Internal Audit and Control

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Structure: 1.1 Introduction Objectives 1.2 Evolution of Financial Audit 1.3 Development of Financial Audit in India 1.4 Definitions 1.5 Objectives of Financial Audit 1.6 Scope of Financial Audit 1.7 Philosophy of Auditing 1.8 Qualifications of an Auditor 1.9 Qualities of an Auditor 1.10 Advantages of Financial Audit 1.11 Limitations of Financial Audit 1.12 Summary 1.13 Glossary 1.14 Terminal Questions 1.15 Answers 1.16 Case Study

Financial Audit

1.1 Introduction
Financial Audit is a specialized discipline with its own principles, standards, postulates, procedures and techniques. It is said that auditing begins where accounting ends. As a student of Finance, you know that every economic unit maintains books of accounts to record the financial transactions and prepares financial statements based on the accounting records. The International Accounting Standards Committee defines the term Financial Statements to cover Balance Sheet, Profit and Loss Account or Income Statement, Cash Flow Statement and Statement of Changes in Equity. Financial Statements reflect the performance of an organization during an accounting period, usually a year, and the financial position at the end of the period. Generally, users of financial statements fall into two categories: (a) Internal stakeholders, viz. the managers of the company who use the information for day-to-day operating decisions
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(b) External stakeholders, such as investors, banks, suppliers, and government authorities, who use the information for making decisions about the company Important management decisions are taken based on the financial reports of the organization. Financial audit ensures that these decisions have been taken based on the reliable and authentic financial statements. The person who conducts a financial audit is called the auditor. The auditor expresses his opinion through the audit report, which states whether the financial statements present truly and fairly the financial results of the company for the period and the financial positionof the company at the end of the period. Figure 1.1 depicts the significance of auditing.

Figure 1.1: Significance of Audit

Financial audits are of two types: statutory audits and internal audits. An audit which is authorized, governed and mandated under anenactment of law is called statutory audit. Audit of limited companies incorporated under the Companies Act, 1956 are examples of statutory audit. Internal audit is
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an audit of the financial records commissioned by the management itself, and is done either by the employees (referred to as Internal Audit department) or by financial experts from outside. The New York Stock Exchange (NYSE) in the United States others in different countries need publicly traded companies for audit activity to provide assessment of internal control management. In India, under certain regulatory requirements, internal audit done is compulsory for Indian companies too. and many an internal and risk getting an

Objectives: This introductory unit will help you to get familiar with the basic concepts of auditing. After studying this unit, you should be able to: discover the evolution of financial auditing study how auditing has developed in India define financial audit state the objectives, scope and philosophy of auditing explain the requisite qualifications and qualities of an auditor describe the advantages and limitations of financial audit.

1.2 Evolution of Financial Audit

Auditing is as old as accounting. The word audit has been derived from the Latin word audire meaning to hear, listen or give credence to. In ancient times the person authorized to check the accounts of an estate did the job by hearing the business records from the record-keepers. There is historical evidence that household accounts of early rulers were kept by at least two persons, independently of one another, to keep a check on mistakes and misappropriations. In the Mauryan, Greek and Roman empires, there was a fool-proof system of control over public revenue and expenditure. The industrial revolution in the 18thcentury and the advent of the joint stock company form of business organisation gave rise to the concept that owners of a business and managers were not the same. The number and complexity of business transactions also multiplied. The owners therefore needed an independent review and audit of the accounts, and a forewarning if the managers indulged in any acts that would be detrimental to their (owners) interests. Independent firms of professional accountants came into existence to audit the accounts. Auditing profession received statutory
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recognition after the British Companies Act was passed in 1862. The main objective of auditing came to be finding of fraud. In the United States, financial audit was introduced in 1900 and ascertaining of actual financial conditions and earning of an enterprise was set out as the main objective. Self Assessment Questions 1. Financial statements reflect the financial position and performance of an organization. (True/False) 2. Why did the evolution of joint stock company system make financial audit of businesses necessary?

1.3 Development of Financial Auditing in India

In India, the compulsory audit of companies was introduced by the Indian Companies Act 1913. The qualifications of the auditor, his powers and duties and the procedure for his appointment were laid down. Only a person holding a certificate from the local government or a member of an association or society duly recognized for this purpose could act as an auditor. In 1930, the accounting profession was brought under the control of the Central Government to ensure uniformity in standards throughout the country. The Central Government maintained a register of accountants and established the Indian Accountancy Board (IAB) to advise it on matters relating to the profession. As the professional accountants in the country grew in number and importance, there was a need for an autonomous body to regulate and control the profession. Accordingly in 1949 the Parliament enacted the Chartered Accountants Act and the Institute of Chartered Accountants of India (ICAI) was established. A council comprising the elected representatives of Chartered Accountants and nominees of the Central Government manage and control the affairs of the ICAI. This council sets the standards of training, education, professional conduct and discipline. A number of Accounting Standards (AS) and Standards on Auditing (SA) has been issued by ICAI for guidance of its members. In 1956 a new Companies Act replaced the Act of 1913. This Act and its subsequent amendments considerably enlarged the scope of the annual financial reporting and financial audit. The Act stipulated that only persons
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with requisite professional qualification could act as Statutory Auditor of a company. The Companies Act, 1956 also prescribed cost audit of companies in specified industries to be conducted by a Cost Accountant within the meaning of the Cost and Works Accountants Act of 1959. In 1984, the Income Tax Act, 1961 was amended to provide for compulsory audit of accounts of certain assesses, which further contributed to the growth of the auditing profession in India. Self Assessment Questions 3. In India, the compulsory audit of companies was introduced by the Companies Act of 1913. (True/False) 4. The affairs of the ICAI are managed and controlled by Government of India. (True/False) 5. Only professional accountants having requisite qualification can act as statutory auditors of limited companies. (True /False)

1.4 Definitions
The International Auditing Practices Committee defines auditing as the independent examination of financial information of any entity, whether profit-oriented or not and irrespective of its size, or legal form, when such an examination is conducted with a view to expressing an opinion thereon. Montgomery has defined Auditing asa systematic and orderly check on the books and records of a business or other organization in order to ascertain or verify and to report the facts regarding the financial operations and the result thereof. According to Ronald Irish Auditing in its modern concept is a scientific and systematic examination of books, vouchers and other financial and legal records in order to verify and report upon the facts regarding the financial condition disclosed by the balance sheet and the net income revealed by the profit and loss account. In the above definitions, the focus is on examination of the financial records and reporting thereon. But over time auditing has extended to costing records, operational data and performance metrics as well. Efficiency audit is a new dimension of auditing today.
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A more comprehensive definition of auditing given by the Institute of Chartered Accountants of India is as follows: Auditing is a systematic and independent examination of data, statements, records, operations and performance (financial or otherwise) of an enterprise for a stated purpose. In any auditing situation, the auditor perceives and recognizes the propositions before him for examination, collects evidence, evaluates the same and on this basis, formulates their judgment which is communicated through the audit report. This definition has described Auditing comprehensively and covers the following essential features: 1. Auditing is a systematic examination of data (financial or otherwise) by an independent expert called an auditor. 2. The stated objective of the auditor is to express an opinion on the truth and fairness of the financial statements. 3. Before expressing their opinion, the auditor has to collect necessary evidence on the proposition placed before him and evaluate it on the basis of his professional knowledge and skill. 4. The auditor expresses their opinion through a report called the auditors report primarily addressed to the owners of the business. Self 6. 7. 8. Assessment Questions Audit is only concerned with checking of financial records. (True/False) ____________ audit has become a buzzword in modern Auditing. The stated objective of auditor is to express an opinion as to the ____________ and __________ of the financial statements.

1.5 Objectives of Financial Audit

According to De Paula, The main object of an audit is to ascertain that the Balance Sheet and Profit & Loss Account of an undertaking shows a true and fair view of its financial position and earnings. The objectives of Auditing can be discussed under two broad heads: 1. Primary objective: The primary objective of auditing is to examine the reliability and validity of the financial statements so as to render an opinion on the truthfulness and fairness of the presentations in those statements. Section 227 of the Companies Act, 1956 requires the auditor of a company to state whether in their opinion, the accounts give
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a true and fair view in the case of Balance Sheet of the state of companys affairs as at the end of the financial year and in the case of the Profit & Loss Account, of the profit or loss for the financial year. According to SA 200A, the objective of audit of financial statements is to allow the auditor to voice their views regarding the truth and fairness of assertions made in those statements. The user must not assume that this belief is an assurance as to the future possibility of the enterprise or the efficiency or the effectiveness with which the management has conducted the affairs of the enterprise. 2. Secondary objective: The secondary objective of audit is to track, detect and prevent any possible errors and frauds. An error may be defined as any unintentional mistake or wrong description in the books of accounts or records whether by way of: (a) Arithmetical or clerical mistakes in the books of records and data; (b) Inaccuracy or misconception of facts; or (c) Mismanagement of accounting guidelines/policies. An error is generally taken to be innocent and not deliberate. Where it appears to be wilfully made, it assumes the character of a fraud. The term fraud refers to an intentional act by one or more individual(s) of management, employees or outsiders, severally or jointly, involving the use of fraud to obtain an undeserved or illegal advantage. The distinguishing factor between error and fraud is the underlying motive. Examples of errors: 1. Goods purchased on credit were not entered in the Journal. 2. A purchase of ` 20,000 was entered in the purchases book as ` 2,000. 3. Goods were sold to X for ` 50,000 but posted to the account of Y instead of X. Examples of frauds: 1. Fictitious purchases were recorded to misappropriate cash. 2. Unearned incomes were recorded in the current year or expenses of current year shown as of next year deliberately, to boost profits for the current year.

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3. Depreciation was charged on non-existing fixed assets to reduce taxable profits and tax liability. Auditors duty with regard to detection and prevention of frauds and error: The perception of auditors duty with regard to detection and prevention of frauds and errors has undergone many changes in the last century. Initially, it was based on the decision given in Kingston Cotton Mills Co. (1896) case. The learned judge Lopse summed up auditors duty by stating Auditor is a watchdog, not a bloodhound. This statement implies: 1. An auditor is appointed by the shareholders in case of a limited company. He is expected to play the role of a watchdog on their behalf and should look after their interests. 2. Unlike the bloodhound the duty of the auditor is verification and not detection. If he discovers something suspicious, during the course of audit, he should probe the matter thoroughly and apprise the shareholders. In the absence of such suspicious circumstances, he is fully justified in relying on representations made by the tried servants of the company. In short, in case of frauds and errors, the auditor has a duty of reasonable care only. In recent years however the scope of auditors duty has been considerably enhanced. SA 240 titled The Auditors Responsibility to consider Fraud and Error in an Audit of Financial Statements issued by ICAI provides expanded guidance on auditors responsibility for identifying and reporting on fraud and error. It is a fact that the main duty/responsibility to prevent and detect the fraud remains with the management of the entity as well as those charged with governance. However, it would be wrong to conclude that the auditor is altogether free from liability as to fraud and errors in the books of accounts or the financial statements of the enterprise under audit. It should be remembered that he is a professionally qualified person and, in that capacity, owes a duty of reasonable care and skill in the conduct of their examination. Duty of reasonable care requires the auditor: 1) To make an intensive study of the system of internal control and check and devise their audit and testing procedure accordingly.
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2) To make all verifications personally or through experienced representatives. 3) To ensure that the financial statements fully conform to the generally accepted accounting procedures and relevant legal requirements. 4) To pursue the lead to its logical conclusion in case of financial statements even remotely hinting at a fraud. 5) To provide reasonable assurance that no material misstatements due to fraud and error exist in the financial statements. 6) To inform the management irrespective of the materiality of such frauds on financial statements in case of suspicion of fraud. However, in case of errors, only material errors need be communicated. 7) To satisfy himself that the material effect of a fraud or an error has been disclosed in financial statements, and if the effect is not ascertainable, the fact is disclosed in their report. 8) To assess and highlight in their report the impact of fraud or error on financial statements as per accepted auditing standards if he is unable to acquire adequate audit proof/evidence to confirm or dispel suspicion of the fraud or error. In conclusion, the judgment in Kingston Cotton Mills, comparing the auditor to a watchdog and not a bloodhound, does not absolve the responsibility to conduct a careful checking of business transactions. Auditors responsibility even extends to areas in which he has no adequate competence, if the true and fair view reporting is at risk. He may take the assistance of domain experts for such matters. Activity: Choose a company of your choice listed on National Stock Exchange (NSE) and go through the auditors report section of its Annual Report. What kind of financial information does it contain? How is it related to the directors report? Hint: Prepare a report on how the auditors report can ensure better quality of financial reporting. Refer companys website for Annual Report.

Self Assessment Questions

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9. The primary objective of Auditing is to examine the ____________ and ____________ of financial statements. 10. In the course of statutory audit of Bright Ltd, a fraud has been discovered in the books of accounts. Comment on whether the auditor can be held liable.

1.6 Scope of Financial Audit

The scope of an audit depends upon the kind of audit being undertaken, and the terms agreed between the auditor and the client. Some common elements in the scope of all audits are: 1. In-depth study of the accounting and internal control system 2. In-depth investigation of the books of accounts and associated records 3. Review of the financial report vis--vis the applicable Accounting Standards, Auditing Standards and statutory regulations 4. Reporting to the client Auditors and directors: The auditor is not responsible for preparing the financial reports of the company. As observed by the Council of Chartered Accountants of England and Wales, the directors are ultimately responsible for maintaining adequate records and preparation of annual accounts showing a true and fair view. Directors are also responsible for safeguarding the assets of the company and they should not depend upon the auditor to protect them from any deficiency in carrying out these responsibilities. The Research Committee of the ICAI has specifically stated that safeguarding companysassets is the primary duty of management and the auditor who is entitled to depend on the safeguards and internal controls which is established by the management. However, the fact remains that in forming and expressing professional opinion on the companys books of accounts, the auditor carries an independent responsibility that cannot be shifted to directors of the company. Self Assessment Questions 11. Auditor is not responsible for the preparation of financial accounts of the company. (True/False) 12. Explain the relative responsibilities of directors and auditors with respect to financial reporting.
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1.7 Philosophy of Auditing

According to Mautz and Sharaf, the philosophy of auditing is based on the following primary concepts: Evidence Due audit care Fair presentation Independence Ethical conduct Evidence: According to SA 500, AUDIT EVIDENCE, issued by ICAI, it is imperative that the auditor collects enough suitable evidence to substantiate the conclusions as described in the auditors report. Adequate suitable evidence does not mean definite proof. But evidence should be such that any reasonably competent person will accept it as a base for forming an opinion. For example, for verifying transactions in the bank book, the auditor should examine counterfoils of pay-in-slips, cheques, vouchers and bank statements thoroughly and not be content with test checking. Due audit care: The concept of due audit care is concerned with the determination of reliability and adequacy of evidence in support of observations made in the audit report. For example, a Bank Reconciliation Statement (BRS) prepared by an internal auditor who is independent of the cashier and accountant has more reliability to the external auditor than a BRS prepared by the cashier or accountant. Fair presentation: Presentation of financial statements is considered to be fair when it complies with recognized accounting principles, practices and standards. For example, accrual basis of accounting is a widely accepted practice whereas cash basis of accounting is not.

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Independence: Auditor should be self-governing in their approach and free from any biases and prejudices. Their responsibility is to safeguard the interest of all stakeholders who might make decisions based on the report. The auditor must make all efforts to earn and preserve their goodwill as a person of character and integrity. For example the Satyam episode involving fraudulent financial reporting abetted by the auditor has shaken the confidence of public at large and violated the concepts forming the philosophy of auditing. Self Assessment Questions 13. Sufficient appropriate evidence means conclusive proof. (True/False) 14. There is no difference between accrual basis of accounting and cash basis of accounting. (True/False)

1.8 Qualifications of an Auditor

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

1.9 Qualities of an Auditor

Apart from the professional qualification required of an auditor by law, he must have certain personal qualities without which he may not be able to perform his duties satisfactorily. These are: 1. Common sense: According to Spicer and Pegler the auditor should have a full share of that most valuable assetcommon sense. The Satyam case demonstrates this aspect vividly, because application of common sense would have raised the question: why was the company sitting on such a huge pile of cash year after year?

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2. Independence: An influenced or biased person cannot form an independent opinion. Thus, a direct or indirect interest in the results of the company under his audit may prevent an auditor from functioning independently. 3. Honesty and Integrity: An auditor is answerable to owners of a business who have no say in its management, and so must have unimpeachable integrity.For example, the auditor of XYZ Company believes that closing stock has not been properly valued but accepts a certificate from the management as to its valuation. This is plain dishonesty. 4. Objectivity: An auditor should not allow subjective judgment to cloud his opinion, which should as far as possible be based on facts. 5. Communication: He should be able to communicate effectively, both orally and in writing. Particularly in the matter of report writing, he should be able to convey his message clearly and unambiguously. 6. Tactfulness: He should be firm, yet diplomatic with his client and staff. Discovering the truth from a mass of facts and figures requires a great deal of tact. 7. Awareness of latest developments: An auditor should keep up to date with changes in laws, changes in professional standards, developments in technical guidelines etc. Self Assessment Questions 15. A partnership firm in which all the partners are ______________ holding certificate of practice may also be appointed as an auditor of a company. 16. The auditor should have a full share of that most valuable commodity ____________.

1.10 Advantages of Financial Audit

1. Statutory financial audit gives the owners of a company and other stakeholders the assurance that annual financial reports give true and rational view about the companys financial performance. 2. Tax audit viz., the audit of financials of the company based on which taxable income is determined and tax paid is mandatory. Tax auditors report has to be filed with the tax return.
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3. Internal financial audit assists the CEO and his team of operating managers regularly and much more frequently in understanding the financial performance of the company and taking corrective actions necessary. 4. Financial audit is an invaluable tool for prevention and early detection of fraud and errors. 5. Audited financial report together with the auditors report is necessary for a company in sourcing funds from banks and other financial institutions. 6. The audited balance sheet of a company read with the auditors report is often the base document for valuation of companies in case mergers, acquisitions or outright sales. Self Assessment Questions 17. Audit keeps management more alert and vigilant. (True/False) 18. The Income Tax Act does not contain a provision for holding tax audit. (True/False)

1.11 Limitations of Financial Audit

As per SA 200A issued by The Institute of Chartered Accountants of India, the objective of an audit is to express an opinion as to the true and fair view of the financial statements. The audit gives no assurance on the future viability of the enterprise or the efficiency or effectiveness with which the management has conducted the affairs of the enterprise. It should also be understood that audit of accounts does not guarantee the detection of all the errors. These conceptual restrictions arise due to following inherent limitations of auditing: 1. It is a post-mortem: The annual statutory audit is not a concurrent activity, but starts only after the year is over. Naturally, the auditor has to rely on explanations given to him by the accountant for activities that happened quite a while ago. The essential truth behind some of the figures may therefore still remain undiscovered. 2. It is a test check: The auditor cannot examine all the transactions given the time and cost constraints. He applies test checks using statistical sampling techniques. The inherent weaknesses of such methods carry an element of uncertainty or risk. Thus, auditing only reduces and does not eliminate the possibilities of erroror fraud.
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3. Inherent limitations of internal control system: An auditor largely relies on the internal controls of the enterprise as he cannot check everything. Internal controls are the inbuilt checks and balances in the companys accounting and administration. But these internal controls themselves are subject to some limitations: (a) Certain levels of management may override control and make exceptions to procedures. (b) Persons operating the internal control and employees or outside parties may collude and render the controls ineffective. (c) There is also human error that may escape the controls. Self Assessment Questions 19. Ram and Rahim invested in shares of Sure Grow Ltd. They lost their investment. They sued the auditor on the plea that auditors had given a clean audit report for the last few years. Comment. 20. Auditing only reduces and does not eliminate the possibilities of errors and frauds in the books of accounts and financial statements. (True/False)

1.12 Summary

Financial audit is a systematic and independent check on the data, statements, records, operations and performance of an enterprise for an identified purpose. An audit consists of the following steps: observing and identifying the suggestions for examination, gathering evidence, evaluating them and formulating their judgment and communicating it through an audit report. The primary objective of financial audit is to examine the reliability and validity of the financial statements and give an opinion on the truthfulness and fairness of the presentations in those statements. The secondary objective of audit is to prevent and detect errors and frauds. The scope of an audit is dependent on the nature or kind of audit and the terms of agreement between the auditor and the client

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The philosophy of auditing is based on certain primary concepts viz. evidence, due audit care, fair presentation, independence and ethical conduct. Only a person who is a Chartered Accountant within the meaning of the Chartered Accountants Act, 1949 and holds a certificate of practice can be appointed as an auditor in an organisation as per section 226 of the Indian Companies Act, 1956. Apart from professional qualifications, an auditor must possess certain personal qualities like common sense, integrity, tactfulness, objectivity and good communication skill. Auditing helps both external and internal stakeholders in taking logical and informed decisions by enhancing the reliability of financial statements. Audit does not guarantee 100% error-free reporting. Users should understand the limitations inherent in auditing.

1.13 Glossary
Postulates: fundamental truths or assumptions of a theory Principles: broad generalizations inferred from postulates Standards: quality of performance criteria Procedures: specific acts to be performed Techniques: methods used for carrying out a procedure Financial Statements: Balance sheet and Profit and Loss Accounts etc. Error: any unintentional mistake or wrong description in the books of accounts or records Fraud: An intentional act by one or more individuals of management, employees or outsiders, severally or jointly, involving the use of deception to obtain an unjust or illegal advantage.

1.14 Terminal Questions

1. Define and explain the term auditing. 2. An auditor is a watchdog and not a bloodhound. Comment. 3. What are the objectives of auditing?
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4. Personal qualities of an auditor are important for the successful conduct of audit. Comment. 5. Discuss, in brief, the advantages and limitations of auditing.

1.15 Answers
Self Assessment Questions 1. True 2. The advent of the joint stock company form of business organisation gave rise to the concept that owners of a business and managers were not the same. The owners therefore needed an independent review and audit of the accounts, and a forewarning if the managers indulged in any acts that would be detrimental to their (owners) interests. 3. True 4. False 5. True 6. False 7. Efficiency 8. True and fair 9. Reliability and validity 10. As per SA 240, Auditors responsibility to consider fraud and error in an audit of financial statements, subsequent discovery of undetected material misstatements of financial information resulting from errors and frauds does not necessarily mean that the auditor has been negligent in performing his duties if he had adopted adequate audit procedures as per auditing standards. 11. True 12. The directors are ultimately responsible for maintaining adequate records and preparation of annual accounts showing a true and fair view. Directors are also responsible for safeguarding the assets of the company, and they should not depend upon the auditor to protect them from any deficiency in carrying out these responsibilities. 13. The auditor is authorised to rely upon the safeguards and internal controls established by the management. However, in forming and expressing professional opinion on the companys books of accounts,

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14. 15. 16. 17. 18. 19.

20.

the auditor carries an independent responsibility that cannot be shifted to directors of the company. False Chartered Accountants Common sense True False According to SA 200A, Objective and Scope of an Audit of Financial Statements, issued by ICAI, the auditors opinion is no assurance of future viability of the business entity. In the given case, if the auditor has conducted audit as per requirements of SA 200, Basic Principles Governing an Audit and other statutory provisions, he cannot be held liable. True

Terminal Questions 1. Auditing is a systematic and independent examination of data, statements, records, operations and performance (financial or otherwise) of an enterprise for a stated purpose. In any auditing situation, the auditor perceives and recognizes the propositions before him for examination, collects evidence, evaluates the same and on this basis, formulates his judgment which is communicated through his audit report. For more details, refer to section 1.4. 2. The learned judge Lopse summed up auditors duty by stating Auditor is a watchdog, not a bloodhound. For more details, refer to section 1.5. 3. According to De Paula, The main object of an audit is to ascertain that the Balance Sheet and Profit & Loss Account of an undertaking shows a true and fair view of its financial position and earnings. For more details, refer to section 1.5. 4. Apart from the professional qualification required of an auditor by law, he must have certain personal qualities without which he may not be able to give satisfactory performance. For more details, refer to section 1.9. 5. Statutory financial audit gives the owners of a company and other stakeholders the assurance that annual financial reports provide a true and rational view of the companys financial performance. For more details, refer to section 1.10 and 1.11.
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1.16 Case Study

Menon & Menon Industries Ltd. Menon & Menon Industries Limited is a small sized family company for which you are appointed as the auditor for the year ended 31st March 2009. The company has made rapid progress during the current financial year. Turnover has increased from ` 2.2 crore to ` 5.5 crore, net profit from ` 6,50,000 to ` 11,25,000 and net assets from ` 2.8 crore to ` 5.6 crore. The entire share capital is owned Mr. Rahul and his two sons. by the Menon family comprising

The Accounts department of the company has also witnessed an expansion with three additions, one of whom is a qualified accountant designated as Chief Accountant and reporting to Mr. Rahul. You have indicated to Mr. Rahul that an increase in the audit fees is inevitable because of the all-round growth in the company and the increased number of transactions. Mr. Rahul considers this unjustifiable and even suggests that his being a family business, an audit itself is not necessary. Questions 1) Explain to Mr. Rahul why audit is necessary. 2) Outline the basis for determining your audit fees. 3) Explain briefly the benefits of an audit and give three specific uses of audited accounts.
Source: AUDITING by Shekhar & Shekhar published by Vikas Publishing House Private Ltd (Adapted)

Answers 1) The Indian Companies Act, 1956 stipulates that every private or public limited company shall appoint an auditor who shall report to the members of the company. Thus, getting the accounts of the company audited by a qualified auditor is an essential legal requirement regardless of size or family holding.In addition to the legal requirement, an independent audit of the accounts of the company would give credibility to its financial statements and confidence to outsiders to deal with the company in whatever capacity.
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2) The criteria for determining the audit fees usually are: The general and special skills involved The extent of responsibility and The time taken to perform the audit In the case of Menon & Menon Industries Limited, it should be noted that the expansion of the Accounts Department is a clear indication of expansion in the nature and number of accounting transactions. This automatically increases the auditors responsibility in carrying out an examination of the companys accounts, mean higher skills and significantly more time. The increase in the audit fees proposed by the auditor is therefore justified. 3) Refer 1.9 for the benefits of an audit. Three specific uses of audited accounts are: 1) In sourcing of funds from banks and other financial institutions 2) In negotiating with major suppliers for obtaining beneficial trade terms 3) In giving assurance to the owners that the business is being carried on efficiently, as the owners will not generally have control over the day to day affairs of the entity. References: Shekhar & Shekhar (2003), Auditing,Vikas Publishing House Private Ltd, New Delhi Ravinder Kumar, Virender Sharma. (2006). Auditing: Principles and Practice, PHI Learning Pvt. Ltd., Jagadish Prakash, (1969) Auditing Principles and Practices, Kalyani Publishers Clifford Gomez (2012) Auditing and Assurance, PHI, New Delhi Basu, S. K., Auditing: Principles and Techniques, Pearson Education, India. S D Sharma (2008).Auditing - Principles & Practice in India,Taxmann Publications e-references: www.icai.org

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