit is to ensure that the accounts being audited show a true and fair view of the state of affairs at a given date and such accounts are in accordance with the underlying records and comply with the appropriate statutory requirements. This object remains the same irrespective of procedure of processing of information i.e. whether manually or with the help of computers. Although the overall objective and scope does not change in EDP or CIS (computerized

information system) environment, however, the use of computers changes the processing, transfer and storage of information in a very significant manner. Accordingly the procedures followed by the auditor in his study and evaluation of accounting system and related internal control may be considerably affected by the Cis environment. This calls for adequate knowledge of Cis, understanding of computer hardware, software and processing system on the part of auditor. The use of computers and computer assisted audit techniques leads to drastic improvements in the effectiveness and efficiency of auditing procedures and performance. For example some transactions may be tested more effectively than


manual system. The CIS does not cause any change in central objective of auditing but it does change the audit process itself as below:

1. Skill and Competence : It is imperative to know how the cis environment affects the study and evaluation of internal control system of the entity. The auditor should have understanding of computer hardware, software and application of various techniques in relation to accounting and auditing. He should have sufficient knowledge of cis to implement the auditing procedures and approaches.

2. Planning : CIS of the auditee has direct relation with the planning of audit. The auditor should collect the information relating to cis e.g.

a) The computer hardware, software and its extent of application in the entity. b) Any revision in the existing system, introduction of new application system; c) Planning of audit of various application processes ; d) Determine the degree of reliance on internal control of cis. e) Planning auditing procedures using computer-assisted audit techniques.

3. Accounting system and Internal control : Internal control objectives apply to all

areas, whether manual or automated. Therefore, conceptually, control objectives in an IS environment remain unchanged from those of a manual environment. However, control features may be different. If the auditor plans to rely on internal control in conducting his audit, he should ensure adherence to manual and controls as prescribed in the charter. 4. Audit evidence : A Cis environment may altogether alter the scene of audit evidence. Computer assisted audit techniques may be required to enhance the effectiveness as well as efficiency of the audit. Generalised audit software may also be called for assistance in audit in cis environment. 2003 June (7) Briefly discuss about any eight areas in which there are noteworthy differences between India's GAAP and USA's GAAP. Answer : Difference between India's GAPP and USA's GAPP.

India's GAAP USA's GAAP

1. Financial statements are prepared as per the Schedule VI of the Companies Act, 1956

The financial statements should comply with disclosure requirements of US Accounting standards. No specific format is prescribed

2. Except the buy back of own securities, investment in own shares is expressly prohibited.

Investment in own shares is permitted. It is shown as reduction in Equity Share capital.

3. Goodwill other than purchased should

not be shown in financial statements. Purchased goodwill is capitalised and amortised over the expected period of benefit or it is charged against the capital reserve if available. Goodwill arising on account of amalgamation can be written off over 5 years.

Goodwill is treated as any other intangible

asset and is capitalised and amortised. The maximum period for carry forward is 40 years.


4. Assets and liabilities are not required to be shown as current and long term components.

It is mandatory to disclose the current and long term components of assets and liabilities. Current component refers to one year of the period of operating cycle.

5. Exchange fluctuations of foreign currency transactions are allowed to be capitalised.

Gain / loss on exchange fluctuations is taken to income statement. Capitalisation thereof is not permitted.

6. Taxation is based on tax payable method.

Taxation is based on asset-liability approach.

7. Cash flow statements are required for companies listed on the stock exchanges and certain other companies. Not mandatory for all companies.

Cash flow statement is mandatory for all companies.

8. Current component of debt is not required to be classified as current liabilities.

Current component of debt is required to be classified as current liabilities.

9. Preoperative expenses : All expenses incurred prior to commencement of business are treated as pre-operative expenses whether they are direct expenses or indirect expenses. Pre-operative expenses are capitalised to the fixed cost of assets. These are allowed as treated as deferred revenue expenditure to be written off over a period of 3 to 10 years.

Such concept does not exist. These are treated as revenue expenses unless they are of capital nature.

10. Related party transactions : No specific disclosures required. The auditor is duty bound to report certain transactions entered into related parties as defined under the Company's Act 1956. AS – 18 is issued wef 01/04/2001

Disclosures are specifically required. Nature of transactions, amounts involved and due should be specifically disclosed.

11. 2003 Dec (1) (C) (b) Briefly furnish your views in connection with the following : (i) Novel Smelters Ltd. has entered into a contract with Bharat Towers Ltd. for supply in December, 2003 of a cooling tower priced at Rs. 80 lacs against cash payment. The company has not provided for the same but has merely shown it in Notes to the Balance sheet as on 31.3.2003 Answer : The order of the company is for the capital asset and Companies Act 1956 does not require that any provision is required to be made on account of capital commitment. Thus there is no necessity to make any provision in the year of placement of order. However, the company needs to comply with the disclosure requirements and a note should be added disclosing that the company has ordered an


asset which would require cash payment of Rs. 80 lacs in the year of delivery. This is nothing but the contingent liability on capital account and should be disclosed as such. The treatment given by the company is as per law and is therefore correct. 2003 Dec (4) (b) '' The impact of …………………………….. computerized accounts ? Page 149 for hindi

Answer : With the advent of computers, the approach to and process of auditing has undergone phenomenal changes. The revolution brought about by the computers in all aspects of life, has touched the auditing field in a significant way. The basic approaches for computer audit are as follows: Auditing around the computer : Under this approach the computer is treated as 'black box' and only input and output documents are reviewed. The controls and procedures used in processing the data are not audited. The process of transformation of input data into output data is altogether ignored. Instead, the auditor selects inputs and tests them against appropriate outputs and vice-versa. If they matched and proved to be accurate and valid, then it is assumed that the system of controls is operating properly.

The advantages include : 1) Simple and straight forward approach can be easily understood by anyone. 2) Good for batch processing operations; 3) No risk of tempering with live data; 4) Cost of audit resources is generally low; 5) Extensive knowledge of computer operation and data processing is not

required for the auditor. The major disadvantages of auditing around the computer are as follows:

Makes very little use of most powerful and valuable audit tool—the computer;

Ignores the system of controls and hence fails to recognise potential errors or weakness in the system;

Amounts to auditing in the nature of post-mortem rather than preventive auditing;

If a system has complexity in terms of size and type of processing, auditor around the computer is not available;

It will be difficult for the auditor to assess the chances of the system degrading, if the environment changes.

Auditing through the computer : Under this approach, the computer is the target of

the audit. The auditor can test the processing and control systems. In auditing through the computers, the auditor submits data to the computer for processing. The results are analysed for finding out the reliability and accuracy of computer programs. It consists of two tasks viz. (a) the review and verification of source documents and (b) the actual testing of the computer program logic and program controls. The reviewed and verified data are submitted to the computer and the results are analysed for accuracy and reliability. Advantages :

1) Utilises the computer as a tool for performing auditing functions; 2) Forces the auditor to get more involved in the system thereby calling for his

ability to perform more and better in complex audits; 3) Test results are immediately available and can be used as measures of internal

processing reliability;


4) Provides effective test for processing logic and program controls; Disadvantages :

1) Requires more of computer time; 2) Represents only a limited test of the system; 3) More exposure and training for the auditor is required.

The cases when auditing through the computer must be used : (a) The inherent risk associated with the application system is high. (b) The application system processes large volumes of input and produces large

volume of output that makes extensive direct examination of the validity of the input and output difficult to undertake;

(c) Significant parts of the internal system are inbuilt in the computer; (d) The processing logic embedded within the application system is complex; (e) Substantial gaps in the visible audit trail are common in the system.

Auditing with the computer : In this approach the computer is used as the tool to help auditor in the performance of his tasks. This approach will require computer program to produce the desired information.

This consists of three steps : (a) Review of system of controls (b) Evaluation and testing of the system of controls and (c) Verification of record contents and generation of information from the input and data base. The computerisation has caused cardinal changes in the fields of accounting and auditing. There is no audit trail, no primary records, no visible output, paperless and personless processing etc., because of these factors, the auditor cannot conduct the audit in the conventional manner of vouch-and-post audit of computerised records. He has to learn, master and modify the compliance and substantive testing for review of internal control. He has to learn the construction and verification of programmes of computer in which the records are maintained. Computerised system of accounting provides the auditor with certain safeguards viz.:

1) Once he is satisfied about the effectiveness of controls, he need not conduct a detailed verification of the arithmetical accuracy of the records and transactions. This enables him to devote more time to other essentials of his audit tasks.

2) He can place a higher degree of reliance on processes and output data. 3) Automatic checks are installed at various locations in the computerised

system and the responsibilities of various people are distinctly delineated. This gives him additional leverage for improvement in his performance as an auditor.

The audit of computerised accounts can be broadly categorised into two major phases : 1. Review of Internal control : Internal control objectives apply to all areas, whether manual or automated. Therefore, conceptually, control objectives in an IS environment remain unchanged from those of a manual environment. However, control features may be different. AAS-6 establishes standards on the procedures to be followed to obtain an understanding of the accounting and internal control systems and on the audit risk and its components: inherent risk, control risk and detection risk. As per this standard, the auditor should obtain an


understanding of the accounting and internal control systems sufficient to plan the audit and develop an effective audit approach. Organisational charts may guide to locate the internal control which the auditor may substantiate. He should conduct compliance testing through performance procedures and arrive at the degree of reliance he can place on the system. If the internal controls are not effective, there is a possibility that material errors may creep in and remain undetected. The auditor should review the general EDP Controls and other Application controls over input, output and processing etc. 2. Examination of records produced by the data processing system Evaluation of internal control should be followed by selection and examination of records produced by the data processing system to ensure the soundness, completeness, exactness and correctness of the output. Here the auditor encounters most significant problem peculiar to EDP environment, absence of audit trail. The journey between input and output is termed as audit trail. Suitable measures must be learnt by the auditor to trace the audit trail in a computerised environment.

2004 June (1)(C) (a) As an auditor of X Ltd. a …………. brief reasons: (i) The Company ……………… 10% on cost. Answer : The stock at the end of the financial year must be valued in accordance with AS-2 based on 'realisation concept' of accounting which states that the stock should be valued at cost or net realisable value wel. This concept also states that incomes should only be brought to books only when they are realised. The notional income should not be recorded at all, worded differently; no provision can be made for the expected or anticipated income. In the cited example in the above question, the realisable value contains an element of profit which is in contravention to the AS-2, and is therefore incorrect. (ii) The Company ………………………..applicable to it.

Answer : The contention of the company is not correct. According to section 209(1)(d) of the Companies Act 1956, the Central Government has powers to direct any class of company to maintain proper books of account in respect of utilisation of resources for production or manufacture of a particular product. The audit of companies directed under section 209(1)(d) may be ordered under section 233-B of the Act. Even if order for audit u/s 233-B has not been made, the company is required to maintain proper books as required u/s 209(1)(d). The statutory auditor is required to verify compliance of section 209(1)(d) and report on the same. (iii) Capitalisation of …………………………………. construction period. Answer : The expenses relating to erection are considered as part of cost of machine. It is sound accounting policy to capitalise the salary of technical staff during the period of erection of plant and machinery by making additions to the cost of the machine. The salaries of non-technical staff during the construction period are in the nature of indirect expenses incidental to and related to construction. Since this expenditure is incurred during the construction period it should be capitalised as part of the construction cost of the project. (iv) The company was……………………………… statutory auditor. Answer : according to section 224(5) of the Companies Act 1956, the first auditor of the company should be appointed by the Board of Directors within one month from the date of registration of the company. This section was not followed in the present case


of Mr. G. because he was not appointed within one month time limit, this makes his appointment invalid ab-initio. As the appointment was invalid, the removal of auditor by the Board of Directors is equally invalid. The auditor of the company has to be appointed in a general meeting of the company. Thus I am not going to accept the appointment letter as this is not as per section 224 of the Companies Act, 1956. 2004 June (5) (a) State the need and also the main sources of generally accepted Accounting Principles in India. [repeated in 2005 Dec (6) (a)] Answer : Need For GAAP in India : With the advent of globalisation, the world has become a big village. The borders of trade and commerce have vanished into thin air. The Indian companies are listed in top exchanges of the world. Thus accounting principles adopted in India should be at par with world standards. In this perspective US GAAP are considered as standard of Accounting Principles and Reporting Standard. In India the main sources of generally accepted accounting principles come from different areas. The sources include (i) The Institute of Chartered accountants of India

(ii) The Reserve Bank of India (iii)Securities and exchange board of India SEBI (iv) Company law board etc. The Indian accounting practices need to be aligned with internationally accepted accounting practices in order to flow with main stream of accounting. The chief sources of GAAP in India are :

a. Accounting standards and Statements issued by the Institute of Chartered Accountants of India;

b. Directives derived from the Companies Act 1956; c. Standards issued under Income tax Act 1961; d. Legislation relating to industry (Banking, Insurance, financial institutions) e. Statements, Guidelines and Regulations issued by SEBI.

2004 Dec (7) : Explain the concept of audit materiality. Also state the relationship

between materiality and audit risk. Answer : See above 2002 Dec (2). 2005 Dec (3) Briefly state how compliance procedures are helpful to an auditor. Answer : The primary task of auditor in any auditing process is to evaluate the efficiency, efficacy and effectiveness of internal controls in operation. This leads him to compute the degree of reliance he can place on internal controls. Compliance procedures are designed to assist auditor in determining the reliance he can place on internal controls. The input, processing and output path is inspected thoroughly by the auditor to gain evidence that controls are operative in proper manner. Compliance procedures are tests of the system itself. The testing can fall in three categories (i) that have trail of documentary evidence and (ii) segmentation of duties (iii) existence of records and procedures. The auditor should specifically make enquiries as regards any departure noticed from prescribed controls. Based on the results of compliance procedures, the auditor should assess whether internal controls are adequate and satisfactory for the purposes of audit. If not, the auditor should discover and ascertain whether there is any other control which would satisfy his purpose on which he might rely after applying appropriate compliance procedures. The compliance procedures assist the auditor mainly in two ways viz.


1) Once he is satisfied about the effectiveness of controls, he need not conduct a detailed verification of the arithmetical accuracy of the records and transactions. This enables him to devote more time to other essentials of his audit tasks.

2) He can place a higher degree of reliance on processes and output data. 2005 Dec (6) (a) About what are Generally Accepted Accounting Principles (GAAP) are concerned with ? Discuss about the need for GAAP in India. Answer : The bookkeeping precedes any accounting process. The economic activity is to be measured in terms of money and recorded in the books of accounts as and when it occurs. Generally Accepted Accounting Principles (GAAP) are concerned with

the measurement and recording of economic activity in chronological order,

translation of data into information,

preparation and presentation of information in the form of financial statements The GAAP include detailed practices and procedures in addition to broad guidelines of general application in respect of accounting. For need for GAAP in India, please see answer to question 2004 June (5) (a). 2005 Dec (7)(a) Do you think that related party disclosure is required in the following cases ?

(i) Two companies………………….. one of them. Answer : Related party transactions require establishment of relationship between two

parties. Relationship is not supposed to exist if both companies have a common director who can influence the policies of both the companies. Presence of a common director is not sufficient to establish that there exists a relationship between the two companies. No disclosure under AS-18 is required.

(ii) Transactions between………………………..key management personnel. Answer : The transaction characteristics will be affected significantly due to the presence of specified relatives. Decision making process of finalisation of transactions with specified relatives will be greatly affected as the key management personnel are indirectly involved in the process. This evidently establishes the relationship between the enterprise and the party. This is related party transaction and required to be disclosed in compliance of AS-18.

(iii) Transactions between……………………….. ……….. of the enterprise. Answer : AS -18 does not require to disclose the transaction between trade union and

enterprise. No relationship is supposed to exist between the trade union and the enterprise. 2006 Dec (8) (a) Explain how disclosure………………………. Financial statements. Answer : Please see 2003 Dec (8) Disclosure of accounting policies 2007 Dec (6) (a) Is the disclosure……………… in this regard ?

Answer : Please see 2003 Dec (8) Disclosure of accounting policies 2008 June (4) (b) List three……………………………. external auditor. Practical Questions : 2004 June (5)(b) Comment on the following situation:


(i) Compensation for an amount of Rs. 75,000 (which is considered material) received from a customer for breach of contract of sale is included in current year turnover of sales. (ii) Claim against the company for breach of contract which is the subject of a law suit and awaits the Court judgement has been shown and included in the current liabilities. Answer : (i) Accounting standard 5 (AS – 5) prescribes the criteria for certain items in the profit and loss account and treatment of particular income and expense which are not related to the period of profit and loss account. The AS -5 also deals with change in accounting policies, accounting estimates and extraordinary items. AS-5 states that the nature and amount of each extraordinary item should be separately disclosed to ascertain its effect on the current year's operating results. The compensation received on account of breach of contract, is an extraordinary item and should be separately shown as income from compensation rather than included in the sales for the period. The notion of company is wrong and against the AS-5.

(ii) On the date of balance sheet the verdict of the Court is yet to come. The judgement can go either way i.e. in favour of or against the company. This is a contingent liability and not a current liability. The contingent liability should be shown by way of a foot note to the balance sheet.

Chapter 2 Verification of assets and liabilities : Write Short Notes On : 2001 Dec (5) (a) Outstanding Assets (c) Capital profits Answer : (a) Outstanding Assets : Outstanding assets are those assets which are recoverable in future. These are the assets on which the company has no immediate claim but which will be converted into cash at a later date. A few examples of outstanding assets are as below:

1. Prepaid expenses such as insurance premium, rent, rates and taxes, 2. Income receivable, such as rent from tenant, accrued interest, commission

accrued, any income due. 3. Deferred revenue expenditure against which advantage will be derived in

subsequent years such as research and development expenditure, expenditure incurred in campaign, publicity and image building, advertisement expenditure.

(b) Capital profits : Capital profits are those profits which are not earned in usual course of business activities, worded differently, the capital profits are those profits which are not trading profits. As they do not arise out of trading activities, they are not credited to profit and loss account but carried straight to liabilities side of balance sheet. Examples of capital profits are as follows:

1) Premium on issue of shares and debentures. 2) Capital profit on sale of fixed assets (i.e. profit over and above the original cost of

fixed assets.) 3) Profits earned prior to incorporation of company. 4) Profit earned on redemption of debentures at a discount. 5) Credit balance of forfeited shares account after reissue of forfeited shares.


There is no legal bar on payment of dividend out of capital profits provided the following conditions are satisfied.

1) Articles of association must authorise such distribution. 2) Profit is actually achieved. 3) In case of revaluation, all assets are revalued in bona fide manner. 4) All losses are recovered before such distribution. 5) Company should remain capable of paying its debts after such distribution.

However, it is not prudent accounting policy to distribute the capital profits as dividend. 2002 June (5) (d) Disclosure requirements for miscellaneous expenditure under schedule VI to the Companies Act 1956. Answer : Disclosure requirements for miscellaneous expenditure under schedule VI to the Companies Act 1956 are as follows : Expenses under following heads of accounts should be shown under the broad head of miscellaneous expenses :

1) Preliminary expenses ; 2) Unadjusted development expenditure ; 3) Discount allowed on issue of shares and debentures; 4) Interest paid during construction. The rate of interest should also be stated; 5) Debit balance of profit and loss account under the distinct head ; 6) Expenses relating to subscription of shares and debentures viz. commission or

brokerage on underwriting. 2003 June (8) (a) Outstanding Assets Answer : Same as above. 2003 Dec (8) (b) Extra-ordinary items Answer :

Accounting standard 5 (AS–5) prescribes the criteria for certain items in the profit and loss account and treatment of particular income and expense which are not related to the period of profit and loss account. The AS -5 also deals with change in accounting policies, accounting estimates and extraordinary items. AS-5 states that the nature and amount of each extraordinary item should be separately disclosed to ascertain its effect on the current year's operating results. According to Accounting standard 5 (AS–5), extraordinary items are gains and losses which arise from events or transactions that are distinct form ordinary activities of the business and which are material and not expected to occur regularly or frequently. It would also include material adjustments demanded by the circumstances, which are determined in the curre-nt period. It should be noted here that extraordinary items are different from abnormal items. Income or expenses belonging to trading activities will not qualify for being termed as extraordinary items however big they may be. (c) Impact of events occurring after balance sheet date. Answer : The balance sheet shows the financial position of the entity at a particular

date. Therefore the events which take place after the balance sheet date cannot be considered by the auditor for verification of balance sheet. However, the following


circumstances or events occurring after the balance sheet date but before the finalisation of the accounts by the board of directors must be taken into account :

1. Where such events removes the uncertainty of any amount appearing on the balance sheet;

2. Where the statutory obligation has undergone change, e.g. the amount of provision for taxation affected by changes in income-tax rates;

3. Where such events are required by law to be shown in the books, e.g. change in accounting policies, contingent liability.

The AS-4 prescribes the accounting of contingencies and events which take place after the date of balance sheet but before approval of balance sheet by Board of directors. According to AS-4, Contingency refers to :

Existing conditions and situations,

Results of which is not known on the balance sheet date

Results of which would be known only on happening or non-happening of certain events in future

Results may be either a gain or loss. As per AS-4, company should make the provision for bad and doubtful debts, as situation of non-recovery from the debtors is existing on the balance sheet date result of which will be known in future. The amount of provision for bad and doubtful debts should be shown as deduction from total debtors in balance sheet. Provision for loss is estimated on the basis of information available up to the date of approval of accounts by competent authority. But the contingency must exist at the date of balance sheet. If contingency does not exist on balance sheet date no provision or note to accounts is required. Events after balance sheet date : Events occurring after the balance sheet date are as follows :

Events, which occur between the balance sheet date and date on which financial statements are approved by competent authority.

These events are significant events and may be favourable or unfavourable Adjusting and non adjusting events :

3. Adjusting Events : Insolvency of a customer occurs after the balance sheet date usually , provides additional information on the condition that existed at the balance sheet date. Therefore, the carrying amount receivables should be adjusted for the event assumptions are made as follows:

The condition of insolvency existed at the balance sheet date.

The entity could not collect the complete information about the collectibility of the receivables because of the unreasonable effort and cost required to collect information.

Therefore, it could not estimate the insolvency of the customer. 4. Non adjusting events : however, insolvency caused by a major casualty

occurring after the balance sheet date is not an adjusting event. For example, insolvency caused by a major fire in the factory and the warehouse is a non-adjusting event. Accordingly, the carrying amount of the receivables should not adjusted for the event. Similarly decline in the market value of investment is also non-adjusting event.


Event affecting going concern : Event occurring after the balance sheet date may indicate that the enterprise ceases to be a going concern (e.g. destruction of a major production plant by fire or earthquake after the balance sheet date) and a need to consider whether it is proper to use the fundamental accounting assumption of going concern in the preparation of the financial statements. Proposed Dividend : Dividends in respect of the period covered by the financial statements, which are proposed or declared after the balance sheet date but before approval of the financial statements, should be adjusted in accounts. Events occurring after the approval of accounts : Events occurring after balance sheet date and also after the approval of accounts by board of directors of a company should be disclosed in the director's report, if material. Disclosure : If material contingent loss is not provided for, its nature and an estimate of financial effect should be disclosed by way of note. If estimate of financial effect cannot be made, the fact should be disclosed. 2007 Dec (4) (c) Outstanding Assets Answer : See above 2001 Dec (5) 2007 Dec (4) (d) Treatment of Purchased Goodwill versus Inherited Goodwill Answer : When an entity is sold, the amount paid for its purchase is called purchase consideration. The amount by which the purchase consideration exceeds the net assets (Assets – external liabilities) of the entity is due to goodwill of the business. This extra amount is paid towards goodwill and such goodwill is treated as purchased goodwill. This appears on the asset side of the balance sheet. Goodwill is different from other assets as it is not subjected to depreciation, however, it may be written off against abnormal profit or capital profit. Inherent goodwill is part of any entity which is successful and profit making. It is inherent strength of the organization and is seldom calculated in monetary terms. Sometimes, when all the assets and liabilities of the entity are revalued for one reason or the other, the company opens a goodwill account in the books which represents the monetary value of goodwill. This goodwill is normally written off gradually against capital profit. Distinguish Between : 2002 June (7) Depreciation and Fluctuation in value. Answer : Depreciation is nothing but the distribution of the total cost of the asset over its useful life. Fluctuation is rise or fall in the value of an asset. The other points of difference between the two are as per the following chart : Depreciation Fluctuation

1. It means fall in value, quality and quantity of assets.

It means rise or fall in value of the asset in the market.

2. It is applicable to fixed assets only. It is applicable to fixed assets as well as current assets.

3. It directly affects the earning capacity of the asset and is charged against profit of current year.

It is not related with the earning capacity of the asset and is not measurable hence not taken into accounts.

4. It is due to passage of time. It is due to market factors.


5. It is essential component of financial statements.

It is not a component of financial statement.

6. It is determined by an acceptable method. It is not reliant on current market value of the asset.

It is not required to be determined.

7. It is unaffected by inflation. It is dependent on inflation.

2003 June (2) (c) Depreciation and Fluctuation in value Answer : See above. (d) Capital reserve and Reserve Capital. Answer : The term ' capital reserve' has not been defined in the Companies Act 1956.

Capital reserve is created out of profits of a capital nature. Examples of capital profits are as follows:

1) Premium on issue of shares and debentures. 2) Capital profit on sale of fixed assets (i.e. profit over and above the original cost of

fixed assets.) 3) Profits earned prior to incorporation of company. 4) Profit earned on redemption of debentures at a discount. 5) Credit balance of forfeited shares account after reissue of forfeited shares.

On the other hand, ' reserve capital' represents that portion of share capital which has not been called up. The reserve capital is determined by the company which can be called up only in the event of and for the purpose of winding up of the company. As per section 99 of Companies Act 1956 a limited company may by special resolution call such an amount in that event and for those purposes. Descriptive Questions : 2001 Dec (3) A newly set up private ltd. manufacturing company has incurred the following expenditure during its construction period:

(i) Technical staff salary during the period of erection of plant and machinery. (ii) Non-technical staff salary during the construction period. (iii) Other sundry expenses such as printing, postage, local conveyance

charges etc. The company intends to capitalise the above expenses. Is the company justified? State with reasons

Answer : The expense s incurred by a newly setup private limited company during the construction period, that is before the commercial production begins, may be of the nature of capital expenditure or revenue expenditure. Before the commencement of commercial production, it is customary to capitalise the revenue expenses as part of

the construction cost. (i) Technical ……………………… machinery. (i) It is universally adopted and accepted principle, to add erection expenses basically in the nature of revenue, to be capitalised as part of the cost of plant and machinery. Salary of technical staff during the period of erection of plant and machinery is capitalised following this principle. (ii) Non-technical………………………………. period.


The non-technical staff salary during construction period is in the nature of indirect expense related to construction. In case of running entity, it would be of a revenue nature. As these expenses are incidental to construction, hence they should be capitalised as part of construction cost to be apportioned against the cost of individual assets on a suitable basis. (iii) Other sundry………………………….. charges etc. Printing, postage, local conveyance expenses incurred during the construction period are indirect expenses which cannot be regarded as incidental to construction cost of the project. As these expenses are not against any revenue because the project is yet to commence commercial activity, they cannot be written off to revenue. Hence these are treated as deferred revenue expenditure to be carried forward as miscellaneous expenses, to be written off to revenue as soon as possible after the commencement of commercial production. 2001 Dec (6)(b) Explain purchased goodwill and inherent goodwill and their treatment in the financial accounts. Answer See answer to question 2007 Dec (4)

2001 Dec (8) (b) [(similar 2007 Dec 7(a)(iv)]State……………………….. longer secret? Answer : Secret reserve as the name indicates, is the reserve which is not disclosed in the balance sheet. The existence of secret reserve indicates that the worth of the business is more than what is disclosed in the balance sheet. Such a situation may arise when the liabilities are overstated or the assets are understated or omitted altogether. Companies Act 1956 requires that the auditor must ensure that the balance sheet and profit and loss account show a ' true and fair' view of the financial position of the company. Any secret item will cause the departure from 'true and fair view' concept; thus it is not allowed at all to keep secret reserve in financial statements. The Act requires unequivocally that all reserves and provisions must be fully disclosed in Company's accounts making it impossible to keep any secret reserve. Companies Act 1956 however, provides that if the company is specifically permitted to keep secret reserve, it can do so after compliance with the rules made in respect thereof. The banking, finance and electricity companies are permitted to keep secret reserve to a limited extent. 2002 June (1) (C) As an auditor of a company, state your views on the following: (a) General administrative ………………………..the said period. Answ er : During the construction phase of the project the company has to incur various expenditure relating to fixed assets, direct expenses and indirect expenses. The indirect expenses may or may be incidental to construction activity. It is universally accepted to capitalise the direct expenditure on fixed assets, indirect expenses relating to construction period should be capitalised if they are incidental to the main construction activity. Thus expenses incurred on supervisory staff of construction work, general administrative and office expenses incidental to construction activity are to apportioned against the cost of individual assets on an suitable basis. General expenses not directly associated with construction activity e.g. training of staff, publicity, advertisement etc. should be treated as Deferred Revenue Expenditure which can be written off within a sensible time following the commencement of commercial production.


In the cited case, the company XYZ ltd. may capitalise the administrative and overhead expenses or treat them as deferred revenue expenditure depending upon the fact whether they are incidental to construction activity or not. Part 1 of the of Schedule VI to the Companies Act 1956, requires that appropriate disclosure of expenditure during construction period should be made in financial statements. The deferred revenue expenditure should be carried forward to the balance sheet under Miscellaneous expenditure duly disclosed with reasons, basis and amount so deferred. (b) After the close…………………………………. assets so destroyed. Answer : The materiality of the incident is of great significance to the share holders. The incident is likely to affect the going concern concept as well. It has a direct bearing on the solvency and existence of the company. Though it has occurred after the balance sheet date, it is not going to affect the balance sheet items as according to AS-4, only those items have to be adjusted in respect of which any evidence existed at the time of preparation of balance sheet. This is no such event. The auditor should disclose the incident by way of a note attached to the balance sheet. U/s 217 of

Companies Act 1956, the directors are also required to include in their report the happening of the incident as well as non availability of funds to carry out repairs on the said assets destroyed by earthquake. 2002 June (4) (b) Mention………………………………………….. in foreign currency. Answer : The clause 4D of Part-II of Schedule VI requires the following information in profit and loss account of the company in respect of dividend in foreign currency.

The amount remitted during the year in foreign currencies on account of dividend.

Mention of nor-residents shareholders,

The number of shares held by them on which dividend were due;

The year to which the dividend belongs. 2002 June (6) How as an auditor you will verify the following : (i) Sale proceeds of junk material; (ii) Payments under hire purchase. Answer : Verification of sale proceeds of junk material : Following steps will be taken by me in respect of above :

Inspection of ledger of Junk materials, receipts, storage and issue. If any

standard is available in this respect, compare with actuals. It is to be ensured that the generation, storage and disposal process was properly followed in every stage.

How sale is executed ? At what price ? Whether price and customer are selected after competitive bids or not? Compare them with market conditions. Check whether undercutting of price exists.

Check whether realistic and reasonable records are kept in respect of sale and disposal of junk material.

Possibility of siphoning good material with junk material by unscrupulous person or group of persons may exist. This is good area for the corrupted people. It must be investigated. Enquire about the use of junk materials by its purchaser.


Ledger of junk material should show all entries of sale proceeds. Vouch the entries. Compare the income from the sale (with rates) of junk materials with the corresponding figures of the preceding three years.

Ensure that every sale of junk materials has been billed; calculation on the invoices be checked.

Answer : Verification of Payments under hire purchase.

First of all examine the hire purchase agreements.

To check voucher for payment of instalments.

Instalments consist of interest and capital components. See that the interest is not capitalised.

See that capital part of instalments and not the whole instalment goes to asset account.

Depreciation is charged on the cost price of the asset and not on the hire purchase price.

2002 June (8) (a) How will……………………………………….. as an auditor ? a) Bonus to employees which has hitherto been charged to profit and loss

account on mercantile basis is now being accounted for on cash basis. b) There is significant fall in the market price of some investments held for a

long time by the concern. c) Outstanding liabilities for expenses show a considerable fall as compared

to previous years. Answer : Auditor must go about the following points in this case :

a) This is change in accounting policy and fundamental accounting assumptions. The reasons must be ascertained and necessity thereof must be understood. AS-1 requires the disclosure of any change in accounting policy to the extent possible.

b) Such changes need approval of top management, auditor should satisfy that approval has been obtained.

c) Any change in accounting policies and assumptions must be disclosed in the financial statement, he should ensure that this has been done.

d) The impact of such changes needs to be disclosed in profit and loss account, balance sheet and other financial statement.

e) If the impact of change is material, report should be qualified to that extent. b)There is significant fall in the market price of some investments held for a

long time by the concern. Answer : a) If the investment is held as stock, it should be valued at market price or cost wel.

It is held for sufficient length of time and it should be considered whether it can be termed as long term investment in which the current market value will have no impact.

b) Whether fall in investment value is of permanent nature, and whether this would affect the final realisable value of investment.

c) If the fall is material in relation to total value of investment held, it should be written down to market value.

(c) Outstanding liabilities for the expenses show a considerable fall as compared to last year.


Answer : The auditor should concentrate on the following points :

a) Whether there has been change in management policy to reduce outstanding liabilities at the year end.

b) Whether discount receivable on cash payment has become significant. c) Provisions made last year and current year may also reveal some figures in this

regard. d) All ledgers of current liabilities must be thoroughly checked for all entries made

during the last year. Ensure that no bills are left to be entered in the books. e) Payment to creditors must be checked. Ledgers of creditors and provisions must

be checked with cash book. f) List of current year item wise must be compared with that of last year. g) Obtain the entire list of liabilities for which provisions have to be made.

2002 Dec (1) (C) (b) State your views on the following in connection with a company audit :

(ii) In the balance sheet …………………………………. and provisions''. Answer : The redemption of debentures should not be shown under current liabilities. Debentures find place under ' Secured loans' in Part I, Schedule VI of the Companies Act 1956. The debentures are to be shown under this subhead irrespective of due date of redemption. (iv) Interest accrued and due on Secured loans has been disclosed in the balance sheet under the head 'current liabilities and provisions' on the ground that such interest has to be paid within six months from the end of the financial year. Answer : Part I, Schedule VI of the Companies Act 1956, requires specifically that the interest accrued and due on secured loans to be disclosed under the appropriate subheads of Secured loans. Interest accrued but not due is to be shown under 'current liabilities and provisions'. 2002 Dec (3) (b) State whether the following should be treated as Capital or Revenue expenditure: (i) Alternation of building so as to provide additional accommodation. Answer :

Capital : The alteration enhances the capacity of the building to accommodate more number of persons. Certificate of chartered engineer should be obtained. The expenditure should be treated as capital expenditure.

(ii) Expenses for shifting of a factory: Answer :

In normal situation shifting does not result in increase in capacity or efficiency of the factory, hence it should be treated as ' revenue expenditure'. However, if the shifting is taking place in compliance with order of statutory body and to avoid a closure, the expenses should be categorised as 'capital expenditure'.

(iii) Expenses on sales promotion for a new product. Answer :

Sales promotional expenses target the establishment of the product, the benefit of which will keep on accruing not only in the current year but also in the years to


come. Such expenditure is neither in nature of capital or revenue. These are to be treated as ' deferred revenue expenditure' which can be written off during the life of the product. If sales promotional expenses are seasonal to get the benefit of short interval e.g. during diwali season, such expenses may be treated as revenue expenses.

(iv) Heavy repairs to the plants. Answer :

Normal repairs and maintenance expenses are treated as revenue expenses and are charged to profit and loss account. It is not mentioned in the question that why heavy repairs were needed. Heavy repairs are required to overhaul the plant, to enhance its capacity and efficiency, or to lengthen its life. These expenses are capital in nature and should be treated as such.

2002 Dec (4) How would you vouch/ verify the following : a) Cash / bank balances ; Answer : Verification of bank balances :

The form of balance sheet contained in Part –I of schedule 6 requires that the bank balance should be segregated as follows (i) With scheduled bank and (ii) With other banks. The accounts with banks other than scheduled, the nature of director's interest if any, of a director or his/her relatives with each of banker, needs to be disclosed.

Bank reconciliation statement for various periods may be checked. The auditor should pay special attention to those items which are pending for a considerable length of time. When a large number of cheques has been issued/deposited and a substantial portion has remained unrepresented in bank account, this may indicate the intent of misstating the figures of debtors and creditors.

The number of bank accounts should match with the size of organization. If disproportionately large number of bank accounts is maintained by the entity, this is indicative of some fraudulent practice; in such case the auditor should exercise greater care in assuring himself about the realness of banking transactions and balances.

The auditor should obtain a certificate from the bank about the bank balance at the close of the year and compare this with the balance sheet figure.

Where the post-dated cheques are on hand on the balance sheet date, the auditor should verify that they have accounted for as collections during the period under audit. The process of transfer from post-dated cheques account to collected cheques account should be checked.

Verification of cash balances :

The most rudimentary point in vouching the cash balance is that the date and time of checking should be known to nobody other than auditor himself. Cash should be preferably checked in remote branches. Surprise checks of cash balance, are also advisable. If possible, the cash balance at the balance sheet date should be checked, however, if it has not been done, the cash balance may be checked on surprise basis at a later date and reconciliation to cash balance at the balance sheet date may be made.


Cash balance consists of many components viz. cash, petty cash, postage and revenue stamps, cash at branches, cash with agents. Unduly large balances during any part of the year, of cash, call for explanation from senior official of the entity. b) Sale of assets: Answer : The necessity of sale of assets must be approved and sanctioned by the

competent authority of the organization. Following points should be considered while auditing the sale of assets :

Ensure that there has been no undercutting in the sale price of the asset.

How the sale was executed ? The transparency of process should be examined.

What is basis of sale ? Whether by auction, or by negotiation or by personal contact by the purchases.

The sale proceeds of the assets should be properly accounted for and credited to the appropriate heads of account.

The profit / loss arising out of sale, should be segregated into revenue and capital components and treated as such in the accounts.

c) Preliminary expenses ;

Preliminary expenses are those expenses which are incurred for bringing the company into existence. These include registration fees, stamp duties, cost of legal proceedings, fees of consultants etc.

The contracts before the incorporation of company should be examined and the expenses incurred should be verified.

If, after the incorporation of the company, the preliminary expenses have been reimbursed to the directors, the resolution of the board of directors and provision of such reimbursement in the articles may be seen.

The preliminary expenses should be shown as 'Miscellaneous expenditure' in the balance sheet. Preliminary expenses do not include brokerage and underwriting commission on issue of shares and debentures.

Preliminary expenses disclosed in prospectus, statutory report and balance sheet should match with one another. Any amount in excess of what is declared in the prospectus requires approval by the shareholders.

d) Provision for doubtful debts. The auditor should judge the possibility of doubtful debts becoming bad debts. Following points should be considered for determination whether or not a debt is recoverable in full:

(i) Debtor has accepted the debt without any strings and conditions. (ii) Legal grounds are available for recovery of debts.

(iii) Debtor is financially sound to repay the debt. (iv) Reputation in the locality and industry is good enough.

If the auditor comes across any reason of doubt in regard to above matters, he should not hesitate to judge the debt as irrecoverable. He should make complete enquiry before considering any debt as bad. Any provisions in excess of normal requirement should be treated as reserve. Following points should be noted in connection with verification of debts:

(i) The age and amount of debt.


(ii) Debts to the same person. His payment attributes. (iii) Increase in outstanding debts should match with corresponding increase in

sales. (iv) If debtors are secured, the securities should be verified. (v) Instalments due. Delay in payments. Soundness of debtors. (vi) Dishonour of cheques. Action by the entity after dishonour of cheques.

2003 June Question 3 How will you vouch/verify the following and what are the allied important aspects to be looked into ?

a) Transfer of goods from one branch to another with loading of 15%; b) Legal expenses incurred for recovery of amount due to the company; c) Customs and excise duties; d) Retirement gratuity to employees.

Answer : a) Transfer of goods from one branch to another with loading of 15%;

The location of auditor is not clearly mentioned. Whether he is auditing head office or

despatching branch or receiving branch is not clear. The distances among the head office, despatching branch and receiving branch have not been mentioned in the question. Assuming that auditor is located at receiving branch, he should verify first the goods transfer note and the forwarding memo attached with it. He should also examine the pricing in the transfer note. The loading is to be removed in opening stock as well as in closing stock of the receiving branch. He should ensure that proper accounting treatment is given to goods despatched and goods received in the respective branches. The branch to branch transfer of goods is governed by the standing instructions of the head office. Auditor should peruse the instructions and check the compliance thereof by both the branches.

b) Legal expenses incurred for recovery of amount due to the company;

The credit worthiness of the debtor was not first established properly by the company, that is why the legal proceedings needed to be taken against him. The lapses in this regard may be investigated and the auditor should recommend measures to ascertain that the company should not engage in legal proceedings to recover the amount due. Whether the case is finally settled, will be clear after examination of concerned files and interview with the persons concerned with the case. If expenses are paid to external lawyer, his receipt may be verified. The expenses paid to the court are supported by proper vouchers, these may be seen. The case register of the concerned case should also be seen, the expenses incurred in connection with the case are entered in the register. The entries may be verified from the cash department.

c) Customs and excise duties; The vouching may be carried on the following lines : Verification of excise duties:

Auditor should ensure that the rate of excise duty is the one prevailing at the time of despatch or clearance of goods. Clearance of goods should tally with the quantity shown in the stock register of the client.


In respect of excisable goods manufactured but remaining to be released, ensure that necessary provision for unpaid excise duty has been made.

The amount deposited in the PLA to the credit of excise authorities may be cross checked with the cash department and from the challans of bank.

The despatch of goods as seen in the goods despatch note should be matched with charging of excise duty in the PLA.

PLA should always show credit balance, otherwise it will amount to clearance of goods without payment of excise duty.

The auditee is allowed to refund of excise duty in certain cases. Such cases are maintained in a separate register. Auditor should make certain that such claims are lodged in prescribed format and time-limit. Auditor should ensure that all refunds have been received and properly adjusted against future payments.

Ensure that in every case cenvat credit has been availed and adjusted; and only net excise duty has been paid.

Verification of custom duties:

Verification from cash book : Verify the amount paid as custom duty in the cash book from the bill of entry.

Check that custom duty has been calculated correctly i.e. as per the prevailing rates for dutiable goods. Test check the calculations.

If custom duty is paid directly by the auditee, the Bill of Entry relevant to the custom duty may be checked with the duty paid as shown in the receipt. The computation of custom duty should also be checked.

If the custom duty is paid through the Clearing and forwarding agent, the bills submitted by him along with Bill of Entry and Shipping Bill may be verified.

Provisional payments of duty may result in either recovery of excess payment or payment of balance amount. Auditor should make certain the final settlement of custom duty has been arrived at.

The auditee is allowed to refund of custom duty in certain cases. Such duty drawback cases are maintained in a separate register. Auditor should make certain that such claims are lodged in prescribed format and time-limit. Acknowledgement from the Directorate of Duty Drawback should be examined. d) Retirement gratuity to employees.

Provisions of Payment of Gratuity Act should be followed in all cases of gratuity payment. Gratuity is paid on disablement /death / retirement. The proof of retirement should be seen. The length of service up to the date of retirement needs to be properly calculated. The calculation may be checked. Proof of payment of gratuity should be seen. Gratuity should not be paid less than the minimum amount as prescribed.

The gratuity should be paid within certain time-limit. Auditor should see whether the time-limit has been adhered to.

If payment is paid out of gratuity fund as maintained by the employer, the contribution to the fund should be charged to profit and loss account. The gratuity fund should show the payment of gratuity.


Accounting standards –15, deal with provisions of retirement benefits. Auditor should see that the accounting treatment of gratuity is as given in AS-15.

The basis for working out gratuity payment is important to be seen by the auditor. The basis should be valid and in accordance with the Act.

2003 Dec. (3) How would you vouch/ verify the following and what are the allied

important aspects to be looked into ? a) Royalty payable to foreign collaborator, b) Goodwill c) Contingent liabilities d) Trade Creditors

Answer : Royalty payable to foreign collaborator,

The following points would be relevant in this regard :

The agreement with the foreign collaborator by the entity is to be studied in detail to comprehend the terms, tenure, timetable of payment and termination of the contract.

The rates of royalty payable, terms of short working, carryover of short working, period of short working, should be studied if applicable.

The terms of exchange rate fluctuations, relevant date for calculation of royalty in foreign currency.

Compliance of provisions of FEMA. Sanction of RBI may be seen. Note that all payments made should have TDS and the tax so deducted is deposited in treasury within time limit.

Comparison of royalty figures with production figures. Calculation may also be checked on tentative basis.

Generally the royalty is payable in cases of use of trade mark or technical know-how. Agreement in respect of royalty has the term, time of computation of royalty, tenure, and timetable of payment. The compliance with agreement may be verified. Computation of royalty should be checked in detail so as to ensure that no excess payment is being made.

Royalty is generally related with turnover, if this is the case then such turnover and the royalty payable should be certified by a practising chartered accountant. This should be verified.

Answer : Goodwill

Goodwill is an intangible asset. The following circumstances give rise to goodwill to be shown on balance sheet. The verification would be in accordance with the acquisition of goodwill.

When the entity has purchased a running business and paid for it a price more than the book value of net assets. The excess amount so paid stands for

goodwill. The agreement with the vendor/seller should be verified. Auditor should make certain that excess amount paid over and above the value of net assets should only be treated as goodwill.

When the assets have been revalued at a higher figure, the difference between old figure and revalued figure will appear as goodwill in balance sheet. Auditor should examine the basis of revaluation of assets. Revaluation of assets should be fair, reasonable and out of necessity. Auditor should make a reference of revaluation in his report. Proper accounting treatment should be given to


revaluation and the excess amount should be credited to Capital reserve account. The enhanced value of the assets should also be disclosed in the balance sheet as required by Schedule VI (Part I) to the Companies Act 1956 with the date on which the increase was applied.

When the goodwill written off earlier by the concern is brought back for writing off debit balance of profit and loss account or some capital loss, the auditor should ascertain the period in which the old goodwill was written off along with amount thereof. The re-introduction of goodwill should be supported by resolution of BOD in this regard. It should also be approved by the shareholders subsequently.

Answer : Contingent liabilities

The future events which are deemed possible at present but not probable are termed as contingent liabilities. These are the liabilities which may or may not rise in future. The future will reveal whether the contingent liabilities become actual liabilities, and then they will result in either an expense or a loss. Law suits, disputes and claims against the entity not acknowledged as debts may be cited as examples of contingent liabilities. Other contingent liabilities may be :

Disputed claims by workers for compensation;

Bills discounted;

Guarantees given in favour of others;

Amount on incomplete contracts;

Calls unpaid on partly paid shares;

Payment of gratuity under Industrial Dispute Act;

Preference dividend in arrears. For verification of contingent liabilities, following points may be noted:

Information from the legal department regarding the pending court cases against the entity.

Present status of each and every court case.

Study of existing contracts, agreements and arrangements.

Review of records relating to contingent liabilities maintained by the entity.

Contingency is the prime factor of contingent liabilities, the loss that is probable should not be treated as contingent liability, but should be adjusted in profit and loss account.

Discussion with top management, study of minutes of board meetings in this regard, fixation of contingent liabilities.

Other than legal suits against the entity, other contingent liabilities may also arise out of the following cases :

Bill Receivables : The bills receivables discounted but not matured upto the date of balance sheet should be examined. If it is anticipated that the bill may be dishonoured, adequate provision should be made.

Guarantee given on behalf of others : The MOA and the AOA should be examined to ascertain whether the directors have powers to give guarantee on behalf of others. It should be verified whether any director was interested in such guarantee. The minutes book of Board Meeting must be scrutinized in detail. The


amount, period, person concerned and mortgage or security related with guarantee, all should be scrutinized. The financial position of the person granted guarantee should always be auditor's primary concern.

Arrears of Preference Shares : The period for which the dividend on preference shares has not been paid may be known from records. In case the company runs into profit, the payment of pref. shares will have to be paid prior to dividend to share holders.

Answer : Trade Creditors. Following are the steps of verification :

1. Schedule of creditors is to be checked with purchase ledgers. 2. The auditor must contact some of the creditors personally. 3. All purchases during the year should find place in the purchase ledger. Special

checking may be made of purchases made during the close of the year. 4. Outstanding bills should be checked. The amount, period of pendency, reason

thereof should be enquired from the management. 5. Proper accounting treatment should be given to creditors to whom bills payable

have been issued. Post dated cheques if issued to creditors, should be credited to them.

2004 June (8) (b) Classify the following audit procedures into compliance / substantive : (2) Examining sales invoices ; (4) Scanning a Debtor account. Answer : Both are substantive tests. 2004 Dec (5) How would you vouch/ verify the following and what are the related aspects to be looked into ?

a) Excise duty ; b) Bank borrowing, c) Bankruptcy dividends d) Dishonour of discounts bills receivable.

Answer : a) Excise Duty The vouching may be carried on the following lines : Verification of excise duties:

Auditor should ensure that the rate of excise duty is the one prevailing at the time of despatch or clearance of goods. Clearance of goods should tally with the quantity shown in the stock register of the client.

In respect of excisable goods manufactured but remaining to be released, ensure that necessary provision for unpaid excise duty has been made.

The amount deposited in the PLA to the credit of excise authorities may be cross checked with the cash department and from the challans of bank.

The despatch of goods as seen in the goods despatch note should be matched with charging of excise duty in the PLA.

PLA should always show credit balance, otherwise it will amount to clearance of goods without payment of excise duty.

The auditee is allowed to refund of excise duty in certain cases. Such cases are maintained in a separate register. Auditor should make certain that such claims


are lodged in prescribed format and time-limit. Auditor should ensure that all refunds have been received and properly adjusted against future payments.

Ensure that in every case cenvat credit has been availed and adjusted; and only net excise duty has been paid.

b) Bank Borrowings : Answer: Bank borrowings may be of the form of term loans, cash credits or overdraft limits. In each case, the borrowings should be verified as per the following:

The auditor should satisfy himself that the borrowings obtained are within the borrowing power of the entity. It should be ensured that the bank loan has been obtained under proper authority.

In case of company; compliance with section 293 of the Companies Act 1956 stating the maximum amount that a company can raise via loan, should be examined. In case of company, only the BOD has the power to raise the loans or borrow from bank and in case the borrowings exceed the paid up capital and free reserve, the approval of share holders in general meeting is imperative.

He should conduct examination of relevant records to gauge the validity and accuracy of the borrowings.

The auditor should examine the important terms of loan agreements. If any charge is made in respect of such borrowings, he should examine the relevant documents. He should particularly examine whether the legal requirements relating to creation and registration of charges have been complied with. The register of charge should have all the necessary entries in this respect.

Auditor should examine the book balances agree with the statements of the lenders. He should see the reconciliation statement prepared by the entity.

It is also important to see the utilisation of loan. The loan should be utilised for the purpose for which it was obtained.

c) Bankruptcy dividends: Answer : It should not be confused with regular meaning of dividend declared by the company. Bankruptcy dividends are amount obtainable from a bankrupt debtor. When a debtor becomes insolvent and is declared as bankrupt, the dues from him are no longer recoverable in full. The Official Receiver as assigned by the Court admits claims against the debtor and allows the amount which can be recovered from his estate or property. The recoverable amount is received usually in instalments and is referred to as dividends. The vouching or verification of bankruptcy dividend can be done with correspondence with the official receiver. The amount recoverable is usually in accordance with time-table. The auditor should ensure that payments are duly received and proper procedure is established for receipt of balance amount. The unrecoverable amount should be written off in the accounts. d) Dishonour of discounts bills receivable. Answer : The statement of bills receivable should be examined. The bank statement will reveal the particulars of dishonoured bills receivables. The account of the debtor should be debited when the dishonoured bill is sent back to him. Auditor should see that proper representation is made to the concerned debtor for dishonour of his instrument. The bank charges debited by bank are also recoverable from the debtor along-with original debt. The debtors, whose bills are


dishonoured, should be marked for future dealings. Auditor should ensure that proper accounting treatment is given in all aspects of discounting.

2004 Dec (6) (b) Explain as to how you would treat the following expenses occurring after the date of the balance sheet in the financial statements : (i) The dispute with the workmen on the issue of Bonus was before the arbitrator and an award was given in favour of workmen for Rs. five lakhs. (ii) The Board …………………………….. in the future. Answer : (i) As the dispute was existing on the balance sheet date, the amount of award could not have been ascertained at the time of preparation of balance sheet. As before the approval of accounts by the BOD, the liability is finalised and quantified, it can be adjusted in the final accounts before its presentation to the BOD. This is an adjusting event. The amount of award may be shown as provision. Accounting standards 4 and AAS – 19 should be followed. (ii) This is futuristic in nature. This is neither present liability not a contingent liability.

This does not relate to year under audit, hence no provision is required to be made. Since the event has occurred after the balance sheet date, adequate disclosure either in accounts or in Director's report should be made in this regarding. 2004 Dec (8) (a) As an auditor how would you react to presence of huge cash balance in auditee's books. Answer :

The auditor should advise that it is not prudent business policy to keep more than usual amount of cash as balance. As most or rather all of the transactions are made on cheque basis, the presence of huge cash balance is a cause of concern. It is imprudent as well as risky to have more than required cash in the chest. The auditor should also verify the cash balance as per the cash book and as per actual cash if he is present on this date, and if any difference is found, he should demand written explanation from a senior official of the organization. If during the course of his audit, he comes across the presence of huge cash balance in the books, he should raise this point in his report. He should advise the management to deposit the cash as early as possible in the bank. Any excess of cash than required to meet the day to day expenses should be viewed as imprudent, as it is easy target for misappropriation, embezzlement, fraud and bogus payment. 2005 June (6) How would you vouch/ verify the following

a) Research and development expenditure ; b) Work-in-progress; c) Share issue expenses ; d) Trade marks and Copyright.

Answer : a) Research and development expenditure ;

(i) The research and development activity must be authorised by the Board. The activity may be carried out under separate department or may be incorporated with regular activities of business.

(ii) The expenses should be segregated into two components viz. revenue expenses which consist of regular expenses and


deferred revenue expenditure which consist of expenses having impact beyond the concerned accounting year. Allocation of expenses on these two accounts should be carefully seen.

(iii) Any plant or machinery acquired specifically for the purpose of research and development, the auditor should ensure that the expenses related to such asset and depreciation thereof, should be charged to research and development costs.

(iv) Expenses on abortive projects are to be charged to profit and loss account irrespective of their magnitude and impact on profit of the current year.

(v) Expenses of successful projects of research and development, should be charged to profit and loss account on deferred basis. A suitable time scale of say three to five years may be adopted for this purpose.

b) Work-in-progress; Verification of work-in-progress may require services of an expert of concerned field.

The auditor should ensure that the cost sheets are available for ascertainment in respect of various items of work-in-progress. The verification will vary in accordance with type of industry and the final product. In chemical industry, the assistance of chemical engineer may become essential for verification of work-in-progress. The following process is suggested in general ;

(i) The cost sheet supplied must be attested by the engineer-in-charge or the works manager. The cost sheet of previous years may be obtained and its contents may be compared with the current cost sheet. The deviations, if material, may be investigated.

(ii) The items of expenses appearing on the cost sheet should be verified from records. The quantities as well as the rates charged should be tallied with the records maintained for issue of materials by the stores department.

(iii) The degree of completion of various items of the work-in-progress may be ascertained from the production department. The allocation of expenses should match with the degree of completion.

(iv) The basis of charging overheads should be reasonable. The basis adopted must be consistent. Overheads charged must exclude the overheads relating to selling and distribution expenses. c) Share issue expenses ;

(i) The accounting treatment and disclosure as required in the schedule VI of Companies Act 1956, should be complied with.

(ii) Commission payable to the brokers or under writers is mentioned in the articles of association. More over the rate of commission is disclosed in the prospectus as well. The commission paid to the brokers should be verified on these lines.

(iii) The various expenses associated with share issue may be several viz. fees charged by registrar, advertisement, printing and publication of prospectus and issue of share certificates. All expenses must be verified and reasonableness must be established. If any exorbitant expenses comes into notice of auditor, he should make enquiries about the same. d) Trade marks and Copyright;


(i) Certificate of grant of trade mark should be examined. It must also be observed that the rights are alive and are enforceable. Latest receipt of fees paid will show whether the right is still alive.

(ii) It the trade mark is purchased, the agreement in this respect may be examined.

(iii) The renewal fees should be paid well in time, and should be charged to profit and loss account.

(iv) Copyrights are also acquired by surrendering of rights. The agreement may be examined.

(v) Copyright and trade marks are generally reviewed and revalued at the end of financial year, the auditor should observe that such revaluation is completed on rational basis.

2005 Dec (2) As an auditor of a limited company state your views on the following facts noticed by you in the course of audit:

(i) Fixed assets acquired in exchange for the shares of the company

are recorded at normal values. (ii) Proposed dividend is not adjusted in the financial statements. (iii) Government Grant received as compensation for losses sustained

negotiable instrument backward areas is credited to revenue reserve.

(iv) No depreciation is charged on an equipment kept idle throughout the year.

Answer : (i) Fixed assets acquired in exchange for the shares of the company are recorded at normal values. According to AS-10, when payment of fixed assets is made in shares or securities, assets should be recorded either at fair market value of asset purchased or fair market value of share or securities, whichever is more clearly available. In no case however, the fixed assets can be recorded at nominal values. (ii) Proposed dividend is not adjusted in the financial statements. The dividend proposal in one of the appropriations of profits of the company and as such it is required to be taken in financial statement as per schedule VI of Companies Act 1956. Thus proposed dividend should be clearly disclosed and adjusted in the financial statement, although it may be subject to approval in the Annual General Meeting. (iii) Government Grant received as compensation for losses sustained negotiable instrument backward areas is credited to revenue reserve. Government grants should not be treated as revenue reserve. Matching concept should be followed in recognising the Govt. Grants. Govt. Grants of revenue nature should be proportionately credited to profit and loss account over the period necessary to match them with related costs. Such grants can be shown as other income or shown as deduction from corresponding loss or expense, if the grant is received in the same year in which the loss is sustained. In case when the grant is towards the reimbursement of lossess of previous years, such grants should be credited to profit and loss account under ' other income' showing them separately. It is not prudent accounting practice to credit the grants to 'revenue reserve'.


(iv) No depreciation is charged on an equipment kept idle throughout the year. AS-6 on Depreciation Accounting makes it clear that depreciation is a measure of the wearing out, consumption or other loss of value of depreciation asset arising out of use, passage of time or obsolescence. It is evident that the charging is necessary not just because of wear and tear of asset, but owing to other factors like passage of time, obsolescence etc. It is therefore incumbent upon the company to charge depreciation, even though it might not be put to use. Depreciation is nothing but charging of its cost over the period of its useful life. It's useful life goes on diminishing with passage of time even though it is kept idle. Schedule XVI of the Companies Act 1956, which prescribes the rates of depreciation, does not lay down the use of assets for charging depreciation on the asset. It lays down condition for claiming extra depreciation for working more than one shift. Therefore, the depreciation should be provided in the accounts even if the asset is kept idle. Charging of depreciation is also compulsory under the Companies Act 1956 and if no depreciation has been charged, the fact should be disclosed by the company. The

statutory auditor should bring all these aspects to the notice of the Board, and if the company still does not provide for decentralisation or disclose a suitable note, he should qualify his report duly quantifying the quantum of depreciation not charged and its impact of the profit and loss account. 2005 Dec (5) (b) How would you vouch/ verify the following and what are the allied important aspects to be considered ? (i) Royalty payable to foreign collaborator, to whom royalty is payable (ii) Disposal of Plant Answer : For part (i) see above. (ii) Disposal of Plant:

1. The disposal of plant should not impair the going concern concept. The auditor should see whether the concern is existing without the plant.

2. The depreciation on plant should be provided up to the date of its disposal. 3. The assets register should be verified. It should be seen that the suitable

accounting treatment is given in the assets register. 4. Permission and authorisation for disposal of plant by competent authority should

be demanded by the auditor. He should also insist on Board's resolution in this regard.

5. How the plant is disposed? Open bids were called or not ? Whether tenders were invited ?

6. He should see that amount received is credited to assets and not to sales account. The profit or loss arising out of the disposal should be transferred to profit and loss account.

2006 June (4) How would you vouch/ verify the following and what are the allied important aspects to be considered?

a) Contingent liabilities ; b) Trade Creditors ; c) Dishonour of discounted Bills receivable ; d) Self constructed asset.

Answer : For a, b and c; please see above.


Self Constructed Asset : When the asset is not acquired from outside the firm, and the firm itself creates or constructs it, such asset is called Self Constructed Asset. According to AS-10 (accounting for fixed assets) such fixed asset, which was constructed by in-house efforts, is called self-constructed asset. Proper permission and authorisation should be available for manufacture of the asset. Adequate control over expenditure should exist so as to keep the cost at minimum. The expenditure incurred should be compared with that provided in the sanctioned estimate and the budget provision. The segregation of expenses on the asset and on other items should be properly done. Allocation of overhead expenses should be done on rational basis. According to AS-10, the Cost of self-constructed fixed asset includes the following :

All costs which are directly related to the specific asset;

All costs that are attributable to the construction activity should be allocated to the specific assets

Any internal profit included in the cost should be eliminated. 2006 Dec (4) How would you vouch/ verify the following and what are the allied important aspects to be considered?

a) Work-in-progress b) Loose tools; c) Railway Siding; d) Royalty payment to Foreign collaborator.

Answer : for work-in-progress, see above. b) Loose Tools : Loose tools require large investment though the items are many and

having low cost per unit. The control is necessary because of the large amount of investment in loose tools. Accounts of individual items may not be kept but some control over issue is required to prevent wastage. Charging of loose tools to production may be done in any of the following manners:

1. One method of accounting is to charge such items to Production account as and when they are purchased. The unused stock is valued at nil value. To prevent wastage and to exercise control, the records are kept for issue to workmen and receipts from stores.

2. Another method is to value such asset at the book value and subsequent purchase is charged to Production account as replacement.

3. Another method is to revalue the inventory of loose tools at the close of the year at cost and making necessary adjustments in accounts.

c) Railway Siding : Verification may be done of following lines : a) Permission of and agreement with the Railways is essential for availing this

facility. b) The cost of railway siding would be aggregate of (a) the amount paid to

railways (b) expenses related with agreements (c) all expenses of laying of rails (d) any other expenses directly related with the project

c) The cost so determined should be depreciated appropriately as per the settled terms with the Railway.

2006 Dec (7) How will you deal with the following as an auditor of a company : a) Bonus to employees which has hitherto been charged to profit and

loss account on mercantile basis is now being accounted for on cash basis.


b) There is significant fall in the market price of some investments held for a long time by the concern.

c) Outstanding liabilities for expenses show a considerable fall as compared to previous years.

d) [repeated in 2001 Dec. (1a)]Sundry debtors include charges made for returnable packing cases.

Answer : for a, b and c , please see answer to 2002 June (8) d) Sundry debtors include charges made for returnable packing cases.

The above procedure is not proper. The packing cases are not for sale as they are returnable and are used again and again. These cases should be treated as assets and depreciation should be charged on them. In balance sheet, they may be shown under distinct head ' packing cases with customers ' at cost less depreciation. Normally the cases should be sent against some deposit by the customer under the condition that he can get his deposit back if he returns the case within a particular time period, otherwise such deposit will be forfeited. Cases may also be sent without any deposit under the condition that cases must be returned by a certain date, if the customer does

not return the case by that date his account will be debited by this amount. 2007 June (5) How would you vouch/ verify the following and what are the related aspects to be looked into ?

a) Excise duty ; b) Trade Marks ; Answer : Please see above. 2007 Dec (2) Your client seeks your opinion on how the following matters should be accounted for and/or disclosed. Give your view with reasons for the same :

a) Sundry debtors include charges made for returnable packing cases. b) Assets bought on hire purchase basis were stated at their full value and

the outstanding instalments payable were shown under Sundry Creditors. c) The debit balance in profit and loss account is shown as deduction from

'Dividend Equalisation Reserve' on the liabilities side of balance sheet. d) Expenditure incurred on grading and preparing the soil for plantations are

charged to Cultivation Expenses. Answer : For part a, see above. b) The instalment paid has two components, the capital and the interest. The capital portion should be capitalised while the revenue portion is charged off to revenue. If full value of the asset is capitalised as in the present case, it should be verified that the total outstanding instalments under the agreement have been reduced from the value of the asset. As the asset is being used by the entity, the depreciation should be charged on full cash price of the asset. Thus showing outstanding instalments as Sundry Creditors as in the given example, is not proper. The outstanding instalments should be shown as deduction from the full value of assets purchased on HP basis. c) Dividend equalisation reserve is a specific reserve for a specific purpose. The deduction of debit balance of profit and loss account from such reserve is not correct. Moreover, according to Schedule VI to the Companies Act 1956, the debit balance of profit and loss account to the extent not written off can be shown as deduction of General Reserve or any uncommitted reserve but not from 'dividend equalisation reserve'.


d) Expenditure incurred on grading and preparing the soil for plantation is not a revenue expenditure, as its impact will be experienced for more than one accounting year, therefore, such expenditure cannot be charged to cultivation expenses. Such expenditure is in the nature of development expenditure and this can be capitalised under the head 'development of property'. Appropriate amount should be written off each year over the life span of benefits expected to be derived from the development of property. 2007 Dec (5) How would you vouch/ verify the following and what are the related aspects to be looked into ?

a) Research and Development expenditure ; b) Sale proceeds of junk materials ;

Answer : see above. 2008 June (1) Discuss whether '' Secret reserve can remain no longer secret''. Answer : see above. 2008 June (7) As an auditor of a company your advice is sought on the following issues :

a) Directors want to declare dividends out of accumulated profit without transferring any amount to reserves.

b) Trial production expenses of Rs.50 lakhs are proposed to be included as part of production overheads.

c) Book entries are made for purchase of land without the sale deed being executed by the vendor.

d) Year-end stock ready for exports are proposed to be valued at realisable value.

e) No provision for income tax is proposed to be made in respect of the profits of the year as the company expected refund of taxes paid in the earlier year.

Answer :

a) According to Sections 205 to 207 of Companies Act 1956, dividend can be declared out of current year profit and not out of accumulated profit. Transfer to reserves is essential before declaring dividend. The directors should be advised not to contravene the provisions of the Act, otherwise they can be prosecuted for this.

b) Trial production is part of the cost of the asset because it is required to bring the asset in operating condition. All expenses before the machine is ready for commercial production should be capitalised as part of machine. The expense of Rs. 50 lakhs should therefore be capitalised and should not be treated as production overheads. According to AS-10 (accounting of fixed assets), the cost of fixed assets includes any directly attributable cost of bringing the asset to the working condition for its intended use. AS-10 makes it clear that expenditure incurred on start up and commission of the project including the expenditure on test runs less income from sale of products forms cost of the asset and is therefore capitalised. Rs. 50 lakhs should be capitalised as deferred revenue expenditure to be written off over a period of say 3 to 5 years.

c) Ownership is established only after the sale deed is executed by the vendor. The land is not yet purchased for want of deed. The book entries in this regard are


incorrect. The payment made on account of purchase of land should be treated as advance to vendor and should be entered as such.

d) Year-end stock should be valued at cost or market value whichever is less. According to AS-2, the inventories should be valued at lower of cost or net realisable value.

e) Expectation of income is not equivalent to realisation of income. The realisation concept of accounting states that expected income should be treated as income only after it has realised. In the present case, the company has not yet received any income hence it is totally imprudent to assume that such income has realised. The refund may or may not come. The provision for income tax should be made irrespective of the refund expected.

Practical Questions

2004 June (8) Briefly furnish your views in connection with the following : (ii) After completion of checking the draft accounts approved by the Board of Directors of the company and placed before you, you observe that the Sundry Debtors and Loans and Advances have been classified in the balance sheet as '' Fully Secured'' on the basis of their being backed unconditionally by Bank Guarantees. Answer : Bank Guarantee is not a form of tangible asset. The sundry debtors and Loans and Advances should be classified as ''unsecured'' even if they are backed by bank guarantee. For being secured, these must be supported by tangible asset. 2005 June (2) Indicate with brief reasons, statutory variations or violations in the following :

(ii) A newly formed company wants to maintain its Books of accounts on mixed system of Accounting Cash Basis for receipts and Mercantile basis for expenses. Answer : The company wants to contravene the provisions of Section 209 of the Companies Act, 1956. The section 209 requires that the books should be kept on accrual basis and according to double entry system. It is statutory requirement to keep proper books in a manner and on matters as prescribed in the Act. The company can be prosecuted for contravening the provisions of Act if it maintains the books on cash basis. The auditor has to give qualified report indicating the maintenance of books on cash basis. 2006 June (5) As an auditor of a company, state your views on the following :

a) A Limited Company selling goods mostly on credit wants to maintain its book of accounts on cash basis. [Similar in 2002 June (1)]

b) A company does not make provision for gratuity payable to its employee, instead, it accounts for gratuity at the time of actual payment.

c) Production expenses of the Company under audit included trial production expenses of Rs. 2 lakhs. [similar in 2008 June (7)]

Answer : For part a, see above. b) If the provision for gratuity is not made, the profit and loss account will not show ' true and fair' view of the affairs of the company. According to section 209 of Companies Act 1956, the books of account should be kept on accrual basis and on double entry system. This is a case of material contravention of the Act.


In the Schedule VI to the Companies Act 1956, liabilities for pension and other staff benefits have to be shown as a provision under '' Current liabilities and Provisions''. Moreover, all liabilities as accrued on the date of balance sheet should be provided for. Liability of gratuity on the date of balance sheet should be taken into account on the basis of actuarial valuation. The auditor should qualify his report, stating that the gratuity has been treated on cash basis instead of accrual basis. He should also indicate the impact of accrued gratuity on the profit and loss account. 2007 June (2) As an auditor of a company, how will you deal with the following ?

a) The company has not provided for FBT liability of Rs. 20 lakhs. b) Executive Director's daughter's marriage expenses…………… the

company. c) Plant and machinery has been ………… Rs. 4,00,000. d) Advertisement ……………………….. to revenue.

Answer :

a) In the Schedule VI to the Companies Act 1956, liabilities for income tax have to be shown as a provision under '' Current liabilities and Provisions''. Moreover, all liabilities as accrued on the date of balance sheet should be provided for. Liability of FBT on the date of balance sheet should be taken into account on a rational basis. FBT is part and parcel of income tax liability. Provision means any amount retained by way of providing for any known liability of which the amount may not be determined with desired accuracy. As the liability of FBT can and will only be quantified in the subsequent year after the close of current financial year, the exact amount of tax liability cannot be anticipated. This requires provision of FBT on some reasonable basis. Like other provisions, the provision for FBT should be disclosed under relevant heads in the financial statements. b) Section 227 (1A) of Companies Act 1956, states that the auditor has to report

specifically whether personal expenses have been charged to the revenue account except those which have been allowed under rules and regulations. The marriage expenses of Executive Director's daughter are not allowed to be charged to revenue account. This is personal expenditure of the executive director which cannot be charged to revenue account of company. The auditor should advise the company to transfer the personal expenses of the ED to his personal account and disclose the same clearly under head '' Loans and Advances'' on the asset side of the balance sheet. If this is not complied by the company, the auditor should qualify his report and mention the fact u/s 227(1A) of the Act. c) Plant and machinery are fixed assets and are not meant for sale, hence their

present market value is irrelevant for accounting purposes. Market value is insignificant when the assets are not going to be sold at all. As such the practice adopted by the company is okay and as per sound accounting principles. The adequacy of depreciation may be ensured by the auditor. However, if the fall in market value is heavy and seemingly of permanent nature, the auditor should disclose this fact by way of a note in the balance sheet. d) Advertisement expenses incurred for a new product should be distributed on a rational basis over the life of the product or to next 3 to 5 years. The impact of


advertisement goes beyond the current accounting year and may be felt on future years, hence it is imprudent to charge the entire amount to revenue account. The expenses should be treated as deferred revenue expenditure and should be written off over a period of say 3 to 5 years. If the advice of the auditor is not complied by the company, he should qualify his report because the profit would be less than actual under this condition. 2007 June (6) As the Statutory auditor of a Public Limited Company, comment on the following situations:

a) Company has paid interest on share capital to the shareholders, as there was a long gestation period before the company would start making profits.

b) The Central Govt. has disbursed subsidy of Rs. 2 crores to the company for setting up a factory in a notified backward area.

Answer : a) The action of the company is in accordance with the section 208 of the Companies Act 1956 which permits payment of interest to shareholders when there is a long gestation period. The payment of interest on capital is however, capitalised as

part of the cost of construction of the project. Certain conditions are to be complied with for payment of interest on capital, the auditor should ensure that :

1) Payment is authorised by the AOA or by special resolution in general meeting. 2) Rate of interest, amount and period of payment are approved by the Central

Govt. 3) Paid up Share capital remains the same.

b) AS-12 is on '' Accounting of Government Grants''. It states that the grant given for acquisition of fixed assets is in the nature of promoter's contribution. In the present case the Company has received a subsidy of Rs. 2 crores for setting up a factory in a notified backward area, this is with reference to total investment related to the project. The accounting treatment of such subsidy will depend on the nature and purpose for which it has been given. In this case it is contribution of the Government towards the investment needed to establish the factory in a notified area, as such this can well be treated as Promoter's Contribution. As it is subsidy, no repayment is generally expected, thus this grant can be treated as Capital Reserve which can be neither distributed as dividend nor considered as deferred income. The amount of Rs. 2 crores should be kept in a special reserve account and treated as a part of Shareholders' funds. 2008 June (2) How will you, as an auditor of a limited company, treat the following items?

a) Receipts of substantial amount by way of damages from suppliers in respect of inferior quality of raw materials received and consumed during the year under audit.

b) Finished goods were valued at cost of production including administrative overheads.

c) Financial expenses and advances paid to contractors during periods of construction.

d) Know-how relating to manufacturing process paid Rs. 50 lakhs and know-how relating to drawing of plant and machinery amounting to Rs. 100 lakhs.

Answer :


Chapter 3 Analysis of Trends 2002 June (5) (a) Gross Profit Comparisons Answer : Gross profit may be expressed as percentage of sales or as an absolute figure in rupees. Thus comparison of gross profit may be on two parameter viz. as percentage or as amount for different accounting periods. The comparison on the basis of ratio is preferable. The comparison of gross profits of different periods is helpful in assessing any abnormal fluctuations from one period to another. If the changes in parameters of gross profit are not significant, it tends to maintain uniformity in value. The abnormal changes in GP ratio will signal the requirements to investigate the matter further. Whether there is change in GP ratio or not, the auditor should demand explanation from the management regarding the trend of GP ratio, and should also investigate the valuation and verification of stock, check the ledgers of sales and purchases and ensure the trading transactions have been recorded properly. 2006 June (8) Write Short notes on : (a) Inter firm and intra firm companies (d) Ratio Analysis Answer : (a) Inter Firm and Intra firm companies : Inter firm comparison implies comparison of different firms of the same industry. The parameters of comparison may be several viz. efficiency, efficacy, cost, sales and profits. This type of comparison guides the firm to know where it stands among its contemporary firms. The inter-firm comparison establishes the standards of performance with which any firm can compare its own performance and investigate the deviations if any. Worded differently the IFC is a technique of evaluating the performance, efficiency, cost and profit of a company and comparing this with other companies of the same industry. The intra firm comparison implies comparison of different departments or divisions of the same organization. The objective of this comparison is to enhance the efficiency and efficacy of different divisions. (b) Ratio Analysis : To evaluate the financial condition and performance of a firm, certain standards are needed. Accounting ratios are frequently used as standards for this purpose. Ration analysis is one of the very powerful and effective tool of financial analysis. Ratio is an expression of the quantitative relationship, which exists between two numbers. Ratios can be expressed in any of the following forms :

(i) Pure ratio : It is shown as absolute figure. (ii) In the form of rate : Stock turnover is 4 time in a year. (iii) As percentage : Gross profit is say 20% of sales. Ratios provide clues and symptoms of internal conditions. Ratios by themselves carry little sense, comparison is essential for making meaningful use of ratios.

Comparison can be with : (i) Past ratios of the same enterprise. This shows trend. (ii) Ratios of other companies. Relative performance may be gauged. (iii) Pre-determined standards. To measure the deviations and take remedial

measures. The ratio analysis is most powerful tool to assess the financial health of the company. It facilitates understanding of financial statements, inter-firm comparison and highlights relative performance of the firm in different areas. It may be noted that the ratios


highlight only the symptoms and it is for the auditor to study those symptoms properly, correlate them and reach definite conclusions or identify the area for further enquiries. 2008 June (5) Write short notes on (c) Inter firm and intra firm comparisons Same as above. 2004 Dec (7) Mention the limitation of Judgement sampling It is a mathematical truth that the sample, if picked purely on a random basis would reveal the features and characteristics of the population. In judgement sampling, the auditor having regard to the nature, size and materiality of transactions, picks up the entries for examination on the basis of his experience, knowledge and intuition. The limitations of the judgement sampling are many viz. (i) It is far from any mathematical or scientific concept. (ii) It lacks any acceptable basis and gives the auditor no idea about the degree of

reliability he can place on his findings. (iii) The so-called random picking is not random in the statistical sense. (iv) Personal judgement may be biased.

Chapter 4 Statutory Auditor : Write short notes on: 2002 Dec (8) : Appointment of Auditors by Special Resolution Answer : Section 224-A of the Companies Act 1956 provides : A company in which not less than 25% of the subscribed capital is held by :

1. a public financial institution or a government company or the Central Govt. or any State Govt. or

2. any financial or other institution established by any Provincial or State or any State Act in which a State Govt, holds not less than 51% of the subscribed capital, or

3. a nationalised bank or an insurance company carrying on general insurance

business; or 4. any combination of the above categories, shall appoint or re-appoint an auditor in the annual general meeting only by passing a special resolution. In case the aforesaid company omits or fails to pass a special resolution in the annual general meeting for appointing auditors, it shall be deemed that no auditor or auditors had been appointed and thereupon the Central Govt's power to appoint the auditor in pursuant to section 224(3) will become operative. Govt. has clarified that for the purpose of section 224-A, the composition of shareholding shall be of the day of annual meeting. It should be noted that subscribed capital includes preference share capital also.

2003 Dec (8) : Restriction of the rights of statutory auditor.

In general the auditor is appointed by the shareholders in annual general meeting and he has certain duties to perform. To enable the statutory auditor to perform the duties, certain rights are vested in him vide section 227 of the Company's Act 1956, viz. (i) Right to access the books and records at all times, (ii) right to acquire information and explanation from officers, and (iii) right to attend AGM. All these rights are vested in him by the Act itself and the company cannot restrict any of these rights. Any


resolution taken at a general meeting of shareholders or any provision in the Articles of Association of the company restricting the rights of auditor is invalid. The company cannot override the provisions of the Act. Distinguish Between : 2002 Dec (3) (ii) Cost audit and financial audit

Answer : The distinction is as follows: Cost audit Financial audit

1. It is an examination of day-to-day operations, from the cost accounting records maintained by the company.

It is examination of the books of account after the close of the financial year.

2. It also concludes efficiency audit and propriety audit.

It concludes the examination of transactions recorded in the books of accounts

3. It is a related with examination of production and manufacture process and analysis of cost components.

It is related with examination of accounting procedures and policies, and analysis of internal process to detect error, fraud and misappropriation of funds.

4. It results in cost statements. It results in financial statements.

5. It depends on order of the govt. It is a regular annual audit exercise.

6. It is governed by Companies Act 1956. Same

7. It is reported to the govt. It is considered to be confidential document.

It is reported to shareholders. It is considered to be open document.

8. It is aimed at ascertaining of cost of production, manufacture, operation or product.

It is aimed at ascertaining net worth, financial position and overall performance of the business regardless of its performance in various segments.

2007 June (8) (b) Distinguish between : Special audit and Cost audit: Special Audit : Special audit is ordered under section 233A of the Companies Act 1956, when the Central Govt. opines that such an order is necessary under the following circumstances :

1. Where the affairs of any company are not managed in accordance with sound financial principles or prudent commercial practices;

2. When any company is being managed in a manner likely to cause serious injury or damage to the interest of the trade, industry or business, to which it pertains;

3. When the financial position of any company is such as to endanger its solvency. The special audit is conducted by the auditor of the company or by any other chartered accountant appointed by the Central Govt. Cost Audit : The Central Govt. can order any company u/s 209(1)(d) to maintain cost records of a particular product or process. Section 233B of the Companies Act 1956, prescribes that the record to be kept u/s 209(1)(d) are to audited by a Cost accountant. The audit will result in cost statement of that product or process. The cost auditor is appointed by the Board of directors of the company with the prior approval of the

Central Govt. subject to necessary certificate of practice from the cost auditor.


2007 June (7) (b): What is operation audit? Show how it is different from Financial audit. Descriptive Questions 2001 Dec (1) (C) As auditor of a company, state your views with reasons on the following: (c) A company in annual general meeting resolved to appoint Mr. T auditor, but he declined to accept the appointment. Thereupon the board of directors of the company passed a resolution to appoint Mr. Z as auditor in place of Mr. T. Answer : Section 224(3) of the Companies Act 1956, reads as follows: Where at an annual general meeting no auditors are appointment or reappointed, the Central Govt. may appoint a person to fill the vacancy. Where an auditor appointed at an annual general meeting declines to accept the appointment, the appointment can not be treated as complete and effective. Only after the acceptance by the auditor, his appointment can be treated as complete. In my opinion, as Mr. T has declined to accept the appointment, the situation is equivalent to such as no auditor has been appointed at the general meeting and the

provisions of section 224(3) will apply. It is ultra vires the Board of directors to appoint Mr. Z in place of Mr. T as it is the Central Govt. who can fill such vacancy and not the BOD. Thus the appointment of Mr. Z should be treated as null and void. 2001 Dec (2) (a) Can a company restrict the rights of its statutory auditor? Answer ; Same as given under question 2003 Dec (8) (b) [repeat 2003 June (8) (c) Audit of Govt. expenditure]. What are the duties of an auditor in respect of audit of Government expenditure? Answer : The basic standards set for audit of expenditure are to ensure that there is provision funds authorised by competent authority fixing the limits within which expenditure can be incurred. These standards are :

(a) That the expenditure incurred conforms to the relevant provisions of the statutory enactment and in accordance with the financial rules and regulations framed by the competent auditor. Such an audit is called as the audit against

rules and orders'. (b) That there is sanction, either special or general, accorded by competent

authority authorising the expenditure. Such an audit is as the audit of sanctions. (c) That there is a provision of funds out of which expenditure can be incurred and

the same has been authorised by competent auditor. Such an audit is called as audit against provision of funds.

(d) That the expenditure is incurred with due regard to broad and general principles of financial propriety. Such an audit is also called as propriety audit.

(e) That the various programmes, schemes and projects where large financial expenditure has been incurred or being run economically and are yielding results expected to them. Such an audit is termed as the performance audit.

Each of the above discussed in detail in the following paragraph. Audit against Rules and orders : Audit against rules and orders aims to ensure that

the expenditure conforms to the relevant provisions of the Constitution and of the laws and rules made thereunder. It also seeks to satisfy that the expenditure is in accordance with the financial rules, regulations and orders issued by a competent authority.


Audit of sanctions : The auditor has to ensure that each item of expenditure is covered by sanction, either general or special, of the competent authority. The audit of sanctions is directed both in respect of ensuring that the expenditure is properly covered by a sanction, and also to satisfy that the authority sanctioning it is competent for the purpose by virtue of the powers vested in it by the provisions of the Constitution and of the law, rules or orders made thereunder, or by the rules of delegation of financial powers made by an authority competent to do so. Audit against provision of funds : Audit against provision of funds aims at ascertaining that the expenditure incurred has been on the purpose for which the grant and appropriation had been provided and that the amount of such expenditure does not exceed the appropriation made. Propriety Audit : The expenditure is incurred as per the financial prudence and with due regard to general principles of financial propriety. The auditor tries to bring out cases of improper, avoidable or infructuous expenditure, even though the expenditure has been incurred in conformity with the existing rules and regulations. Performance audit : Performance audit can be performed under three broad

strictures : Efficiency : To ensure whether the various schemes/projects are executed and their operations conducted economically and whether they are yielding the results expected of them. It is examination of resources consumed with respect to goods and services produced by them. Economy : Govt. has observed proper economy in securing and spending of financial, physical and human resources and whether the sanctioning and spending authorities have observed economy, and Effectiveness : appraisal of the performance of programmes, schemes, projects with reference to the overall targeted objectives obtained. 2001 Dec (4) (a) Mention the circumstances in which special audit of companies may be ordered by Central Government. Answer : Same as above. 2007 June (8) (b) (b) State briefly the provisions governing special audit report.

Provision governing special audit : The auditor of the company or any chartered accountant directed by Central Govt. can conduct the special audit. He will have the same powers, rights and duties as contained in section 227 of the Act. Apart from the above certain special provisions apply in relation to the report of special audit. If the special may require, the Central Govt. may order any person to furnish within a time limit information in connection with the special audit. On receipt of the special audit report the Central Govt. may take necessary action as per the provisions of Companies Act 1956 or any other Act or alternatively send the copy of report or part thereof with comments to the company for information of its members for discussion at its next annual general meeting. All expenses relating to special audit are borne by the company. 2002 June (1) (C) As an auditor of the company, state your views on the following : (c) The auditor of a company wanted to address the members at the Annual General Meeting on matters concerning accounts and audit. The company's contention is that he cannot address.


Answer : Company's contention is in violation of Section 231 of the Companies Act 1956 which prescribes that the auditor shall be entitled to attend any general meeting and to be heard at that meeting which he attends. The auditor is also entitled to receive all notices of, and other communications relating to any general meeting of a company which any member of the company is entitled. However, it is general practice that auditor exercises the power of section 231 exclusively when he has reasons to believe that the directors are deliberately concealing some serious facts and states of affairs, which must be known to the shareholders. The auditor may address the meeting with a view to bring to the notice of the shareholders any matter which has come to his knowledge subsequent to his signing the report. 2002 June (3) (a) X & Co. is a firm………………………… in the circumstances.

Answer : The case relates to section 229 of the Companies Act 1956 which states that the person appointed as auditor may sign the audit report. If a firm is appointed as auditors, only a partner to the firm may sign the report. In this case neither of the partners has signed the report. Z has signed the report on which he is not at all authorised to sign the report. Thus the report is not prepared in accordance with

section 229 of the Companies Act 1956 and this attracts the provisions of Section 233 of the said Act under which X, Y and Z shall be punishable with fine which may extend to Rs. 1000. 2002 June (6) (a) (repeated in 2003 Dec.5) State whether responsibilities are joint and several.

Answer : Joint audit basically implies pooling together the resources and

expertises of more than one firm of auditors to render an expert job in a given time period which may be difficult to accomplish acting individually. It essentially involves sharing of total work. Two or more auditors are sometimes appointed, particularly in case of big concerns such as banking or insurance companies, or where the regulations of company so require. In such cases each auditor is jointly responsible, but where the work performed by the auditors is divided by mutual agreement, it may desirable for each auditor to avoid responsibility for work he has not performed by a specific statement in the report as to the extent of the audit carried out by him. It the joint auditors are in agreement, a joint report may be furnished, in that case all the signatories of the report will be jointly and severally liable to any and every part of the report. If however, there is no unanimity among the auditors, they may issue separate reports and in that case each one will be liable to his own account of report which he has signed and issued. There is no question of majority opinion prevailing over minority opinion in respect of such audit report. In addition to above, it is the responsibility of the joint auditors to evaluate the internal control system, and to determine the nature, timing and extent of the audit procedure in respect of the area allotted to him.

2002 Dec 1(c)(a) State whether the following appointments are valid : (i) S & Co. are the statutory………………………. Of Rs. 25 lakhs. Answer : Section 224(1B) of Companies Act 1956 lays down the conditions for ceiling of audits. In accordance with this section, the total no. of company audits that the firm can hold in this case is 20 out of which not more than 10 companies should have a paid-up share capital of Rs. 25 lakhs or more. The provisions of this section shall not apply on or after the commencement of companies act 2000, to a private company.


The appointment of S and Co. as statutory auditors of SAP(P) Ltd. is perfectly valid as the company to be audited is a private company and not counted in determining the ceiling limit as set under section 224(1B) of the Act. (ii) Mr. S an individual ……………………………… in the company. The appointment of cost auditor is governed by the section 233B of the Companies Act 1956 which provides that the cost auditor is appointed by the BOD of the Company with the previous approval of the Central Govt. and in accordance with Sec. 224(1B). In the present case the state govt. has granted approval to the appointment of cost auditor, this is not in conformity of law and therefore is null and void. 2002 Dec (6)(a) A Limited Company ……………in the Director's Report ? --Discuss.

Answer : If there is any difference of opinion between the auditor and the BOD, the auditor has all the rights to qualify his report accordingly. In the present case the company has credited the profit and loss account in respect of insurance claims which is not materialised, of a very large amount and the Directors are of the view that the claims will be settled in full. The Directors are violating the basic principle of accounting

viz. the realisation concept; which states that the anticipated income should never be provided for and all anticipated losses must be provided for. U/s 227(2) of the Companies Act 1956, it is duty of the auditor to make a report to the members of the Company on the accounts audited by him and on the balance sheet, profit and loss account and any documents attached to the financial statements. As the Director's report is not covered by section 222 of the Act, it is no duty of the auditor to report on it. However, section 222 also states that any information which is required by the Act to be given in the accounts, may be given in the Director's report instead of accounts. If any such information is so given, the report on such information will be annexed to the accounts and the auditor shall also report on the said information. (b) Complex Ltd. defaulted in the repayment of deposits together with interest on the due date for more than a year…………………….. company.—Discuss.

Answer : According to section 227 of the Companies Act 1956, the auditor has to state the contravention by the Company of the non payment of public deposit and interest thereon. Moreover, Section 274(1)(g) requires that a person shall not be capable of being appointed director of the company, if such person is already a director of a public company which has failed to repay its deposit or interest thereon on the due date and such failure continuous for one year or more. Such person shall not be eligible to be appointed as director of any other public company for a period of 5 years from the date on which such company in which he is a director has defaulted. In view of the above provisions, the auditor must mention the fact of default in the repayment of deposit and interest thereon, in his report. 2003 June (1)(C) : As a statutory auditor of company, give your comments and observations on the following: (i) The company ………………………. put to use. Answer : AS-6 on Depreciation Accounting makes it clear that depreciation is a measure of the wearing out, consumption or other loss of value of depreciation asset arising out of use, passage of time or obsolescence. It is evident that the charging is necessary not just because of wear and tear of asset, but owing to other factors like passage of time, obsolescence etc. It is therefore incumbent upon the company to charge depreciation, even though it might not be put to use.


Depreciation is nothing but charging of its cost over the period of its useful life. It's useful life goes on diminishing with passage of time even though it is kept idle. Schedule XVI of the Companies Act 1956, which prescribes the rates of depreciation, does not lay down the use of assets for charging depreciation on the asset. It lays down condition for claiming extra depreciation for working more than one shift. Therefore, the depreciation should be provided in the accounts even if the asset is kept idle. Charging of depreciation is also compulsory under the Companies Act 1956 and if no depreciation has been charged, the fact should be disclosed by the company. The statutory auditor should bring all these aspects to the notice of the Board, and if the company still does not provide for depreciation or disclose a suitable note, he should qualify his report duly quantifying the quantum of depreciation not charged and its impact of the profit and loss account. (ii) During the course…………………………… stores consumed account. Answer : According to Accounting standard 5 on '' net profit or loss for the period, prior period items and changes in accounting policies'', two aspects are important:

1. All items of income and expenses which are recognised in a period should be included in the determination of the net results of the period;

2. When items of income and expense within the profit and loss from ordinary activities are of such size, nature or incidence that their disclosure is relevant to explain the performance of the enterprise for the period, the nature and quantum of such item shall be disclosed separately.

The embezzlement of stock by an employee which has taken place during the course of business, is a '' business loss''. It is incidental to the business itself. This is an abnormal event which needs to be disclosed separately. The loss on account of embezzlement is an abnormal loss and should be debited to profit and loss account separately. Its adjustment against the sores consumed account is imprudent treatment of the item.

(iv) X Structural Ltd…………………………………. wing is Rs. 3 lakhs.

Answer : It is self constructed asset and the treatment given to it should be in accordance with AS—10 '' Accounting for fixed assets''. It is clearly stated in AS-10, that any self constructed fixed asset should be valued at actual cost incurred and any profit element should be eliminated. The cost chargeable by the outsider is notional cost and is irrelevant for accounting purposes. The building account should be charged with Rs. 3 lacs only and the rectification should be done accordingly. 2003 June (6)(a) How is '' casual vacancy'' …………………….. Is this valid ? Answer : The expression 'casual vacancy' has not been defined in Companies Act 1956, Taking its natural meaning, casual vacancy stands for vacancy caused by the auditor ceasing to act as auditor after he was validly appointed to the post. This situation may arise due to a variety of reasons which includes resignation, death, disablement, disqualification, dissolution of firm of auditors etc. The Companies Act 1956 provides that the casual vacancy in the office of auditor can be filled by the BOD, provided such vacancy is not caused by the resignation of the auditor. In the present case the vacancy is caused by death of the auditor and not by his resignation. Thus the appointment of B & Co. by the Board is valid and as per law. (b) XYZ Ltd. was registered with……………………… in these acts.


Answer : According to Companies Act 1956, the first auditor(s) of a company shall be appointed by the BOD within one month of the registration of the company and such an auditor shall hold office till the conclusion of the firs AGM. If the Board fails to make such an appointment the company in general meeting may appoint the first auditor(s). The company may, however, at a general meeting remove any such auditor(s) and appoint in his or their places any other person or persons who have been nominated for appointment by any member of the company. Such nomination must be given to the members of the company not less than fourteen days before the date of the meeting. Here the Board has failed to appoint the first auditor within one month of registration of the company, the alternative left is to appoint the first auditor in the general meeting. The first appointment of Mr. Rakesh is invalid ab-initio as the time limit of one month from the date of registration (April 1, 2003) expires on May 1, 2003 and he was appointed on May 4,2003. The removal of Mr. Rakesh is equally invalid and appointment of Mr. Mukherjee is not as per the procedure of law. The only course left

to the company is to appoint the first auditor in the general meeting. (c) An auditor……………………………………….. auditor's opinion. Answer : The central purpose of auditing is to express an opinion on the affairs and working results of the company. After the conclusion of audit process, the auditor should review and assess the conclusions drawn from the audit evidence obtained as the basis for the expression of an opinion on the financial statements. The opinion expressed by the auditor may be unqualified or qualified. An unqualified opinion should be expressed when the auditor concludes that the financial statements give a true and fair view in accordance with the Companies Act 1956, an unqualified opinion indicates, implicitly, that

1. the financial statements have been prepared using the generally accepted accounting principles, which have been consistently followed;

2. the financial statements comply with statutory requirements; 3. there is adequate disclosure of all material matters.

Where the auditor gives an opinion subject to certain objections, conditions and/or reservations, he is said to have given a qualified opinion. A qualified opinion implies that the auditor states that the financial statements reflect a true and fair view subject to certain reservations. If that condition or reservation is not satisfied or fulfilled, the question mark may appear on true and fair view. Thus an auditor may furnish his particular objection or reservation in his report and state ''subject to the above, we report that the balance sheet shows true and fair view………'' If the auditor is left with no alternative but to give a qualified report, he must clearly express the nature of the qualification in his report along with the reasons of qualification. In the case of audit of companies as required in Companies Act 1956, section 227(4) provides that where the auditor answers any of the statutory affirmations in the negative or with qualification, his report shall state the reasons for such answers. When the conditions or reservations are substantial, the auditor may give adverse opinion in which he states that the financial statements do not represent a true and fair view of affairs and working results of the company. When he presents adverse opinion, he is required to furnish all reasons behind forming such opinion.


Where an auditor fails to obtain sufficient information to warrant an expression of opinion, he can give a disclaimer of opinion. Accordingly, the auditor may state that he is unable to express an opinion because he has not been able to have sufficient evidence and information to form an opinion on the financial statements. An example of disclaimer of the opinion can be statement by the auditor that '' we have been unable to state whether the balance sheet shows a true and fair view……………………'' The necessary of disclaiming an opinion may arise due to a variety of reasons. In certain circumstances, the auditor may not get access to all the books of account for certain reasons. Some material items may exist the value of which may be wholly uncertain. In other cases material items may remain unexplained or some material information is just not available. The auditor is always required to furnish reasons and explanation when he disclaims the opinion. 2003 Dec (1){C}(b) Briefly furnish………………………………….. to the branch. Answer : Reference to branch audit in the audit report: The Central Govt. has formulated Companies Branch Audit Exemptions Rules 1956 under section 228(4) of the Companies Act 1956 to confer exemption to any branch

office of a company from being audited, having regard to quantum of activity. According to these rules, a branch is exempted from audit, if during the financial year under question; the average quantum of activity of the branch does not exceed Rs. 2 lacs or 2% of the average of total turnover and the earning from different sources of the company as a whole, whichever is higher. In the given situation, the turnover of the branch is Rs. 3 lacs. Hence the branch has to be audited. That the branch was not referred to in the earlier year's report is irrelevant and immaterial. Even if this exemption has been granted, it is still necessary that the fact must be mentioned in the audit report. The auditor remains liable in this regard. 2003 Dec (2) (a) : When can special audit……………….. audit report. Answer : Special Audit : Special audit is ordered under section 233A of the

Companies Act 1956, when the Central Govt. opines that such an order is necessary under the following circumstances :

1. Where the affairs of any company are not managed in accordance with sound financial principles or prudent commercial practices;

2. When any company is being managed in a manner likely to cause serious injury or damage to the interest of the trade, industry or business, to which it pertains;

3. When the financial position of any company is such as to endanger its solvency. The special audit is conducted by the auditor of the company or by any other chartered accountant appointed by the Central Govt. He will have the same powers and duties as an auditor of a company in accordance with section 227. however, certain special provisions apply in respect of the report of the special audit. The special provisions and requirements are :

1. Apart from including the matters required u/s 227 of the Companies Act 1956, The report, will further include a statement on any other matter which may be referred to the auditor by the Central Govt.

2. If the special auditor may require, the Central Govt. may order any person to furnish within a time limit information in connection with the special audit.

3. On receipt of the special audit report, the Central Govt. may take necessary action as per the Companies Act 1956, or it may alternatively send the copy of the report or part thereof with comments to the company for information of its


members for discussion at its next AGM. All expenses of the special audit are to be borne by the company.

2003 Dec (5)(a) What do you mean by Joint audit? (b) Discuss whether the liability of Joint Auditors is joint or several. Answer (a) Please see answer to question 2002 June (6) (b) The liabilities of Joint Auditors : On the question of liabilities of joint auditors, the Institute of Chartered Accountants of India suggest the following :

1) There should be mutually agreed division of work between the auditors at the very commencement of auditing function, and the company should be informed in advance of the same.

2) The auditors will be jointly held responsible, when certain areas of audit work are done jointly, owing to the importance of nature of the work involved.

3) Each joint auditor will be responsible only for the work allocated to him. 4) In the absence of agreement, each auditor is entitled to adopt his own criteria

regarding the selection of items, the extent of test checks, the extent of auditing

and his own criteria regarding the materiality of the items involved. 5) Which the joint auditors are in disagreement with regard to the report, each one

of them would be justified in expressing his opinion through a separate report. Even when two or more auditors are appointed, there is no question of the majority or minority with regard to the audit report. Each auditor is entitled to express his own separate report, and in fact, it is his duty to do so.

2004 June (1)(C)(b) [ repeated 2007 Dec (7)(b)] Briefly state the ……following (i) The audit report………………………………………………. Sri Lanka Answer : Signature of Audit Report : The provisions in respect of signature of audit report are contained in section 229 of the Companies Act 1956 which provides that only the person appointed as auditor of the company, can sign the report. Moreover, if a firm is appointed as auditors of the company, any partner who is practising in India, of the firm, so appointed may sign the audit report or sign or authenticate any document of the company required by law to be signed or authenticated by the auditor. In the instant case, although Mr. H can sign as partner of the firm but he does not fulfil the other requirement of practising in India. As he is practising in Sri Lanka, his signature on the report will render the report invalid. It is in the violation of the Act, if the auditor report is signed by the partner who is not practising in India. 2004 June (4) (c) : State the powers…………………………………… in his report. Answer : The independence of auditor is guaranteed in the Companies Act 1956, he is given full freedom for making his judgement. The branch audit report is just another document to him and he can make use of it in any manner he wishes. At his discretion he may incorporate some of the points of the report in his report or he may altogether disregard everything contained in the report. However, if the branch audit report contains qualification of matters specifically required to be disclosed in the company accounts in pursuant to schedule VI, then it is just obvious that the company auditor is left with no alternative but to incorporate them in his own report after confirming the accuracy of the report. 2004 June (6)(b) : In company audit it is customary for an auditor to obtain from his client a certificate in respect of stock. Briefly state— (a) What are the objects of obtaining such a certificate?


(b) Whether it will absolve the auditor from his liability for inclusion of wrong figure of stock in Final accounts. Answer : (a) The following are the chief objects behind obtaining certificate regarding stock from the client:

1) To appreciate and impress upon the client his basic responsibility regarding stock and inventory.

2) To obtain the affirmation from the client that he owns the stock and all stocks belonging to him have been valued and reported and no stocks belonging to any other have been taken in the valuation.

3) To obtain the valuation of all the stocks and ensure consistency of such valuation method.

4) To obtain confirmation that stock and inventory have been taken as per the cut-off the procedures adopted by the management.

5) To obtain the report on physical conditions of the stock at the year-end. Answer (b) :

The auditor is essentially accountable to and answerable for his report. He is to report on the states of affairs of the company and if he relies on any figure supplied by anybody, he is accountable for his reliance. Any certificate of stock or whatsoever by the management does not absolve the auditor from his liability for inclusion of wrong or incorrect figure in his report. He is to report whether the balance sheet and profit and loss account represent true and fair view of the affairs of the company and as the stock is imperative component of the report, he should exercise due care with regard to stock valuation. The CARO also requires to specifically report whether the stocks are physically taken. The auditor has to report whether the valuation procedure is fair, consistent and proper. When such importance is granted to stock valuation, the auditor cannot just take shelter in the figures supplied by the management. AS-2 also requires the auditor to adopt standard procedures for verification and valuation of stock and it also states that the auditor is not supposed to rely exclusively on the certificate supplied by the management. Answer (c) : Apart from the above, the AAS-1 on '' Basic principles governing audit '' makes it abundantly clear that in cases where the auditor is required to delegate a part of his work to his assistants or use the work performed by others, he continues to remain responsible for expressing his opinion on financial statements. Thus he can rely on the work performed by others provided he exercises reasonable skill and care and he has no reasons to believe that he should not have so relied on the work of such other party. 2004 Dec (1) (C) Point out with brief reasons, statutory variations or in-consistencies in the following :

a) In Kiran Alloys Ltd. 20% of the share capital is held by West Bengal State Govt, and 10% by Unit Trust of India…………………. general meeting.

b) V.S.Ltd., appoints………………………………. firm's name. c) Mr. Ram and Mr. Rahim……………………………………. fill the vacancy. d) Mr. Ajay Goopta………………………………… his removal. e) Mr. Bhar has ……………………………………….. or more. f) Mr. Chandran……………………………………… in the company.

Answer :


a) According to Section 224 A of the Companies Act 1956, the appointment or reappointment of the statutory auditor in a general meeting shall be made by special resolution if not less than 25% of the subscribed share capital of the company is held whether singly or in any combination, by a public financial institution or a government company or central government or any state government. In the present case, more than 25% of the subscribed share capital is held by state government and a public financial institution, thus the provisions of section 224A are applicable, thus the reappointment of statutory auditor by ordinary resolution becomes invalid in the light of section 224A. Thus no appointment is deemed to have been held in the general meeting and provisions of section 224 shall apply in such company.

b) This is related with section 226(1) of the Companies Act 1956, as per this section a person shall not be qualified for the appointment as auditor of a company unless he is a chartered accountant within the meaning of the Chartered accountant Act, 1949. The proviso to this section states that a firm

whereof all the partners practising in India are qualified for appointment as aforesaid may be appointed by its firm name to be the auditor of a company, in which case any partner so practising may act in the name of the firm. In the given case, the firm can be appointed as auditor of a company as all the partners in India are practising in India and it is assumed that all the partners are qualified chartered accountants having proper certificate of practice. The partners based at Singapore are not considered for this purpose. Moreover, section 224(1B) also states that a partnership firm can be appointed as the statutory auditors of a limited company, hence appointment in the name of the company is valid.

c) The expression 'casual vacancy' has not been defined in Companies Act 1956, Taking its natural meaning, casual vacancy stands for vacancy caused by the auditor ceasing to act as auditor after he was validly appointed to the post. This situation may arise due to a variety of reasons which includes resignation, death, disablement, disqualification, dissolution of firm of auditors etc. The Companies Act 1956 provides that the casual vacancy in the office of auditor can be filled by the BOD, provided such vacancy is not caused by the resignation of the auditor. In the present case the vacancy is caused by his resignation. Thus the appointment of B & Co. by the Board is invalid and as per law. The vacancy caused by resignation can only be filled up by the company in general meeting. Hence the appointment of Mr. Wilson by the BOD is invalid.

d) To ensure the independence of the auditor, The Companies Act 1956 has provisions so that any auditor who is inconvenient to the management cannot be removed so easily. As per section 224(7), an auditor may be removed from office before the expiry of his term, by the company in a general meeting, obtaining the prior approval of the Central Govt. on this behalf except that such approval of Central Govt. is not necessary for the removal of the first auditor appointed by the Directors u/s 224(5). In the given case, as the prior approval of Central Govt. has not been sought and obtained, the removal of Mr. Ajay Gupta becomes invalid.


e) Section 224(1B) of the Companies Act 1956, prescribes the specific number of companies for which an auditor can be statutory auditor. According to this section the specific number means

1. In the case of a person or firm holding appointment as auditor of a number of companies each of which has a paid up share capital of less than Rs. 25 lakhs, twenty such companies;

2. In any other case, twenty companies, out of which not more than ten shall be companies each of which has a paid up share capital of Rs. 25 lakhs or more

In the given case, paid up share capital of twelve companies exceed Rs. 25 lakhs. Hence Mr, Bhar should not have accepted the appointment of the last two of the said twelve companies.

f) Section 226(3) of Companies Act 1956 prescribes the disqualification for appointment of auditor of a company. In the present case, the wife of Mr. Chandran is holding 10,000 equity shares of the company, in which he is sought to appointed as auditor. As Mr. Chandran himself has no security in the

said company, he is not disqualified for the appointment as auditor of the company.

2005 June (8) (a) State the extent to which the statutory auditor of a company can rely on work performed by others.

Answer : The AAS-1 on '' Basic principles governing audit '' does recognise 'work performed by others' as one of the basic principles governing an audit but makes it abundantly clear that in cases where the auditor is required to delegate a part of his work to his assistants or use the work performed by others, he continues to remain responsible for expressing his opinion on financial statements. Thus he can rely on the work performed by others provided he exercises reasonable skill and care and he has no reason to believe that he should not have so relied on the work of such other party. Such other parties may be different kinds of persons, experts in any other fields, other auditors, management people or his own assistants and associates. 2005 Dec (2) (b) How does the ……………………………… of cost audit ? Answer : The cost auditor should examine the following aspects to ensure the adequacy or otherwise of budgetary control system : Preparation of Budgets :

1. Organization of budget preparation. 2. Types of budgets prepared, functional budget, income and expenditure budgets,

flexible budgets, short term budget and long term budgets etc. 3. Method of preparation of budget, Zero base, bottom up, top down. 4. Scheduling for submission of budgets, 5. Separation of revenue and capital budgets, 6. Master budget, the assimilation of various budgets into master budgets. The adequacy of control mechanisms should be tested on following grounds :

1. System of reporting actuals against the budgeted targets. 2. Variance analysis and fixing of responsibilities. 3. Review intervals, 4. Remedial measures, 5. Timeliness of control procedures and measures.

2005 Dec (4)(a) Explain the concept………………………… auditors.


Answer : See answers to 2003 Dec (5)(b) and 2002 June (6) (a) 2005 Dec (8)(a) Cost audit can be considered as part of Management audit. Discuss the scope of Cost audit and explain how are these inter related and different from each other. Answer :

Management audit Cost audit

1. It is optional for the company. It is directed by Central Govt., therefore compulsory for the company.

2. It can cover all aspects of management viz. planning, organising, control etc.

It covers all aspects of a particular product for which audit is specifically ordered.

3. It is independent appraisal activity of the management to ensure compliance with organizational objectives.

It is dependent on order of the Central Govt. to ensure compliance with statutory requirements.

4. It is carried out to evaluate the efficacy of the control system in the organization.

It is carried out to evaluate the efficacy of the costing system of a specified product.

5. It is intended to review all managerial aspects of the company so as to enhance efficiency and efficacy of the entire system.

It is intended to review, examination and appraisal of cost accounting records so as to ensure true and correct cost of production.

6. The scope is pretty wide as it includes review and appraisal of all the decisions taken by the management.

The scope is narrow to activities relating to a particular product and includes review and appraisal of cost accounting system, variation in cost per unit, sales and export sales, abnormal and non-recurring costs, efficiency and adequacy of control of a particular product.

7. Can be conducted by any suitable person acceptable to the management. Generally a team of experts is designated the task. The

experts are qualified in different fields. The qualification is not prescribed in any Act.

Can be conducted by a Cost accountant appointed by BOD after approval of the Central Govt. Qualifications of Cost accountant are specified in Section

233(B) of Companies Act 1956.

8. No fixed periodicity. Periodicity is as per directives of Central Govt., It is conducted on year to year basis.

9. Report is submitted to the top management.

Report is submitted to the Central Govt. with a copy to company.

10. The copy of report need not be circulated to the shareholders of the

company.

The copy of report can be circulated to the shareholders of the company only

when it is so desired by the Central Govt.


2006 June (2) Enumerate the rights duties and responsibilities of Company' auditor in relation to the Company's Branch accounts, branch audit and branch auditor. Answer : As directed in Companies Act 1956, the accounts of the branch office of a company are required to be audited by :

The company's auditor appointed u/s 224 or

The person qualified for appointment as contemplated by section 226 or

Where the branch office is situated in a foreign country, either of the above or by an accountant duly qualified to act as auditor in accordance with the laws of that foreign country (section 228)

Two different cases may occur viz. When the company's auditor himself is the auditor of the branch accounts : In this case as the auditor is responsible to audit the company's accounts, he needs no separate directives and rights to audit the branch accounts as the branch falls within the gamut of company's activities. There is no question of any separate report on accounts of branch office, or any right to visit the branch or to have access to branch office records. When the branch accounts are audited by a person other than company’s auditor: AAS-1 on '' Basic principles governing audit '' makes it abundantly clear that in cases where the auditor is required to use the work performed by others, he continues to remain responsible for expressing his opinion on financial statements. Thus it is optional on the part of auditor to visit the said branch and audit the accounts, if he thinks it necessary to audit the branch accounts as well, there is nothing which can prevent him from doing so. Section 228(2) grants the auditor to visit the branch and to have access to all records maintained by the branch office. He is free to use the branch office audit report in any manner he deems fit. He has to report according to section 227(3) whether branch office audit report has been forwarded to him and how he has dealt with the same. He is also free to make such enquiries as he thinks fit from the branch auditor. His freedom to decide the relevance, reference and the impact of branch office audit report on his audit report is unquestionable. He, at his discretion may drop any or all the qualifications made in the branch audit report unless such qualifications belong to statutory requirements. AAS-10 on '' Using the Work of Another Auditor'' makes it clear that in certain situations, the statue governing the entity may confer a right on the principal auditor to visit a component and examine the books of account and other records of the said component, the principal auditor would normally be entitled to rely upon the work of such auditor unless there are special circumstances to make it essential for him to visit the component and/or to examine the books of account and other records of the said component. 2006 Dec (8) Narrate the rights and powers of statutory auditor of a public limited company. Answer : The auditor must be free from the interest and wishes of the persons

appointing him and remunerating him for his services. His independence for performance of his duty is central aspect of auditing and to ensure his independence,


assured rights and powers have been granted to him in the Companies Act 1956 which are as follows: Rights and Powers of Auditors are as follows :

1) Right to access to books of accounts : The auditor of a company, at all times, has the right to access to the books and accounts and vouchers of the company whether kept at the head office or elsewhere.

2) To require from officers of the company such information and explanation as he may think necessary for the performance of his duties as auditor. (Section 221)

3) To attend the general meeting of the company and address the members if he deems fit. He can make his representation in writing or orally in the general meeting.

4) all notices and other communications relating to any general meeting of a company which any member is entitled to have sent to him shall also be forwarded to the auditor of the company. (Section 231)

5) specific procedure as described in the Act shall have to be followed for his pre term removal from the post of auditor.

2007 June (8)(a) What do you mean by independence of an auditor? State the provisions of the Companies Act 1956 which aims to safeguard the independence of of auditor. Answer : same as in 2006 Dec (8) 2007 Dec (3)(a) What is meant by Joint audit?

Answer : See Above. (b) What are the reporting responsibilities of the joint auditors ? Answer : See above (c) Ram is principal……………………………….. same entity. (i) do they become Joint Auditors? (ii) what are their reporting responsibilities ? Answer : (i) No. If a company appoints one person or firm as principal auditor and at the same time appoints another person or firm as an auditor of a part/component/branch/division of the company, they do not become joint auditors. They cannot become joint auditor after separate appointments, they can become joint auditors only when they are appointed as such. In this case Ram is principal auditor and Rahim is an auditor of the part of the company. 2007 Dec (5) (a) Briefly state the objectives of cost audit from the point of view of government. (Also see 2003 Dec (7) : Discuss the purposes and potentialities of cost audit under chapter 9) Answer: The chief objectives of cost audit from the point of view of government :

1. to ensure whether the national resources are prudently and optimally used. 2. to reduce cost of production of commodities and regularise their distribution. 3. to determine whether particular industry should be given subsidy/grants. 4. to determine whether particular industry should be protected from external

competition. 5. to make comparisons of cost parameters of different firms manufacturing same

product.


6. to assess the costs of the same product on different regions so as to decide to grant incentives etc.

7. to fix the maximum price of a commodity. 8. to devise, apply and evaluate cost control measures.

2008 June (4)(a) State some of the features of Companies Act 1956 which aims to preserve and project the independence of statutory auditor. Answer : See above. 2008 June (4)( (b) Outline the general disadvantages of joint audit. Answer :

1. Confrontation of ego of auditors : Joint auditors are equally qualified and generally stand on same footing. The ego confrontation is likely among them. Psychological problems are likely to surface when firms of different standing are associated in joint audit.

2. Sharing of fees : The audit fees to be shared by all the joint auditors. The basis for

distribution of fees may not be acceptable to all. Some disputes are just possible. 3. Problems of co-ordination of work : This is something like a ship without any captain. The

coordination of work is complicated as no nodal agency is recognised. 4. Area of common interest is generally neglected. Everybody's responsibility is nobody's

responsibility. 5. Fixing of responsibility being ambiguous. Uncertainty about the liability of the work done.

Answer : 2008 June (4)( (c) The cost auditor of a company can be internal auditor, and is to be appointed by

the shareholders of the company. Comment on the validity. Answer : The cost auditor comments inter-alia, on adequacy, efficacy and efficiency of the internal control system of the company. In his report he has to comment whether the internal control system existing in the company is commensurate with the nature and size of the company. The internal auditor is overall in charge to check the internal control system. Thus if the cost auditor is also internal auditor of the company, he will have to comment on his own performance as internal auditor. The true and fair view is unlikely if cost auditor and internal auditor are same person. The internal auditor is employed by the company. Any person who is in full time employment can not get certificate of practice from the ICWAI. Moreover, the cost auditor cannot be internal auditor because this will be contravening the provisions contained in section 226 of Companies Act 1956. According to sub-section (2) of section 233(B), a cost auditor shall be appointed by the Board of Directors of the company in accordance with the provisions of sub-section (1B) of Section 224 and with the previous approval of the Central Govt. Further it has been provided that before the appointment of any cost auditor is made by the Board a written certificate shall be obtained by the Board from the auditor proposed to be so appointed to the effect that the appointment, if made, will be in accordance with the provisions of sub-section (1B) of section 224. Appointment of Cost auditor :

2008 June (4)( (d) Briefly state the basis and types of liability of auditors. Practical Questions : 2003 Dec (1) (C)(a)[Repeated in 2005 Dec (1)(C)] Briefly comment on the following appointments:

(i) Mr. Dasgupta, Chartered accountant, is appointed as statutory auditor of

X Ltd., in which two Government Companies jointly hold 30% of the subscribed share capital. The appointment is through an ordinary resolution passed in the annual general meeting.

(ii) Since the appointment of Mr. Narang as statutory auditor in an annual general meeting is held to be void ab initio, the company holds another general meeting and appoints Mr. Bhar, through a special resolution.

Answer :


(i) According to Section 224 A of the Companies Act 1956, the appointment or reappointment of the statutory auditor in a general meeting shall be made by special resolution if not less than 25% of the subscribed share capital of the company is held whether singly or in any combination, by a public financial institution or a government company or central government or any state government.

In the present case, more than 25% of the subscribed share capital is held by two government companies, thus the provisions of section 224A are applicable, thus the reappointment of statutory auditor by ordinary resolution becomes invalid in the light of section 224A. Thus no appointment is deemed to have been held in the general meeting and provisions of section 224 shall apply in such company.

(ii) In case the appointment of statutory auditor becomes void ab-initio, it shall be deemed that no auditor or auditors had been appointed and thereupon the Central Govt. power to appoint the auditor pursuant to section 224(3) will become operative. Hence in the present situation, the vacancy cannot be filled up by the company, but only by the Central Govt., accordingly the appointment of Mr. Bhar as the new auditor at the subsequent general meeting will not be valid.

2004 June (8)(a) Briefly furnish your views in connection with the following : (i) You have not been paid the fees for audit of a company. You are asked by the Managing Director of the company to send him the papers relating to the tax computations of his own proprietorship business, the taxation work of which is looked after by you. The auditor wants to exercise his lien. Answer : This is related with the auditor's lien. The auditor can exercise lien on books and documents placed at his possession by the client for non-payment of fees for work done on the books and documents. Following points are noteworthy in this respect:

Documents retained must belong to the client who owes the money.

Documents must have come into possession of the auditor on the authority of the client. They must not have been received through irregular or irregular means. In case of company client, they must be received on the authority of the BOD.

The auditor can retain the documents only if he has done work on the documents assigned to him.

Such of the documents can be retained which are connected with the work on which fees have not been paid.

It can be seen that in the above case, none of the above conditions have been fulfilled. The client of the auditor is the company and not managing director, hence there is no point of exercising lien on the documents of managing director if fee is not paid by his employer viz. the company. The auditor has not done any work on the documents of managing director, hence he cannot exercise lien on his documents.

2005 June (1)(C)(a) L& Co., a firm of ………………….. as statutory auditors. Answer : Section 224(1B) of Companies Act 1956 lays down the conditions for ceiling

of audits. In accordance with this section, the total no. of company audits that the firm can hold is 20 out of which not more than 10 companies should have a paid-up share capital of Rs. 25 lakhs or more. The provisions of this section shall not apply on or after


the commencement of companies act 2000, to a private company. The Act also specifies further that no company shall appoint or re-appoint any person who is in '' full time employment''. In case of a firm of auditors, the specified number of companies shall be construed as the number of companies with regard to each and every partner who is not in full time employment elsewhere. In the present situation :

20 private companies will not be considered for ceiling.

The authorised capital has no significance in this context, it is the paid up capital which is relevant for computation of specified numbers.

Maximum no. of companies @ 20 companies per auditor for 9 auditors : 180. Thus in all the firm can audit not more than 180 companies.

Out of 180 companies, the no. of companies which can have paid up share capital of more than Rs. 25 lacs @ 10 companies per auditor : 90

The firm has 25 + 70 = 95 companies having capital more than Rs. 25 lacs for audit. This is more than ceiling of 90 numbers as per section 224(1B). Among the balance 100 companies, it can act as auditors for 90 companies.

2005 June (2)(a) Indicate with………………………… at the branches. Answer : The duties and responsibilities of branch auditors are prescribed u/s 227(3) and 228 of Companies Act 1956 and shareholders are not empowered to make any alteration, addition, reduction or extension in the Act. Auditor should ignore such special resolution and continue with his task as per the directions of Companies Act 1956 and not as per the directions of shareholders. 2005 June (2) (b) Briefly furnish………………………………….. to refer to them. Answer : (i) In exercise of powers conferred by section 228(4) of Companies Act 1956, the

Central Govt. has framed certain rules, entitled ''The Companies (Branch audit Exemption) Rules 1961'' to confer exemption to any branch office of a company from being audited, having regard to quantum of activity. In accordance with these rules, a branch office of the company is exempted from audit, if during the financial year under audit, the average quantum of activity of the branch does not exceed Rs. 2 lacs or 2% of the average of total turnover and the earnings from other sources, of the company

as a whole, whichever is higher. In the present situation, the turnover of the branch is Rs. 3 lacs hence the branch is to be audited. (the average total turnover and earnings has not been mentioned in the question, hence it is assumed it is below Rs. 150 lacs. If it is above Rs. 150 lacs, the branch can be omitted from audit.). It is immaterial whether the branch was audited earlier or not. Even if exemption has been granted, it is still necessary that the fact must be mentioned in the audit report. The auditor remains liable in this regard as he is auditor of the company as a whole and the branch office is part of the company. (ii) The payment of Rs. 80 lacs is not a current liability, hence it is not necessary to make any provision in this respect. The purchase of machinery is a capital expenditure and therefore no provision needs to be made. AS- dealing with disclosure requirements requires that a note should be mentioned in the financial statements that a contract has been entered into which would require payment of Rs. 80 lacs in cash in


the year of delivery. This is a contingent liability on capital account. If sufficient disclosure of the contract has been made, the treatment given is correct. (iii) [(repeat 2003 Dec (1bii)] This is a serious misconduct on the part of the BOD. In section 227 of Companies Act 1956 the auditor has been granted powers to access all the books and documents which he deems necessary for the conduct of the audit. He can also ask for information and explanation from the officers and employees of the company to make a true and fair view of the affairs of the company. The minutes book is a statutory record and the auditor should have access to it. The BOD has no powers to deny this access. The auditor should make a written request in this regard and if the minutes book is still not provided to him, he should make a disclaimer of opinion. The denial also indicates some dubious matter. The auditor should use his powers to attend and address the general meeting and bring this matter to the notice of members. 2005 June (7)(a) You are auditor …………………………….. denied any liability. Answer : (i) The realisation concept of accounting states that the stock should be valued at cost

or net realizable value wel. AS-4 and AAS-19 calls for the consideration of the effect of subsequent event on the financial statement and the auditor should include such effect in his report. In the present situation, the stock costing Rs. 10,000 on balance sheet date was subsequently sold at Rs. 25,000. Following the basic principle of valuing the stock at cost or NRV wel, the stock should be recorded at cost of Rs. 10,000. The profit arising out of the transaction is a revenue profit on next accounting year and should find place in profit and loss account of next year. Secondly, the stock costing Rs. 30,000 was sold for Rs. 15,000 subsequent to the balance sheet date. Subsequent event provides information about its realisable value which was unknown at the balance sheet date. Again following the basic principal of stock valuation, the stock should be recorded at cost or NRv wel, the stock should be stated at Rs. 15,000 and necessary adjustment be made in the accounts of current year. The loss occurring in this transaction should be charged to profit and loss account of this year and should not be carried to next year though the selling has taken place in next accounting year. (ii) This is a case of contingent liability as the matter is not yet decided. The quantum of contingent liability is totally uncertain and cannot be estimated at present. However, the company should be advised to take legal advice on this matter and should establish the truth behind the customer's claim of damage. As the matter is not taken to court by either the company or the customer, efforts should be made to settle it mutually. This is an important event which needs to be disclosed properly in the financial statement. 2005 June (7) (b) Y Ltd. had borrowed……………………… above situation?

Answer : The auditor should first ensure that entire amount of interest and accrued penal interest is provided for in the account. This is an item of profit and loss account and if Y ltd. does not provide this amount, the auditor should qualify his report duly quantifying the impact of non-provision of interest on balance sheet and profit and loss account. This event was known at the balance sheet date i.e. 30th June,2004. The liability was existing on the date of balance sheet; how it was omitted in financial statement is amazing. It demands an investigation on whether the company is following proper and


prudent accounting policies or not. It should be seen whether proper books of account as required u/s 209 of Companies Act 1956, are kept by the company or not. This lapse is a serious one and is more than what appears. Pending application with the bank is not important at all. 2005 Dec (1)(C) : Briefly comment of the following : (i) Mr. B…………………………………………….. general meeting . (ii) Since ……………………………………………. Special resolution. Answer : 2003 Dec (1) (C)(a) 2006 June (1)(C)(b) (i) The auditor of a company ………………………….. same correct ? (ii) The directors of a company …………………….. sustainable ? (iii) L & Co., is a firm ………………………………… auditors of a company ? Answer : (i) Section 227 (1) of the Companies Act 1956 reads as follows : '' Every auditor of a company shall have a right of access at all times to the books and accounts and vouchers of the company, whether kept at Head office or elsewhere, and shall be

entitled to require from the officers of the company such information and explanations as the auditor may think necessary for the performance of his duties as auditor.'' From the above, it is evident that the auditor can demand data from any officer of the company and the sales officer is no exception to this. The sales officer is bound to furnish data to the auditor, and if does not do the needful the auditor should ask the management to dictate the sales officer in this regard. (ii) There is specific mention of audit of book entry in the section 227(1A) of the Companies Act 1956 which says that the auditor should inquire whether transactions of the company which are represented merely by book entries are not prejudicial to the interests of the company. Thus the auditor is duty bound to conduct critical examination of book entries to find out the real scene behind those book entries. The objection of the directors is not only sustainable but makes the matter suspicious and the auditor should go deeper into this entry. (iii) Section 226(1) states that the firm having all the partners of required qualification and practising in India may be appointed by its name to be auditor of the company, in which case any partner so practising may act in the name of the firm. Here one partner is not in private practice, and hence the firm cannot be appointed as statutory auditor of the any company. 2006 June (5) As an auditor of a company, state your views on the following : (d) During the year under audit, one of the joint auditors died. The Board of directors appointed another auditor in his place. Answer : The vacancy is caused by death of the auditor. Section 224(6) of the Companies Act 1956, states that the BOD can fill the vacancy caused by any reason other than resignation. The appointment is valid in the eyes of law. The auditor so appointed shall hold the meeting until the conclusion of next annual general meeting. 2006 Dec (1)(C)(b)(i) XLW has a branch…………………………visit the branch? Answer : As directed in Companies Act 1956, the accounts of the branch office of a

company are required to be audited by :

The company's auditor appointed u/s 224 or

The person qualified for appointment as contemplated by section 226 or


Where the branch office is situated in a foreign country, either of the above or by an accountant duly qualified to act as auditor in accordance with the laws of that foreign country (section 228)

Thus Mr. X, can conduct the audit of the branch at Malasia. As per section 228(2) where the accounts of any branch office are audited by a person other than the company's auditor, the company's auditor :

Shall be entitled to visit the branch office, if he deems it necessary to do so for the performance of his duties as auditor, and

Shall have a right of access at all time to the books and accounts and vouchers of the company maintained at the branch office.

Thus Mr. Z has the right to visit the branch, if he feels it necessary for the purpose of his audit.

(ii) The share capital …………………………………………… correct position. Answer : According to Section 224 A of the Companies Act 1956, the appointment or reappointment of the statutory auditor in a general meeting shall be made by special resolution if not less than 25% of the subscribed share capital of the company is held whether singly or in any combination, by a public financial institution or a government company or central government or any state government.

In the present case, less than 25% (Total 24%) of the subscribed share capital is held by two government companies, thus the provisions of section 224A are not applicable, thus the reappointment of statutory auditor by ordinary resolution becomes valid. Note that authorised share capital is irrelevant for this purpose. 2007 June(1)(C)(b): Z and Co. are proposed……………………………… Rs. 20 lacs. Answer : Section 224(1B) of Companies Act 1956 lays down the conditions for ceiling of audits. In accordance with this section, the total no. of company audits that the firm can hold is 20 out of which not more than 10 companies should have a paid-up share capital of Rs. 25 lakhs or more. The provisions of this section shall not apply on or after the commencement of companies act 2000, to a private company. The Act also specifies further that no company shall appoint or re-appoint any person who is in '' full time employment''. In case of a firm of auditors, the specified number of companies shall be construed as the number of companies with regard to each and every partner who is not in full time employment elsewhere. In the present situation : M and N both have 10 no. each of Companies having paid up capital of Rs. 25 lacs or more, thus none of them can accept any appointment for audit of company having paid up capital of Rs. 25 lacs or more. As the paid up capital of ABC ltd. is more than Rs. 25 lacs, Z ltd cannot be appointed as auditor of ABC Ltd. The answer will be different if the paid up capital of ABC ltd is Rs. 20 lacs. The Z ltd can accept one more audit of company having paid up capital of less than Rs. 25 lacs. It presently has appointment of 19 companies and is thus open for one more company having capital less than Rs. 25 lacs. Authorised capital is not relevant in deciding the specified number. 2007 June(1)(C)(c): S Ltd. is subsidiary……………………………… your answer. Answer : This is related with qualification and disqualification of auditors as prescribed

in section 226 of the Companies Act 1956.


Section 226(3) states that a person who has given guarantee in connection with the indebtness of any third person to the company for an amount exceeding Rs. 1,000 shall not be qualified to appointed as auditor of the company. Hence Laxaman cannot be appointed as auditor of S Ltd. Section 226(4) states that where a person is not qualified to be appointed as auditor of a company, the disqualification shall extend to the holding company of the said company. Hence Laxaman cannot be appointed auditor of H Ltd. as well. 2007 June (3)(b) The total turnover…………………………………. 2006 and 2007. Answer : (i) In exercise of powers conferred by section 228(4) of Companies Act 1956, the Central Govt. has framed certain rules, entitled ''The Companies (Branch audit Exemption) Rules 1961'' to confer exemption to any branch office of a company from being audited, having regard to quantum of activity. In accordance with these rules, a branch office of the company is exempted from audit, if during the financial year under audit, the average quantum of activity of the branch does not exceed Rs. 2 lacs or 2% of the average of total turnover and the earnings from other sources, of the

company as a whole, whichever is higher. In the present situation, the turnover of the branch is Rs. 1.80 lacs hence the branch is not required to be audited. Even if exemption has been granted, it is still necessary that the fact must be mentioned in the audit report. The auditor remains liable in this regard as he is auditor of the company as a whole and the branch office is part of the company. In the present case, the auditor has no responsibility of the audits of earlier period accounts. Thus the auditor for the year ended 31.3.07 is in no way responsible for the position relating to the year ended 31st march, 2006. 2007 June (3)(c) On account of …………………………… part of Y? Answer : This auditor does not know the basics of auditing. The audit is not carried out in accordance with the fee received but it is conducted as per the directives and guidelines provided in Companies Act 1956. The amount of fee will not decided the quantum, scope and extension of audit. The auditor may consider the reduction in fees but any reduction in extent of audit is out of question. No restriction is his duties, powers, responsibilities and liabilities is possible either by the directors or by the entire body of shareholder. There is no concept of full audit or part audit in section 227 of the Companies Act 1956. The fee of the auditor is a matter of arrangement between the company and the auditor. Section 224(8) specifies the remuneration of an auditor, shall be fixed by the company in general meeting or in such manner, as the company in general meeting may determine. Even if Y accepts the suggestions of the directors regarding the scope of audit and work to be done, he still remains responsible of the views expressed by him as an auditor. Under the circumstances, Y is violating the provisions of Companies Act 1956. 2007 Dec (7)(b) The audit report…………………………….. Is this proper? Signature of Audit Report : The provisions in respect of signature of audit report are contained in section 229 of the Companies Act 1956 which provides that only the person appointed as auditor of the company, can sign the report. Moreover, if a firm is appointed as auditors of the company, any partner who is practising in India, of the firm, so appointed may sign the audit report or sign or authenticate any document of the company required by law to be signed or authenticated by the auditor.


In the instant case, although Mr.X can sign as partner of the firm but he does not fulfil the other requirement of practising in India. As he is practising in Singapore, his signature on the report will render the report invalid. It is in the violation of the Act, if the auditor report is signed by the partner who is not practising in India. Audit Report : Write Short Notes On : 2008 June (5) (f) Qualified Opinion : Answer : The central purpose of auditing is to express an opinion on the affairs and working results of the company. After the conclusion of audit process, the auditor should review and assess the conclusions drawn from the audit evidence obtained as the basis for the expression of an opinion on the financial statements. The opinion expressed by the auditor may be unqualified or qualified. Where the auditor gives an opinion subject to certain objections, conditions and/or reservations, he is said to have given a qualified opinion. A qualified opinion implies that the auditor states that the financial statements reflect a true and fair view subject to certain reservations. If that condition or reservation is not satisfied or fulfilled, the

question mark may appear on true and fair view. Thus an auditor may furnish his particular objection or reservation in his report and state ''subject to the above, we report that the balance sheet shows true and fair view………'' If the auditor is left with no alternative but to give a qualified report, he must clearly express the nature of the qualification in his report along with the reasons of qualification. In the case of audit of companies as required in Companies Act 1956, section 227(4) provides that where the auditor answers any of the statutory affirmations in the negative or with qualification, his report shall state the reasons for such answers. When the conditions or reservations are substantial, the auditor may give adverse opinion in which he states that the financial statements do not represent a true and fair view of affairs and working results of the company. When he presents adverse opinion, he is required to furnish all reasons behind forming such opinion. Where an auditor fails to obtain sufficient information to warrant an expression of opinion, he can give a disclaimer of opinion. Accordingly, the auditor may state that he is unable to express an opinion because he has not been able to have sufficient evidence and information to form an opinion on the financial statements. An example of disclaimer of the opinion can be statement by the auditor that '' we have been unable to state whether the balance sheet shows a true and fair view……………………'' The necessary of disclaiming an opinion may arise due to a variety of reasons. In certain circumstances, the auditor may not get access to all the books of account for certain reasons. Some material items may exist the value of which may be wholly uncertain. In other cases material items may remain unexplained or some material information is just not available. The auditor is always required to furnish reasons and explanation when he disclaims the opinion. Distinguish between 2002 Dec (3) Report and certificate 2003 Dec ( 2) Qualified opinion and Disclaimer of opinion The central purpose of auditing is to express an opinion on the affairs and working results of the company. After the conclusion of audit process, the auditor should review and assess the conclusions drawn from the audit evidence obtained as the basis for


the expression of an opinion on the financial statements. The opinion expressed by the auditor may be unqualified or qualified. Where the auditor gives an opinion subject to certain objections, conditions and/or reservations, he is said to have given a qualified opinion. A qualified opinion implies that the auditor states that the financial statements reflect a true and fair view subject to certain reservations. If that condition or reservation is not satisfied or fulfilled, the question mark may appear on true and fair view. Thus an auditor may furnish his particular objection or reservation in his report and state ''subject to the above, we report that the balance sheet shows true and fair view………'' If the auditor is left with no alternative but to give a qualified report, he must clearly express the nature of the qualification in his report along with the reasons of qualification. In the case of audit of companies as required in Companies Act 1956, section 227(4) provides that where the auditor answers any of the statutory affirmations in the negative or with qualification, his report shall state the reasons for such answers. Where an auditor fails to obtain sufficient information to warrant an expression of

opinion, he can give a disclaimer of opinion. Accordingly, the auditor may state that he is unable to express an opinion because he has not been able to have sufficient evidence and information to form an opinion on the financial statements. An example of disclaimer of the opinion can be statement by the auditor that '' we have been unable to state whether the balance sheet shows a true and fair view……………………'' The necessary of disclaiming an opinion may arise due to a variety of reasons. In certain circumstances, the auditor may not get access to all the books of account for certain reasons. Some material items may exist the value of which may be wholly uncertain. In other cases material items may remain unexplained or some material information is just not available. The auditor is always required to furnish reasons and explanation when he disclaims the opinion. 2005 Dec (8) Audit report and audit certificate 2007 Dec (8) Negative opinion and Disclaimer of opinion. When the conditions or reservations are substantial, the auditor may give adverse opinion in which he states that the financial statements do not represent a true and fair view of affairs and working results of the company. When he presents adverse opinion, he is required to furnish all reasons behind forming such opinion. Where an auditor fails to obtain sufficient information to warrant an expression of opinion, he can give a disclaimer of opinion. Accordingly, the auditor may state that he is unable to express an opinion because he has not been able to have sufficient evidence and information to form an opinion on the financial statements. An example of disclaimer of the opinion can be statement by the auditor that '' we have been unable to state whether the balance sheet shows a true and fair view……………………'' The necessary of disclaiming an opinion may arise due to a variety of reasons. In certain circumstances, the auditor may not get access to all the books of account for certain reasons. Some material items may exist the value of which may be wholly uncertain. In other cases material items may remain unexplained or some material information is just not available. The auditor is always required to furnish reasons and explanation when he disclaims the opinion. Descriptive Questions :


2001 Dec (1)(C)(a) [ Repeated in [2006 Dec (7)(d)] As an auditor of a company, state your views with reasons on the following :

(a) Sundry debtors include charges made for returnable packing cases. Answer : The above procedure is not proper. The packing cases are not for sale as they are returnable and are used again and again. These cases should be treated as assets and depreciation should be charged on them. In balance sheet, they may be shown under distinct head ' packing cases with customers ' at cost less depreciation. Normally the cases should be sent against some deposit by the customer under the condition that he can get his deposit back if he returns the case within a particular time period, otherwise such deposit will be forfeited. Cases may also be sent without any deposit under the condition that cases must be returned by a certain date, if the customer does not return the case by that date his account will be debited by the specified amount. 2001 Dec (1)(C)(b) [ repeated in 2008 June (7d)] As an auditor of a company, state your views with reasons on the following :

(b) B Ltd valued at the year end its stock of goods ready for export at realisable

value yielding a margin of 15% of cost. Answer : The basic principle of valuation of stock is that the year-end stock should be valued at cost or market value whichever is less. According to AS-2, the inventories should be valued at lower of cost or net realisable value. In the present case the stock is valued at net realisable value which has a margin of 15% on cost. This is improper and imprudent accounting policy as the profit is not yet materialised. General accepted accounting principle states that all anticipated losses should be provided for whereas expected or anticipated profits should be altogether ignored. Inclusion of unrealised profit in the financial statement will distort the true and fair view of the statements as such the profit should be eliminated from valuation and the stock should be stated at cost only. 2001 Dec (4c) In what circumstances the auditor of a company should consider in his report the matters contained in the director's report. Answer : U/s 227(2) of the Companies Act 1956, it is duty of the auditor to make a report to the members of the Company on the accounts audited by him and on the balance sheet, profit and loss account and any documents attached to the financial statements. As the Director's report is not covered by section 222 of the Act, it is no duty of the auditor to report on it. However, section 222 also states that any information which is required by the Act to be given in the accounts, may be given in the Director's report instead of accounts. If any such information is so given, the report on such information will be annexed to the accounts and the auditor shall also report on the said information. Following events if treated in the director's report, must be scrutinised by the auditor and, if necessary, considered in his report :

Cancellation of any contract after the balance sheet date;

Disposal of substantial portion of the undertaking;

Changes in capital structure;

Changes in wages structure;

Major loss of capital nature;

Verdicts on litigation leading to fixation of contingent liabilities;


2001 Dec (7)(a) You have been appointed as auditor of XYZ Ltd. State your opinion on the following : XYZ Ltd. had acquired an asset from USA at a cost of US $1,00,000, immediately after acquisition of the asset, the Indian rupee was devalued by 10%. The company transferred the additional liability to exchange fluctuation reserve account. Answer : The purpose of creating exchange fluctuation reserve account is to accommodate any changes is exchange rate and the company has rightly done to transfer the increased liability on account of devaluation to this reserve of balance sheet. If this account is not settled in the current accounting period, year-end balance sheet will carry this amount on liabilities side. 2001 Dec (7)(b) On being appointed the auditor of a company for the first time, you find that the cashier also handles the books of account and that cash receipts are not being banked intact but parts of these are being utilised for cash payments. As an auditor of the company, what would be your reaction and what recommendations would make to the company in this connection? Answer : The cashier should be entrusted with the cash book only. Other books of transactions must be recorded by some other person. The following recommendations

may be made in the situation described in the question : (a) The daily cash receipts and incoming should be banked promptly. It is improper

and imprudent to use cash receipts for making payment of daily expenses. It makes the surprise checking of cash balance fruitless, it is also a sign of weak internal control. The payments may be made by a different person through petty cash book or through imprest account.

(b) The internal auditors should conduct physical verification of cash on surprise basis but quite often.

(c) The cashier should not be allowed to open incoming mails and letters as they may contain some complaint about his own acts and performance. Moreover, he should not be exposed to see all correspondence of the company.

(d) Sales proceeds should not be entrusted to cashier and should promptly be banked daily.

(e) Wages bills should be prepared by the accounts departments and cashier should have no roles to play.

(f) Payment should be authorised by some senior person of the company. The payment should be made only after getting proper payment order from some competent authority.

(g) Cash deposited to and withdrawn from the bank should be counter checked with the bank slips and check book.

Giving the cashier the responsibility of writing accounts book also is equivalent to making a cat to guard the milk. Company should not do this and limit the responsibility of cashier to write cash book only.

2001 Dec (8)(a) [repeat 2004 June (4)] '' The report of an auditor should not be regarded as a hard and fast guarantee nor as a certificate of insurance covering the quality of the accounting information which has been audited.'' – Discuss. Answer : No final verdict of Court is declared up till now establishing the clear-cut liabilities of auditor towards the shareholders and investors for placing their reliance on his report. The liability to the company for faulty audit has been established in the statute however, the auditor is still free from any such liability.


In City Equitable Fire Insurance Co. Ltd. case it was held that an auditor of company is not an insurer and does not guarantee that the books of the company show the true position of its affairs or that its balance sheet is accurate according to the books. But it is his duty to ascertain and certify to the shareholders the true financial position of the company at the time of the audit. The auditors do not interfere in the matters of managerial wisdom but he can and should question it whenever he feels so. The auditor is supposed and expected to render his service with due care, skill and diligence but if he does not do so, the remedy is not readily available to those who rely on his report. The Government is empowered to order special audit if it feels that the practices of management are unsound and detrimental to the interests of the company. 2002 June (2)(b) What are the aspects to be covered in qualifying the Audit report? Answer : Where the auditor gives an opinion subject to certain objections, conditions and/or reservations, he is said to have given a qualified opinion. A qualified opinion implies that the auditor states that the financial statements reflect a true and fair view subject to certain reservations. If that condition or reservation is not satisfied or fulfilled,

the question mark may appear on true and fair view. The various items to be considered in qualifying report are as follows :

1) The grounds on which qualification to based; whether the required information is not available or whether there is disagreement between the viewpoint of auditor and the company.

2) List out the various items calling for qualification. 3) Whether the items will materially effect the true and fair view or will effect on

single item only, 4) The items listed for contravention of the provisions of Companies Act 1956,

Thus an auditor may furnish his particular objection or reservation in his report and state ''subject to the above, we report that the balance sheet shows true and fair view………'' If the auditor is left with no alternative but to give a qualified report, he must clearly express the nature of the qualification in his report along with the reasons of qualification. In the case of audit of companies as required in Companies Act 1956, section 227(4) provides that where the auditor answers any of the statutory affirmations in the negative or with qualification, his report shall state the reasons for such answers. The statement of qualification should be based on well established principle that they must give full information about the subject matter of the qualification exclusively so that there is no suspicion or doubt in minds of shareholders. 2003 Dec (1)(C)(b) [ repeat 2005 June (2) (b) ]Briefly furnish your views in connection with the following : (ii) Board of Directors refuse to allow access to the Minute Books to the statutory at when he wants to refer to them. Answer : This is a serious misconduct on the part of the BOD. In section 227 of Companies Act 1956 the auditor has been granted powers to access all the books and documents which he deems necessary for the conduct of the audit. He can also ask for information and explanation from the officers and employees of the company to make a true and fair view of the affairs of the company. The minutes book is a statutory record and the auditor should have access to it. The BOD has no powers to deny this access. The auditor should make a written request in this regard and if the minutes


book is still not provided to him, he should make a disclaimer of opinion. The denial also indicates some dubious matter. The auditor should use his powers to attend and address the general meeting and bring this matter to the notice of members. 2004 June (4) '' The report……………………………………….—Discuss. Answer Same as 2001 Dec (8)(a) 2004 Dec (3) As an auditor of XYZ Ltd, state your views on the following points noticed by you in course of audit:

a) Interest charges………………………………………………. In the accounts. b) The branch auditor ………………………………………………. Auditor thereof. c) Company has ……………………………………………………….. accounting year. d) Company has given………………………….. its subsidiaries.

Answer : a) The question is silent whether the interest charges relate to working capital loan or for some other loan taken during period of construction. We can therefore consider both the aspects as follows :

If interest charges and commitment fees are related to working capital loan taken during construction period, they should be treated as deferred revenue expenditure to be written off during a period of 3 to 5 year after commencement of commercial production.

If interest charges relate to some other loan, these should be capitalised as these are capital expenditure. The commitment fees of working capital loan should be treated as deferred revenue expenditure to be written off during a period of 3 to 5 year after commencement of commercial production.

b) [similar to 2004 June (4) (c)] The independence of auditor is guaranteed in the Companies Act 1956, he is given full freedom for making his judgement. The branch audit report is just another document to him and he can make use of it in any manner he wishes. At his discretion he may incorporate some of the points of the report in his report or he may altogether disregard everything contained in the report. However, if the branch audit report contains qualification of matters specifically required to be disclosed in the company accounts in pursuant to schedule VI, then it is just obvious that the company auditor is left with no alternative but to incorporate them in his own report after confirming the accuracy of the report. c) The section 209 of Companies Act 1956,requires that the books should be kept on accrual basis and according to double entry system. It is open to investigation how could the company maintain accounts on cash basis contravening the provisions of the Act. When the company changes the method of accounting from cash basis to accrual basis, all accounting books should undergo checking and adjustments. All transactions should be scrutinised and its impact on previous years and the following year should be segregated and reported as such. Apart from this, the transactions of the previous year need to be scrutinised again for the similar treatment and their impact on current year accounts needs to established and incorporated. This being material change in accounting policies, must be disclosed distinctly in the financial statement as required in accounting standard 1. AS-1 states that if there is any change in accounting policies in preparation of financial statement from one period

to subsequent period and such change affects the state of affairs of balance sheet and profit and loss account of current period or the financial statement of the later period,


then such change must disclosed in financial statement. The amount, by which the financial statement is affected, should be disclosed to the extent ascertainable. d) Section 295 governs the loan between holding and subsidiary company. However, the provisions of section 295 will not be applicable here as the subsidiary company to which the loan is granted is a private limited company. The auditor should bring this fact to the notice of all concerned by disclosing the fact of loan to subsidiary company suitably in the financial statement. 2006 Dec (3) As an auditor of a company, state your views on the following :

a) Company has capitalised sundry expenses like postage, stationery etc incurred during construction period. [Same 2001 Dec (3)]

b) The directors wanted………………………………………. such securities. c) The company wants to destroy its books of accounts, vouchers etc. for a period

prior to the last six years. d) The records of the company were seized by the income tax department. The

directors require the auditor to issue a qualified report to the shareholders explaining the position.

Answer : a) Printing, postage, local conveyance expenses incurred during the construction

period are indirect expenses which cannot be regarded as incidental to construction cost of the project. As these expenses are not against any revenue because the project is yet to begin commercial activity, they cannot be written off to revenue. Hence these are treated as deferred revenue expenditure to be carried forward as miscellaneous expenses, to be written off to revenue as soon as possible after the commencement of commercial production.

b) There is no provision in Companies Act 1956, to give any confidential report to directors by the auditor on any matter. The auditor is there to report whether the states of affairs in the company are represented on its financial statement on a 'true and fair' concept. He cannot report differently to the shareholders and directors. The basic duty of an auditor under the Act is to report to shareholders and not to directors. In this case, the auditor should state clearly the amount which, in his opinion, the securities are expected to realize. The famous case of Re London and General Bank, is relevant in this regard, which states that an auditor who gives means of information instead of information, in respect of company's financial position, does so at his peril, and runs the very serious risk of being held, judicially to have failed to discharge his duty.

c) As per the section 209(4A) of the Companies Act 1956, the books of accounts relating to a period of not less than eight years immediately preceding the current years are to be kept in a good condition by the company. The directors should not destroy the records for the period prior to the last six years, as this would contravene the provisions of section 209(4A) of the Act. The auditor has to report regarding maintenance of proper books of accounts and he can issue a qualified report if proper books of accounts are not kept by the company.

d) Section 227(3) of the Companies Act 1956, provides that the auditors report shall also state inter alia : 1. whether he has obtained all the information and explanations necessary for the purpose of audit;


2. whether in his opinion, proper books of accounts, as required by law have been kept by company; 3. whether the company‘s balance sheet and profit and loss account dealt with by the report are in agreement with the books of accounts and returns. It is obvious the books of accounts were not available in the company, so the auditor could not obtain them for the purpose of audit. When there are no books to be audited and audit is not possible to be conducted, there is no question of any report whether qualified or unqualified. Auditor should give disclaimer and not a qualified report.

2007 Dec (5)(b) State the circumstances under which a qualified Audit Report is issued (any five circumstances). Answer : Where the auditor gives an opinion subject to certain objections, conditions and/or reservations, he is said to have given a qualified opinion. A qualified opinion implies that the auditor states that the financial statements reflect a true and fair view subject to certain reservations. If that condition or reservation is not satisfied or fulfilled, the question mark may appear on true and fair view.

Some of the circumstances under which the auditor can give qualified opinion are as follows:

1) When proper books of accounts are not maintained by the company as required u/s 209 of Companies Act 1956;

2) When personal expenses of the directors are charges to miscellaneous expenditure of the company;

3) When depreciation is not charged properly and adequately; 4) Non-disclosure of changes in accounting policies and the effect of such change

in policy; 5) Interest on capital borrowed for purchase of fixed assets stood capitalized for the

period after the assets have been put to business. 6) Non-provision of minimum alternate tax; 7) Existence of unauthorised ' Secret Reserve'.

2007 June(3)(a) : Subsequent to the issue…………………….. this situation? Answer : Generally speaking, an auditor considers subsequent events upto the date of issuance of the audit report. Subsequent to the issue of audit opinion, Here the auditor of a company comes to know an important matter about the company and Had he known about this earlier, he would have given a different opinion. In such case he should bring this fact to the notice of shareholders. According to section 231 of the Companies Act 1956, the auditor is empowered to attend and address any general meeting of the company, to receive all the notices and other communications relating to the general meeting, which members are entitled to receive, the auditor should exercise this right to bring the fact to the knowledge of shareholders. 2007 Dec (7)(a) How will you deal with the following in the course of audit of the accounts of a limited company?

1) The sales are very high at the year end when compared to the earlier months in the ratio of around 2:1,

2) Debentures issue at face value but repayable at premium; 3) Payment of Rs. 50,000-each to the Directors as allowances to cover travelling

and entertainment expenses in the course of their normal duties.


4) Under the head ' Reserves and Surplus' of Rs. 5 lakhs includes secret reserve of Rs. 1 lakh.

Answer : 1) When the sales are not uniform, it is very likely that business may be seasonal. There is nothing wrong, serious and suspicious if sales are very high at the year end, however, the auditor should ascertain the figures are related with reality and not the distorted ones. Following lines are suggested for audit :

Sales, production, despatch challans and excise duty payment register should match with one another.

Purchase ledger entries should match with creditors ledger and payment vouchers.

Stock records should be verified. Ensure that the goods sold are despatched and not remaining in the stores. Closing stock should not include goods already sold.

Sale order book should be examined. Some bulk orders may change scene altogether.

Whether all sales were recorded in the initial portion of the year. 2) Debentures issued at par and redeemed at premium: It is assumed here that the audit is taking place in the year when the debentures have been issued at premium. The auditor should examine the following aspects to ensure compliance:

The amount of premium on redemption represents loss on issue of debentures. The loss should be debited to the '' Loss on issue of debentures account'' and should be credited to '' Premium of Redemption of debenture account''.

The premium at which the debentures are to be redeemed should be spread over the life of debentures.

The amount of debentures should be shown as liability at the nominal value and a note should be given to disclose their redeemable value.

Proportional yearly amount of the premium at which the debentures are to be repaid, should be debited to '' loss on issue of debentures account'' and credited to '' Premium on redemption of debentures account''.

If redemption fund is created, whether a proportional amount of the nominal value of the debentures and premium thereon has been credited to this fund.

3) Audit can be conducted on the following lines :

Schedule VI of the Companies Act 1956 requires the allowances paid to the directors of the company to be disclosed properly in the profit and loss account of the company, auditor should see whether this is done.

The payment should be authorised by the Articles of Association.

The resolution passed in BOD meeting should be seen. The minutes book of BOD meeting should be examined.

Payment vouchers and receipts obtained from the directors need to be verified. Needless to say that payment should be made through a/c payee cheques only.

4) Secret reserve as the name indicates, is the reserve which is not disclosed in the balance sheet. The existence of secret reserve indicates that the worth of the business is more than what is disclosed in the balance sheet. Such a situation may arise when the liabilities are overstated or the assets are understated or omitted altogether.


Companies Act 1956 requires that the auditor must ensure that the balance sheet and profit and loss account show a ' true and fair' view of the financial position of the company. Any secret item will cause the departure from 'true and fair view' concept; thus it is not allowed at all to keep secret reserve in financial statements. The Act requires unequivocally that all reserves and provisions must be fully disclosed in Company's accounts making it impossible to keep any secret reserve. Companies Act 1956 however, provides that if the company is specifically permitted to keep secret reserve, it can do so after compliance with the rules made in respect thereof. The banking, finance and electricity companies are permitted to keep secret reserve to a limited extent.

Chapter 6 Divisible Profits : Descriptive Questions : 2002 June (2) (a) Discuss the law relating to the following with reference to payment of dividend: (i) Adjustment of loss incurred in the previous years against the profit for the current year. (ii) Dividend on shares transferred in respect of which transfer deeds have been lodged with the company, but the transfer has not been registered. Answer :

(i) If the company has incurred any loss in any previous financial year or years, which falls of fall after the commencement of the Companies (Amendment) Act, 1960, then the amount of the loss or an amount which is equal to the amount provided for depreciation for that year or those years whichever is less, shall be set off against the profits of the company for the year for which dividend is proposed to declared or paid or against the profits of the company for any previous financial year or years, arrived at in both the cases after providing for depreciation in accordance with the provisions of section 205 (1) or section 205(2).

(ii) Dividend is normally paid to the registered shareholders (section 206). The transferee becomes entitled to dividend only when the transfer of shares is registered by the company. But if transfer deed is lodged with the company along with the mandate to transfer the dividend accruing on such shares to the transferee, it is obligatory on the part of the company to pay dividend to the transferee. Registration of transfer of shares by company is not necessary for payment of dividend, if transfer deed is lodged with the company along with the mandate.

2002 Dec 1(C)(b) State your views on the following in connection with a company audit: (ii) The Directors of a company propose to transfer unclaimed dividend to profit and loss account. Answer : The unclaimed dividends are liabilities on the company and should be shown as such on the liabilities side of the balance sheet up to next three years. Unclaimed dividend should not be treated as income and therefore its transfer to profit and loss


account is not correct. Such amount should be transferred to Unclaimed dividend a/c, if the same has not been paid as warrant has not been posted within 30 days from the date of declaration. Such unpaid dividend will have to be deposited within seven days after the expiry of the said 30 days to bank under the heading of '' unclaimed dividend a/c of …. Limited.'' Section 207 of Companies Amendment Act, 2000 states that in case of default of payment of dividend, every director of the company if he is knowingly a party to default, shall be punishable to simple imprisonment for a term which may extend to 3 days and shall also be liable to the fine of one thousand rupees for every day during which the default continues and the company shall be liable to pay simple interest at 18% per annum. 2005 Dec (4)(c) What are the items under '' Reserves and Surplus'' appearing on the liabilities side of the Balance sheet of a company which are not available for declaration of dividends? (any four items) Answer : The fundamental principle underlying the payment of dividend is that the dividend is return on capital and not return of capital. Therefore the following items are

not available for declaration or payment of dividend. (i) Capital Redemption Reserve (ii) Fixed assets revaluation reserve (subject to satisfaction of certain conditions) (iii) Excess amount of forfeiture/ reissue of shares. (iv) Any specific reserve created out of specific provisions of law.

2008 June (4)(c) State the sources of payment of dividend in the case of company limited by shares. According to section 205 of Companies Act 1956, dividends can be paid out of the following sources :

1. Profit from the current year after providing depreciation as per the provisions of law. Profit here means net profit after charging relevant expenses, depreciation and provisions and after transfer of prescribed percentage to reserves.

2. Undistributed profits of the previous year. 3. Money provided by state govt. and central govt in a scheme of guarantee. 4. Out of capital profit subject to provisions of law.

Practical Questions 2005 June (2)(a) Indicate with brief reasons, statutory variations or violations in the following : (iii) A company wants to declare dividend at 16% by transferring 6% of the current profits to Reserves. Answer ; According to section 205(2A) of the Companies Amendment Act 1975 states that minimum amount of profits should be transferred to the reserves of the company at the rates prescribed by the government. These rates have been prescribed in Companies (transfer of profits to reserve) Rules 1975. Following table is relevant

Dividend to be declared as % of paid up capital Transfer to reserve

Less than 10% 2.5% of current year profit

10% to 15% 5% …………. do……….

15% to 20% 7.5% …………. do……..

Above 20% 10% …………. do……….

According to the above table the action of company is incorrect, it should transfer 7.5% of current year profit if it wants to declare dividend at 16%.


It is also to be noted that the amount of profits to be transferred to reserves prescribed is only the minimum amount. There is no bar for a voluntary transfer to the reserves of company amounts which are higher than the minimum percentage prescribed under these rules. 2005 June (4)(a) ABC Ltd. has been charging depreciation on its assets by adopting Straight Line Method since inception. During the year 2004-2005 (financial year) it decided to change over to written down method of depreciation. During the years 2000-2004, the company declared dividends when depreciation was charged on straight line basis. However, due to revision of charging depreciation on written down basis, losses resulted for the year 200-2004. Substantial profit is still available for the year 2004-2005. In this contest state : (i) Whether there is any legal bar in changing the method of depreciation from

SLM to WDM. (ii) Whether the distribution of dividend for 2000-2004 will be viewed as void in

view of lossess arising from revised calculate of depreciation under WDV basis.

(iii) What an adjustment the company should make in the accounts for the year ended 31.3.2005?

Answer ; (i) There is no legal bar in changing the method of depreciation from SLM to

WDM. However, as per AS-6, change is method of depreciation should be treated as change in accounting policy and as such its impact should be quantified and disclosed. According to this standard, change in method of depreciation is justified if it is (i) for compliance of statute (ii) for compliance of accounting standards (iii) for better and more appropriate presentation of the financial statement.

(ii) As the change in method of depreciation took place in later years, the directors cannot be expected to anticipate the changes when dividend was declared. The distribution of dividend during the years 2000-04 would not become void because all provisions of law were followed as per section 205 of Companies Act 1956. Although the change resulted in loss, the company cannot be said to have distributed dividend out of capital.

(iii) AS – 6, states the procedure to be followed in case of change in method as follows :

Depreciation should be recomputed applying the new method from the date of its acquisition / installation till the date of change of method.

Difference between the total depreciation under the new method and accumulated depreciation under the old method will the date of change may surplus or deficiency.

Such resultant surplus is credited to profit and loss account under the head '' Depreciation written back''.

Such resultant deficiency is charged to profit and loss account.

Chapter 7 : Auditor and Internal Auditor : Distinguish Between 2008 June (6) Bring out the fundamental difference between statutory audit and internal audit in terms of (i) Status and Scope (ii) Approach to work (iii) Responsibility.


Answer : The Internal auditor and the Statutory auditor function in the same field. Both are intended to determine that there is :

1. an effective system of internal control to prevent or detect errors and fraud and that it is operated efficiently;

2. an adequate accounting system to generate information for preparation of true and fair financial statements.

3. both of them have to offer their comments on efficiency, efficacy and economy of the operations including physical and financial control.

The two auditors adopt common techniques viz.

verification of internal control system to see whether it is sound in principle and effective in operation,

verification of accounting records and statements;

verification of assets and liabilities;

statistical sampling techniques, surprise checks. The two forms of audit have fundamental differences as follows : Status : The internal control is designed and deployed by the organization itself according to its own size and requirement whereas the statutory auditor is designed as per the requirement of Companies Act 1956. The internal control and its audit is optional on the part of organization while the statutory audit is compulsory. Scope : The scope of work taken up by internal auditor is decided, determined, directed and designed by the management of the organization whereas the statutory auditor discharges his duties in accordance with the responsibilities placed on him by the statue. Approach : The Internal auditor operates with a view to ensure that the accounting system is efficient and is in accordance with the statues and as per the various guidelines and accounting practices and that the accounting information presented to the management are correct and disclose material facts. The internal auditor also suggests various ways for control of expenditure and minimising costs. The statutory auditor's approach would be governed by the duty placed on him to satisfy him that the accounting statements to be presented to the shareholders show a true and fair view of the profit and loss during the year and of the state of affairs of the company as on the date of balance sheet. Responsibility : The internal auditor is accountable and responsible to the

management who is his master. The management can change the internal auditor if it desires so. The statutory auditor is responsible to the Central Govt. and the management of the company being audited cannot change him so easily. Internal Auditor Statutory Auditor

Status and Scope Status and Scope

He is appointed by the management of the concern and his duties are defined under the terms of his agreement with the management/

He is appointed by the BOD or shareholders or the GOI and his duties are defined under the Companies Act 1956,.

His appointment is optional on the part of management.

His appointment is mandatory as per provisions of law.

The scope of work taken up by internal auditor is decided, determined, directed and designed by the management of the organization

The statutory auditor discharges his duties in accordance with the responsibilities placed on him by the statue.


He is dependent on management. He is independent of management and the company of which he is auditor.

He need not be a chartered accountant.

He is ought to be a chartered accountant.

The management can change him if and whenever it desires so.

His removal procedures are defined in the law. The management cannot remove him if it desires so.

Approach Approach

The Internal auditor operates with a view to ensure that the accounting system is efficient and is in accordance with the statues and as per the various guidelines and accounting practices and that the accounting information presented to the management are correct and disclose material facts.

The statutory auditor's approach would be governed by the duty placed on him to satisfy him that the accounting statements to be presented to the shareholders show a true and fair view of the profit and loss during the year and of the state of affairs of the company as on the date of balance sheet.

Descriptive Questions 2002 June(3)(b) Mention the areas of common interests between the Internal Auditor and Statutory Cost Auditor. Answer : The Internal auditor and the Cost auditor function in the same field. Both are intended to determine that there is :


2. an adequate accounting system to generate information for preparation of true and fair financial and cost statements.






statistical sampling techniques, surprise checks. Paragraph 16(e) of the annexure to cost audit report rules requiring the cost auditor to report on the scope and performance of internal control and audit. 2002 Dec (2) Explain the following relationships with reference to the relevant SAP's: (a) Internal Auditor and External Auditor.

Answer : Same as above in 2008 June (6) 2004 June (1)(C)(b) Briefly state the statutory violations or fallacies if any, in respect of the following :


(i) Foreign branch of a company can be audited only by a foreign auditor. Answer : Audit of Branch Office accounts : The accounts of the Branch office of a company are required to be audited by the company's auditor appointed under section 224 or by a person qualified for appointment as contemplated by section 226, or where the branch office is situated in a foreign country, either by the company's auditor or by a person qualified as aforementioned or by an accountant duly qualified to act as an auditor in accordance with the laws of that foreign country [section 228(1)] 2006 June (7)(b) Is the statutory Auditor entitled to rely on the Internal Auditor of the Company under his audit? Discuss. Answer : The function of internal auditor being an integral part of the system of internal control, it is obligatory for a statutory auditor to examine the scope, efficiency, efficacy and effectiveness of the performance of the internal auditor. CARO requires that the statutory auditor is required to comment on the internal audit system. For this purpose he should examine the internal control system, internal audit department, the strength of internal audit staff, their qualifications and powers. The extent of independence exhibited by the internal auditor in discharge of his duties and his status in the

organization are important indicators of effectiveness of his audit. If the statutory auditor is satisfied with internal control system and performance of internal auditor, he often decides to curtail his audit programme by dispensing with checking already done effectively and efficiently by internal control staff. Depending upon the efficiency and efficacy of the internal controls, the statutory auditor may determine the nature, scope, timing and extent of his compliance and substantive procedures and thus reduce the quantum of his work. The statutory auditor can also entrust certain items of work to the internal auditor viz.

1) verification of system of internal control, 2) verification of assets e.g. stock in transit, fixed assets, book debts etc. 3) verification of amounts provided for expenses; 4) verification of amounts adjusted as prepaid expenses.

It must however, be mentioned that the responsibility of statutory auditor is towards the shareholders while that of internal auditor is towards the management, thus statutory auditor is not protected against the liabilities for negligence which may arise due to his reliance on work performed by the internal auditor. Apart from the above, the AAS-1 on '' Basic principles governing audit '' makes it abundantly clear that in cases where the statutory auditor is required to delegate a part of his work to his assistants or use the work performed by others, he continues to remain responsible for expressing his opinion on financial statements. Thus he can rely on the work performed by others provided he exercises reasonable skill and care and he has no reason to believe that he should not have so relied on the work of such other party.

Chapter 8 Internal Auditing : Write short notes on : 2006 Dec (6)(d) Compliance audit Answer : When audit is conducted specifically in compliance with certain requirement, it is called compliance audit. If a bank requires stock valuation certificate from the client before sanctioning his loan, the client requests the cost accountant to issue such


certificate in favour of him. The cost accountant conducts stock verification and audits before issuing the required certificate. This audit conducted before issuance of certificate is compliance audit. Compliance audit may be required by any concern to satisfy itself regarding the authenticity of documents, availability of stocks, payment of debts or interests, or for any other requirements. 2007 Dec (4) (a) Pre-Audit (b) Propriety Audit Answer : (a) Pre-Audit :Pre-audit is prior scrutiny of bills before releasing payment against the same. The bills submitted for payments are properly scrutinised prior to passing them for payment. Pre-audit is usual for making payments against salary, medical bills, travelling allowance bills etc. Pre-audit may be done by any person authorised by the management and specific appointment is not made for this task. Generally senior person of the department is entrusted with the task. No specific qualification is necessary for conducting pre-audit.

1) (b) Propriety Audit : Please see descriptive questions below. Distinguish Between :

2003 June (2) State the main points of distinction between: (a) Operational audit and Internal audit Answer : The main points of distinction between: Operational audit and Internal audit

Internal Audit Operational audit

1. It is an essential component of external audit.

It is essential component of internal audit.

2. It is independent appraisal activity within the organization for the review of operations as services to the management.

Same

3. It is mainly concerned with financial monitoring system and its analysis.

It is concerned with all operations of the management whether financial and non financial. It is mainly concerned with cost analysis of operations.

4. It is managerial control which functions by measuring, evaluating and modifying other controls.

It is managerial control which functions by measuring the efficiency, efficacy and economy of all operations in the organization.

5. This is the systematic appraisal of major controls of the business against norms of the organization.

This is the systematic appraisal of major functional areas of the business against corporate and industry standards.

2003 Dec (2)(b) (ii) Financial audit and Operational audit ( any four areas) Answer : Operation audit has been defined by the Institute of Internal Auditing as '' future oriented independent and systematic evaluation performed by the Internal auditor for management of the organisational activities and controlled by top, middle and lower level management for the purpose of improving organizational profitability and increasing the attainment of the organizational objectives, achievement of


programmes, purpose, social objectives and employees development areas in which efficiency and effectiveness may be designed to enable realization of the improvements.'' As both the audits viz. financial audit and operational audit have common objective of optimum utilisation of resources of organization, the line of demarcation between the two is thin. The objective, techniques, areas, aspects, and scope of both the audits overlap quite significantly, however, following points of difference may be cited :

Financial audit Operational Audit

1. To ensure compliance with established procedures and systems

To ensure the operations are in tune with the central objective of the management,

2. To see that scrap, salvage and surplus materials are properly accounted for.

To see that scrap, salvage and surplus are within the standard fixed in this respect.

3. To see that proper records have maintained for the fixed assets of the concern.

The operations relating to fixed assets are in commensurate with the investment made in them

4. To look into correctness of data To look into adequacy of data for making information to be supplied to top management for making decisions.

5. To see that the payments are released against proper bills.

To see that the payments are released against proper allotment and within budgetary provisions.

6. To see that internal control is working properly.

To see that MIS is working properly.

7. To see that abrupt variations in sales and purchases are not due to any irregularity.

To study the variance either favourable or unfavourable.

8. To see that credit control system is operative with efficiency.

To study the credit control system and suggest improvement measures if necessary.

2005 June (3)(b) Financial audit and Operational audit Answer : Same as above. Descriptive Questions 2004 June (6) (a) State briefly the scope and limitations of propriety audit. Propriety Audit : Propriety audit means that the decisions have been taken and the transactions have been done in conformity with established rules, principles, standards and statutory regulations to meet the test of public interest. In simple words the propriety audit ensures that the disbursing officer applies the same prudence as he applies towards his own money, while using the government money. The system of propriety audit applies to government companies and departments because public money and public interest are involved therein. The instructions contained in the '' Audit Code'' issued by the Comptroller and Auditor General of India regarding '' propriety audit'' is reproduced below to have a clear idea

about it:


' It is essential function of Audit to bring to light not only cases of clear irregularity but also every matter which in its judgement appear to involve, improper expenditure or waste of public money or stores, even though the accounts themselves may be insufficient to see that sundry rules and orders of competent authorities have been observed. It is of equal importance to see that the broad principles of orthodox finance are borne in mind not only by disbursing officer but also by sanctioning authorities.' The auditor conducting the propriety audit should examine that the operations are carried on financial prudence, regulatory compliance, economical reliance, adequate intelligence and wisdom. He should also ensure that :

1. Proper recording has been done in the appropriate books of accounts. 2. The expenditure should not exceed what the occasion demands 3. No authority should exercise its power of sanctioning expenditure to pass an

order which will be directly or indirectly to his advantage. 4. Public money should not be utilised for the benefit of a particular person or a

section of community unless the expenditure is insignificant or a claim could be

enforced by law or such expenditure is in pursuance of a recognised policy of custom.

5. The amount of allowances granted to meet the expenditure of a particular type should be so regulated that these are not on the whole source of profit to the recipients.

6. The concern is yielding the expected results. 7. The assets have been properly safeguarded and have not been misused. 8. The business funds have been utilized properly in the best interests of the

concern. The auditor is expected to detect the cases of improper expenditure by scrutinising the individual transactions. Apart from this, he should also see whether the expenditure sanctioned is adequate in discharging the financial responsibilities with regard to various schemes undertaken. To asses this adequacy, the auditor should :

1. Whether the technical estimates or detailed programme and cost schedules have been framed and adhered to. Whether the excess expenditure, delays in execution, cost overruns are due to improper and incorrect estimates.

2. Whether there have been unavoidable delays in progress and completion of schemes resulting in increase in the total cost of the schemes.

3. Whether there have been any losses of recurring nature. 4. Whether there has been wasteful expenditure including that resulting from the lack

of coordination. 5. Whether the performance and the cost is comparable with similar schemes in

other fields or in other public projects. 6. How far the ultimate objective of expenditure has been fulfilled. 7. How far is the departure of actual achievements from the estimated targets.

Limitations : Proprietary audit has the following limitations: 1. In decision making process : all decisions are subjected to proprietary audit, the

auditor examines and scrutinizes every decision of the executive. This may cause the executive to take decision after a lot of thought. It may adversely affect the dynamism and risk taking attitude of the executive.


2. The executive works well within the framework of rules and regulations. This hampers the progress and achievement of estimated targets.

3. The report is more like a post mortem. It is not of much use. 2005 June (4b) Mention briefly the behavioural problems involved in conducting management audit. Answer : Management audit is conducted to study the current state of all affairs of the management and suggest suitable measures for improvement. Management auditor is generally seen as fault finder who has to find fault with everything he comes across and gives suggestions which are far from being used practically. The general disagreement between management auditors and line managers is that the management auditors suggest better measures in a particular situation while the line managers insist that this is the best in practical situation. Confrontation of egos is quite common during conduct of management audit. The bones of contention between management auditor and the line managers are many, some of them are reproduced below:

1) For management auditor, It is easy to be safe from a distance. The line

managers insist that the management auditor should not only suggest but should work in their place and apply his suggestions to himself as well.

2) There is always a fear of criticism emanating from adverse findings. This may also result in action against them.

3) Reports of management audit along with defects and deficiencies found, are source of retaliatory actions on the part of superiors. Some may use this report to settle personal scores with somebody.

4) Excessive concentration on petty and insignificant matters and errors. 5) Hostile attitude of management auditor, with lack of understanding of the

practical problems of auditees. 2005 June (5a) Discuss the relationship between Internal audit and Statutory audit. The Internal auditor and the Statutory auditor function in the same field. Both are intended to determine that there is :

1) an effective system of internal control to prevent or detect errors and fraud and that it is operated efficiently;

2) an adequate accounting system to generate information for preparation of true and fair financial statements.

3) both of them have to offer their comments on efficiency, efficacy and economy of the operations including physical and financial control.





statistical sampling techniques, surprise checks. The two forms of audit have fundamental differences as follows : Status : The internal control is designed and deployed by the organization itself according to its own size and requirement whereas the statutory auditor is designed as per the requirement of Companies Act 1956. The internal control and its audit is optional on the part of organization while the statutory audit is compulsory.


Scope : The scope of work taken up by internal auditor is decided, determined, directed and designed by the management of the organization whereas the statutory auditor discharges his duties in accordance with the responsibilities placed on him by the statue. Approach : The Internal auditor operates with a view to ensure that the accounting system is efficient and is in accordance with the statues and as per the various guidelines and accounting practices and that the accounting information presented to the management are correct and disclose material facts. The internal auditor also suggests various ways for control of expenditure and minimising costs. The statutory auditor's approach would be governed by the duty placed on him to satisfy him that the accounting statements to be presented to the shareholders show a true and fair view of the profit and loss during the year and of the state of affairs of the company as on the date of balance sheet. Responsibility : The internal auditor is accountable and responsible to the management who is his master. The management can change the internal auditor if it desires so. The statutory auditor is responsible to the Central Govt. and the

management of the company being audited cannot change him so easily. The function of internal auditor being an integral part of the system of internal control, it is obligatory for a statutory auditor to examine the scope, efficiency, efficacy and effectiveness of the performance of the internal auditor. CARO requires that the statutory auditor is required to comment on the internal audit system. For this purpose he should examine the internal control system, internal audit department, the strength of internal audit staff, their qualifications and powers. The extent of independence exhibited by the internal auditor in discharge of his duties and his status in the organization are important indicators of effectiveness of his audit. If the statutory auditor is satisfied with internal control system and performance of internal auditor, he often decides to curtail his audit programme by dispensing with checking already done effectively and efficiently by internal control staff. Depending upon the efficiency and efficacy of the internal controls, the statutory auditor may determine the nature, scope, timing and extent of his compliance and substantive procedures and thus reduce the quantum of his work. The statutory auditor can also entrust certain items of work to the internal auditor viz.

1) verification of system of internal control, 2) verification of assets e.g. stock in transit, fixed assets, book debts etc. 3) verification of amounts provided for expenses; 4) verification of amounts adjusted as prepaid expenses.

It must however, be mentioned that the responsibility of statutory auditor is towards the shareholders while that of internal auditor is towards the management, thus statutory auditor is not protected against the liabilities for negligence which may arise due to his reliance on work performed by the internal auditor. Apart from the above, the AAS-1 on '' Basic principles governing audit '' makes it abundantly clear that in cases where the statutory auditor is required to delegate a part of his work to his assistants or use the work performed by others, he continues to remain responsible for expressing his opinion on financial statements. Thus he can rely on the work performed by others provided he exercises reasonable skill and care and he has no reason to believe that he should not have so relied on the work of such other party.


2005 June (8b) State the Directions of Comptroller and Auditor General of India under section 619(3a) of the Companies Act 1956 in regard to : (i) System of Accounts (ii) System of Financial Control. Answer : (i) System of Accounts : Directions of Comptroller and Auditor General of India under section 619(3a) of the Companies Act 1956 in regard to System of Accounts, are as follows : Examination of specific system and ascertaining deficiencies and provisions of suggestions relating to :

a) recording of receipts and expenditure; b) taking of trial balance; c) compilation of accounts d) recording, procurement and disposal of stores; e) reconciliation of inter-office accounts; f) proper accounting of expenditure during the construction period; g) reconciliation of bank balances; h) recording of entries in control accounts and periodic reconciliation of the same

on regular basis; i) review of accounting policies and their conformity with accounting standards and

practices. (ii) Examination of system of delegation of financial powers : Need for overdraft or credit facilities from banks and existence of a system for monitoring of credit and periodical reconciliation of various Control A/c with subsidiary records for prompt action of the irregularities of appropriate level of authority.

2005 Dec (6b) '' Financial Audit suffers from a number of limitations.'' – Discuss. Answer : The process of auditing is such that it suffers from certain inherent limitations i.e. limitations which cannot be overcome irrespective of the nature or extent of audit procedures. It is very important to understand these inherent limitations of an audit since understanding of the same would only provide clarity as to the overall objectives of an audit. Following are the limitations of financial audit :

1) The auditor of a limited company is expected to submit his report on annual accounts viz. profit and loss account and balance sheet which are placed before an annual general meeting. The work of financial audit is generally limited to justify such report.

2) The work of audit usually depends upon the amount of discretion exercised by an auditor in his work. As such it is not possible at all to lay down any hard and fast rules in this regard.

3) It is not possible for an auditor to check every item of every transaction and as such, he has to rely on the system of internal control in vogue. Test checking has to be exercised by him during the course of audit. He has to exercise reasonable care and skill during the course of his work.

4) An auditor is not a technical man and therefore, he has to rely upon the statements and explanations of other officials.


5) The auditor is primarily concerned with items which either individually or as a group are material in relation to the affairs of an enterprise. However, it is difficult to lay down any definite standard by which materiality can be judged.

6) Financial audit does not cover quantitative aspects of business or human resources/ factors in the organization.

7) Financial audit does not cover to examine supervisory efficiency, propriety of managerial decisions, and contribution of the enterprise towards the society at large. The scope of financial audit does not cover audit efficiency, economy, effectiveness and last but not the least, the need for incurring expenses-propriety aspects.

8) The AAS-2 makes it clear that an opinion expressed by the auditor is neither an assurance as to the future viability of the enterprise nor the efficiency or effectiveness with which management has conducted affairs of the enterprise.

9) Auditor's work involves in deciding extent of audit procedures and in assessing the reasonableness of the judgement and estimates made by the management in preparing the financial statements.

10) Much of the evidence available to the auditor can enable him to draw only reasonable conclusions therefrom. The audit evidence obtained by an auditor is generally persuasive in nature rather than conclusive in nature.

11) The entire audit process is by and large dependent on the existence of effective system of internal control. Further, any system of internal control may be ineffective against fraud involving collusion among employees or fraud committed by management as happened in case of Satyam Computers. Certain levels of management may be in a position to override controls, for example, by directing subordinates to record transactions incorrectly or to conceal them or by suppressing information relating to transactions. Such inherent limitations of internal control system also contribute to inherent limitations of financial audit.

Because of the limitations stated above, the auditor can only express an opinion; therefore, absolute certainty in auditing is rarely attainable. There is also likelihood that some material misstatements of the financial information resulting from fraud and error, if either exists, may not be detected.

2007 June (5)(2) Why and how is internal audit is necessary to the management ? Answer : The objectives and importance of internal audit are as follows:

1) It is an integral part of management by system. 2) It ensures compliance of CARO (Companies Auditors Report Order) 2003. 3) Internal auditing is a specialised service to look into the standards of efficiency of

business operation. It ensures that standard accounting practices and policies are followed in the organization.

4) It provides special investigations for management. 5) It detects and prevents frauds, misappropriation of money and other assets. 6) It ensures the adequacy, reliability and accuracy of financial and operational

data. 7) It establishes that there is a proper authority for acquisition, protection, utilisation,

maintenance, retirement and disposal of assets. 8) It ensures the promptness and reliability of the MIS.


9) It reviews the operation of the overall internal control system and brings material departures and non-compliance to the notice of the appropriate level of management.

10) It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control and governance process.

2007 June (7)(b) What is Operational Audit ? State how is it different from Financial audit. Answer : See above under 2003 Dec (2)(b) (ii).

Chapter 9 CARO and Internal audit : 2001 Dec 1(c) As an auditor of a company, state your views with reasons on the following: (d) Dark Ltd. requiring to make and maintain cost accounts and records contends that the statutory auditor need not report on the non-maintenance of cost records because of provisions of cost audit were not made applicable to it. Answer : Section 227 of Companies Act 1956 requires the statutory auditor to report specifically that whether in his opinion, proper books of account as required by law have been kept by the company. The term proper 'books of account' is defined indirectly under sub section (1) of section 209 and cost accounting records are included in it. Cost audit of cost records is made applicable under section 233-B of the Act. It states that if in the opinion of the Central Govt. it is necessary to do so, it may direct that an audit of cost accounts shall be conducted in relation to any company described in section 209(1)(d). The statutory auditor has to report on maintenance of proper books of accounts and it is immaterial for him whether the Central Govt. has ordered any audit of those books or not. Thus the contention of Dark Ltd. is not correct the auditor must report that

proper books of account as required by law have not been maintained by the company in respect of particulars relating to factors of production viz. material, labour and other items of cost. 2002 June (3)(c) In the case of a manufacturing company, briefly state the requirements of manufacturing and other companies (Auditor's report) order 1988 as regards the finished stocks and stores. Answer : According to MAOCARO, the auditor's report should report :

1) Whether physical verification has been conducted by the management at reasonable intervals of finished goods, stores, spare parts etc.

2) Whether material discrepancies have been noticed on physical verification and necessary adjustments effected in accounts.

3) Whether on examination, auditor is satisfied regarding valuation of finished goods, stores, spares parts,-- whether it is fair and proper and is in conformity with the generally accepted accounting principles.

4) Whether the basis of valuation is consistent with the previous year and if there is any deviation in the basis of valuation, the effect of such deviation, if material, should be reported to the shareholders.

Additional Knowledge : The MAOCARO has been replaced with CARO with effect from 31.12.2003. According to CARO, the auditor has to make following statements on verification and valuation of inventories :


(a) Whether physical verification of inventory has been conducted at reasonable intervals by the management.

(b) Are the procedures of physical verification of inventories followed by the management reasonable and adequate in relation to size of the company and the nature of its business ? if not, the inadequacies in such procedure should be reported.

(c) Whether the company is maintaining proper records of inventory and whether any material discrepancies have been noted on physical verification and if so, whether the same have been properly dealt with in the books of account.

2003 Dec (7) Discuss the purpose and potentialities of Cost Audit. Answer : The purpose of cost audit are :

1) To see that proper cost accounting records have been maintained by the company as required u/s 209(1)(d) of Companies Act 1956 ;

2) To see that the cost accounting principles have been properly followed in the maintenance of cost accounts in the manner and in the forms as prescribed under the Relevant Cost Accounting Record Rules.

3) To ensure the optimum utilisation of resources used by the organization. 4) To perform efficiency audit and propriety audit as well.

Whether the planned expenditure would present optimum results;

Whether the size and channels of expenditure were designed to produce the best possible results

Whether the return on the capital employed could or could not be improved by adopting some alternative plan of action.

5) To underline the cost consciousness concept in the employees; 6) To compare historical costs with present cost and with those attainable. 7) To facilitate inter-firm comparison on same parameters;

The potentialities of cost audit are as follows : The cost audit as profession has immense possibilities and potentialities in India. Following are some illustrations.

1) Cost audit is extremely functional and helpful in the cases of under utilisation of capacity, low rate of efficiency and productivity, prevention of wastages of national, financial, physical and human resources.

2) The inefficient management of enterprise may improve following the findings of cost audit.

3) It reveals the efficiency with which the companies engaged in manufacturing, processing and mining activities have been operating.

4) The management can determine the movements of cost both total and various components of different products produced in conditions of varying market prices and varying market segments.

5) It is akin to efficiency audit, data shown by cost audit offer an opportunity at the level of Central Govt., to compare the efficiency levels of different firms brought under cost audit.

6) Information relating to cost may be used for the purpose of determining and formulating sensitive export-import policy with respect to different products and markets. The information is quite useful in formulating policy on export incentive, drawback, refunds and reliefs etc.


7) Formulation of price policy of different products in the private and public sectors. 2004 June (8)(c) What would be your response as an auditor where the company does not have a regular procedure for the determination of damaged stores, raw materials and finished goods. However, the company has made an adhoc provision for possible losses on the basis of its past experience. Answer : I as an auditor, would not question the managerial wisdom in this regard, but would like to be sure that the basis adopted for making provision for possible losses must be sound, rational and acceptable. The inventory valuation and report on losses find place in reports required under CARO. Losses must be investigated if they are significant and remedial measures should be taken. If losses are significant, I would like to make detailed examination thereof to ensure the adequacy of provision. 2005 Dec (4)(b) Briefly list out the points of distinction between the Companies Auditor's Report Order, 2003 and Section 227 of the Companies Act 1956. Is the order intended to limit the duties and responsibilities of the auditors ? Are all private companies exempt from the applicability of the said order ?

Answer : CARO 2003 may be viewed as an extension of Section 227 of Companies Act 1956, however, certain points of difference between the two are as under : Section 227 is applicable to all the companies while CARO exempts certain classes of companies from its application. Section 227(1A) requires the auditor to specific enquiries during the course of his audit. If he is satisfied with the findings of his enquiries, there is no obligation to report that he is so satisfied. CARO requires that opinion must be expressed on every matter specified therein even if he has no comments to offer. In this regard, the provisions of CARO are similar to provisions of sub-section (2), (3) and (4) of section 227. The order is not intended to limit the auditor's duties as explained below : The CARO requires a statement to be attached to the auditor report in respect of matters specified therein. For example, if a company obtains a loan, the auditor will normally enquire whether the loan has been utilized for the intended purpose and if it is so utilised there is no obligation to mention about the same in his report. However, CARO expects the auditor to state specifically whether the loan has been utilised in the purpose for which it was obtained. All private companies are not exempt from the applicability of CARO. Exemption is granted to a private limited conditions which fulfils all the following conditions :

1) The paid up capital and reserves of the company does not exceed Rs. 50 lakhs. 2) Not public deposit has been accepted. 3) There is not outstanding loan of Rs. 10 lakhs or more from any bank or financial

institution; and 4) Its turnover does not exceed Rs. 5 crores.

Note that for exemption, all the four conditions mentioned above should be satisfied. If even one condition is attracted, CARO will apply. To be exempt, none of the conditions should be attracted. 2006 June (6)(b) Explain the major aspects of ' Propriety Audit' in the Companies (Auditor's Report) Order, 2003. Answer : The Proprietary elements in CARO are as mentioned below :


1) Has the company either granted or taken any loans, secured or unsecured to/from companies, firms or other parties covered in the register maintained u/s 301 of the Act? If so, give the number of parties and amount involved in the transactions.

2) Whether the rate of interest and other terms and conditions of loans given or taken by the company; secured or unsecured, are prima facia prejudicial to the interest of the company.

3) Whether payment of the principal amount and interest are also regular. 4) If overdue amount is more than one lakh, whether reasonable steps have been

taken by the company for recovery/payment of the principal and interest. 5) Whether transactions that need to be entered into a register in pursuance of

section 301 of the Act have been so entered. 6) Whether each of these transactions have been made at price which are

reasonable having regard to the prevailing market prices at the relevant time (this information is required only in case of transaction exceeding Rs. 5 lacs in respect of any party and in one financial year).

7) If the company is regular in depositing undisputed statutory dues including Provident fund, Investor Education and Protection fund, Employee's state Insurance, Income Tax, Sales Tax, Wealth Tax, Custom Duty Excise Duty, and any other statutory dues with the appropriate authorities and if not, the extent of the arrears of outstanding statutory dues as at the date they became payable, shall be indicated by the auditor.

8) Whether adequate documents and records are maintained in cases where the company has granted loans and advances on the basis of security by way of pledge of shares, debentures and other securities, if not, the deficiencies to be pointed out.

9) Whether the repayment schedule of various loans granted by the NIdhi is based on the repayment capacity of the borrower and would be conducive to recovery of the loan amount.

10) Whether the company has made any preferential allotment of shares to parties and companies converted in the Register maintained u/s 301 of the Act and if so whether the price at which shares have been issued is prejudicial to the interest of the company.

2007 Dec (8)(a) What are the categories of companies which are specially exempted from the application of Companies (Auditor's Report) Order, 2003 ? Answer : The Companies (Auditor's Report) Order,2003 is applicable to all types of companies but if provided that it shall not apply to :

1. a Banking Company as defined in clause (c) of section 5 of the Banking Regulation Act 1949;

2. an Insurance company as defined in clause (2) of section 2 of the Companies Act 1956;

3. a company licensed to operate u/s 25 of Companies Act 1956; 4. Exemption is granted to a private limited conditions which fulfils all the following

conditions : 1. The paid up capital and reserves of the company does not exceed Rs. 50 lakhs. 2. Not public deposit has been accepted.


3. There is not outstanding loan of Rs. 10 lakhs or more from any bank or financial institution; and 4. Its turnover does not exceed Rs. 5 crores.

Note that for exemption, all the four conditions mentioned above should be satisfied. If even one condition is attracted, CARO will apply. To be exempt, none of the conditions should be attracted.

Chapter 10 – Organization of Internal auditing 2008 June (5)(d) Write Short notes on : Audit Committee Answer : See Descriptive Question. Descriptive Questions : 2004 Dec (4)(a) Should all public companies constitute an audit committee under the Companies Act 1956? Briefly state the provisions relating to an audit committee. Answer : Companies Act 1956 in its section 292A stipulates that every public limited company having paid up capital of not less than Rs. 5 crores shall constitute a committee of the Board known as ' Audit Committee'. Hence all public limited companies need not constitute an Audit Committee. The other statutory provisions relating to an Audit Committee are as under :

1) It shall consist of not less than three directors and such number of other directors as the Board may determine of which two-third of the total of member shall be directors other than managing or whole-time directors.

2) Every Audit Committee constituted under sub-section (1) shall act in accordance with terms of reference to be specified in writing by the Board.

3) The members of gthe Audit Committee shall elect a chairman from amongst themselves.

4) The annual report of the company shall disclose the compositions of the Audit

Committee. 5) The auditors, the internal auditor, if any, and the director-in-charge of finance

shall attend and participate at meetings of the Audit Committee but shall not have the right to vote.

6) The Audit Committee should have discussions with the auditors periodically about internal control system, the scope of audit including the observations of the auditors, shall have full access to information contained in the records of the company and external professional advice, if necessary.

7) The recommendations of the committee on any matter relating to financial management including the audit report, shall be binding on the Board.

8) If the Board does not accept to recommendations of the Audit Committee, it shall record the reasons therefore and communicate such reasons to the shareholders.

9) The chairman of the Audit Committee shall attend the annual general meeting of the company to provide any clarification on matters relating to audit.

10) If a default is made in complying with the provisions of this section, the company, and every officer who is in default, shall be punishable with imprisonment for a term which may extend to one year or with fine which may extend to fifty thousand rupees, or with both.


2004 Dec (6)(a) As the Chief Internal auditor of a large manufacturing company, what are the factors to be borne in mind in the process of selection of internal audit staff? Answer : The selection of Internal audit staff should be on the basis of qualities required for the task assigned to them:

a) An internal auditor must be tactful and must have ability to work with and handle the people;

b) The internal auditor should have thorough knowledge of the subject as theoretical, practical and analytical.

c) He must be well aware about the accounting policies, procedures and practices prevailing in the organization. He should have clear understanding of the objectives of the organization and must have capacity to integrate the activities of the organization to its ultimate objectives.

d) He must have indepth understanding of accounting standards and auditing standards.

e) He should have transparency in discharging all his duties. He should be independent of any inclination, intimidation, interests, incentive and insecurity.

f) He must have strong appetite for latest introduction in the field of accounting and auditing. He must be alert to opportunities for improvements in current procedures and practices relating to accounting, manufacturing, budgeting and related activities of the business.

g) He should have necessary skills to record and report his findings during the course of audit along with remedial measures as he deems fit to the occasion.

However, the selection is not limited to selection of internal auditor only. The other staffs of the internal audit system are equally important as the internal audit has assumed high importance in the present scenario. The staff selected should have detailed knowledge of the practices and techniques of accounting and auditing. They should have integrity of high degree as they are to have access to the confidential information of the organization. 2006 Dec (5)(b) Discuss briefly the scope of audit committee in a big public limited company. Answer : The scope of the Audit Committee is as follows : The audit committee is the highest body of accounting and auditing in the organization. The scope of Audit Committee is decided by the Board of Directors and it has access to all financial information of the system.

a) To review of annual financial statements before submission to the Board of Directors.

b) To provide a link between the Board of Directors and the statutory auditor. c) To review, evaluate and suggest remedial measures in, internal control system; d) To review, modify and approve, financial information for publication. e) To review and approve, proposed changes in accounting procedures, systems

and policies; f) To report on the activities of Audit Committee, in the annual report of company. g) To ensure reliability of financial statements and information of the organization. h) To help resolve differences and disputes among the management, statutory

auditor and internal auditor. i) The audit committee has a four-fold responsibility, and, therefore, has to interact

with management, internal auditor, statutory auditor and the public.


Chapter 11 Planning of Internal audit 2005 Dec (5)(ii) Write short notes on : Summary Internal audit report. Answer : Please see below. 2003 Dec (4)(a) When are summary reports on internal audit report submitted to top management? How should they be drafted ? Answer : The summary report is submitted by the internal auditor to the top management in respect of his findings during the course of internal audit conducted by him. This report states major irregularities, lapses on part of supervisors, frauds or misappropriation of funds and lapses on observance of standard practices and procedures. It also draws attention of the management on the matters requiring immediate action on their part. The important features of summary reports are :

1. It, in itself is summary report of usefulness of the internal audit department. It indicates planning, competence, completeness and assessment of internal audit function. The report tells about the achievement of internal audit department against what was planned.

2. It shows the conclusions drawn by auditors in a summarised form. 3. It underlines the matters of grave nature and consequences to the notice of

management demanding its immediate action. The management would be interested in taking action on the conclusion and recommendation of the auditor. It would be desirable that the conclusions and recommendations are presented in summarised form highlighting the suggested remedial measures. It would not be possible for the management to accept and incorporate all the suggestions and recommendation of the summary report but they can decide to take up action on the priority attached to the issue. The significant cases may be taken up immediately while the remaining ones may be delayed for the time being.

Summary report should be drafted and presented under distinct subheads like the following :

(a) Major irregularities needing immediate attention and action. This may contain non-maintenance or wrong maintenance of stores ledger, cash book, unauthorised collection or payment of cash, abnormal wastage, siphoning of money and material etc.

(b) Routine irregularities of significance and consequence. This may include delay in making entries, delay in making payment, non-reconciliation of stores ledgers with control ledgers, improper attendance recording, etc.

(c) Cases of supervisory lapses which may result in heavy loss etc. This may include surprise checking of cash and stores, quality checks, absence of mandatory checks by the supervisor etc.

The significant aspects of the report should be highlighted in a summarised form at the beginning of the report separately. The findings should always be suggested in a non-technical language. The top people are busy and generally prefer to have a snapshot of what is to be done. Summaries of findings, conclusions and recommendations provide them the action to be taken in a capsule form. The report to top management should be precise, concise, succinct, direct and conclusive. The auditor should not be tempted to give details and lengthy descriptions.


2006 June (3b) : Should the Internal audit report contain deficiency and irregularities only, or should cover scope for improvement also ? Discuss. Answer : The audit report on any matter should not be limited to pointing out the deficiencies and irregularities only, it should also devote equal attention to the causes thereof and the remedies available so as to ensure such deficiency and irregularity do not recur in future. The report should pave the road to solution of problems and inefficiencies mentioned in the report. The internal audit report should also comply this notion. Not only internal audit report but any audit report should have such fundamentals to be effective and impressive as objective, clarity, correctness, courtesy, character (audit should stand for what he believes), timeliness, appropriateness etc. There is long controversy as to whether the audit report should contain deficiencies and irregularities and scope for improvement as well as aspects which are efficient and effective. Our view is that the internal audit report should follow the principle of exception'' i.e. the report should deal with only such issues which are deficient and need

improvements. Management cannot afford to spend time on matters which are in order. On the contrary to the above, another school of thought suggests that the report should contain the matters which are in order so as to boost the moral of the employee concerned. This would be a favourable feature in implementation of the recommendations mentioned in the report. In such a situation, it will be prudent that the top management, operation management and the internal auditor should consult each other and arrive at the pattern of internal audit reporting. The significant aspects of the report should be highlighted in a summarised form at the beginning of the report separately. The findings should always be suggested in a non-technical language. The top people are busy and generally prefer to have a snapshot of what is to be done. Summaries of findings, conclusions and recommendations provide them the action to be taken in a capsule form. The report to top management should be precise, concise, succinct, direct and conclusive. The auditor should not be tempted to give details and lengthy descriptions. 2007 Dec (1b)(C) Explain the necessity and method of presentation of summary report to the top management by the internal auditor of a company. Answer : Please see above. 2007 June (4)(b) What is meant by '' Audit Programme''? What are the aspects to be borne in mind in developing an Audit Programme by the Internal auditor? Answer : Audit programme is a detailed plan of applying the audit procedures in the given circumstances with instructions for the appropriate techniques to be adopted for accomplishing the audit objectives. It is list of examination and verification steps to be applied to documents and records. It is not practicable to evolve one audit programme applicable to all business under all circumstances. However, it is necessary to specify in detail in the audit programme, the nature of work to be done so that no time is wasted on irrelevant matters. Audit programme for internal audit may be said to be guideline to the internal auditor as to how to go about with the audit work he is going to perform. It is drawn to attain the results expected by the management. Audit programme follows the audit plan. The


auditor should prepare a written audit programme setting forth the procedures that are needed to implement the audit plan. The programme may also contain the audit objective for each and should be sufficient to monitor and control the execution and progress of the work.

To start with, an auditor should assess the extent to which he can rely on the internal control in vogue in the organization, nature, size and composition, the dependability on internal control and the given scope of work, are the chief parameters for framing the audit programme. The programme should aim at providing for a minimum essential work which may be termed as a standard programme. The outcome of compliance and substantive procedures during the course of audit should guide the extent and scope of audit work beyond the standard programme. According to the experience gained by actually carrying out the work, the programme may be altered to take care of situation which were left out initially, but are subsequently found of relevance and concern. Similarly, if any matter originally provided for, proves to be beyond doubt subsequently, may be left. Everybody associated with the audit should understand to keep open mind beyond the programme and to note and report all

significant matters. Periodical assessment of the progress of audit programme should be made to

see that everything is moving as per design. The auditor normally has flexibility in deciding when to perform audit procedures. However, in some cases, the auditor may have no liberty as to timing e.g. while taking inventory or verifying cash balances or spot checking of receipts. 2008 June (3)(c) Enumerate six important points that can be included in the internal control questionnaire regarding purchase of raw materials. Answer :

1) a) Are purchases made only from approved suppliers ? b) Whether a list of approved suppliers maintained for immediate reference ? c) What are the alternative sources of supply of raw materials along with their

respective delivery time ? Whether they have the required quality and quantity of raw materials available with them and whether they can be relied upon in case of emergency ?

2) Are the purchase orders are based on valid requisitions ? Are purchase orders are duly signed by the competent authority ? Is the price variation clause is included in purchase order ?

3) Are purchases based on competitive quotations from three or more suppliers ? Investigate the price at which and the supplier from which, the raw materials are purchased. The transparency in finalisation of rates be ensured.

4) Do the purchase orders contain the following minimum information (i) Name of

supplier (ii) Details of delivery items (iii) Quantity (iv) Price (v) Freight terms (vi) Payment terms

5) Ensure that goods ordered have been actually received in proper quality and exact quantity. Whether the goods are received in receiving department or directly in user department ? Who certifies the quality and quantity of goods?

6) Are the Goods inward book or goods received notes pre-numbered ? Whether stores ledger is tallied with the goods supply note of the supplier or the invoices


issued by the supplier? Are the reconciliations made of quantities and values received, as shown by the purchase invoices with receipts into stock records?

7) Are all cases of material returned, shortages in supply, rejections are informed to

accounts department ? Whether these are considered before releasing payments to suppliers?

8) Is special approval is required / obtained for purchase from employees, directors and companies in which the directors are interested

Distinguish Between : 2007 Dec (8) (ii) Internal Check and Internal auditing Answer : A system of internal check implies that one person should not carry through any transaction completely. The system of internal check is introduced to ensure that work of one person comes in for automatic check by the work of another person without duplication of work. Internal check can be defined as ' checks on day-to-day transactions which operate continuously as part of the routine system whereby the work of one person is proved independently or is complementary to the work of

another, the object being the prevention or early detection of errors and frauds.' Internal audit is a review of the operations and records, sometimes continuously undertaken, within a business by a specially assigned staff. But the internal audit should not be confused with internal check and following points of difference between them should be noticed :

Internal Check Internal audit

1. It consists of a set of rules or procedures that are part of the accounting system, introduced so as to ensure that accounts of a business shall be correctly maintained and possibility

of occurrence of errors and frauds are eliminated.

It is thorough examination of the accounting transactions as well as of the system according to which they have been recorded, with a view to reassuring the management that the accounts are being

properly maintained and the system contains adequate safeguards to check any leakage of revenue and to ensure optimum utilisation of resources of the entity.

2. The aim is to prevent errors and frauds. The aim is to detect errors and frauds.

3. Simultaneous recording and checking. Checking after recording is done

4. Very limited scope It covers internal check and internal control.

5. No specific appointment is made for the purpose.

Specific appointment is made.

Chapter 12 Verification of Evidence : Write Short notes on : 2001 Dec (5) (d) [repeat 2003 June (2) (b)] Test checking and routine checking Answer : Routine checking generally applies checking of all transactions in a routine manner. It stresses on checking and vouching of all the entries. As the volume of work grows, the option and practicability of routine checking fall. Existence of effective internal controls also reduces the meaningfulness of routine checking and it is seldom expected to reveal anything material. There is a growing realisation that the traditional


approach to audit is economically wasteful because all efforts are directed to check all transactions without exception. This invariably leads to more emphasis on routine checking which often is not necessary in view of the time and the cost involved. Large volume of work requires sample checking of transactions as it is impracticable to check the entire gamut of transactions. Test checking is adopted on selected transactions. The selection is based on statistical sampling techniques. The auditor draws a sampling plan and judges the nature, size and significance of transactions. The entries relating to material accounts are seen in detail while less significant ones are proportionally checked. Some sampling assumptions are adopted for the conduct of checking viz. checking of a particular period of year under audit, checking of entries of transactions of more than a particular amount, checking of entries on some random basis. If the transactions so checked are ok, it leads to conclusion that all other transactions are also ok. If the test checking reveals any irregularity the extension and expansion of checking are taken up in more areas and entries. 2002 June (5)(b) [repeat 2004 June (3) (a)] Sampling Risks Answer : Sample risk arises from the possibility that the sample selected for test

checking may not be true representative of the population and that the conclusion drawn by the auditor based on a sample will materially be different from the conclusion that would be reached if the entire population is subjected to the same audit procedures. Sampling risk with tests of control : (i) Risk of under reliance : the risk that although the result on sample does not support the auditor' assessment of risk, the actual compliance rate would support such an assessment. (ii) Risk of over reliance : the risk that although the result on sample supports the auditor's assessment to control risk, the actual compliance rate would not support such an assessment. Sampling risk with substantive procedures : (i) Risk of incorrect rejection : the risk that, although the sample result supports the conclusion that a recorded account balance or class of transactions is materially misstated, in fact it is not materially misstated. (ii) Risk of Incorrect acceptance : the risk, although the sample result supports the conclusion that a recorded account balance or class of transactions is not materially misstated. The risk of under reliance and risk of incorrect rejection affect the audit efficiency and will cause more work to be performed to draw audit satisfaction. The risk of over reliance and risk of incorrect acceptance will lead to incorrect opinion on the financial statement and will thus affect the effectiveness of the audit. The size of sample varies inversely with the degree of risk the auditor is willing to accept. The lower risk will require larger size of sample and vice-versa. 2002 Dec (8) (d) Evaluation of Audit Evidence Answer : The evaluation of audit evidence may be done on the following lines :

1) The straight forward information may be directly relied upon as there is nothing mysterious about it.

2) Evidence may vary in reliability. When the auditor checks or recalculates certain figures, like depreciation or inventory valuation, he may be completely convinced about the reliability of the company's figure. However, information supplied by an


employee may not be that reliable because he may have certain vested interests in divulging the information. Thus the auditor should evaluate the evidence on the basis of its origin.

3) Some evidence may be easy to gather like inventory present in the stores, while evidence may be difficult to evaluate like inventory present elsewhere.

4) It is difficult to get conclusive evidence in many cases on account of time and cost constraints. Persuasive evidence is used in giving the opinion.

5) The evaluation is certain when evidence gathered from different sources emit the same information. Conversely when audit evidence obtained from one source is inconsistent with that obtained from another, further procedures may have to be performed to resolve the inconsistency.

6) The auditor should be thorough in his efforts to obtain evidence and be objective in its evaluation. In selection of procedures to obtain evidence he should recognise the possibility that the financial information may be materially misstated.

7) There should be cost benefit analysis of evidence collection and its evaluation. A

rational relationship must exist between cost and utility of evidence. 2004 June (3) (a) Sampling risk (b) Letter of representation (d) Measurement standards in the context of field work vis-à-vis collection of internal audit evidence Answer : (a) Sampling risk : Please see above. (b) Letter of representation : The auditors have developed practice to request the management to issue a certificate stating that all liabilities incurred by the company till the date of balance sheet have been incorporated in the books of account. This practice has gradually developed into what is termed as a comprehensive representation by the management wherein the management not only certifies that all liabilities incurred including the contingent liabilities, have been properly reflected in the financial statements but also includes certain other matters like the stock certificate and matters in respect of which it is considered desirable to obtain representation from the management. Often the other matters include basis of capitalisation, consistency of application of the accounting principles, capital commitment, taxation, compliance with the law, and the events subsequent to the balance sheet date. It should be clearly understood that the certificate or the letter of representation of the management does not absolve the auditor from his duty. He has to carry out all usual tests and procedures to determine every aspect of the accounts and also to ascertain that no liabilities remain to be represented in the financial statement. AAS-1 on '' Basic principles governing audit '' makes it abundantly clear that in cases where the auditor is required to delegate a part of his work to his assistants or use the work performed by others, he continues to remain responsible for expressing his opinion on financial statements. Thus he can rely on the work performed by others provided he exercises reasonable skill and care and he has no reason to believe that he should not have so relied on the work of such other party. (c) Measurement Standard : During the course of his audit, the auditor is also required to evaluate various standards adopted in the organization. This becomes important because of fast changing technology, changes in statues, procedures, contracts. Standards which are


developed yesterday may not be applicable or relevant today. For this reason, a revision and revaluation of standards is necessary. The standards may be assessed on the following points :

Quality : 1) The drawings have been checked by some competent authority. If any changes

or alterations are required, these are incorporated and approved. 2) All deficiencies noticed in the drawings and specifications, have been corrected

and duly certified by the concerned authority of the entity. 3) Certificate that the drawing is conclusive so as to produce or manufacture the

desired product. 4) Time frame of applicability of drawings is well narrated in the drawings.

Cost 1. The actual hours spent on drawings should be compared with the

budgeted allotment of time for this purpose. 2. Cost of preparation of drawings along with necessary changes on

subsequent examination should be prepared. 3. Actual cost should be compared with the budgeted one.

2006 Dec (6) Audit in Depth Answer : Audit in depth signifies thorough audit of a particular item or transaction. This is also similar to test checking except that in this case the selected item or transaction is checked right from the inception to conclusion stage wise. It is practically very hard for the auditor to check every transaction because of time, cost and utility constraints, so he selects some transactions and conducts thorough audit by examination of each stage and ascertaining whether all the requirements laid down in the system of internal check and control is operative with efficiency and effectiveness. For example if an item of purchase is selected for audit in depth. The entire route from the requisition, tender, quotation, selection of supplier, supply order, receipt of item, quality and quantity check, stores and issue of item will be thoroughly audited. Any deficiency found will be again checked in other transactions. 2007 Dec (4) Analytical Procedures Answer : Analytical procedures are based on the premises that certain logical relationship exists among various data and this relationship may be expected to continue under similar situations and conditions. The analytical procedures essentially consist of analysis of ratios and trends of unusual fluctuations. If the GP ratio of one year is say 25% and it is 10% in the next year without any noticeable changes in the circumstances, it calls for some more investigation and analysis as to why such reduction in the ratio has taken place. Analytical procedures help the auditor to determine the nature, timing and extent of other audit procedures. Analytical procedure establishes a mutual relationship between transactions of different periods in the financial statements and acts as an indicator where detailed examination and investigation are required. The auditor can place reasonable reliance on the results of analytical procedures depending on the materiality of item involved, predictability of data and effectiveness of internal control. The Institute of Chartered Accountants of India (ICAI) has issued Standard Audit

Practices (SAP) for the auditor to follow these SAP's while conducting the audit.


SAP 14 contains Analytical procedures and introduces the auditors on the application of analytical procedures at the planning and review stages of audit, with detailed clarification of nature and purpose of such exercise. It also explains the extent of reliance on analytical procedures and the circumstances leading to analysis and investigation of unusual items. Distinguish Between : 2002 June (7) (a) and 2004 June (2)(1b) : Internal evidence and external evidence Answer : Audit evidence can be classified as follows: Classification based on nature : Visual , Documentary and Oral. Classification based on source : Internal and External Internal evidence is that evidence which originates within the organization e.g. Sales invoice, Challans, Quality control report, copies of cash memo. The bulk of evidence that an auditor gets is internal in nature. External evidence as the name implies is the evidence which has its genesis outside the organization e.g. certificate from bank, goods forwarding notes, purchase invoice,

credit and debit notes from outside parties, quotations etc. The external evidence is considered more reliable than internal evidence as they come from third parties who are not normally interested in manipulation of the accounting information of others. Since the staff and the client himself have control over internal evidence, the auditor should be more careful and vigilant in placing reliance on such evidence and he should be aware of the possibilities of manipulation and creation of false and misleading evidence to suit the requirements of the client. As an established rule the auditor should try to match the external evidence with internal evidence as far as possible. Descriptive Questions : 2002 Dec (5)(b) '' Analytical Procedures act as indicators when detailed examination is required.'' – Explain. Answer : Please see above. 2005 June (7)(c) Mention any four transactions not suitable for text checking. Answer : The following transactions are not suitable for test checking.

Opening and closing entries.

Bank reconciliation statement ;

Transactions of non-recurring nature;

Transactions which are recognised by law to be looked into by the auditor carefully e.g. dividend, director's remuneration, payment of taxes etc.

Computational entries like depreciation, royalty, commission to agents etc.

Transactions that may be small in number but important and material.

2006 June (2)(a) For what purposes Analytical Procedures are used by the auditor? Answer : Please see above. 2006 June (6)(a) '' Certain sampling risks are associated with test of control procedures and substantive procedures adopted in carrying out the audit.'' – Briefly explain. Answer : Please see above.


2008 June (3)(a) '' An auditor must select his sample carefully because the results of a representative and unbiased sample can be mathematically interpreted.''—Explain this statement. Answer : The factors which are relevant for deciding the extent of checking on a sampling plan are following :

1. Size of the organization under audit. 2. Efficiency and effectiveness of internal control and internal audit; 3. Adequacy of books and records; 4. Tolerable limits and range; 5. Degree of risk acceptable; 6. Degree of desired confidence.

It has been realised that the auditor can derive good satisfaction by undertaking a much lesser checking by adopting the sampling techniques. It is mathematical truth that the sample, if picked purely on a random basis would reveal the feature and characteristics of the population. By adopting the sampling techniques, the auditor checks only a fraction of the whole

mass of transaction provided he can put reliance on the internal control, internal audit and internal checks within the organization. if such control, audit and checks are adequate and satisfactory in design and implementation, a much smaller sample would suffice to provide the required reliability and confidence. On the other hand, if in certain domains the controls are ineffective, the auditor may have to take a much larger sample for getting desired satisfaction and confidence. As per AAS 15, '' Audit Sampling'', the auditor should select sample items in such a way that the sample can be expected to be representative of the population. This requires that all items in the population have an equal opportunity of being selected. The sample must be closely similar to the whole population although it may not be exactly the same. The sample must be large enough to provide statistically meaningful results.

Chapter 13 Flow Chart Techniques Short Notes : Write short notes on : 2005 June (3a) : (i) Cut off arrangements (ii) Use of flow charts by an auditor in understanding Internal controls. Answer : (i) Cut off arrangements : One of the basic concepts of accounting is going concern concept which assumes that the business will exist for a long time and transactions are recorded from this point of view. It is this that necessitates distinction between expenditure that will render benefit over a longer period and that whose benefit will be exhausted quickly, say , within the year. It is therefore, necessary that transactions of one period would be separate from those in the ensuing period so that the results of working of each period can be correctly known. This becomes relevant at the close of current financial year and the cut off date is generally March 31 of the current year. The arrangement made for the purpose is known as ' cut off ' arrangement. It essentially forms part of internal checking of the organization accounts,


of sales, purchases and stock. The auditor should satisfy himself that the cut off arrangements are properly operative. By examination he should ensure that :

Goods sold have been excluded from the inventories. Credit has been taken for the credit sales and concerned party has been properly debited.

Goods purchased have been included in the inventories, if property has passed to the organization. In case of credit purchase, the supplier has been credited and the liability is provided for.

The auditor may examine a sample of document indicating the movement of stock into & out of stores, including documents pertaining to the period shortly before and after the cut off date & check whether the stocks represented by those documents were included or excluded as may be appropriate, during the physical stock taking. (ii) Use of flow charts by an auditor in understanding internal controls. Answer : A flow chart is graphical or diagrammatic or pictorial representation of a system. As a house can very well be understood with the help of its drawing rather than by narrative description, the flowchart enables any one to understand any system easily. A flowchart provides a concise and comprehensive overview of what takes place in the system for example, what is input and output data, how the input data is processed, what documents are raised, what is the flow of goods and cash etc. Narrative descriptions are, hard to understand, lengthy and time consuming while the flow chart can depict the same situation in a simple, concise and easy to understand manner. As a route can be easily understood and memorised with the help of a map like wise the flow chart is capable of explaining all parts of a system and interconnection among them. Flow charts are equally useful in understanding the internal control system of any organization and thus provide a great deal of assistance to the auditor. Geometrical symbols are used along with short narration to understand, explain and evaluate the internal control system. The auditor can draw his own flow chart using his own symbols. Studying the flow chart, the auditor can decide upon the weak links requiring his more attention. 2005 Dec (5a)(i) EDP application controls Answer : EDP application controls are controls on application of the system and consist of specific procedures to ensure that all transactions are authorised, recorded, and processed in a complete and timely manner. The EDP application controls include controls over input, processing and output of data. Control over input of data : This is to ensure the authenticity, accuracy, completeness and authority of data to be introduced into the system. The transactions which are incorrect, are either corrected or rejected. Control over processing : It implies that the transactions are processed properly by the computer. The errors if any, occurring during processing are identified and corrected timely and processing is faultless and flawless. Control over output : The computer is safe from unauthorised access and output is received by authorised person only. Summarised form of application controls is as follows : Input controls :

Preparation and collection of source data;

Authorisation of data;


Transmission of data into the system;

Correction and re-submission of rejected data.

Transactions are not lost, added, duplicated or improperly changed. Processing and Files Controls :

Validation and edit of data;

Sorting, manipulating of data;

Updating of master files;

Transactions are not lost, added, duplicated or improperly changed.

Processing and producing the required information; Output Controls :

Control and reconciliation of data;

Distribution of output data to authorised person. 2006 Dec (6b) Idle Facilities Answer : Idle facilities are those facilities which remain idle because of certain bottlenecks present in the system. This is not in the interest of the organization as the capital invested in them remains unproductive. The auditor should take a serious view of the idle facilities and should incorporate this in his report. The audit can proceed on the following lines:

1. To enquire the reasons for idle facilities; 2. To identify and rectify the bottlenecks; 3. To review the plans, procedures, requirement, utilisation and control of idle

facilities; 4. To examine the alternative ways of utilisation of idle facilities by leasing out etc. 5. To see that the idle facilities have been brought to the knowledge of top

management, 2007 Dec (4)(i) Auditing through the computer Answer : With the advent of computers, the approach to and process of auditing has undergone phenomenal changes. The revolution brought about by the computers in all aspects of life, has touched the auditing field in a significant way. The basic approaches for computer audit are as follows:

1) Auditing around the computer 2) Auditing through the computer 3) Auditing with the computer Auditing through the computer Under this approach, the computer is the target of the audit. The auditor can test the processing and control systems. In auditing through the computers, the auditor submits data to the computer for processing. The results are analysed for finding out the reliability and accuracy of computer programs. It consists of two tasks viz.

(a) the review and verification of source documents and (b) the actual testing of the computer program logic and program controls. The reviewed and verified data are submitted to the computer and the results are analysed for accuracy and reliability. The cases when auditing through the computer must be used : (f) The inherent risk associated with the application system is high. (g) The application system processes large volumes of input and produces large



(h) Significant parts of the internal system are inbuilt in the computer; (i) The processing logic embedded within the application system is complex; (j) Substantial gaps in the visible audit trail are common in the system.

2008 June (5b) Flow Chart Answer : Please see above. Descriptive Questions : 2001 Dec (6a) What are the special points to be borne in mind in evaluating a system of internal control for application processed in an EDP service bureau ? page 151 hindi Answer : The salient points to be borne in mind in evaluating a system of internal control :

1) Review and evaluate whether proper and adequate data processing controls, administrative controls, procedural controls, system safety, security, access and operation controls, have been developed and implemented.

2) Review integrity, reliability and efficiency of information system and financial reports it generates.

3) Test of accuracy and integrity of data, its processing in important computer application.

4) Review all aspects of the design, operation, maintenance, safety, access and scope of data processing system of the organization to ensure that the system operates effectively and efficiently, that it meets the requirements of the various users and the possibilities for fraud and error are reduced or eliminated.

5) Check that the data processing system is safe and secure from unauthorised access and it is properly safeguarded against atmospheric vectors.

The application controls must also be effective and should conform to the following : Input controls :












Distribution of output data to authorised person.

2002 June (7b) What are the two major disadvantages of '' Auditing around the computer''? Answer : The major disadvantages of auditing around the computer are as follows:

Makes very little use of most powerful and valuable audit tool—the computer;


Ignores the system of controls and hence fails to recognise potential errors or weakness in the system;

Amounts to auditing in the nature of post-mortem rather than preventive auditing;

If a system has complexity in terms of size and type of processing, auditor around the computer is not available;

It will be difficult for the auditor to assess the chances of the system degrading, if the environment changes.

The process of transformation of input data into output data is altogether ignored.

The computer is treated as 'black box' 2002 Dec (7b) Explain the types of internal controls in computer based system. Answer : Please see below. 2004 June (4b) What are the types of internal controls likely to be found in computer based system? Answer : The internal controls over computer processing which help to achieve the overall objectives of internal control, include both manual procedures and procedures designed into computer programs. Such manual and computer control comprise the overall controls which may generally be categorised as

General CIS controls and

specific controls over the applications (Application controls). General CIS controls : The purpose of general CIS control is to establish a structure of overall control over CIS activities and to provide a sensible level of satisfaction that the overall objectives of internal control are achieved effectively. General CIS controls may include :

1) Organization and management controls : Comprising of policies and procedures relating to control functions. This can also be called as administrative controls. These include division of responsibility, controls over files and programs of computer, standard of maintenance etc.

2) System development and maintenance controls : to ensure that the system is developed, maintained and operated in an authorised and effective manner.

3) Computer Operation controls: designed to control the operation of and access to the systems.

4) System software Control: designed to provide reasonable assurance that the system software is acquired or developed in an authorised and effect manner.

The specific controls over application may include : Input controls :













Distribution of output data to authorised person. 2004 June (8b) Classify the following audit procedures into compliance and substantive : (i) Preparation of flow chart showing the detailed procedure for purchase. (ii) Reviewing controls in the EDP section. Answer (i) compliance (ii) compliance 2004 Dec (4b) [repeat 2007 Dec (6b)]Mention briefly the important points to be kept in view in establishing / evaluating a system of internal control for application processed at a computer service bureau. Answer : Service bureau processes the application for its client. The following specific points are to be attended in evaluation or establishment of a system of internal control for application processed at a computer service bureau.

1) The error of communication should be avoided. The relation between the client and the bureau should be clearly defined. Some senior person should be assigned the responsibility of liaison officer.

2) The client has no physical control over files. A high degree of control over the master and data files is obviously necessitated.

3) System testing involving all clerical procedures at the user company. 4) Additional control physical movement of data. The data sent to bureau can be

copied in a CD or in a micro film or in a pen-drive of high capacity. 5) Maintain output distribution controls of sufficient magnitude. Only authorised

person should collect the processed data from the bureau. Authorised person should observe that all the reports and documents are properly, timely and completely received.

6) Test checking of processed data should be conducted on daily on a random basis.

7) The bureau must provide sufficient documentation for the errors to be identified. The user must ensure the prompt correction and resubmission or rejection to cater to processing schedule needs of the bureau.

8) User should ensure that all the program checks are functioning properly. The program can be locked and can be changed only on proper authority (password etc.) from the user.

2004 Dec (8c) Enumerate five cases when auditing through the computer must be used. Answer : The cases when auditing through the computer must be used :

(k) The inherent risk associated with the application system is high. (l) The application system processes large volumes of input and produces large


(m) Significant parts of the internal system are inbuilt in the computer; (n) The processing logic embedded within the application system is complex; (o) Substantial gaps in the visible audit trail are common in the system.


2005 June (5b) State the peculiarities that are normally associated with EDP Accounting system. Answer : The peculiarities that are normally associated with EDP Accounting system:

1) Absence of input documents : Data may be entered directly into the computer system without any supporting documents.

2) Lack of visible transaction trail : Certain data may be maintained or computer files only. Further more the data may exist only for a limited period from the time of entry. The transaction trail may vanish with passage of time. The auditor is no longer able to observe the processing of data to determine whether proper procedure is being followed. Audit trail is not available in computer environment.

3) Lack of visible output : In many transactions the results of processing may not be printed, this may result in the need to access data retained on files on readable only by the computer.

4) Ease of access of data and computer program : The data and computer program may be accessed and altered at the computer or through the use of computer equipment at remoter locations. Therefore, in the absence of appropriate

controls, there is increasing potential for unauthorized access to, and alternation of, data and program by persons inside and outside the organization. Big volume of data can be copied in a pen-drive in no time and may be concealed simply in the pocket.

5) Vulnerability of data and program storage media : large volumes of data and the computer programs used to process data are stored in a portable medium like CD, magnetic tape, pen-drive etc, which are susceptible to theft or incidental or accidental damage and destruction.

6) System generated transactions : Certain transactions may be generated in the system as per the pre-set program. The computer may calculate the interest and transfer the same to customer's account without any operation or command by the user.

7) Single transaction updating : A single transaction entered into the computer may automatically update all the accounts associated with it. A single expense will change the profit and loss account and balance sheet and other financial statement as per the program. Any erroneous entry may cause error in all the associated transactions and statements.

8) Consistency of performance: Computer system perform functions exactly as programmed and are potentially more reliable than manual systems, provided that all transaction types and conditions that could occur are anticipated and incorporated into the system. On the other hand, a computer program that is not correctly programmed and tested may consistently process transactions or other data erroneously.

2005 Dec (3a) What are the conditions or events peculiar to an EDP environment that increase the risk of fraud and error? Answer : This is related to Standard Audit Practices (SAP) 4, issued by Institute of Chartered Accountants of India. SAP4 states that the conditions or events that are peculiar to an EDP environment that increase the risk of fraud and error concerning the sphere of management, accounting records and routines, are as follows:


1. Inability to extract information from computer files due to lack of documentation of programmes.

2. Large number of programme change that are not documented, approved or tested.

3. Inadequate overall balancing of computer transactions and data basis to the financial accounts.

4. Lack of audit trails. 2006 Dec (5a) Briefly discuss about the impact of computerisation on the audit approach. What are the problems faced generally by the auditor at the time of undertaking the audit? Will training be of any help in this regard ? Answer : The answer is same as given in 2005 June (5b) above. Usefulness of training : It is understood that the organization will naturally not impart any training to external statutory auditor, thus training will mean training to internal auditors to cope up with the computer environment. The training of internal auditors is important to make them aware of, conversant with and amicable to EDP environment. They should have knowledge of the system they

are going to control. Such knowledge can be had only through appropriate training. The training can be imparted to them according to a well defined and properly designed program. The training may be of different nature to auditors and staff. The staff may be trained on routine checking aspects while auditors may be trained keeping in view to make them experts so that they can outsmart the hackers, unscrupulous persons, or persons having misappropriation of funds in mind. General introductory courses may be made compulsory to all and more advanced course tailored to specific requirements of the entity may be designed for specifically selected auditors. As the number of well trained EDP auditors increases, organization will require less resources for training but some training will always be required to keep pace with rapidly changing computer technology and environment. 2007 June (7a) Briefly discuss about the impact of computerisation on the audit approach. Also state the difficulties, the auditor has to face at the time of undertaking the audit. Answer : Please see above. 2007 Dec (6b) What precautions are required to be taken in establishing a system of internal control for application processed at an outside Computer Service Bureau? Answer : Please see above.

Chapter 14 Internal control Descriptive Questions 2002 Dec (5a) State the inherent limitations of internal control. Answer : Internal control can provide only reasonable, but not absolute, assurance that its objectives and purposes are fulfilled or achieved. This is because there are inherent limitations of internal control, such as :

(a) Management consideration that the internal control should be cost-effective. (b) The transactions of exceptional nature may escape the general internal controls. (c) The potential of human error can't be altogether omitted or overlooked. (d) Collusion of management with employees, employee with employee and

employee with outside agency may make the internal control totally ineffective.


(e) Authority may be abused. For example, member of management overriding a control.

(f) The procedure may become ineffective due to change in conditions. 2002 Dec (7a) How can a review of internal control be done by the Auditor? Answer : The examination and evaluation of internal control system is an integral part of the overall audit program. The auditor needs reasonable assurance that the accounting system is adequate and that all accounting information which should be recorded has in fact been recorded. Internal control normally contributes to such an assurance. A review of the internal control can be done by a process of study, examination and evaluation of the control system installed by the management. The following lines may help :

(a) Determination of control and procedures laid down by the management. By reading company manuals, studying organizational charts, flow charts and by making suitable enquiries from the officers and employees, the auditor may ascertain the character, scope and efficacy of the internal control system. The

internal control questionnaire is an effective tool for this purpose. (b) Evaluation process : the next step is to assess whether the manuals, guidelines,

procedures and controls are properly followed and are working in efficient and effective manner. The auditor should review a number of transactions to assure himself that the existing procedures and controls are functioning properly. Any weakness noticed by him would require further investigation and a major lacuna may call for change in his audit programme.

(c) Testing : After assessing and assimilating the internal control system of the entity, the auditor needs to examine whether and how far the same is actually in operation. For this he resorts to actual testing of the system in operation on selective basis. Selective testing is done by application of procedural tests and auditing in depth.

(d) Reference to the management : The auditor should invariably bring his findings on internal control to the notice of the management. He should make management aware as soon as practicable and at an appropriate level of responsibility, of material weakness in the design and operation of the accounting and internal control system, which have come to his attention. He may make his own recommendations and suggestions in this regard as well.

2002 Dec (7b) [repeat 2004 June (4)] Explain the types of internal controls in computer based system. Answer : see 2004 June (4b) chapter 13. 2003 June (5b) Discuss the importance of internal control questionnaire and how flowcharting as a tool in planning and programming the audit assignment. Answer : The examination and evaluation of internal control system is an integral part of the overall audit program. The auditor needs reasonable assurance that the accounting system is adequate and that all accounting information which should be recorded has in fact been recorded. Internal control normally contributes to such an assurance. A review of the internal control can be done by a process of study, examination and evaluation of the control system installed by the management.


The internal control questionnaire is nothing but a series of logically developed questions about each functional area of the organisation with three columns of 'yes', 'no' and 'not applicable'. On the other hand, flowchart is a pictorial representation of what takes place in the organization and how a transaction passes through various stages / sections / departments. Both or anyone of these techniques can be used to assess the internal control. Review of internal control questionnaire response at the first stage involves concentration on areas which show poor control. The weakness found in first review is further ascertained by the auditor by performing compliance procedures and testing a few transactions in depth. Such testing would expose the areas where the internal control is not effective up to desirable standard. Similarly, the flow chart is also used to determine weak links in the system and further compliance tests would reveal whether the internal control is up to or above the desired level or not. With the assistance of both these techniques the auditor becomes capable of assessing the internal control system and he can determine the extent and degree of reliance he can place on the internal control system. When the auditor finds certain weaknesses or irregularities in the system, he can try to assess and evaluate the

impact of the same in related transactions. His findings based on these two techniques will lead to alternations in his previously planned audit programme. 2004 June (8b) Classify the following audit procedures into compliance/ substantive: (3) Circulating an internal control questionnaire relating to wages paid to contract labour. Answer : compliance. 2004 Dec (7b) State the objectives of internal control. Answer : SAP 6 defines the system of internal control as '' the plan of organization and all the methods and procedures adopted by the management of an entity to assist in the achieving management's objective of ensuring, as far as practicable, the orderly and efficient conduct of its business, including adherence to management policies, the safeguard of assets, prevention and detection of fraud and error, the accuracy and completeness of the accounting records, and the timely preparation of reliable of financial information.'' The system of internal control extends beyond the accounting matters and in fact, pervasive over all aspects of management. The objectives of internal control are that :

(a) Transactions are executed according to general or specific authorisation, guidelines, procedures and standards.

(b) All transactions are promptly, properly and timely recorded within the framework of the accounting policies and standards and in compliance with law.

(c) All assets are properly recorded, used, maintained and disposed. Physical verification of assets is integral part of internal control.

(d) To provide reasonable assurance that the accounting system is adequate and that all accounting information which should be recorded has in fact been recorded.

2006 Dec (2b) Briefly narrate the steps suggested by you for proper internal control over stores of a large manufacturing concern. Answer : The following steps are suggested for proper control over stores of a large manufacturing concern:


1. The levels of stores should be fixed by a capable and competent person. The store keeper should be instructed to send requisitions to purchase department as soon as the reordering level on any item is reached. The storekeeper should not be allowed to place order directly neither he should anywhere be associated with the payment of items received by him. He should receive the goods duly passed by Quality control deptt. and issue receipt of the same.

2. The requisitions from the storekeeper should be scrutinized at appropriate level and competent authority should sanction it. The purchase deptt. should place supply order for the same in a printed and numbered form to suppliers. The list of suppliers should also be approved by the purchase committee. The order should contain the description of items, rate, delivery terms, penalty clause, price fluctuation clause along with the time and place of delivery of the items. One copy of this order should also be sent to storekeeper.

3. Goods received should first be entered in goods inwards note kept at the gate. After entry the goods should be allowed to the place of delivery which may be stores or the user department, along with the delivery note issued at the gate.

4. The quality control department should see the material and pass it with the comment that it can be received at the stores. If the quality controls have been observed at the place of manufacture, the QC deptt should still inspect that goods are proper and no damage has been during the transit period.

5. The storekeeper should receive the goods in proper condition, quality and quantity and compare it with the delivery note issued at the gate. He should send the copy of goods received note to the purchase department. He should make a detailed report on deliveries which are not in accordance with the order for necessary subsequent thereof.

6. The responsibility of placing, safety, security, receipt, issue and control of the items should be placed on the storekeeper. He should make necessary entries in his record book and on the bin cards. No material should be allowed to lie on stores unaccounted.

7. The storekeeper should issue the material only when authorised by a competent authority of the entity. The issue order should have all the details of the items to be issued. The details of issue should immediately be recorded in the records as well as on the bin cards. The physical quantity available in the stores should always match with that shown by the records. Any competent person can be allowed to do the surprise checking of the stores and report the findings to the superintendent in charge of the stores.

8. All goods returned to suppliers should be recorded in the goods forward note. The copy should invariable be sent to the accounts department. A credit note from the supplier should be obtained against the goods forward note. All GFNotes should be tallied with the corresponding credit note from the supplier, any such note without credit note should be investigated.

9. The payment should be released after reconciliation of goods received at the stores and goods supplied by the supplier after accommodating any deficiency or return of goods. The officer signing the cheque should himself satisfy that everything is in order before making the payments.

10. Purchase manual should be prepared and followed.


2008 June (3b) Internal control can be classified into two broad categories. Briefly elucidate the areas of control.

Chapter 15 : Audit Notes and working papers 2005 Dec (5a) Write short notes on : (ii) Summary Internal audit Report Answer: See chapter 11. Descriptive Questions : 2003 June (4a) Discuss the reasons as to why the audit working papers should be carefully preserved by the auditor. Answer : The records of audit work carried out by the auditor and his staff are termed as Working papers. The auditor records his audit findings from the beginning to the end of his audit work, in working papers. The audit working papers constitute the link between the auditor's report and the client's records. According to AAS 1, documentation referes to working papers prepared or obtained by the auditor and retained by him in connection with performance of his audit. The working papers generally provide for :

a) Evidence of audit work performed; b) Information about the entity being audited; c) Guide, conduct and control the audit work; d) Specific and exceptional information relating to performance of the entity.

Importance of Audit working papers may be used : a) As guidance to the audit staff with regard to the manner of conducting the audit aspects like,

checking the schedules, vouching, making computations etc.

b) As evidence in court of law when a charge of negligence is brought against the auditor; c) For the computation of expected time required to conclude the audit. d) As storehouse of the information gathered during audit through questioning,

reviewing, instructions, requests to the management, etc. e) To determine the existence and extent of deficient situations and to document

deficiency findings. f) As an annexure to audit report. g) As supporting documents in replying the queries in respect of audit report.

2003 June (5a) As a principal incharge of a statutory audit of a limited company, how would you supervise and review audit notes, working papers and queries of your audit assistants? Answer : The supervision and review is not an instantaneous process but a continuous process. The supervision is required to ensure and satisfy the chief auditor that the audit is progressing in the defined direction and the records of progress are being preserved properly to help preparation of the end product namely opinion on financial statement. The records of progress are nothing but the working papers generated during the course of audit. The auditor should see that the working papers are properly prepared and preserved. Normally the working papers should be filed on two separate distinct files namely the permanent audit file and current audit file. The supervision and review is greatly improved if permanent working papers (for example, checklists, specimen letters, blank forms of details,) are standardised. This also facilitates the delegation of work while providing a means of supervision, review and control of its quality. Working papers should be sufficiently complete and detailed for an auditor to obtain overall understanding of the audit. The extent of documentation is matter of professional prudence and judgement since it is neither necessary nor practical that every


observation, comment, consideration or conclusion should be documented as working papers. The permanent audit file normally includes :

1) General information about the organization. Audited financial statements of previous years. Significant audit observation of previous years.

2) Rudimentary documentary of its existence, memorandum and articles of association, certificate of its incorporation, certificate for commencement of business, any Act or regulation concerned.

3) Relevant papers regarding, appointment as auditor, communication with retiring auditor, other pertinent information.

4) Records of study and evaluation of internal control system. 5) Analysis of trends and ratios. 6) Copies of letters issued to the client. 7) Notes regarding significant accounting policies of the organization.

The temporary or current file normally includes : 1) Audit programme;

2) Analysis of transactions and balances. 3) Evidence of work performed by others. 4) Records of various audit procedures performed, the nature, timing and result

thereof. 5) Copies of communication with other parties, experts and other auditors. 6) Details of exceptional matters, any other significant aspects of audit. 7) Copies of final audit report and other financial statements.

The first step in commencement of formal audit is preparation of audit programme. Auditor himself or his senior assistant should chalk out the programme covering all areas of audit with tentative time schedule and responsibility assignment. The auditor should commence by inspection of internal control system and evaluate it. The evaluation may also necessitate some alteration in audit programme. As the work proceeds, the principal auditor should review the periodic progress by going through the documents of the work performed. He should satisfy himself the work being carried out is properly recorded and the audit is going along the predefined path. The principal should see that the compliance of audit notes issued to the client is done to the extent possible and non-compliance have been properly explained. He should pay particular attention to the materiality aspects of transactions. He has to justify any qualifications made in the report. If he has to give adverse report such report should be properly and adequately supported by docments. 2004 June (7) State the importance of and the various aspects to be noted in the context of follow-up of Audit Report. Answer : Audit report may be submitted by the statutory auditor or the internal auditor. The statutory auditor does not follow up his report. His duty is concluded and his assignment is over as soon as he submits his opinion on the financial statements of the entity. Thus the question of follow-up arises only in the context of audit report of the internal auditor. As a prudent management practice, there should be clearly established procedure for the follow up of audit report. Following points are to be decided to follow-up of Audit Report.

1) Who is initially responsible for compliance of audit report ? 2) Who is finally responsible for compliance of audit report ?


3) Whether the follow-up will be assigned to any official other that internal auditor or the head of unit which is audited.

4) Whether internal auditor should follow-up as soon as he submits his report or he should do so at the time of next audit to be conducted by him?

5) If the existing follow-up procedures are not up to the mark, who is to take the remedial measures ?

6) Whether the management is competent and willing enough to comply and follow-up the audit report?

The management and the internal auditor should realise that the internal audit is fruitless if the recommendations are not incorporated into the system. The auditor and the management should see that :

1) The objections, challenges and discrepancies in the audit report as presented by the auditee should receive due and timely consideration and attention.

2) If the auditee presents practical difficulties in implementation of suggestions, discussion should follow to accommodate or dissipate or dilute his difficulties.

3) To reap the full benefits of audit, the recommendations and suggestions made in

the report should either be implemented or challenged without any loss of time. 4) The loss, the organization is likely to suffer if proper and prompt action is not

taken, should be well assessed by the management and internal auditor. It should be remembered that the audit does not have any staff or organization to implement its recommendations. The auditor is dependent on management in this regard; thus the role of auditor is advisory. 2006 June (3b) Should the internal audit Report contain deficiencies and irregularities only, or should it cover scope of improvements also? Discuss. Answer : see chapter 11. 2006 Dec (2a) Briefly state the objects or aims of working papers. Answer : The objectives or aims of audit working papers are as follows:

1) They contain the details of work carried out by different persons associated with the audit work and they help the auditor in assessing the efficiency of such persons.

2) They constitute permanent record and evidence of work carried out by the auditor.

3) They are of great importance and may be used as : (a) As evidence in court of law when a charge of negligence is brought against the

auditor; (b) For the computation of expected time required to conclude the audit. (c) As storehouse of the information gathered during audit through questioning,

reviewing, instructions, requests to the management, etc. (d) To determine the existence and extent of deficient situations and to document

deficiency findings. (e) As an annexure to audit report. (f) As supporting documents in replying the queries in respect of audit report.

2007 June (4a) What are the aspects to be taken into account with regard to the follow-up of the Audit Report? Also explain the need and necessity for the same. Answer : Please see above.


2007 Dec (1b)(C) Explain the necessity and method of presentation of summary report to the top management by the internal auditor of a company. Answer : See Chapter 11. 2008 June (6a) Explain the concept of auditor's lien on (i) Working papers (ii) Correspondence with taxation authorities and third parties. Answer : Working papers are the property of the auditor. It is up to auditor to make available the working papers or any portions thereof to client. As per Chantery Martin & Co. Vs Martin , the audit working papers are the property of the auditor and he is entitled to retain them. AAS 3 issued by ICAI on Documentation also states that, '' Working papers are the property of the auditor. The auditor may at his discretion make portions of or extracts from his working papers available to his clients. The auditor should also adopt reasonable procedures for custody and confidentiality of his working papers and should retain them for a period of time sufficient to meet the needs of his practice and satisfy any pertinent legal or professional requirements of record retention.''

Chapter 16 Auditing of Enterprises Short Notes : Write short notes on : 2003 June (8) (c) Audit of Govt. expenditure. 2001 Dec (2) (b) What are the duties of an auditor in respect of audit of Government expenditure? Answer : The basic standards set for audit of expenditure are to ensure that there is provision funds authorised by competent authority fixing the limits within which expenditure can be incurred. These standards are :

(f) That the expenditure incurred conforms to the relevant provisions of the statutory enactment and in accordance with the financial rules and regulations framed by the competent auditor. Such an audit is called as the audit against rules and orders'.

(g) That there is sanction, either special or general, accorded by competent authority authorising the expenditure. Such an audit is as the audit of sanctions.

(h) That there is a provision of funds out of which expenditure can be incurred and the same has been authorised by competent auditor. Such an audit is called as audit against provision of funds.

(i) That the expenditure is incurred with due regard to broad and general principles of financial propriety. Such an audit is also called as propriety audit.

(j) That the various programmes, schemes and projects where large financial expenditure has been incurred or being run economically and are yielding results expected to them. Such an audit is termed as the performance audit.

Each of the above discussed in detail in the following paragraph. Audit against Rules and orders : Audit against rules and orders aims to ensure that the expenditure conforms to the relevant provisions of the Constitution and of the laws and rules made thereunder. It also seeks to satisfy that the expenditure is in accordance with the financial rules, regulations and orders issued by a competent authority. Audit of sanctions : The auditor has to ensure that each item of expenditure is covered by sanction, either general or special, of the competent authority. The audit of


sanctions is directed both in respect of ensuring that the expenditure is properly covered by a sanction, and also to satisfy that the authority sanctioning it is competent for the purpose by virtue of the powers vested in it by the provisions of the Constitution and of the law, rules or orders made thereunder, or by the rules of delegation of financial powers made by an authority competent to do so. Audit against provision of funds : Audit against provision of funds aims at ascertaining that the expenditure incurred has been on the purpose for which the grant and appropriation had been provided and that the amount of such expenditure does not exceed the appropriation made. Propriety Audit : The expenditure is incurred as per the financial prudence and with due regard to general principles of financial propriety. The auditor tries to bring out cases of improper, avoidable or infructuous expenditure, even though the expenditure has been incurred in conformity with the existing rules and regulations. Performance audit : Performance audit can be performed under three broad strictures : Efficiency : To ensure whether the various schemes/projects are executed and their operations conducted economically and whether they are yielding the results

expected of them. It is examination of resources consumed with respect to goods and services produced by them. Economy : Govt. has observed proper economy in securing and spending of financial, physical and human resources and whether the sanctioning and spending authorities have observed economy, and Effectiveness : appraisal of the performance of programmes, schemes, projects with reference to the overall targeted objectives obtained. 2004 June (3)(c) Improving the auditor-auditee relationship Answer : It may be appreciated that for carrying out internal audit functions properly and efficiently, there should be a cordial relation between the auditor and the auditee. Both should think that they are organs of the same body and both act in the same direction of attainment of organisational objectives. The auditor must have a product which the auditee needs and if the product is of standard quality, the auditee must be ready to accept. It is the management which is key factor in the auditor-auditee relationship. It can go more cordial if the internal audit department can present better and if the management is interested, powerful and efficient, it can direct the internal audit to conduct audit in a aggressive, dynamic way so as to provide recommendations which are useful to auditee. The audit product would vary in quality with the experience, tenure and sophistication of staff and head of the internal audit department. On the other hand, the management who is customer must have adequate education and background to be able to appreciate the audit report. The following points may be assisting better auditor-auditee relationship:

(a) The internal audit should be thorough and sound. (b) Each report should manifest professional quality and have sufficient substance. (c) The management must recognise the usefulness and importance of internal

audit department and give it proper status to ensure that the audit renders the desired service with efficiency.

(d) The internal audit deptt. should continue to make its audit report attractive, fruitful and meaningful to make the cordial relationship with auditee to foster and prosper.


(e) The auditor should appear to be benevolent guide and not as fault-finder. 2006 June (8b) Buy back of Company's own shares. Answer : The expression 'buy back of shares' means purchasing of own shares of the company. Sources of Funds for buy-back (Section 77A(ii) of Company's Act 1956) : A company can buy its own shares out of :

(a) Free reserves ; or (b) The securities premium account ; or (c) The proceeds of any shares or other specified securities.

Buy-back from whom [Section 77(A)(5)]: A company can buy its own shares from either of the following :

(a) Existing equity shareholders on a proportional basis; (b) Open market; (c) Old lot of shareholders; (d) Employees of the company.

Conditions of buy-back : A company can buy-back its shares or other specified

securities only if (a) The buy-back is authorised by its Articles of Association. (b) A special resolution is passed in the general meeting of the company authorising

the buy-back. (c) The buy-back is or less than twenty five per cent of the total paid-up capital and

free reserves of the company. It may be noted that in a year buy-back cannot exceed twenty five percent of its total paid-up capital.

(d) The debt-equity ratio after the buy-back should not be less than 2 : 1. Debt for the purpose shall be secured debt as well as unsecured debt.

(e) The shares being bought-back are fully paid up. (f) If the shares or other specified securities are listed on a recognised stock

exchange, then buy-back must comply with the regulations made by SEBI in this behalf.

The company shall have to complete the buy-back process within a period of twelve months from the date of passing the special resolution or the resolution passed by the Board of Directors. The company is not allowed to issue further shares or other specified securities of similar kind within a period of six months from the date of completion of buy-back, except where they have been issued by way of bonus shares or in discharge of subsisting obligation. A company is prohibited from buy-back of its own shares and securities :

(a) Through any subsidiary company including its own subsidiary companies. (b) Through any investment company or group of such companies. (c) If default is committed by the company in repayment of deposits or interest

thereon, redemption of debentures or preference shares on payment of dividend to any shareholder or repayment of any term loan or interest thereon to any financial institution or bank, then during the period of default, the company cannot buy-back its own shares.

(d) Further, if a company has not complied with the provisions of section 159, 207 and 211 of the Company's Act 1956, then the company cannot buy-back its own shares and securities.


Descriptive Questions : 2003 Dec (6) What are the special points that you would usually take into consideration in the audit of accounts of (a) Education Institution (b) Public Library Answer : (a) Audit of Education Institution: The auditor needs to conduct audit on the following lines :

(a) Schools or Colleges are governed by different legislations than those for university. Study the relevant legislations. Make a brief note of all the matters affecting the accounts.

(b) Minutes of management committee or Governing body, noting resolutions affecting accounts specially the decisions regarding the operation of bank accounts and sanction of expenditure.

(c) The basis adopted for allocation of capital and revenue expenditure, provisions for depreciation and contingencies etc.

(d) Evaluate the internal controls and internal checks operative in the institution. Study the accounting controls existing and operative in the institution. Check whether receipts and payments, grants-in-aid, donations, caution money, stipends, scholarships are duly recorded under appropriate heads of accounts.

(e) Registration of students is recorded in a register. Check the fee register class-wise and student-wise. See whether the fee deposited is properly entered against student's name. Counterfoils of receipts given to students must tally with the amount entered in cash book.

(f) Fees outstanding, fees paid in advance are kept in a register. Check the month-wise cash book and compare it with the register of fees and ensure the feed paid in advance and outstanding are duly entered.

(g) Admission fees should be capitalised unless otherwise decided by the management committee. The refundable amount e.g. caution money, library

deposits should be shown as liabilities. (h) As advised in every audit, physical verification of assets must be carried out to

the extent possible. Laboratory equipments, furniture, vehicles, sports items, should be verified and ensure that proper accounting system exists in respect thereof.

(i) Verification of various items appearing in the balance sheet. (j) Items appearing in the income and expenditure account should be verified.

Donation entries should be vouched, concerned parties may be contacted on phone verifying the contribution made by them.

(k) Stock registers should be checked against the inventory available. Values assigned to various items of inventory may be enquired. The depreciation charged should be justified. Depreciation account should be matched with the income and expenditure account and balance sheet.

(l) Confirm that the refund of taxes deducted from the income from investment (interest of securities etc.) has been claimed and recovered since the institutions are generally exempted from income-tax.

(b) Audit of Public Library:

The following important matters should be considered in the course of its audit ;


(a) Scrutiny of items appearing in the income and expenditure statement and those at the balance sheet.



(d) The rules and regulations relating to administration, accounts and audit. (e) As advised in every audit, physical verification of assets must be carried out to

the extent possible. Equipments, furniture, vehicles, should be verified and ensure that proper accounting system exists in respect thereof.

(f) Evaluate the internal controls and internal checks operative in the institution. Study the accounting controls existing and operative in the institution. Check whether receipts and payments, grants-in-aid, donations, caution money, are duly recorded under appropriate heads of accounts.

(g) Verification of various items appearing in the balance sheet.

2004 June (2)(2) What are the points you would consider while auditing the accounts of a hotel?

(a) The nature of business, proprietorship, partnership, private limited company, public limited company. The relevant legislations thereof. Other legal documents relating to the business should be studied.



(d) Evaluate the internal controls and internal checks operative in the institution. Study the accounting controls existing and operative in the institution.

(e) As advised in every audit, physical verification of assets must be carried out to the extent possible. Equipments, furniture, vehicles, should be verified and ensure that proper accounting system exists in respect thereof.

(f) Verification of various items appearing in the balance sheet. (g) Operation audit in detail. Books of accounts relating to purchase, preparation,

consumption of materials, wastage, sales, incentives, business promotion expenses, etc. should be scrutinised.

(h) Division wise expenses, like, laundry, restaurant, cooking, bar, etc. should be checked.

2004 Decd(8)(b) Briefly discuss the provisions regarding audit of Govt. Companies. Answer ; Audit of Govt. Companies: Section 619 of the Company's Act 1956 lays down special provisions regarding the audit of accounts of govt companies. Provisions of Sections 224 to 233 of the Company's Act 1956, are also applicable to audit of Govt. Companies if they are consistent with the provisions of section 619. Appointment of Auditors for Govt. Companies : Section 619 states that the auditor of a Government company shall be appointed or re-appointed by the Central Govt. on the advise of the Comptroller and Auditor General of India (C&AG). The C and AG also issues directions to the company auditors for reporting on specific aspects of their


work. In addition, the C & AG conducts a supplementary test audit of the accounts as well as periodical financial audit and appraisal performance. Section 619(3) specifies the powers of the Comptroller and Auditor General as under :

(a) To direct the manner in which the company's accounts shall be audited by the auditor and to give such auditor instructions in regard to any matter relating to the performance of his functions as such.

(b) To conduct a supplementary or test audit of the company's accounts by such person or persons as he may authorise in his behalf; and for the purpose of such audit, to require information or additional information to be furnished to person or persons so authorised, on such matters by such person or persons, and in such form, as the Comptroller and Auditor General may by general or specific order, direct.

The statutory auditor shall submit a copy of his report to the Comptroller and auditor general of India who shall have the right to comment upon or supplement the audit report in such manner as he may think fit. Any such comments on the audit report shall be placed before the annual general meeting of the company at the same time and in

the same manner as the audit report. 2005 Dec(7)(b) How would you audit ' Inventory Control and Management'' as an Internal auditor? Answer : The internal auditor should ensure the following as regards ' Inventory control and management':

1) Is there any manual available for stores/purchase for reference? 2) Are the stocks stored in specified area? Is the access to stores restricted? 3) Whether the stocks are adequately covered by insurance against the following

risks : (a) fire (b) strike, riot and civil commotion (c) flood 4) Whether the records are maintained properly and reviewed periodically? 5) Is there periodic reporting for (a) slow-moving items (b) damaged items (c) over-

stocked items and (d) obsolete items. 6) Is there a well-defined written procedure for inventory count ? Are stocks

physically verified periodically ? 7) If there are significant variations between the book stocks and actual stocks ? if

yes

Are they investigated ?

How the discrepancy is reconciled ? 8) Does the storekeeper issue raw materials, stores and other items only against

proper requisition notes issued by a competent authority? 9) If standard costing is used :

(a) are the variances investigated (b) are the standards reviewed periodically? 10) How the inventory is controlled? Is the ABC analysis adopted? 11) How are the inventory levels fixed and maintained? 12) Various inventory ratios should be worked out to judge the inventory build-

up.

Working capital to stores inventory;

Inventory turnover;

Current assets to inventory


13) Whether separate stores ledgers or bin cards are opened for material returned to stores?

14) Review whether there is periodical reconciliation of store records. 15) Physical checking and verification should be done by authorised official of

company. 2006 June (7)(a) What special points should be borne in mind in the audit of Govt. Expenditure? Answer : Please see above. 2006 Dec (8)(c) Mention steps which may be followed by you for audit of incomplete records (any six major steps). Answer : When the accounting records are destroyed by fire, flood, theft or other malicious acts, or seized by Government authorities, the auditor can proceed on the following lines :

1) Request the management to furnish a list of accounting records available with it. 2) First of all, enquire about the internal control system in operation, custody of

cash, vouchers, cheque book, etc. Physically verify cash and compare it with

book balance. Make detailed investigation if some discrepancy is noticed. 3) Physical verification of assets and inventory should be made to the extent

feasible. 4) The management may be requested to reconstruct the accounting and other

records to the extent feasible. 5) Search for evidence from external sources like, banks, lenders, creditors,

debtors etc. 6) If single entry system is followed, the records should be prepared on double

entry system, accrual concept should also be followed. 7) Analytical procedures may be applied to anticipate the trend of business. Ratio

analysis of past years available at other points like head office if any, income tax authorities or excise authorities may be obtained and applied to the present year.

Chapter 17 Internal auditor and the Investigation of Frauds : Distinguish between 2004 June (2)(1d) [repeat 2007 June (8)(bi)] Audit and investigation Answer : To understand auditing in its proper perspective, one should know how auditing is distinct and different from investigation. Auditing is different from investigation which is a critical examination of records with a special purpose. For example if a fraud is suspected and an accountant is called upon to check the accounts to whether fraud really exists, the character of the enquiry changes into investigation. Investigation may be undertaken in numerous areas of accounts, e.g. the extent of waste and loss, profitability, significant variance from standard value, cost of production, duty payable etc. Investigation normally covers specified areas but occasionally it may engulf whole area of accounting. Audit is a general and regular examination of the financial information and statements of an entity with the objective of expression of an opinion on the state of affairs and on the financial statements. Auditing never undertakes discovery of specific happenings and is never started with a pre-conceived notion about the state of affairs.


Investigation is a specific verification of certain events, circumstances or information for finding out frauds, errors, deviations and variations. Investigation is done with a preconceived notion that frauds and errors exist in the system whereas audit is done with unbiased approach. The form of report is prescribed by law in case of auditing while there is no such form in the investigation. An investigator is not bound by accounting concepts, conventions, policies or standards but the auditor is. The auditor seeks to report what he finds in the normal course of examination of the accounts adopting generally followed techniques unless circumstances call for a special probe: fraud, error, misappropriation, irregularity, whatever comes to the auditor's notice in the usual course of checking, are all looked into detail and depth and sometimes investigation results from the prima facia findings of the auditor. Description questions 2005 Dec (3b) What factors lead the auditor to suspect the possibility if fraud and error in manually maintained accounts? Answer : The auditor seeks to report what he finds in the normal course of examination of the

accounts adopting generally followed techniques unless circumstances call for a special probe: fraud, error, misappropriation, irregularity, whatever comes to the auditor's notice in the usual course of checking, are all looked into detail and depth and sometimes investigation results from the prima facia findings of the auditor. The following circumstances lead to suspicious aspects of records and operations of business :

(a) A number of accounts in various banks. Multiple bank accounts indicate unscrupulous attitude of management.

(b) Management is controlled by a group of closely related persons or relatives. If all the management activities of the business by a single person or a handful of persons, and other members are for name sake only, it provides good ground for suspicion.

(c) Frequent change of legal counsellors and auditors. (d) Management committees or executive committees are non existent or not

effective. (e) Frequent turnover of key accounting personnel. Prolonged understaffing of the

accounting department. (f) Poor and weak internal control system and procedures. (g) Poor and incomplete financial statements and information. (h) Unusual transactions may point out the possibility of fraud and error such as

large transactions with related parties, exorbitant payment for service rendered, unusual large transactions at the year end.

(i) Unusual pressure from management to complete the audit early, diversion of attention of audit party towards other non relevant areas may also give rise to suspicion.

(j) Decline in sales without justification, dependence on a single large customer or creditor, non payment of loan instalments, large number of court cases against the company, dishonour of cheques may give rise to suspicion.

Chapter 18 Secretarial Audit Write short notes on :


2002 Dec (8b) Secretarial Audit 2006 June (8c) Secretarial Audit Descriptive Questions : 2007 June (6c) As the Statutory auditor of a Public limited company, comment on the following situations : ' Briefly explain the need for Secretarial Audit.' 2008 June (8a) What is Secretarial Audit? What are the objectives and benefits of secretarial audit. Answer : Secretarial audit comprises of verification of various formalities to be complied by the company with regards to different directions and guidelines issued by statutory bodies from time to time. Worded differently, a secretarial audit is intended to check whether the company is complying with various legal requirements. Economic, industrial and corporate laws impose numerous obligations for compliance on companies in order to serve the needs of the public, investors, employees, shareholders, lenders and creditors. As the financial audit is conducted by a chartered accountant and the cost accountant conducts the cost audit, similarly a company secretary is expected to conduct secretarial audit. The objectives of secretarial audit are :

a) To certify that the company is following sound procedures and is complying legal requirements in respect of maintenance of books, records etc.

b) To highlight that the various provisions under the legislations applicable to the company have been complied with.

c) To vouch and certify that the company and the management have duly complied with the all the requirements of the Acts covered.

d) Such an audit will help the administrative authorities, financial institutions and corporations which have extended financial assistance to the company.

Section 2(2) of the Company Secretaries Act provides that a member of the Institute of Company Secretary of India in practice can act as or perform services as can be performed by a 'Secretarial Auditor' or consultant. The benefits of Secretarial Audit are as follows :

a) Secretarial audit helps in ensuring adequate compliance with provisions of various laws. b) Benefits to the Government; c) Benefits to the companies; d) Benefit to the stakeholders of the companies; e) Cost benefit analysis.

Chapter 19 Objective Questions 2003 June (1C)(a) Mention whether the following statements are true or false :

(i) The first auditor of a company is appointed by the Board of Directors. (ii) A new 'auditor' must inform the Registrar of his acceptance of the office of at but

he need not do so if he does not accept the office? (iii) A person can hold office of Director in more than 55 companies at a time. (iv) Cost auditor has right of access to the financial books of the company. (v) Private limited companies shall not be excluded in reckoning the number of

companies which an auditor can audit. (vi) The auditor appointed to fill a casual vacancy shall hold office till the

conclusions of the next General meeting. (b) Match the following columns :

Column I Column II

(i) GAAS (a) An auditor fails to obtain sufficient information to warrant an expression of opinion.

(ii) Efficiency Audit (b) Tracing of a transaction through its various stages


from origin to conclusion.

(iii) Revaluation Reserve account

(c) Studying competence in achieving goals.

(iv) Auditing in depth (d) Quality of the audit performed by the auditing standards while conducting the audit.

(v) Disclaimer of opinion (e) Profit on revaluation of land and building.

Answer (a) (i) T (ii) F (iii) F (iv) T (v) F (vi) T (b) (i) (d), (ii)(c), (iii)(e), (iv)(b), (v)(a), 2003 Dec (1C)(c) Answer : (i) (iii) , (ii) (v) , (iii) (i), (iv) (v), (v) (vii) 2004 Dec (2C) State with reasons whether each of the following statement is correct or not:

(a) Know-how relating to Manufacturing process is added to cost to be depreciated annually.

(b) Accounting policies vary from enterprise to enterprise. (c) Sweat shares are share given to the Directors of Company at discount or for

consideration other than cash. (d) In the absence of declaration of dividend, there is no need to provide for

depreciation in the accounts of companies. (e) Auditing in depth means checking all the transactions in minute details. (f) Audit planning commences soon after the current year's audit is begun. (g) The overall objectives and scope of an audit change drastically in an EDP

environment. (h) Operational audit is merely an extension of Internal audit.

Answer : (a) Incorrect. The know-how relating to manufacturing process is not a capital

expenditure. It is in the nature of revenue expense and should be debited to profit and loss account. It may also be treated as deferred revenue expenditure and may be written off over the period of agreement with the collaborator.

(b) Correct. The accounting policies vary from enterprise to enterprise depending upon circumstances and practice in the industry. There are many areas, which have more than one method of accounting treatment such as : method of depreciation, treatment of expenditure during construction, conversion of foreign currency item, valuation of inventories etc. The accounting policy is disclosure as to what method has been followed in the preparation of financial statements.

(c) Correct. Sweat equity shares can be issued for consideration other than cash for providing know-how or for making available the right in the nature of intellectual property rights or value additions also.

(d) Incorrect. Depreciation represents wear and tear of asset due to passage of time and constant use. The depreciation must be provided so that the financial statements represent true and fair view of the state of affairs of the company. Section 205 of the Company's Act 1956 provides that dividend cannot be declared unless adequate provisions in respect of depreciation have been made.


(e) Not correct. Auditing in depth is checking of selective transactions in depth and detail. Auditing in depth implies that audit trail from origin to conclusion, of a specific transaction is checked in every stage and ascertaining whether all the requirements laid down in the system of internal check have been followed. This leads to formation of general view regarding all the unchecked transactions.

(f) Not correct. Audit planning ideally commences at the conclusion of the previous year's audit and along with the related programme, it should be reconsidered for modification as the audit progresses.

(g) Not correct. The basic objectives of audit remain same whether the environment is manual or computerized. The principal objective of an audit is to ensure that the accounts being audited show a true and fair view of the state of affairs at a given date and such accounts are in accordance with the underlying records and comply with the appropriate statutory requirements. This object remains the same irrespective of procedure of processing of information i.e. whether manually or with the help of computers.

(h) True. In operational auditing function, the internal auditor goes beyond financial

controls and looks into operational areas as well. The objective and scope of operational auditing is same as that of internal audit and therefore it can be treated as extension of internal audit.

2005 June (1C)(b) Discuss with brief reasons, whether the following statements are true or false :

(i) Capitalisation of Borrowing costs would continue during extended periods in which active development is interrupted.

(ii) A chartered accountant who has taken a loan of Rs. 10,000 from a Mumbai Branch of a Nationalised Bank can audit the accounts of Chennai Branch of the same Bank.

(iii) In the case of amalgamation by take over, the statutory reserves of the transferor company need not be shown in the financial statements of transferee company.

(iv) Where an auditor fails to obtain sufficient information to warrant an expression of opinion, he gives an adverse opinion.

(v) Materials in inventory are to be valued always at cost. Answer :

(i) Partially true. This deals with AS -16 para 15.7 which states ' Capitalisation of borrowing costs should be suspended during extended periods in which active development is interrupted. For example, if construction of a bridge is suspended as a result of high water level. Capitalisation of borrowing cost is not suspended when a temporary delay is a necessary part of the process of getting an asset ready for its intended use or sale. Capitalisation of borrowing cost should cease when substantially all the activities necessary to prepare the qualifying assets for its intended use or sale or completed. It means all relevant activities, which are essential for intended use or sale of qualifying assets, should be completed.

(ii) False. The proposed appointment is not correct. As per section 30 of the Banking Regulation Act, 1949, the auditor of a Bank, shall be qualified under the


provisions of Company's Act 1956. As per section 226 of the Company's Act 1956, any person who is indebted to the company for more than Rs. 1000/- or who has given any guarantee or provided any security in connection with the indebtedness of any third person to the company for more than Rs. 1000/ will not be qualified for appointment of auditor of the company.

(iii) False. When amalgamation is by way of takeover, treatment of reserves shall vary between statutory reserves and other reserves. In the case of statutory reserves, the reserve will retain its identity and shall be disclosed in the balance sheet of transferee company under the head 'reserve and surplus'. For this purpose, a corresponding entry is made to the debit of the Amalgamation Adjustment Account which will be disclosed in the asset side of the balance sheet under the head ' Miscellaneous Expenditure' or may be prescribed in the scheme of sanction under statue/ court.

(iv) False. Where an auditor fails to obtain sufficient information to warrant an expression of opinion, he can give a disclaimer of opinion. Accordingly, the auditor may state that he is unable to express an opinion because he has not

been able to have sufficient evidence and information to form an opinion on the financial statements. An example of disclaimer of the opinion can be statement by the auditor that '' we have been unable to state whether the balance sheet shows a true and fair view……………………'' The necessary of disclaiming an opinion may arise due to a variety of reasons. In certain circumstances, the auditor may not get access to all the books of account for certain reasons. Some material items may exist the value of which may be wholly uncertain. In other cases material items may remain unexplained or some material information is just not available. The auditor is always required to furnish reasons and explanation when he disclaims the opinion.

(v) The fundamental principle of valuation of inventory states that the inventory should be valued at cost or market value wel (whichever is lower).

2005 June (1C)(c) Match each of the item in Column A with the appropriate item in Column B: Answer : (i) – (iii) ; (ii) – (i); (iii) – (vi); (iv) – (ii); (v) – (viii), 2005 Dec (1C)(a) Discuss with brief reasons, whether the following statements are true or false :(answer without reason will not be given any credit.)

(i) The auditor of a company………………………. Such views. Answer : True. Section 231 of Company's Act 1956, provides that the auditor shall be entitled to attend any general meeting and to be heard at any general meeting which he attends on any part which concerns him as auditor. He is empowered to speak about company's accounts. The proposed expansion plan does not require his services as an auditor and thus he is not authorised and empowered to speak on such matters. Board has rightly asked him to be within his limit. Board can prevent him speaking on any subject which lies outside his scope of services.

(ii) A company can refuse to provide access to its books of accounts to the company's auditor outside the normal working hours of the company, as it will inconvenience the accounts staff?

Answer : False. Section 227(i) of the Company's Act 1956, provides that every auditor of a company shall have a right to access to books, accounts and vouchers of the company at all times and shall be entitled to require from the officers of the company


such information and explanation as he may deem necessary for performance of his duties.

(iii) Companies can change………………….. Company's Act 1956. Answer : False. The rates provided in schedule VI of the Company's Act 1956, for the purpose of depreciation as the minimum rates of depreciation. The company can charge depreciation at higher than the prescribed rates but in no case it can charge less than prescribed rates. (iv) Unpaid dividend can be kept by the company without any time limit. Answer : False. As per section 205A of Company's Act 1956, if the dividend remains unpaid within 30 days from the date of declaration, the company within 7 days from the expiry of 30 days time limit, shall transfer the amount of unpaid dividend to an account called unpaid dividend a/c. After a time period of 7 years from the date of such transfer, if the amount still remains unpaid such amount shall be transferred to the ' Investor education and protection fund' established by the Central Govt. under section 205C of the Act. (v) Reclassification of long-term……………………….. such classification.

Answer : False. This is related with AS-13 which deals with ' accounting for investment', this standard declares that the transfer should be lower of cost and carrying amount of the investment at the date of reclassification of long term investment. Worded differently, if the long-term investment, is reclassified as short-term investment, the cost or market value whichever is lower should be the formula for reclassification. (vi) Audit is concerned with ethics of business. Answer : False. Audit is not connected with ethics of business. Audit is related with expression of opinion regarding state of affairs of the business. (vii) Cost auditor has right of access to the financial books of the

company. Answer : True. According to the Company's Act 1956, the cost auditor shall have

the same powers and duties as per prescribed under section 227(1) of the Act for the auditors appointed under section 224. He, thus have all the rights of access to the financial books of the company.

2006 June (1C)(a) (i) If the scope of audit work suffers limitations or restrictions, the auditor should

give a qualified report. Answer: False. If the scope of audit work suffers limitations or restrictions, in such case he can either furnish disclaimer of opinion, or adverse opinion, depending upon the parameters and circumstances of the case. (ii) Splitting of shares will not affect Earnings per share calculation. Answer : False. If the shares are split, the number of shares will increase. The eps is earning per share, more number of shares will naturally reduce the eps. (iii) Permanent difference under Income Tax Act may get reflected in the Company's

accounts under deferred Tax assets or deferred Tax liabilities. Answer: False. Permanent difference occurs when an item is neither allowed to be amortised or when an item suffers irreversible disallowance as per the provisions of Income Tax Act. Hence, they cannot be reflected in deferred tax liability / asset in the company's accounts.


(iv) Accounting standard 17 on '' Segment Reporting'' is mandatory in respect of business enterprises whose turnover for the accounting period exceeds Rs. 50 crores and/or any other conditions.

Answer : True. AS 17 is mandatory for all the enterprises where equity or debt securities are listed or likely to be listed with recognised stock exchange in India and for other commercial, industrial and business enterprises whose turnover for the accounting period exceeds Rs. 50 crores. (v) Retiring auditor is always reappointed automatically. Answer : False. The auditor is appointed by the shareholders in the general meeting. The retiring auditor is eligible for reappointment but he has to go through the appointment process as per law. The reappointment is not automatic. Automatic reappointment is not mentioned in any provisions of the Company's Act 1956, hence the statement is false. (vi) Internal check is part and parcel of internal control. Answer : True. The internal check is part and parcel of internal control. The objectives of internal control cannot be achieved without an effective system of internal check.

(vii) Dividends can be declared out of Balances in share premium account. Answer: False. Dividends can be declared only out of revenue profits available for distribution. Share premium a/c may be applied in the following manner as per section 78 of Company's Act 1956,

1. in paying up unissued shares of the company to be issued to the members of the company as fully paid bonus shares;

2. in writing off the preliminary expenses of the company; 3. in writing off the expenses of, or the commission paid, or discount allowed

on, any issue of shares or debentures of the company; or 4. in providing for the premium payable on the redemption of any redeemable

preference shares or of any debentures of the company. Section 78 of the Act, does not permit share premium account to eligible for payment of dividend.

(viii) Contingent gains are recognised in financial statements. Answer : False.AS-4, specifically states that contingent gains should not be recognised in the financial statement. It is also against the realisation concept of accounting which states that all losses should be provided and anticipated income should be excluded from the books of account. 2006 Dec (1C)(a): (i) In auditing, the concept of materiality can be judged only in the relative context.

Answer : True. In auditing, the concept of materiality can be judged only in the relative context. For a small enterprise, an amount say Rs. 1,000 may be a material item while in big giants an amount say Rs. 100,000 may not be material. Materiality concept is subjective in nature, hence, an item or amount, may be material for one concern may be negligible in some other concern.

(ii) All expenses/ losses incurred during construction period should be capitalised,

including abnormal losses. Answer : False. Abnormal losses during construction can be capitalised but should be written off over a period of 3 – 5, years after the commencement of operation or commercial production.


(iii) The system of propriety audit is applied in respect of private companies. Answer : False. The system of propriety audit is applied in respect of government company, and government departments only. (iv) A flow chart enables one to understand even a complicated system easily.

Answer; True. Flowchart is pictorial, graphical representation of the system. It helps a great deal to understand a complicated system easily.

(v) Loss of major market means the Going concern assumption is lost. Answer : False. Loss of market may be an indicator of question mark on going concern assumption but it is not conclusive. Other parameters like, negative networth, adverse key financial ratio, lack of liquidity, inability to comply with the conditions in loan agreement, etc. are some of the other indicators. (vi) An auditor can place reliance on the work of expert. Answer : AAS-1 on '' Basic principles governing audit '' makes it abundantly clear that in cases where the auditor is required to delegate a part of his work to his assistants or use the work performed by others, he continues to remain responsible for expressing his opinion on financial statements. Thus he can rely on the work performed by others

provided he exercises reasonable skill and care and he has no reasons to believe that he should not have so relied on the work of such other party.

(vii) While designing audit sample, auditor should consider only on the specific audit

objectives and none else. Answer : False. Sample selection should be based on the specific audit objectives but it is not the only consideration; other points to be kept in mind are, population in question, peculiarity of data, method of sampling, size of sample etc.

(viii) For calculating minority interest there is need to distinguish between capital and revenue profits of the subsidiary.

Answer : False. To ascertain minority interest neither of capital profits and revenue profits are taken into consideration. Minorities are concerned with their stake in the holding company. Their rights relate to share capital and reserve and surpluses only. 2007 June (1C)(a) (i) Shareholders, by a majority vote, have authorised the Board of Directors to keep

the books of accounts of the company in its administrative office, as against the earlier practice of keeping them in the Registered Office. No Government authority has been informed about this. Company contends that the practice is in order.

Answer : This relates to section 209 of Company's Act 1956, which states that the books of accounts should be kept at registered office. If the company decides to keep the books of accounts at a place other than the registered office of the company, the board should intimate the registrar of companies by giving a written notice in respect of this within 7 days of such change. (ii) As per Indian GAAP, where the company has obtained credit limits from a bank

but has not availed them, the details of unused credit limits need not be disclosed in the financial statements.

Answer : True. Only the current portion of the debt being used needs to be disclosed. There is no requirement to disclose the unused credit limits. (iii) Where the accounts of the company do not represent a 'true and fair' view, the

auditor of the company can give a qualified opinion.


Answer : When the conditions or reservations are substantial, the auditor may give adverse opinion in which he states that the financial statements do not represent a true and fair view of affairs and working results of the company. When he presents adverse opinion, he is required to furnish all reasons behind forming such opinion. (iv) Audit committee has a two-fold relationship and has therefore, to react only with

Management and Internal auditor. Answer : False. The audit committee has a four-fold responsibility and therefore, has to interact with management, internal auditor, statutory auditor and the public. (v) EDP Audit is the process of auditing in a computerised environment which

changes the fundamental nature of auditing. Answer : False. The objectives and fundamental nature are independent of accounting environment. EDP audit will not change the fundamental nature of auditing but it certainly brings substantial changes in the methods of evidence collection and evaluation. (vi) Where, at an AGM, no auditors are appointed or reappointed, the vacancy will be

filled in the next Annual general meeting.

Answer : When at an annual general meeting, no auditors are appointed or reappointed, the Central Govt., may appoint a qualified person, to fill the vacancy. It is the duty of the company to give notice to the Central Govt. under section 224(3) of the Company's Act 1956.

Chapter 21 : Objective Questions 2007 Dec [1] (C) (a) Discuss with reasons, whether the following statements are ‗True‘ or ‗False‘ (Answer without reasons will not be given any credit):

(i) A shareholder wishing…………………… the existing auditor. (ii) For an internal…………………. To be audited. (iii) Non-adjusting events of ………………… to the accounts. (iv) A company can appoint………………… its Annual General meeting. (v) Working papers …………………….. of the client. (vi) Compliance procedures………………….. to internal control system. (vii) Efficiency audit ………………….. established standards. (viii) Auditor‘s primary …………… errors and frauds. (ix) A and B joint……………………… in place of A.

Answer : (i) False. Auditor is not removed as per the wishes of a shareholder. The Companies Act

1956, has specific provision for the appointment and removal of statutory auditor. Moreover the auditor is not nominated, he is appointed as per the set procedure of law.

(ii) True. If the auditor is not independent of the activities being audited by him, he will not be able to give a realistic and fair opinion on such activities.

(iii) True. The non-adjusting events are not adjustable. If material contingent loss is not provided for, its nature and an estimate of financial effect should be disclosed by way of note. If estimate of financial effect cannot be made, the fact should be disclosed.

(iv) False. The cost auditor is appointed by the Central Government. The shareholders have

no role in his appointment.

(v) False. The working papers are the property of auditor. They are to be kept by auditor for further reference and use in respect of the audit conducted by him.

(vi) True. Compliance procedures are designed to assist auditor in determining the reliance he

can place on internal controls.


(vii) True. The efficiency audit is carried out to ensure whether the resources and assets of the organisation are used in optimum manner and the activities being performed conform to established norms and standards.

(viii) False. The auditor‘s primary duty is to report his opinion on the financial statements of

the company.

(ix) True. The BOD is authorised to make appointment in any casual vacancy caused for any reason other than resignation.

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Following points, You must revise before examination : Sec 209 : Books of accounts to be kept by the company.

.According to section 209(1)(d) of the Companies Act 1956, the Central Government has powers to direct any class of

company to maintain proper books of account in respect of utilisation of resources for production or manufacture of a

particular product.

The audit of companies directed under section 209(1)(d) may be ordered under section 233-B of the Act.

Sec 210 : At every GM, the BOD of the company shall lay a balance sheet and profit and loss a/c.

Sec 211 : The forms and contents of balance sheet and profit and loss a/c shall be in accordance with section 211. Section

211 of the Companies Act 1956 makes it compulsory for the companies to follow AS-1. As per section 227, the auditor's

report shall state, whether in auditor's opinion, the profit and loss account and balance sheet complied with the accounting

standards referred in section 211. Obviously the auditor has to make a qualified report if accounting standards (AS-1) are

not followed.

Sec 212 to Sec 214 relate to accounts of holding companies.

Sec 215 : Balance sheet and profit and loss a/c should be authenticated by Secretary (or manager) and by two directors.

Sec 216 : The profit and loss a/c shall be annexed to balance sheet and Auditor's report shall contain profit and loss a/c and

balance sheet.

Sec 217 : The Director's report shall be attached with the balance sheet.

Sec 224 : Appointment of Company auditor

Sec 224 A: Appointment by Special Resolution

Section 224-A of the Companies Act 1956 provides :

A company in which not less than 25% of the subscribed capital is held by :

a public financial institution or a government company or the Central Govt. or any State Govt. or

any financial or other institution established by any Provincial or State or any State Act in which a State Govt, holds not

less than 51% of the subscribed capital, or

a nationalised bank or an insurance company carrying on general insurance business; or

any combination of the above categories,

shall appoint or re-appoint an auditor in the annual general meeting only by passing a special resolution. If the company

fails to pass a special resolution, it shall be deemed that, no auditor is appointed by the company.

Section 224 (3) and Section 224 (4) : The CG may appoint a person to the casual vacancy in the office of the auditor.

Section 224(5) of the Companies Act 1956, the first auditor of the company should be appointed by the Board of Directors

within one month from the date of registration of the company

Section 224(6) of the Companies Act 1956, states that the BOD can fill the vacancy caused by any reason other than

resignation.


Sec 225 : Removal of auditor. Sec 224 also deals with it.

Sec 619 : The auditors of Govt. Companies shall be appointed by the CG on the advice of CAG of India. Section 224 and

Section 233 are NOT applicable to such appointments of Govt. auditors.

Section 226 : Prescribes the qualifications and disqualification of auditors.

Sec 227 : Rights, Duties and liabilities of the auditor.

Sec 228 : Where a company has a branch office, the accounts of that office shall be audited either by the company's

auditor as appointed u/s 224 or by any other auditor possessing qualification prescribed u/s 226.

Sec 229 : Signature of Audit Report : Only the person or partner of the firm of Chartered Accountants appointed as

Auditor may sign the auditor's report or any other document of the company required by law to be signed by the auditor.

Sec 230 : The auditor's report shall be read before the company in GM.

Sec 231 : Right of Auditor to attend GM.

Sec 232 : Penalty for non compliance with Sec 225 to Sec 231.

Sec 233 : Penalty for non-compliance by Auditor with Section 227 and Sec 229. If the auditor's report is signed by any

person other than as prescribed in law, the auditor concerned and the person be punishable with fine.

Sec 233 A : Power of CG to direct special audit in certain cases.

Sec 233 B : The Cost Auditor shall be a Cost Accountant to audit the cost records of the company.

Section 233 B : Audit of Cost accounts in certain cases.

Auditing June 2008

Question 1 (a) Answer :

(i) Not correct. As per Schedule VI Part II Clause B of the Companies Act 1956, the amount paid or payable to the auditor should be stated in profit and loss a/c as follows (a) As auditor (b) As advisor or any other capacity in respect of (i) taxation (ii) company law matters (iii) Management services and (iv) in any other manner. Such classification is also applicable in respect of payment made to any of the Branch auditors or Joint Auditors

(ii) Not Correct. A shareholder is not entitled to inspect the books of accounts of the company. Companies Act 1956, prescribes the books of accounts to be kept by company in its Section 209 and states that such books are to kept in the registered office of the company or at such places as may be specified and intimated to the ROC. The books are open to inspection during office hours by the Directors / Auditors / ROC or any person authorized by ROC.

(iii) Not Correct : To enable the statutory auditor to perform the duties without fear or favour, certain rights are vested in him vide section 227 of the Company's Act 1956, viz. (i) Right to access the books and records at all times, (ii) right to acquire information and explanation

from officers, and (iii) right to attend AGM. He can also ask for information and explanation

from the officers and employees of the company to make a true and fair view of the affairs of the company. The auditor is required to state as per sec 227, whether he has obtained all the information and explanations which to the best of his knowledge and belief were necessary for the purpose of audit and whether the financial statements are in agreement with the books of accounts and records. Hence the company has to furnish all the information required by the auditor and the concept of confidentiality does not apply to requests and requirements of auditor. In case of any refusal by the company for the


presentation of information and records to the auditor, the auditor can give a negative or qualified opinion depending upon the materiality of the information not presented to him.

(iv) Not correct. Kohlen has defined propriety audit as ‗‘ that which meets the test of public

interest commonly accepted customs and standard of conduct and particularly as applied to professional performance, requirement of government regulations and professional codes.‘‘ The system of propriety audit is applicable to government companies and departments because public money and public interests are involved therein. For the non government companies the auditor does not conduct propriety audit although he has to comment upon certain aspects of propriety audit under CARO.

(v) Not correct. One of the basic concepts of accounting is going concern concept which assumes that the business will exist for a long time and transactions are recorded from this point of view. Key financial ratios are indicators of financial health of the company and adverse financial ratios may be indicating poor health of the company but they are not the sole determinants of survival of the company.

(vi) True. It relates to basic concept of consistency in following same accounting policy from

year to year. AS-1, requires disclosure of policies at one place and as part of financial statements. It facilitates proper understanding of the financial performance and position of the enterprise.

(vii) True. The internal auditor also performs the staff specialist function

(b) Discuss whether ‗‘ Secret reserves can remain no longer secret‘‘. Answer : Please see Chapter 2 : Verification of assets and liabilities 2001 Dec (8b). Question 2: How will you, as an auditor of a limited company, treat the following items?

1. Receipt of substantial amount by way of damages………….audit. 2. Finished goods ………………….. overheads. 3. Financial expenses…………………… during construction. 4. Know how relating…………………… 100 lakhs.

Answer :

Answer : 1. This receipt is not of general nature and is not expected to be repetitive. Schedule VI of the

Companies Act 1956, states in Part II that the receipt of substantial amount by way of damages from suppliers of raw materials during the year under audit being not a general and recurring feature of business has to be distinctly disclosed in the profit and loss a/c. Hence, a separate disclosure is necessary in the books of account and financial statements.

2. AS-2 Valuation of Inventories states that finished goods should be valued at historical cost of production or net realizable value whichever is lower. The cost of production includes all overheads directly connected to production. Administrative overheads are not part of production activity hence should be excluded from computations of cost of production of finished goods. The auditor should advise the management to correct the valuation of finished goods in the light of AS-2. He should qualify his report if this is not corrected and state the amount involved.

3. The financial expenses paid during construction of project should be capitalised if these are incurred on construction or in relation to construction of the project. However, if the financial expenses are incurred for loan for working capital such expenses should not be capitalised but should be shown under Miscellaneous expenditure. Such expenditure can be written off in a period of say 3 to 5 years. Advance payments to contractor during the period of construction are still advance payments and therefore cannot be added to the cost of project. These advances are adjusted against the bill of contractor for the work executed by him. Till the final adjustment of advances, such advances may be shown under the temporary head of ‗‘ Advances of capital nature‘‘ in the balance sheet under the head ‗‘ Loans and Advances‘‘.

4. The know-how relating to manufacturing process is not a capital expenditure. It is in the nature of revenue expense and should be debited to profit and loss account. It may also be treated as deferred revenue expenditure and may be written off over the period of agreement with the collaborator.


The payment of Rs. 100 lakhs in relation to design of plant and machinery is in the nature of capital expenditure and should therefore be capitalised. Depreciation should be charged on it over its useful life. It should be noted here that if the payment for know how is in relation to making improvements in existing product, it should not be treated as capital nature instead it should be treated as deferred revenue expenditure to written off in say 3 to 5 years after commencement of production.

Question 3 (a) ‗‘ An auditor must select………………..interpreted.‘‘ Explain this statement. (b) Internal control can ……………. of control. (c) Enumerate six important…………. of raw materials.

Answer : (a) It is a mathematical truth that the sample, if picked purely on a random basis would reveal the features and characteristics of the population, The auditor having regard to the nature, size and materiality of transactions, picks up the entries for examination on the basis of his experience, knowledge and intuition. He can also use random number tables for selecting samples. The sample selected must be unbiased, at random, reliable and accurate. The sample must represent the population. The limitations of the judgemental sampling are many viz.

(a) It is far from any mathematical or scientific concept. (b) It lacks any acceptable basis and gives the auditor no idea about the degree of

reliability he can place on his findings. (c) The so-called random picking is not random in the statistical sense. (d) Personal judgement may be biased.

(b) Accounting controls and administrative controls are two broad branches of internal controls. Accounting controls relate chiefly with the safeguarding of assets, prevention and detection of frauds and errors, accuracy and completeness of records, and timely preparation of reliable financial statements. The administrative controls include all other managerial controls concerned with the decision making process. Administrative controls are those controls which ensure proper administration, discipline, efficiency and efficacy in the organization. It is somewhat not possible to draw a line of demarcation between these two controls because they overlap in many areas. An auditor is primarily concerned with the effectiveness of accounting controls as these may significantly affect the reliability of financial statements being audited by him. He is not much attached with the administrative controls although he may evaluate those administrative controls which concern him as auditor.

(c) Answer : 2) d) Are purchases made only from approved suppliers ? e) Whether a list of approved suppliers maintained for immediate reference ? f) What are the alternative sources of supply of raw materials along with their respective

delivery time ? Whether they have the required quality and quantity of raw materials available with them and whether they can be relied upon in case of emergency ?

2) Are the purchase orders are based on valid requisitions ? Are purchase orders are duly signed by the competent authority ? Is the price variation clause is included in purchase order ?

3) Are purchases based on competitive quotations from three or more suppliers ? Investigate the price at which and the supplier from which, the raw materials are purchased. The transparency in finalisation of rates be ensured.

4) Do the purchase orders contain the following minimum information (i) Name of supplier (ii) Details of delivery items (iii) Quantity (iv) Price (v) Freight terms (vi) Payment terms

7) Ensure that goods ordered have been actually received in proper quality and exact quantity. Whether the goods are received in receiving department or directly in user department ? Who certifies the quality and quantity of goods?


8) Are the Goods inward book or goods received notes pre-numbered ? Whether stores ledger is tallied with the goods supply note of the supplier or the invoices issued by the supplier? Are the reconciliations made of quantities and values received, as shown by the purchase invoices with receipts into stock records?

9) Are all cases of material returned, shortages in supply, rejections are informed to accounts department ? Whether these are considered before releasing payments to suppliers?

10) Is special approval is required / obtained for purchase from employees, directors and companies in which the directors are interested.

Question 4 (a) State some of the features of the Companies Act 1956, which aims to preserve and project the independence of statutory auditor. Answer : The auditor must be free from the interest and wishes of the persons appointing him and remunerating him for his services. His independence for performance of his duty is central aspect of auditing and to ensure his independence, assured rights and powers have been granted to him in the Companies Act 1956 which are as follows:

Rights and Powers of Auditors are as follows : 6) Right to access to books of accounts (u/s sec 227): The auditor of a company, at all times, has

the right to access to the books and accounts and vouchers of the company whether kept at the head office or elsewhere.

7) To require from officers of the company such information and explanation as he may think necessary for the performance of his duties as auditor. (Section 221)

8) To attend the general meeting of the company and address the members if he deems fit. He can make his representation in writing or orally in the general meeting (u/s 231)

9) all notices and other communications relating to any general meeting of a company which any member is entitled to have sent to him shall also be forwarded to the auditor of the company. (Section 231)

10) Powers to inspect / receive branch audit accounts and comment if he feels necessary (section 228)

11) To ensure the independence of the auditor, The Companies Act 1956 has provisions so that any auditor who is inconvenient to the management cannot be removed so easily. As per section 224(7), an auditor may be removed from office before the expiry of his term, by the company in a general meeting, obtaining the prior approval of the Central Govt. on this behalf except that such approval of Central Govt. is not necessary for the removal of the first auditor appointed by the Directors u/s 224(5).

Question 4 (b) : List three examples of situations in which the techniques of observation can be employed by external auditor. Answer : The following are three situations where the auditor can employ the technique of observation for gathering information for the purpose of the audit:

Physical observation of payments being made and incomes being received in the cash department;

Physical counting and examination of various countable items of balance sheet e.g. Inventory stocks etc.

Physical verification of fixed assets as arranged by the management. Question 4 (c) State the sources of payment of dividends in the case of a company limited by shares. Answer : According to section 205 of Companies Act 1956, dividends can be paid out of the following sources :

5. Profit from the current year after providing depreciation as per the provisions of law. Profit here means net profit after charging relevant expenses, depreciation and provisions and after transfer of prescribed percentage to reserves.

6. Undistributed profits of the previous year. 7. Money provided by state govt. and central govt. in a scheme of guarantee.


8. Out of capital profit subject to provisions of law. The fundamental principle underlying the payment of dividend is that the dividend is return on capital and not return of capital. Therefore the following items are not available for declaration or payment of dividend.

(i) Capital Redemption Reserve (ii) Fixed assets revaluation reserve (subject to satisfaction of certain conditions) (iii) Excess amount of forfeiture/ reissue of shares. (iv) Any specific reserve created out of specific provisions of law.

Question 4 (d) : Briefly state the basis and types of liability of auditors.

Answer : The auditor is supposed to exercise required care and caution in performance of assignment entrusted to him. The auditor is liable for disciplinary action by the ICAI under the Chartered Accountants Act, 1949 for his failure to conduct the audit with reasonable care and caution called for on him under the facts, situations and circumstances of the case. The auditor will also be held criminally liable for negligence in performance of his task and for collusion with the company management in the commission of frauds etc. The liability of the auditor may also arise for his failure to report properly and adequately the misstatements in the financial statements in order to hide more than they reveal. Auditor‘s liabilities can be categorized as under :

1. Liabilities for negligence; 2. Liabilities under the Companies Act 1956,; 3. Liabilities for misfeasance; 4. Liabilities under Penal Code; 5. Liabilities under Chartered Accountants Act, 1949 6. Liabilities under Cost and Works Accountants Act, 1959 7. Liabilities under Income tax Act, 1961 8. Liabilities to the third parties.

1. Liabilities for negligence : Negligence implies carelessness, failure to use standard degree of care and skill while performing as auditor. If it is proved that auditor is guilty of negligence he is liable to compensate the loss sustained by others, may be appointing company or any third party like Bank, Income tax deptt. as decided in the case. 2. The liabilities of auditor under the Companies Act 1956, are as follows

(a) In respect of signing of prospectus : The auditor is liable if he signs misleading statements in the prospectus and he is required to compensate equivalent damages suffered by the persons (civil liability sec 62).

(b) Sec. 253 : Liable for signing false reports or documents u/s 227 and u/s 229 and if held guilty in this regard, he shall be punishable with the fine which may extend to Rs. 10,000.

(c) Sec 539 : He is liable for falsification of books with intent to deceive or commit fraud. The punishment under this section is imprisonment for a term which may extend to 7 years and also liable to fine.

(d) Sec 628: It relates to false statement. If in any return, report, certificate, balance sheet, prospectus statement, or any other documents required under Companies Act 1956, a false statement is made and knowingly it to be false, if the auditor certifies it to be true, he shall be punishable for a term which may extend to 2 years and also be liable to fine.

3. Liabilities for misfeasance : Misfeasance means breach of trust or duty. Sec 543 : liabilities for misfeasance: The auditor is liable for equivalent damages suffered by the Company to third party.

4. Auditor is liable under Indian Penal Code for frauds and furnishing false information, report and statements.

Question 5 : Write short notes on any four of the following :

(a) Generally Accepted Auditing Standards (GAAS)


The GAAS / GAAP (Generally Accepted Auditing Standards) / (Generally Accepted Auditing Practices) imply the norms of auditing as per provisions and requirements of law, AS (Accounting standards), AAS (Auditing and Assurance Standards) and other statutory provisions. It is required of the auditor to follow GAAS / GAAP while conducting and concluding the audit and reporting his findings. The GAAS are categorized into three categories: (i) General Standards (ii) Field Work Standards and (iii) Reporting Standards (i) General Standards :

a) Independence : The auditor should feel, behave and act with an independent attitude in all matters relating to her assignment.

b) Due care : Auditor should exercise due care in conducting the audit. (ii) Field Work Standards :

a) Planning and Supervision : Before the beginning of an audit, the audit work should be properly planned and the work assigned to assistants be carefully supervised.

b) Internal Control : The internal controls existing in the enterprise be studied and evaluated before hand.

c) Evidential Matter : While auditing, auditor should collect the evidential documents to afford a reasonable basis for forming an opinion on the financial statements.

(iii) Reporting Standards: a) Financial statements : Auditor should mention whether the financial statements are prepared

in accordance with GAAS principles or not. b) Consistency : Auditor should mention whether the financial statements prepared follow the

GAAS consistently from year to year. c) Disclosure : The financial statements are taken as reasonable adequate if nothing is

mentioned by the auditor against those statements. d) Obligation : Auditor should submit his report, when the work in finalized expressing his opinion

on the state of affairs in the company. If he is not able to express an opinion because on any reason whatsoever he should make a mention to that effect.

(b) Flow Chart :

Answer : Please refer Chapter 13 Flow Chart Techniques Short Notes : 2005 June (3a) : (c) Inter firm and intra firm Comparisons : Answer : Chapter 3 Analysis of Trends 2006 June (8) (d) Audit Committee :

Answer : The scope of the Audit Committee is as follows : The audit committee is the highest body of accounting and auditing in the organization. The scope of Audit Committee is decided by the Board of Directors and it has access to all financial information of the system. The scope of audit committee is listed below :

a) To review of annual financial statements before submission to the Board of Directors. b) To provide a link between the Board of Directors and the statutory auditor. c) To review, evaluate and suggest remedial measures in, internal control system; d) To review, modify and approve financial information for publication. e) To review and approve, proposed changes in accounting procedures, systems and policies; f) To report on the activities of Audit Committee, in the annual report of company. g) To ensure reliability of financial statements and information of the organization. h) To help resolve differences and disputes among the management, statutory auditor and

internal auditor. i) The audit committee has a four-fold responsibility, and, therefore, has to interact with

management, internal auditor, statutory auditor and the public. j) To act as evidence in litigation cases in which the BOD and other officials of the organization

may be involved. (e) Options in Establishing Computer Audit


For establishing computer audit various options are available. The options may be used in isolation or in combination with one another. The computer audit may be a totally new field for the auditors who became auditor before the advent of computers in the auditing field. The new auditors have to keep pace with rapidly changing computer environment. The following methods may be employed for establishing computer audit:

a) A group of experts may be employed or hired to provide the necessary skills. b) Computer auditors in small number may be utilized. c) The existing auditors may be imparted proper training to make them suitable for the new

assignment. d) Computer consultants may be called to provide the necessary services.

(f) Qualified Opinion :

Answer : See Chapter 4 : Statutory auditors 2003 June (6)(c) Question 6 (a) Explain the concept of auditor’s lien on (i) Working papers (ii) Correspondence with taxation authorities and with third parties;

Answer : (i) This is related with the auditor's lien. The auditor can exercise lien on books and documents placed at his possession by the client for non-payment of fees for work done on the books and documents. Following points are noteworthy in this respect:

Documents retained must belong to the client who owes the money.

Documents must have come into possession of the auditor on the authority of the client. They must not have been received through irregular or irregular means. In case of company client, they must be received on the authority of the BOD.

The auditor can retain the documents only if he has done work on the documents assigned to him.

Such of the documents can be retained which are connected with the work on which fees have not been paid.

The records of audit work carried out by the auditor and his staff are termed as Working papers. The auditor records his audit findings from the beginning to the end of his audit work, in working papers. Audit working papers may include bank reconciliation statements, schedule of assets, depreciation computations, etc. It has been held in famous case of Chantrey Martin and Co. Vs. Martin that the Audit working papers are the property of auditor and as such he has a lien over them. (ii) Correspondence with taxation authorities and with third parties. The correspondence with taxation authorities with respect to company accounts and tax computations thereon (both copies and originals) are undoubtedly the property of client because in such cases auditor is entertained by the taxation authorities as representative of the client and not as auditor. In such cases auditor acts as agent of client thus the relationship between him and client is that of principal and agent, The nature of correspondence with third parties is altogether different from that with taxation authorities because the auditor acts as auditor while corresponding with third parties for verification of assets and liabilities and other matters related with his role as auditor. Such correspondence is undoubtedly the property of auditor and he can exercise his lien if his fee regarding the relevant work has not been paid to him. On the request of client, the auditor can furnish the copies of such correspondence to the client keeping the originals with him. Question 6 (b) : Bring out the fundamental difference between statutory audit and internal audit in terms of (i) Status and scope (ii) Approach to work and (iii) Responsibility. Answer :

Answer : The Internal auditor and the Statutory auditor function in the same field. Both are intended to determine that there is :


5. an adequate accounting system to generate information for preparation of true and fair financial statements.







statistical sampling techniques, surprise checks. The two forms of audit have fundamental differences as follows : Status : The internal control is designed and deployed by the organization itself according to its own size and requirement whereas the statutory auditor is designed as per the requirement of Companies Act 1956. The internal control and its audit is optional on the part of organization while the statutory audit is compulsory. Scope : The scope of work taken up by internal auditor is decided, determined, directed and designed by the management of the organization whereas the statutory auditor discharges his duties in accordance with the responsibilities placed on him by the statue. Approach : The Internal auditor operates with a view to ensure that the accounting system is efficient and is in accordance with the statues and as per the various guidelines and accounting practices and that the accounting information presented to the management are correct and disclose material facts. The internal auditor also suggests various ways for control of expenditure and minimising costs. The statutory auditor's approach would be governed by the duty placed on him to satisfy him that the accounting statements to be presented to the shareholders show a true and fair view of the profit and loss during the year and of the state of affairs of the company as on the date of balance sheet. Responsibility : The internal auditor is accountable and responsible to the management who is his master. The management can change the internal auditor if it desires so. The statutory auditor is responsible to the Central Govt. and the management of the company being audited cannot change him so easily. Distinction between Internal Auditor and Statutory Auditor

Internal Auditor Statutory Auditor

Status and Scope Status and Scope

He is appointed by the management. He is appointed by the BOD or the shareholders or GOI.

His duties and functions are defined vide the terms of his agreement with the management.

His duties and functions are defined by the Companies Act 1956, under which he is appointed. He has no agreement with the company being audited by him.

His appointment is optional on the part of management.

His appointment is mandatory under the provisions of law.

He can be removed by the management as and when it desires so.

His removal procedures are described in the statute. He cannot be removed by the management so easily.

He is dependent of the management. He is independent of management.

The scope of work taken up by internal auditor is decided, determined, directed and designed by the management of the organization

His scope of work is well defined in Companies Act 1956,.

He need not be a chartered accountant

He must be a chartered accountant.

Approach Approach

The Internal auditor operates with a view to ensure that the accounting system is efficient and is in

The statutory auditor's approach would be governed by the duty placed on him to satisfy him that the


accordance with the statues and as per the various guidelines and accounting practices and that the accounting information presented to the management are correct and disclose material facts.

accounting statements to be presented to the shareholders show a true and fair view of the profit and loss during the year and of the state of affairs of the company as on the date of balance sheet.

Responsibility Responsibility

He is responsible to the management of the company.

He is responsible to the shareholders of the company or the CG as the case may be.

Question 7: As an auditor of a company your advice is sought on the following issues : 1. Directors want to declare dividends out of accumulated profit without transferring any amount

to reserves. 2. Trial production expenses of rupees 50 lakhs are proposed to be included as part of the

production overheads. 3. Book entries are made for purchase of land without sale deed being executed by the vendor. 4. Year end stock ready for exports are proposed to be valued at realizable values. 5. No provision for income tax is proposed to be made in respect of profits of the year as the

company expected refund of taxes paid in previous year. Answer :

1. In the absence of current profits or inadequacy thereof, The Directors can declare the dividend out of accumulated profits earned by it and transferred to reserves in previous years subject to fulfilling following conditions.

(a) The rate of dividend declared shall not exceed average of rate at which dividend was declared by the company in the 5 years immediately preceding the year or 10% of its paid up capital whichever is less.

(b) The total amount to be drawn from accumulated profits earned in previous years and transferred to reserves, shall not exceed an amount equal to 10% of the sum of paid up capital and free reserves and the amount so drawn shall first be utilized to set off losses incurred in the financial year before any dividend in respect of preference or equity shares is declared; and

(c) The balance of reserves after such withdrawn shall not fall below 15% of the paid up capital.

In the light of above provisions, the proposal of directors does not appear to be valid. f) Trial production is part of the cost of the asset because it is required to bring the asset in

operating condition. All expenses before the machine is ready for commercial production should be capitalised as part of machine. The expense of Rs. 50 lakhs should therefore be capitalised and should not be treated as production overheads. According to AS-10 (accounting of fixed assets), the cost of fixed assets includes any directly attributable cost of bringing the asset to the working condition for its intended use. AS-10 makes it clear that expenditure incurred on start up and commission of the project including the expenditure on test runs less income from sale of products forms cost of the asset and is therefore capitalised. Rs. 50 lakhs should be capitalised as deferred revenue expenditure to be written off over a period of say 3 to 5 years. In the light of above, the inclusion of trial run cost in production overheads is wrong.

a. The purchase of land is not supposed to be complete without sale deed being executed by the seller. The title of the property is transferred in the name of company only after execution of the sale deed. This book entry should be reversed as it is not in the interest of the company. According to section 227 (1-A) of the Companies Act 1956, the auditor has to state in his report whether the transactions of the company which are represented by mere book entries are not prejudicial to the interest of the company. This is transaction as recorded in not in the interest of the company.


b. The basic principle of valuation of stock is that the year-end stock should be valued at cost or market value whichever is less. According to AS-2, the inventories should be valued at lower of cost or net realisable value. In the present case the stock is valued at net realisable value which is improper and imprudent accounting policy as the profit is not yet materialised. General accepted accounting principle states that all anticipated losses should be provided for whereas expected or anticipated profits should be altogether ignored. Inclusion of unrealised profit in the financial statement will distort the true and fair view of the statements as such the profit should be eliminated from valuation and the stock should be stated at cost only.

c. Expectation of income is not equivalent to realisation of income. The realisation concept of accounting states that expected income should be treated as income only after it has realised. In the present case, the company has not yet received any income hence it is totally imprudent to assume that such income has realised. The refund may or may not come. The provision for income tax should be made irrespective of the refund expected. Further in the balance sheet under schedule VI, provision for taxes should be distinctly shown under current liabilities. Unless adequate provision is made for all known liabilities, the profit and loss a/c together with the balance sheet will not present a ‗ true and fair view‘ as required by the statute. The auditor should advise the company against the proposal or else qualify the report quantifying the amount of under provision of taxes.

Question 8 (a) What is Secretarial audit ? What are the objective and benefits of secretarial audit? (b) Outline the general disadvantages of joint audit. (c) The cost auditor of a company can be its internal auditor, and is to be appointed by the shareholders of the company. Comment on the validity.

Answer : Secretarial audit comprises of verification of various formalities to be complied by the company with regards to different directions and guidelines issued by statutory bodies from time to time. Worded differently, a secretarial audit is intended to check whether the company is complying with various legal requirements. Economic, industrial and corporate laws impose numerous obligations for compliance on companies in order to serve the needs of the public, investors, employees, shareholders, lenders and creditors. As the financial audit is conducted by a chartered accountant and the cost accountant conducts the cost audit, similarly a company secretary is expected to conduct secretarial audit. The objectives of secretarial audit are :

e) To certify that the company is following sound procedures and is complying legal requirements in respect of maintenance of books, records etc.

f) To highlight that the various provisions under the legislations applicable to the company have been complied with.

g) To vouch and certify that the company and the management have duly complied with the all the requirements of the Acts covered.

h) Such an audit will help the administrative authorities, financial institutions and corporations which have extended financial assistance to the company.

Section 2(2) of the Company Secretaries Act provides that a member of the Institute of Company Secretary of India in practice can act as or perform services as can be performed by a 'Secretarial Auditor' or consultant. The benefits of Secretarial Audit are as follows :

f) Secretarial audit helps in ensuring adequate compliance with provisions of various laws. g) Benefits to the Government; h) Benefits to the companies; i) Benefit to the stakeholders of the companies; j) Cost benefit analysis.

(b) Answer :


6. Confrontation of ego of auditors : Joint auditors are equally qualified and generally stand on

same footing. The ego confrontation is likely among them. Psychological problems are likely to surface when firms of different standing are associated in joint audit.

7. Sharing of fees : The audit fees to be shared by all the joint auditors. The basis for distribution of fees may not be acceptable to all. Some disputes are just possible.

8. Problems of co-ordination of work : This is something like a ship without any captain. The coordination of work is complicated as no nodal agency is recognised.

9. Neglect of common interest area :Area of common interest is generally neglected. Everybody's responsibility is nobody's responsibility.

10. Uncertainty about fixing responsibility : Fixing of responsibility being ambiguous. Uncertainty about the liability of the work done.

(c) The cost auditor comments inter-alia, on adequacy, efficacy and efficiency of the internal control system of the company. In his report he has to comment whether the internal control system existing in the company is commensurate with the nature and size of the company. The internal auditor is overall in charge to check the internal control system. Thus if the cost auditor is also internal auditor of the company, he will have to comment on his own performance as internal auditor. The true and fair view is unlikely if cost auditor and internal auditor are same person. The internal auditor is employed by the company. Any person who is in full time employment can not get certificate of practice from the ICWAI. Moreover, the cost auditor cannot be internal auditor because this will be contravening the provisions contained in section 226 of Companies Act 1956.

The appointment of cost auditor is governed by the section 233B of the Companies Act 1956 which provides that the cost auditor is appointed by the BOD of the Company with the previous approval of the Central Govt. and in accordance with Sec. 224(1B). The ceiling on the number of audits is also applicable to persons or firms appointed as cost auditors. The shareholders of the company have no role in the appointment of cost auditor.

Paper IP6 : Commercial and industrial laws and auditing December 08

Question 1: Comment of the following statements based on legal provisions:

(a) An agreement with insufficient of consideration is void abinitio. (b) Every employee in an establishment is entitled to bonus under the Payment of Bonus Act. (c) Mr. X………………mistake as defense. (d) Mr. X…………. state the correct position. (e) Consumer under……………….. purpose. (f) Public information ………………….. required information. (g) Workmen………………….. giving notice.

Answer : (a) False : It is neither void nor voidable agreement. The consideration should be of some value in

the eyes of law. Even the smallest consideration is sufficient provided it has some value. The law simply provides that a contract should be supported with consideration.

(b) False : Following conditions should be satisfied for entitlement of bonus under Payment of Bonus Act. (i) he has worked not less than 30 days‘ (ii) his salary / wages does not exceed Rs. 3500 per month [section 2(13)] (iii) provided such establishment comes under the Payment of Bonus Act. However, an employee who is dismissed from service for fraud or riotous behaviour r theft, mis-appropriation or sabotage of any property of an establishment is not entitled to bonus.

(c) As the offer is accepted, he cannot plead defense. He has offered Rs. 70,000 and the offer was accepted. According to sec 22 of Contract Act, a contract is not voidable merely because it was caused by one of the parties under a mistake as to a fact mentioned in the agreement.

(d) The buyer is required to inform the seller regarding inferior quality of goods within reasonable time. Unless otherwise stated in the agreement, the buyer is not bound to return goods to seller, it is duty of the seller to lift the poor quality goods at his own cost and risk.


(e) False : A consumer under the Consumer Protection Act 1986 implies any person who buys goods and uses it for his personal matters. If any person buys goods for commercial purposes, he/she will not be defined as consumer in Consumer Protection Act 1986. Commercial purpose does not include use for earning livelihood by means of small employment.

(f) If the information sought is related for concern for life and liberty, the Public Information officer will provide the requisite information within 48 hours of receipt of such request. In other case, the officer shall as expeditiously as possible and in any case within 15 days of receipt of request provide the information on payment of prescribed fees or reject the request for any of the reasons specified in section 8 and 9.

(g) No person employed in a public utility service can go on strike without giving ‗notice of strike‘ to the employer. (i) within 6 weeks before strike (ii) within 14 days of giving notice (iii) before expiry of the date of strike specified in notice (iv) during the pendency of any conciliation proceedings before a conciliation officer and 7 days after the conclusion of such proceedings.

Question 2: (a) Ramesh promised………………………………… is justified? (b) BEE owes……………………………………suretyships.—comment. (c) In case of ………………………… legal positions. (d) Personnel Manager……………………………….. Do you agree ? (e) An agent…………………………….. legal positions. (f) Calculate……………………………. Rs. 5,000. (g) Mr. Ramesh directs………………………….. Ramesh take ? (h) When and………………………………. Fund scheme? (i) Dr.B has been………………………….. legal position.

Answer : (a) No. Ramesh is not justified. The nature of promise made by Ramesh to pay Rs. 10,000 jointly

to Bhadesh and Naresh does not undergo any change after the expiry of Naresh as his representative or legal heir will take his place. Thus Ramesh has no right to claim the whole amount and payment of Rs. 10,000 will be jointly paid to Bhadesh and legal heirs of Naresh.

(b) False. Gee is not automatically discharged from his surityship just because CEE does not sue BEE unless such provision is expressed in the guarantee agreement GEE still remains guarantor for B to C.

(c) False. According to Workmen‘s Compensation Act, if a workman receives personal injury by accident arising out of and in the course of his employment, compensation in accordance with the Act, shall be paid within 30 days from the date when it fell due otherwise the Employer is required to pay interest and penalty too.

(d) False. According to Factories Act, 1948, a canteen is required to be provided in any specialized factory if the number of workers working in it is more than 250. Hence it is not mandatory for every factory to provide canteen.

(e) True. The agent has lien over stock and other papers of the principal if his fee / commission is not paid to him. Unless some contrary measures exist in the agreement, the agent has right to retain property, papers or stock of principal until the amount due to him is paid to him or accounted for or adjusted in any manner in his accounts.

(f) Mr. X worked from 1.5.78 to 30.11.08. The period is 30 years 6 months and 29 days (30.11.08 is not included), for the purpose of computation of gratuity the period of service is taken as 31 years. Gratuity is (31 x 26,000 x 15) / 26 = Rs. 465,000 subject to Rs. 350,000. Thus he will be entitled for a gratuity payment of Rs. 350,000.

(g) The principal has all the rights to reject and repudiate the actions of agent if the agent deals on his own account without the knowledge of the principal. In this case, the action of agent has been detrimental to the interests of principal and he should repudiate the action taken by the agent.

(h) Pension can be allowed if the following conditions are satisfied :

Reaching superannuation age of 58 years after putting in at least 10 years of service.

On death of the member while in service or not in service.


Permanent disability totally unfit for the employment which the member was doing at the time of such disablement.

(i) As per Industrial Dispute Act, a workman includes any person including an apprentice employed in an industry to do manual, unskilled, skilled, technical, operational, clerical or supervisory work. However, it excludes those employed in managerial or administrative capacity.

Dr. B can be treated as workman under the above definition, and the workmen can demand her reinstatement.

The management may treat Dr. B as employed in the managerial and administrative capacity and deny reinstating her.

Thus an industrial dispute is very likely in such case. Question 3 :

(a) What will be the consequences when goods are sold by a person not the owner and without owner‘s consent?

(b) Maker of cheque is not liable under NI Act for dishonour of cheque under certain conditions. State such conditions.

(c) One…………………….and how ? (d) An employer…………………………………….legal position. (e) Who……………………………. complaints.

Answer : (a) The buyer gets no title of goods because the seller has no title of goods sold by him. However,

if the owner has by his conduct not denied the seller‘s authority to sell, the sale would be treated as valid.

(b) Maker of the cheque is not liable under the following conditions under the NI Act.

If the cheque is not presented to the bank within the validity of the cheque.

Where the cheque is issued not for the purpose of discharge of any debt or any other liability. A cheque given as gift or for any other purpose or reason but not for satisfaction of any debt and / or liability.

(c) Yes. With a view to rectifying any mistake apparent from the records, The Commission may amend any order passed by it under the provision of this Act (i) on its own motion (ii) if the mistake is brought to its notice by any party to the order.

(d) Compensation is paid for injury / accident arising out of and in course of employment. In other words, the injury / accident would not have occurred to him if the workman was not employed. Also in certain circumstances, an employer is liable for injury to its workman even the workmen are away from the premises at the time of accident.

(e) The complaint can be filed by any complainant ; According to Consumer Protection Act 1986, Complainant means : (i) A consumer ; (ii) Any voluntary consumer association registered under the Companies Act 1956, or

under any other law for the time being in force; (iii) The CG or State Govt. (iv) One or more consumers where there are numerous consumers having the same

interest; (v) In the case of death of a consumer, his / her legal heir or representative.

Limitation for filing complaint: Two years after the date on which the cause of action has arisen. However, if the complainant satisfies the respective forum regarding the cause of delay, the complaint can be filed beyond the period of two years and the delay may be condoned by the forum. Question 4 (a) : Write explanatory notes on any four :

(i) Time is the essence of the contract; (ii) Permissible deductions under the Payment of Wages Act; (iii) Rights of the unpaid seller ; (iv) Misrepresentation; (v) Sale and agreement to sale


(b) A dismissed employee is not entitled to bonus under Bonus Act—Comment on legal provisions. Answer :

(i) The time is an essence of contract according to section 55 of the Indian Contract Act 1872 which provides that :

When time is of essence : If the promisor fails to perform his obligation within the time limit set in the contract, the contract becomes voidable at the option of the promisee. The client can decide whether to continue with the contract or to discontinue it. If he decides to continue with the contract in spite of delay, he will not have any claim on compensation for the delay. But he decides to continue with claims for damages for delay in performance; he should give a notice in this regard to the contractor at the time of giving his acceptance for continuance of the contract. (ii) The deductions from wages of an employee may be of the following kinds subject to limit

on deductions as prescribed in the Act. The deductions relate to following may be made as per the provisions of the Act : (i) For fines (ii) for absence from duty (iii) for damage or loss (iv) for services (v) for recovery of advances (vi) for payments to cooperative societies and insurance claims (vii) other permissible deductions. It is needless to state the deductions made should not exceed the prescribed limits. If the aggregate of deductions made exceeds the limits prescribed in this regard, the excess recovery may be made in such manner as prescribed.

(iii) Rights of unpaid seller : The credit sales are indispensable to any business and non payment of debts is an inseparable part of credit sales. The seller who has not received full payment against the goods sold by him must have certain rights and remedies to recover or reduce the loss being suffered by him. The Sale of Goods Act has elaborate provisions regarding the rights of unpaid seller.

By virtue of section 45 of the the seller of goods is unpaid seller (i) when the whole price has not been paid or tendered (ii) when the legal instrument received by him as conditional payment has not been honoured.

An unpaid seller has the following rights as per the Sale of Goods Act 1. Rights of lien (Section 47) : The unpaid seller has a lien on the goods for the price while he is in

possession, until the payment or tender of the price. A lien is a right to retain possession of goods until payment of the price. He is entitled to lien in the following three cases, namely

(i) Where goods have been sold without any condition of credit; or (ii) Where goods have been sold on credit but the terms of credit has expired, or (iii) Where the buyer becomes insolvent.

The seller can exercise the lien although he holds the goods as the agent or bailee for the buyer. Where an unpaid seller has made part delivery of the goods, he may exercise his right of lien on the remainder, unless such part delivery has been made under such circumstances as to show an argument to waive the lien. 2. Rights of Stoppage in transit (Section 50) : The unpaid seller has the right of stopping the

goods in transit after he has parted with their possession to a carrier, in case of insolvency of buyer, The right is exercisable by the seller only if the following conditions are fulfilled

(i) The seller must be unpaid; (ii) He must have parted with the possession of goods; (iii) The goods must be in transit; (iv) The buyer must have become insolvent; (v) The right is subject of provisions of the Act.

3. Rights of re-sale (Section 51) : When the goods are of a perishable nature, the unpaid seller may

re-sell the goods without giving any notice to the buyer. (vi) Misrepresentation : (Section 18 of Indian Contract Act 1872) Where a person asserts

something which is not true, though he believes it to be true, his assertion amounts to misrepresentation. Misrepresentation may be either innocent or without reasonable ground.

Misrepresentation means and includes : 1. The positive assertion, in a manner not warranted by the information of the person making it, of

that which is not true, though he believes it to be true;


2. Any breach of duty which, without an intent to deceive, gains an advantage to the person

committing it, or any one claiming under him, by misleading another to his prejudice or to the prejudice of anyone claiming under him; 3. Causing, however innocently, a party to an agreement to make a mistake as to the substance of the thing which is the subject of the agreement.

(iv) Please refer Chapter 12 Sale of goods Act. 2006 Dec (6)

Question 4 (b) Following conditions should be satisfied for entitlement of bonus under Payment of Bonus Act. (i) he has worked not less than 30 days‘ (ii) his salary / wages does not exceed Rs. 3500 per month [section 2(13)] (iii) provided such establishment comes under the Payment of Bonus Act. Section 21 of the Bonus Act, states that for the purpose of bonus due from employer, the term employee includes a person who is no longer in service. Hence a dismissed / retrenched employee is also entitled to receive bonus. However, if the dismissal or retrenchment is on account of fraud, riotous behaviour, misappropriation, theft and sabotage, he shall not be entitled to any bonus. SECTION 2 : AUDITING : Question 5 : Comment on the following statements on the legal provisions :

(a) US-GAAP is not different from that of India. (b) Reserve not ………………………… verify it. (c) Auditor can…………………………….exists. (d) When information ………………………. system. (e) To comply with………………………….. certain points. (f) Management audit………………… the company. (g) ABC Ltd. in its………………… the appointment ?

Answer : (a) False. GAAP stands for Generally Accepted Auditing Principles. The GAAP in U.S. of A are

different from those of India in many areas. The major areas of difference between the two countries are in respect of (i) Preparation and presentation of financial statements (ii) Disclosure requirements in financial statements (iii) Depreciation (iv) Investment in own shares (v) Treatment of pre-operative expenses etc.

(b) False. The reserve not appearing on the Balance sheet is a secret reserve and an auditor is

supposed to detect, verify and correct it. Any secret item will cause the departure from 'true and fair view' concept; thus it is not allowed at all to keep secret reserve in financial statements. The Companies Act 1956, requires unequivocally that all reserves and provisions must be fully disclosed in Company's accounts making it impossible to keep any secret reserve.

Additional knowledge regarding secret reserve : Any reserve not appearing in the balance

sheet is a secret reserve. Any intelligent verification of the accounts by the auditor may reveal to him the existence of such reserve. Generally such type of reserve appears in the financial statements of Financial Institution, Banks and Insurance Companies. Secret reserve may be caused by :

Overvaluation of liabilities;

Showing contingent liabilities as real liabilities;

Stating the assets much below their costs.

Providing excessive depreciation;

Providing excessive reserve for doubtful debts;

Writing down the goodwill considerably;

Charging capital expenditure to revenue account;

Omitting certain assets altogether from the balance sheet; Regarding the secret reserve, the auditor should keep the following points in his mind:

Whether there is any necessity to create such reserve and he should not qualify his report if it is ascertained by him that the intention of company is honest and in the bona fide interest of the shareholders and the amount is reasonable.


He may pass a remark in his report that the assets are understated or the liabilities are overstated as the case may be.

(c) If the statutory auditor is satisfied with internal control system and performance of internal auditor, he often decides to curtail his audit programme by dispensing with checking already done effectively and efficiently by internal control staff. It must however, be mentioned that the statutory auditor is not protected against the liabilities for negligence which may arise due to his reliance on work performed by the internal auditor.

(d) False. When information system audit is also information technology audit, auditor is

supposed to have detailed knowledge of accounting as well as information system. He already has detailed knowledge of auditing because that is why he is there as auditor.

(e) True. The CARO requires the following points to be dealt in Auditor‘s report in respect of loans:

(i) Has the company either granted or taken any loans, secured or unsecured to / from companies, firms or other parties covered under the register maintained u/s 301 of the Companies Act 1956,. If so, give the number of parties and amount involved in the transactions.

(ii) Whether the rate of interest and other terms and conditions of loans given or taken by the company, secured or unsecured are prima facia prejudicial to the interest of the company;

(iii) Whether the payment of the principal amount and interest are also regular; (iv) If over payment is more than Rs. One lakh, whether reasonable steps have been

taken by the company for recovery / payment of the principal and interest. (f) False. The management audit is conducted by ; (i) An administrative staff (ii) An audit

committee (iii) An officer on special duty (iv) Outside management consultants (g) False. According to section 226(3)(c) of Companies Act 1956, a person holding any security of

a company after a period of one year with effect from 13.12.2000 is disqualified for appointment as statutory auditor of that company. In the light of above provision, Mr.X cannot accept the appointment.

Question 5 : (a) What are the contents of good Audit Report. (b) As an auditor, mention the points and books to be checked in accordance with issue of Corporate Governance Report. (c) Explain how the following are dealt with under CARO (i) Fixed Assets (ii) Deposits of Statutory dues. (d) State the particulars which are to be included in the balance sheet of a holding company of its subsidiary. (e) Risk occurring ………………………………… statement correct ?

Answer : (a) Auditing guidelines have laid down certain guidelines relating to contents of Audit Report viz. (i) Title (ii) Address (iii) Observations (iv) Auditing Standards – to make reference to standard AAS (iv) Opinion – Opinion may be qualified, adverse or disclaimer. (v) Signature (vii) Auditor‘s address (viii) dale of audit report. (b) The Corporate Governance Report requires following points to be checked by auditor during the audit : (i) Minutes of BOD‘s meetings (ii) Minute book of general body meeting (iii) Minute book of Audit

committee (iv) Corporate Governance Report (v) Mandatory annual intimations filed by each director about directorship in other companies (vi) Consistency of segment wise information with the segment information and consistency with the opinion expressed by him under CARO 2003.

(c) With regard to fixed assets, In accordance with the requirements of CARO, the auditor should comment (i) Whether the company is maintaining proper record of fixed assets, (ii) Does the management verify the fixed assets frequently or at regular intervals;


(iv) Whether any discrepancy or difference was found in the book balance and physical balance and if yes, how the difference was reconciled?

(iv) Whether depreciation is provided properly and there is no case of excessive depreciation being charged to create any secret reserve. (v) Whether such substantial part of fixed assets has been sold to affect the going concern concept of the entity. Deposit of statutory dues : The company auditor has to report that :

(i) Is the company regular in depositing undisputed statutory dues including Provident Fund, employees state insurance, income tax, sales tax, wealth tax, custom duty, excise duty, cess and any other statutory dues as at the last date of the financial year concerned for a period of more than six months from the date they seem payable, shall be indicated by the auditor.

(ii) In case dues of income tax, sales tax, wealth tax, custom duty, excise duty, cess have not been deposited on account of any dispute, the amounts involved and the forum where dispute is pending may be mentioned, but he should, while reporting remember that a mere representation to the department should not constitute a dispute.

(d) As per section 212 of Companies Act 1956,, following points shall be included in the balance sheet of holding company.‘

(i) Financial statements of Subsidiary company viz. (a) Balance sheet (b) Profit and loss a/c (c) Audit report (d) Directors report

(ii) Statement of interest of holding company in subsidiary company, (iii) When the financial years are different, details of any material change between the end

of the financial year of the Sub. Co. and financial year of the holding co. in respect of (a) Fixed assets (b) investments (c) Money lent / borrowed by subsidiary company.

(e) False. The audit risk implies and involves risks associated with process of auditing as well as performance of auditor. Audit risk occurs due to insufficiency or incompetent evidence collected by the auditor to express his opinion on the financial statements.

Audit risk is the risk that the opinion of the auditor on the affairs of the company may be inappropriate because the information on which he has based his opinion may be misstated. Audit risks may be categorized as :




Question 7 : (a) How an auditor ……………………. Contingent liability? (b) What is computer assisted audit technique? (c) How as an auditor you will treat the amount received after 2 years? This was written off as Bad

debt. (d) Statutory auditor can be appointed as Internal auditor of the company for the same period. Do

you agree ? (e) What are the objectives of Operational audit ? (f) Auditor in his report is to comment whether the ,,,,,,,,,,,,,,,,,, all companies?

Answer :

(a) Some examples of contingent liability are : (i) Disputed claims by workers for compensation (ii) Bills discounted (iii) Guarantees given in favour of others; (iv) Amount of incomplete contract; (v) Calls unpaid on partly paid shares; (vi) Payment of gratuity under Industrial Dispute Act; (vii) Arrears of preference shares. Verification of Contingent Liability :


For the verification of contingent liability, the auditor should (i) Obtain certificate from some responsible officer of the company regarding the contingent

liability disclosed in the financial statements. (ii) Examination relevant documents and records to ascertain the existence of contingent liability. (iii) Assess on his own the likelihood of contingent liability to turn to actual liability. (iv) Verify the court cases pending in the court, when the verdict is likely to come, he can also

consult the company advocates in the regard. (v) Examine the claims by the workers pending decision of court, tribunal etc. (vi) Maturity dates of bills discounted by the company. Verify whether there are any discounted

bills against which payment has been received, then see that such bills are not included in the contingent liability.

(vii) Verify the contract register, check calculations of estimates for completion of incomplete contract.

(b) Computer assisted audit techniques : CAAT are those techniques which are used to process the data and information stored in the auditee‘s computer system, for the purpose of audit. According to the ICAI guidance notes such techniques will enhance the efficiency and effectiveness of the audit procedure. The guidance notes require that the auditor must have experience and expertise in using these techniques and he must be capable of using the results provided by these techniques. It is required of the auditor to ensure that the technique being employed makes no or least disturbance or disruption in auditee‘s routine activities. Before using the technique, the auditor should ensure that the techniques are suitable, reliable and useful for the desired audit work. The techniques should be properly controlled. Some of the CAAT available are as follows : (i) Test data (ii) Integrated Test facility (iii) Audit software (iv) Audit automation (v) Log analyzers (vi) Data Base analysis (vii) Online Testing (viii) Program code and program library analyses etc. Auditor should maintain adequate records and documents describing the application of the techniques and interpretation of results thereof.

(c) Following treatment may be suggested in this regard (i) The item may be treated as income in the year of receipt. (ii) This can be shown in the statement of profit and loss account after determination of current year profit or loss. This item should be grouped under the heading of ‗‘ Prior period items‘‘. (d) No. The statutory auditor cannot be appointed as an internal auditor for the same company for

the same period. The independence of auditor will not be there. (e) For operational audit, see chapter on Internal auditing June 2003 and December 2003. (f) No. It is not applicable to all companies. Auditor is to comment on his report that the company

has Internal Audit System commensurate with size and nature of business in the following cases : (i) Listed companies (ii) Companies having a paid up capital and reserves exceeding Rs. 50 lakhs as at the commencement of financial year (iii) companies having an average annual turnover exceeding Rs. 5 crores for a period of 3 consecutive financial years immediately preceding the financial year.

Question 8 :

(a) In connection…………………… are those ? (b) Auditor should …………………. State the position. (c) State the need for Management audit. (d) Auditors are …………………………….. state the position. (e) Auditor while…………………….. what are these ? (f) Audit committee is……………….. you agree ? (g) As an auditor…………………… investment?

Answer 8 :

(a) Information system auditing is the process of collecting and evaluating evidence to determine whether a computer system safeguards asset, maintains data integrity, allows organizational goals to be achieved effectively and uses resources efficiently. Thus the objectives of


Information system audit are (i) Safeguarding of assets (ii) Data integrity (iii) system effectiveness (iv) system efficiency. Sometimes information system auditing has another objective –namely ensuring that an organization complies with some regulation, rule or condition.

(b) Checking of controls is essential component of any audit procedure. As per the guidelines laid down in the International Auditing Practical Statement, the auditor shall verify the controls established to reduce the risks which are associated with the e-commerce transactions.

(c) The objectives of management audit are (i) to detect and correct the human limitations of top management; (ii) to improve upon management‘s productivity; (iii) to avoid possible losses arising from inefficient management and (iv) to study the current state of all affairs of the management and suggest suitable measures for improvement.

(d) Please see Chapter 4 : 2004 June (6)(b) (e) Inadequate control measures can create serious problems like (i) theft, alteration or loss of

data (ii) physical damage to data (iii) reduction in efficacy and efficiency of system. (f) False. Audit committee is not a luxury and it serves as communication channel among various

departments and has to interact with management, internal auditor, statutory auditor and the public.

(g) Verification of Investment : (i) AS – 13 deals with accounting of investments. Auditor should ensure that all the provisions

of AS – 13 are followed by the company. (ii) See that investments made by the company are not contrary to the provision of section 372

of the Companies Act 1956,. (iii) See that regarding investments in subsidiaries, disclosure requirements of section 212 of

Companies Act 1956, are complied with. (iv) Remember that in case of trusts, the investments are valued at cost while in case of

finance companies they are treated as current assets and valued at cost or market price wel.

(v) Insist on schedule of investments as maintained by the company specially in the case when there are a large number of investments.

(vi) Physically verify the investments by checking certificates, documents, deposits receipts etc.

(vii) Obtain a certificate from bank of certain securities. (viii) Match the investments in the register and those shown in balance sheet. Demand

explanation if any discrepancy is noticed. June 2009 : COMMERCIAL AND INDUSTRIAL LAWS

QUESTION

1. Comment on the following statement based on legal provisions : (a) An hirer, who obtains…………….title to the car. (b) A limited…………………………..body corporate. (c) A complaint……………………………….action arose (d) Every person…………………………….to contract. (e) ‗A‘ (Workman), …………………………..disputes act 1947 (f) A workman……………………………..compensation Act 1923 (g) ―A‖ saved………………………………..would succeed.

Answer To Question 1 1.(a) According to the Sale of Goods Act, It is implied condition of sale that only owner can sell the goods. It is expressed in the Latin phrase as ' Nemo dat quod qui non habet.' which means that ''none can give who does not himself possess.'' A hirer is not the owner of the goods and does not posses title of the goods. Since sale involves transfer of ownership and a hirer, being a non-owner, cannot transfer ownership in the given case, buyer shall not get a good title.


(b) A limited liability partnership is a body corporate with legal personality separate from that of its members. It is formed as per the Limited Liability Partnership Act 2009.

(c) False : Limitation for filing complaint: Two years after the date on which the cause of action has arisen. However, if the complainant satisfies the respective forum regarding the cause of delay, the complaint can be filed beyond the period of two years and the delay may be condoned by the forum.

(d) Sec. 11 of the contract Act reads ―Every person is competent to contract who attains age of majority according to the law to which he is subject and who is of sound mind and is not disqualified from contracting by any Law to which he is subject.‘‘ (e) Sec. 25 E of Industrial Dispute Act 1947 provides that no compensation shall be payable to a work man who has been laid off if such laying off is due to a strike or slowing down of production on the part of workmen in another part of the establishment whether one establishment is part of another establishment or not depend upon several factors. As such no compensation is payable to ‗A‘. (f) . Since the workman was on the spot only for his employment and accordingly his wife/legal heirs is/ are entitled for compensation. (Naima Bibi-vs. Lodhne Colliery) In this case, there was casual and approximate connection between the accident and the employment

(g) Consideration should be at the desire of promisor. ‗A‘ can not demand payment for his service to save ‗B‘s life because (1) it was voluntary gratuitous act and (2) not at the desire of ‗B‘. Where, however, a ‗Person‘ lawfully does anything for ―another person not intending to do so gratuitously and such other persons enjoys the benefit thereof the ―another person‖ bound to make compensation to the ―person‖ in respect of the thing so done. Question No-2 2(a) Mr. Paul gave a cheque…………………………………….liable for prosecution. (b) Mr. A agreed to purchase…………………………………. Who will bear loss? (c)‖A‖ executed a guarantee………………………………Is A‘s stand correct in law? (d) Is there any time………………………………………under bonus act? (e) Occupier of a factory………………………………legal provision (f) Every employee……………………..if not correct. (h) State the right…… (i) ―A‖ is owner…………reimburse to ―B‖ (ii) ―A‖ authorizes………………………………………pay to ―B‖ (iii) An auctioneer…………………………..time and cost. Answer to Question 2

(f) 2(a) Maker of the cheque is not liable under the following conditions under the NI Act.

If the cheque is not presented to the bank within the validity of the cheque.


Where the cheque is issued not for the purpose of discharge of any debt or any other liability. A cheque given as gift or for any other purpose or reason but not for satisfaction of any debt and / or liability.

2(b) Since 70 bales were ascertained and appropriated, property in those 70 bales were transferred to A. Hence A is liable for 70 bales only and B is liable for remaining stock. 2(c) Lawful consideration is an essential component of a contract of guarantee. Sufficiency of consideration is not required and it is not necessary that something must have been done for the benefit of the Guarantor. Anything done or any promise made for the benefit of the principal debtor is a sufficient consideration to the surely/guarantor for giving the guarantee. 2(d) (a) where there is dispute regarding payment of Bonus pending before any Authority, under sec.22 all amounts payable within a month from the date on which the award becomes enforceable or the settlement come into operation in respect of such disputes. (b) In any other case within 8 months from the close of accounting year.

Appropriate Government or such Authority authorized by Govt. may extend the said period of 8 months but total period so extended shall not in any case exceed 2 years.

2(e) False : Occupier has been defined in the Factories Act in section 2(n) as the person who has ultimate control over the affairs of the factory. It is also stated further that in case of firm or other association of individuals, any one of the partners or members thereof shall be deemed to be the 'occupier'.

The section 2 further states that in case of a company, any of the directors shall be deemed to be the 'occupier'. 2(f) False : Now all the employees of the specified establishment excepting Apprentices are entitled to gratuity under the act. 2(g) (i) In this case ―B‖ was not authorized to pay the premium for a policy for the products. Since both the policy and the value can be separated, A is bound to pay the premium for the policy on factory buildings but not the premium for the policy on the products. 2(g) (ii) In this case, the agent i.e. ―B‖ does more than he is authorized to do and the amount of rupees 5000/- can not be separated between sunlight and henko. ―A‖ may repudiate and say no to the whole transaction. As per Contract Act, the principal is not bound when excess of Agent‘s Authority is not separable and measurable. 2(g) (iii) A can not file a suit against the Auctioneer for his loss of time and cost because the Advertisement was merely a declaration of intention to hold Auction. Moreover there was no agreement between A and the party. Question no- 3 3(a) As per………………………………..citing rules (b) A minor……………………………- comment. (c) What is………………………….(completion Act 2002?) (d) In an ………………………………..citing rules. (e) Stipulation as to………………………………comment (f) As per sales………………………………………action against B? (g) When…………………………sale or return (h) A Railway…………………………………… any remedy? (i) What is ……….Contract Act, 1872?


Answer to Question 3 3(a) False: in every factory wherein 500 or more workers are ordinarily employed, the occupier shall employ such number of welfare officer as may be prescribed. 3(b) False: Any person may become an agent between the principal and third party . An agent is supposed to be responsible to the principal hence no person who is not major and of sound mind can become an agent. 3(c) Dominant position means a position of strength enjoyed by an enterprise in the relevant market in India which enable it to:- (i) Operator Independently of competitive force prevailing in the relevant market. OR (ii) Affect the competitors or consumers or the relevant market in its favour. 3(d) In the case of sale by Auction, the sale is complete only when the auctioneer announce its completions by the fall of a hammer or in other customary manner and until such announcement is made any bidder may retract / withdraw his bid. 3(e) Unless the terms of the contract show a different view and intention, stipulation as to time of payment is not deemed to be of essence of a contract of sale. Whether any other stipulation as to time of the essence of the contract or not, depends on the terms of the contract. If the time and manner of payment have been outlined in the contract, time of payment becomes essence of contract. 3(f) As B has accepted all the quantity supplied by A hence ―B‖ is to pay in full. As per sale of goods Act, B may accept quantity of 2 MT or he may reject the whole lot. Since ―B‖ has accepted 22MT, he is liable to pay the value of 22MT. 3(g) When goods are delivered to the buyer on approval or on sale or return or other similar terms the property therein passes to the buyer ; (a) When he signifies his approval or acceptance to the seller. (b) If he does not signify his approval or acceptance to the seller but retains the goods,

without giving notice of rejection then if a time has been fixed for the return of goods on the expiration such time, and if no time have been fixed on the expiration of reasonable time.

3(h) The consignee is entitled to recover the amount as was illegally excessive because a person to whom money has been paid or anything delivered, by mistake or under coercion must repay or return it. 3(i) As per Sec 17 Fraud means and includes any of the following acts committed by a party to contract or with his connivance (means support or responsibility) , or by his agent with intent to deceive another party there to or his agent or to induce him to enter into a contract.

1) The suggestion as a fact, or that which is not true by one who does not believe it to be

true. 2) Active concealment of a fact by one having knowledge or belief of the fact. 3) A promise made without any intention of performing it. 4) Any other act fitted to deceive. 5) Any such act or commission as the law specially declares to be fraudulent. Question no- 4 4(a) Write explanatory notes on any four:


(i) Effects of ‗coercion‘ on a contract; (ii) Powers of Inspector (Minimum Wage Act); (iii) Bailee‘s particular lien; (iv) Recovery of Gratuity; (v) Seller‘s lien.

(b) Mr. B (a broker) by the orders of Mr. A Purchases 10 Drums of oil A from Mr. C. Afterwards Mr.A refuses to receive oil. Mr. C sues Mr. B who informs Mr. A repudiates the contract although Mr. B defends but failed. Mr. B has to pay cost, damages and incurs expense. Can B recover any amount from A?

Answer to Question 4 4(a)i) Effect of Coercion Following are the effect of coercion on contract.

Sec 19 : Contract induced by coercion is void able at the option of aggrieved party whose consent was obtained by coercion.

Sec 64 : If the aggrieved party decided to rescind the contract, it will have to restore benefit to party from whom it was received as per sec.64.

The aggrieved party can insist that contract be performed.

Sec 75 : If a party rightfully rescinds a contract, it can claim compensation for any damage/loss/suffers through non-fulfillment of contract.

4(a)ii) Powers of Inspector : (Minimum Wages Act) The inspector may enter at all reasonable hours any premises for the purpose of examining any register, record of wages or notices and require the production of such documents for inspection. Examine any person whom he finds in any such premise or place and who he has reasonable cause to believe is an employee / employed therein or an employee to whom work is given out therein. Require any person giving out work and outworkers to give any information. Seize or take copies of such register, record of wages or notice, or portion thereof as he may consider relevant in respect of an offence under the minimum wages Act 1948, which he has reasons to believe has been committed by an employer and Exercise such other powers as may be prescribed. 4.(a) iii) Where the bailee has in accordance with the purpose of the bailment rendered any service involving the exercise of labour or skill in respect of the goods bailed he has in the absence of a contract to the contrary, a right to retain such goods until he received due remuneration for the services he has rendered in respect of them. 4(a) iv) Recovery Of Gratuity :- If the amount of Gratuity payable under the act is not paid within the prescribed time i.e 30 days to the entitled thereto, the said employee may apply to the Controlling Authority for direction to pay the gratuity. Controlling Authority may give a reasonable opportunity of showing cause After hearing both the parties, the Controlling Authority, issues orders for payment of gratuity with interest specifying the last date for such payment. If the employer fails to pay the gratuity within the prescribed time against the order of the controlling Authority, then the controlling Authority issues certificates for that amount to the collector who shall recover the same with compound interest at such rate as the central Govt. may specify from the date of expiry of prescribed time as arrears of land revenue and pay the same to the employee entitled thereto.


4(a)v) Sellers lien 1. The unpaid seller of goods who is in possession od goods entitled to retain possession of such

goods until payment are tendered of the price in the following cases viz. a) Where the goods have been sold without any stipulation as to credit. b) Where the goods have been sold on credit but the term of credit had expired. c) Where the buyer becomes involvement. The seller may exercise his right of lien not withstanding that he is in possession of the goods as against agent or bailee for the buyer. 4(b) In this case ―A‖ is liable to ―B‖ for such damages, costs and expenses because the employer of an agent is bound to indemnify him against the consequences of all lawful acts done by such agent in exercise of the authorities conferred upon him. B acted on the instruction of A which makes A liable to take responsibility of all lawful acts done by B on his behalf. SECTION II Auditing Question no – 5 5. Comment on the…………..on legal provisions:

(a) it is mandatory that…………..all the companies. (b) When assets are………..profit and loss account. (c) When chairman…….board of directors. (d) While auditing……..non computerized environment. (e) Auditors primary ………….errors and frauds. (f) An information……………financial audit. (g) Management emphasis…………problem solving. (h)

Answer to question- 5 5(a) False . Companies Act 1956 in its section 292A stipulates that every public limited company having paid up capital of not less than Rs. 5 crores shall constitute a committee of the Board known as ' Audit Committee'. Hence all public limited companies need not constitute an Audit Committee. (b) Part I of Schedule VI of Companies Act 1956, requires each balance sheet for the first five years, subsequent to the date of reduction or addition on account of revaluation or reduction of capital should disclose such reduction or addition. (c) When the chairman is also the managing director of a listed company, the board of directors

should have minimum of 50% independent directors.

(d) True, while auditing in computerized environment, overall objective and scope of audit remains same as for audit in non-computerized environment.

(e) False, auditor‘s primary responsibility as per AAS-2 is to express an opinion on financial

statements.

(f) False. As the names of two audits differ, An information audit is not entirely similar to that of a financial statement audit. An evaluation of internal control may or may not take place in an information system audit. There are other differences as well.


(g) True. Identification of problems is the first step towards its solution.. The management ensures and examines whether policies and procedures adopted in the organization, are consistent with objectives and understood properly at all functional levels.

Question 6 :

(a) State the limitations of management audit. (b) State in brief the important points that should be considered by the auditor while

conducting vouching. (c) State the components of Audit risk. (d) State what aspects should be checked while conducting audit of Bills receivable. (e) Auditors are to observe certain standards in field works and reporting under GAAP /

GAAS. Explain. Answer :

(a) The limitations of Management audit are as given below :

The management audit is audit of the management, by the management, and for the management. The management auditors are selected by the management itself. Such auditors may or may not be able to handle the job assigned to them.

The management auditors are generally familiar with the organization and the staff and employees. The personal aspects cannot be overlooked in such audits. Some may use this audit to level the score with someone while other may utilize it to favour someone.

They are more likely to take the facts for granted and may not probe into depth to investigate the matter any further.

Time and cost constraints may limit the scope, operation and extent of such audits.

The management audit team as selected by the management may not look, act and work as a team. Conflicting interests, attitude and inclination may jeopardize the entire objective of the audit.

(b) Salient aspects which must be borne in mind while vouching :

Vouchers must be printed and serially numbered and filed in chronological order. They should also match with the entries made in the books of accounts. Hand written vouchers should be objected and seen in more detailed manner.

All payments must be authorized / sanctioned by the competent authority. In case, there is a system of pre audit before releasing payment, the approval must be seen in vouchers.

Allocation of heads must invariably be there along with the number codes of the heads.

Payments should be supported with receipts vouchers of the payee.

Reasonableness of amount should be ascertained. (c) Please see Chapter 1 ;2001 Dec (5) (d) The bills receivables should be audited as per the following lines ;

Bills receivable is obtained against some credit sales. Order to supply, dispatch of goods, invoice generation and receipt of bills receivable should be seen in detail to ensure adherence to prescribed procedure in this respect.

Get the schedule of bills receivables from the management and check whether the total tallies with the balance sheet.

Check every bills receivable to see whether it contains all the required details. It should be flawless so as to be acceptable to bank while being paid.

The discounted bills should be marked in the bills receivable ledger. The payments received against them should match with the figures in cash book amount wise and date wise. All discounted bills should appear in the financial statement as contingent liabilities.

Opening balance of bills receivable should tally with balance sheet of last year while closing balance should tally with balance sheet of this year.

Physical safety of bills receivable and their up keeping should be checked. (e) For GAAS / GAAP: Please see June 2008 Question 5

Question 7:


(a) Under certain circumstances the accounts of Branches may not be audited. Comment citing rule position.

Answer Please see : 2005 June (2) (b) Chapter 4 Statutory Auditor

(b) How as an auditor you will verify the ‗ Sales Tax / VAT ? Answer : Sales Tax / VAT stands for ratio of sales tax to VAT.

(i) See the payment vouchers of sales tax and VAT. Verify the challans and returns and also see the cash book regarding cash payments.

(ii) The applicability of audits in respect of sales tax and VAT may be seen. If applicable, study the audit findings in this respect.

(iii) Ratio is useless unless it is compared with that of past years. Trend of Sales tax / VAT may be studied for consistency, growth. Any noticeable change must correspond with change in sales.

(iv) Accounting for set off, if any, should be checked. (v) Verify the assessment order to calculate any excess or deficit in payments and see

whether proper accounting is done in respect thereof. (c) As an auditor, how you will audit in case of data processing through computer service centre ?

Answer : AAS 24 relate to Audit considerations relating to entities using service organizations. Sometimes the audit clients take the services of outside service organization to carry out particular activities. The auditor should consider how the service organization affects the client‘s accounting and internal control system accordingly the assessment can be done of the following basis :

Nature of the service provided;

Terms of the contract;

The material financial statements affected by the use of the service;

Client‘s internal control system applied to the transactions processed by the service organization;

Service organization‘s capability and strength

Use of audit report of service organization. The auditor can follow the following procedures for assessment:

Visit the service centre;

Use third party reports on service organization for example, statutory audit report, internal auditor report or any report of some authority;

Request the client that necessary information in the form of report may be obtained from service organization.

If the auditor concludes that activities of the service organization are significant to the client, he should assess the control risk.

In addition to the above, the following points should also be kept in mind:

Verify that the vendor is reliable and suitable having the requisite skill, experience and expertise called for his assignment;

Examine the contract of client with its vendor with respect to terms, responsibility, rate, time limit and recovery of damage clause;

How the data integrity, back up, recovery are ensured by the vendor; (d) Explain how the following are dealt with under CARO ? (i) Transactions in which Directors are

interested and (ii) Internal audit system. Answer: (i) : CARO in point 5 requires : Transactions in which Directors are interested: Auditors statements are required on the following :

Whether transactions that need to be entered into registered in pursuance of sec 301 of Companies Act 1956, have been so entered.

Whether each of these transactions have been made at prices which are reasonable having regard to the prevailing market prices at the relevant time;

These should be commented only on the cases of transactions exceeding the value of 5 lakhs. (ii) CARO in point 7 requires :


In the case of listed companies and other companies having a paid up capital and reserves exceeding Rs. 50 lakhs as at the commencement of the financial year or having an average annual turnover exceeding Rs. 5 crores for a period of three consecutive financial years immediately preceding the financial year concerned, Whether the company has an internal audit system commensurate with its size and nature of business. (e) Find out the differences between India‘s GAAP and US GAAP in respect of (i) pre operative

expenses (ii) Foreign currency transaction. Answer ; Please see Chapter 1 Auditing techniques.2003 June (7)

Question no. 8 :

(a) State basic items which the auditor should be familiar to understand the computer system used by the clients. (b) How you will conduct the (i) physical verification of Fixed Capital assets (ii) Idle facilities. (c) How Internal Audit become an important management tool. Answer with reasons. (d)

(i) Ray and Bose, Chartered Accountants, who were appointed as Auditor for financial year 2008—09 were removed during the month of Dec 2008, Whether the said auditors can claim any compensation?

(ii) Statutory auditor of the company is legally bound to attend the AGM of the company. State correct position.

(iii) Auditor has no liability under Companies Act 1956,. Do you agree? Answer citing rules. Answer :8(a)

(i) Computer system consists of hardware and software. Auditor should have adequate knowledge of both the aspects.

(ii) He must have knowledge of EDP terms, vocabulary etc to understand the system as well as its operations.

(iii) The auditor should have understanding of computer hardware, software and application of various techniques in relation to accounting and auditing. He should have sufficient knowledge of CIS and EDP to implement the auditing procedures and approaches.

(iv) He must be familiar with the type of computers being used by the client. He must be able to understand how the transactions are being processed in the system.

(v) He must understand the preventive, detective and corrective control system incorporated in the system. He should be able to assess the efficacy and sufficiency of the control system.

(vi) Audit evidence : A CIS and EDP environment may altogether alter the scene of audit evidence. Computer assisted audit techniques may be required to enhance the effectiveness as well as efficiency of the audit. Generalized audit software may also be called for assistance in audit. Auditor needs to have adequate knowledge in this respect as well.

(vii) Knowledge of flow chart is also important. (viii) He needs ability to read various types of documentations.

Answer :8(b)(i)

In all types of transactions vouching is must, but in case of capital items the auditor is required to go beyond that and verify the physical existence of various assets. It is statutory liability of the auditor to verify assets and liabilities and if he fails he is liable for negligence. The verification of assets is a process by which the auditor substantiates the accuracy of the right hand side of the balance sheet, and must be considered as having three distinct objectives – namely (a) the verification of the existence of assets (b) the valuation of assets and (c) the authority of their acquisition. In short the verification is a function of examining assets to check (i) Value (ii) Ownership (iii) Title (iv) Existence (v) Possession (vi) to see whether the assets are free from any charge or encumbrance etc. The verification of assets can be conducted on the following lines :

1. Examine the documentary evidence and see that the assets are properly recorded in the books of accounts. The Assets register as maintained by the client may be examined and see whether total of assets register tallies with that shown in balance sheet.


2. Verify the self constructed assets on the basis of contractor‘s bill, work order or other relevant documents.

3. Verify that the fully written off fixed assets are properly recorded and deleted from the assets register.

4. Authority for disposal of fixed assets may be ensured. See that the assets have been disposed off at best available price.

5. Verify ownership of the fixed assets on the basis of the title deeds. 6. Verify existence of assets by physical verification. He should examine whether there is any

system of physical verification of assets at regular intervals. If not, he should insist that such system should be incorporated.

7. See whether the assets are charged. He should verify the Loan agreement, Register of charge, Board Resolution etc.

8. He should keep in mind the following points while verifying the assets and liabilities : (a) Whether the assets ledgers correspond with the balance sheet. (b) Whether assets are acquired for the business. (c) Whether the assets are properly grouped in the balance sheet. (d) Whether the assets are properly valued in the balance sheet. (e) Whether the title and possession of assets lie with the client.

Answer :8(b)(ii) Please see chapter 13 Flow Chart Techniques 2006 Dec.(6) Answer : 8 (c) See Chapter 8 : 2007 June (5)(2) Answer : 8 (d) (i) The Auditor is entitled to full year remuneration. It is immaterial whether he is removed before the expiry of his term or not. (ii) Section 231 of Company's Act 1956, provides that the auditor shall be entitled to attend any general meeting and to be heard at any general meeting which he attends on any part which concerns him as auditor. He is empowered to speak about company's accounts. Whether he exercises this right is up to him. (iii) Please see June 08 Question 4 (d)