Back to basics — Audit

A change in nature and scale of operations has also resulted
into a change in the manner of record keeping. Enterprises have shifted from
manual records to computerised system of book keeping. Most of the records are
now kept in computerised format. Certain important controls are built in the
computerised system itself. With the opening up of the economy, exposure of
domestic businesses to the world market has increased. It has given rise to
substantial foreign currency transactions, various types of financial
products/instruments and different way of addressing the fund requirement. As a
result, accounting has also become much more complex. To deal with some of the
complexity, number of accounting standards have been introduced/revised which
are mandatory.

The new challenges have obviously brought a change in the
audit approach as well. To bring uniformity in audit and to maintain its
quality, various standard auditing practices have been prescribed by The
Institute of Chartered Accountants of India (ICAI). In all, there are more than
35 Auditing and Assurance Standards which have been issued by ICAI. With a view
to converge them with the International Standards, recently they have been
renumbered and are now called Engagement & Quality Control Standards. These
auditing standards are guide to an auditor for conducting an audit in an
effective manner. It also provides elaborate procedures and tools for conduct of
audit.

In spite of this, worldwide many enterprises are suddenly
folding and many of them have gone into liquidation. When such an event happens,
role of the auditor is always questioned and in many cases auditors are found to
have committed lapses in their work. The question which arises is whether all
these auditing standards and using modern techniques have improved quality of
audit ? I believe that it has not yielded expected results as the basics of
the audit are either forgotten or not applied properly. In the subsequent
paragraphs, I have discussed certain basics which should not be forgotten in the
new era. In my view, these basics need to be applied along with the modern
techniques of ‘audit’ to improve quality of audit.

1. Cut-off procedure and checking :

Cut-off is a process by which one accounting period is
separated from another. It is important to have proper check of cut-off
documents to make sure that there is no over or understatement of revenue or
expenses. In the computerised environment it is difficult to check ‘cut-off’
procedures. It is important to understand the accounting software used and
control in the system by which no new transactions can be entered after the
cut-off date. It is important to check certain physical records such as
invoices, purchase orders, receipts and issue notes with the entry in the
computer software. To meet the stricter time deadline, one should not compromise
checking of ‘cut-off’ procedures.

2. Control in the Computerised

One should not blindly rely on the accounting software used
in the preparation of financial statements. In-built checks and balances in the
accounting software should be examined and it is necessary to confirm that they
meet the internal control norms. It is also necessary to ascertain other
software packages which interact with the accounting software and one must
ensure that there is no possibility of unauthorised intervention. It is also
important to keep record of changes made in the accounting system and their
implication. In case there is a weakness noticed in the computer system, manual
controls exercised to overcome the same should be verified. In manual record
keeping any changes made in the records are apparent, while in case of
computerised system it is not so. It is important to check the history file
created by the system to ascertain changes made in the record.

There is a general feeling that computer-generated statements
will not have any totalling error and will capture all the relevant items. Many
times this results into an error. It is therefore important to confirm that
relevant fields are properly captured in totalling. Simple technique like hash
total will ensure that relevant items are properly considered.

3. Prudence :

With the emphasis of fair value accounting in the modern world, accounting prudence is forgotten. The importance of prudence is highlighted only when something goes wrong. One should always keep in mind prudence even at the time of fair value accounting. In other words, when one is calculating fair value of assets or liabilities, prudence should be giVen importance and in the shadow of fair value, assets should not be overvalued or liabilities should not be undervalued. One should remain conservative in recognising revenue and in case of uncertainty, should follow the principle of postponing the revenue till the time certainty of its recovery is established. At the same time probable loss or expense should be recognised in the financial statements and should not be reversed till the time probability exists of its materialising. As India is preparing for conversion of its accounting standards to International Financial Reporting Standards (IFRS), it is also moving towards fair value accounting and in this journey it is important to keep the principle of prudence alive. With the recent financial crisis the world is facing, a debate has already started in the United States and Europe about blind acceptance of fair value accounting.

4. Substance over Form:
This concept is quite important in current scenario. With the advent of various structured products in the financial market, it is important to understand the intrinsic nature of a product. Without this understanding, there can be fatal error in accounting. In-depth understanding of the product is required before one judges its accounting treatment. Many times, implication of certain clauses in such agreements are not known even to the management of the company and in the process they are not aware of risks the organisation is exposed to. It is the duty of the auditors to go into the important terms and conditions of such products and if necessary, make management aware of the substance and its implication. In a situation where audit firm does not have internal expertise in understanding such products, one should not shy away from taking help of another fellow member or an expert. Many frauds happen when substance is different than form. Auditors need to keep in mind that form of instrument should not over-shadow its substance. An audit team needs to have proper training, so that such instances can be detected to make appropriate adjustments in accounting.

5. Professional Judgment:
With so many quality control (auditing) standards and importance given to documentation, audit is becoming a rule-based exercise and many times lacks proper application of mind. Here, I am not trying to undermine importance of documentation. It is important to have proper documentation to prove that proper audit was conducted and to avoid charge of negligence. At the same time, professional judgment is also important, which is gained by experience. Professional judgment is an art and is an important element of any audit.

An experienced auditor is aware of the need to develop a rapport with key personnel of the organisation without compromising independence. It is important to have constructive conversation with key employees in departments other than finance. Many times such interaction gives important clues to something wrong happening in the accounting. A Latin meaning of the word ‘Audit’ is ‘he hears’ and this quality of hearing others is important part of audit. The acquisition of technical knowledge and skill, no matter how extensive, will take one so far and no further. Good auditors are those who have developed their intuitive skills in a manner that technical knowledge can be applied in a given situation. Professional judgment is also to be applied in ascertaining that audit findings are material enough to affect true and fairness of the financial statements presented. For materiality, one should not merely go by percentage of profit or sales, but should apply his professional judgment for correct reporting on the financial statements.

Substantive Tests:

Substantive test is one of the important audit tests performed. It is a test of transactions and balances, and other procedures such as an analytical review, which provides audit evidence as to the completeness, accuracy and validity of financial information contained in the accounting records. The nature, extent and timing of the tests are determined by the degree of reliance which the auditor can place on the internal and operational controls.

Successful of audit depends upon proper selection of samples. Nowadays, substantive tests are conducted in a routine manner. Samples are chosen on the basis of random number selections. What is missing is proper designing of substantive tests. There should be intelligent selection of samples based on the review of main ledger accounts and after conducting analytical review. One should also remember that vouching has its place in audit, though this method of audit testing is time-consuming. By vouching the auditor goes behind the accounting records and traces the entries to their source. Where the internal controls system is weak, vouching may not be effective as the information may have been purposely entered and may be contrary to the facts. In case of a reasonable internal control in place, vouching should be carried out of key operational areas.

Before I conclude I would strongly recommend that the auditor should ensure that the business carried on by the auditee is authorised by its objects clause and the various authorities within the company operate within their sanctioned prescribed limits.

Conclusion

The challenge is to have a blend of basic and modern techniques for an effective audit. Basics of audit should not be forgotten whilst implementing modern audit techniques and approach.