Q. What do you understand by Auditing ? Briefly explain the advantages and limitations of Auditing.
Ans. MEANING OF AUDITING: The English word ‘Auditing’ is derived from the Latin word ‘Audire’, which literally mean ‘to hear’. Auditing implies the examination of books of accounts and related documents of an organisation in order to correctly estimate their accuracy, completeness and regularity. Such an examination is carried out by a competent and unbiased person with the help of evidences, documents, information and explanations given to him. For example, if a person goes to a doctor to have himself examined, the doctor, only after a thorough examination of his body, gives his report as to whether he is healthy or not, and if not, what is the ailment he is suffering from. In the same manner, a businessman gets his books of accounts examined by a doctor of books of accounts (i.e the auditor) who, after a thorough examination of the books, gives his report as to whether or not they give a true and fair view of the statement of affairs of the business, and if not then what are the errors, deficiencies and faults in them.
According to Montgomery, “Auditing is a systematic examination of the books and records of a business or other organisation in order to ascertain or verify and to report upon, the facts regarding its financial operation and the result thereof.”
Thus, Auditing is a special and critical examination of the books of accounts of a business organisation, conducted by a competent and unbiased person with the help of vouchers, documents, information and explanations provided by the organisation, on the basis of which he can report on the books of accounts for a specific period as to:
(a) Whether the accounts are complete and drawn up according to conventions or not,
(b) Whether the Balance Sheet gives a true and fair view of the financial position of the organisation, and
(c) Whether the Profit and Loss Account depicts the true profits or losses of the organisation or not.
ADVANTAGES OF AUDITING: The various advantages of audit are as follows:
(I) General Advantages: The general advantages of audit are as follows:
(1) Knowledge of the Actual Position of the Business: Through an audit the actual position of the business comes to light. The owners of the business are assumed that the results being shown by the Profit and Loss Account and Balance Sheet are correct.
(2) Detection of Frauds and Errors: During the examination of accounts in the course of the audit, the frauds and errors contained therein, also come to light. This also reduces the chances of frauds and errors being committed in the future.
(3) Moral Pressure on Employees: When the employees are aware of the fact that their work is going to be examined by an independent person, there is an indirect fear among them, and they do their work with much greater regularly, competency and caution. They do not have to do anything wrong or be negligent. As a result of this the possibilities of frauds and errors being are also reduced.
(4) Alertness among Employees and Management: Audit makes the employees and the management more alert as it results in healthy criticism of their work. The employees become more disciplined and adopt better policies and procedures. Work gets completed as per schedule. The control exercised through the audit also helps in reducing corruption and judging the honesty and capability of employees.
(5) Proper Valuation of Business: If any business is to be sold or in case a firm is to be converted into a company, then audited accounts are helpful in proper valuation of the business and the valuation of goodwill. In fact, audited accounts are considered more dependable than unaudited ones.
(6) Increase in Goodwill: Public puts greater faith in accounts of organisations who get their accounts audited, which enhances the goodwill of the business. The increase in goodwill makes it very easy for the organisation to obtain loans from banks and other financial institutions.
(7) Helpful in Receiving Compensation: In case of accidents such as fire, theft, etc., audited accounts are more helpful in receiving compensation from insurance companies.
(8) Helpful in Assessment of Tax: Assessment of tax is much easier on the basis of audited accounts otherwise officers usually define tax liability arbitrarily. Hence, audited accounts are helpful in preventing arbitrary assessment of tax.
(9) Helpful in Getting Declared as Insolvent: When the state of the business becomes so bad, that its liabilities exceed its assets, then the businessmen often wants to be declared as insolvent so that he may be relieved of his liabilities. In such cases, the description provided by audited accounts serves as a better evidence in courts.
(10) Helpful in Formulating Dividend and Bonus Plan: The audit of accounts certifies the truthfulness of the Profit and Loss Account, and as a result, it becomes easier to declare and distribute dividends as well as proper disbursement of bonus is facilitated. This is because the shareholders and the workers consider the audited accounts as correct and have faith in them.
(11) Availability of Valuable Suggestions: The auditor from fime to time keeps on giving
suggestions to his client regarding book-keeping and accountancy, so.as to prevent frauds and errors. Apart from this, the suggestions of the auditor are also useful in other business matters.
(II) Advantages to Various Organisations:
(A) To Sole Proprietorship Concerns: Apart from the above benefits, audit has the following advantages in case of a sole proprietorship concern:
(1) Proof in Court: If in any business dispute any fact is to be established through the books of accounts, then audited accounts can be produced as evidence in courts.
(2) Helpful in Conversion of Business into Partnership: In case a sole proprietor wants to convert his business into a partnership firm, i.e. wants to take in another person as a partner in his business, or himself wants to become a partner in another firm, then audited accounts prove very helpful.
(3) Comparative Study Possible: In case the accounts for a number of years need to be compared, on the basis of the audit reports of the said years the accounts of one year can be compared with those of another. This makes a comparative study of profits and losses or income and expenditure possible.
(4) Helpful in Assessment of Wealth Tax: If the sole proprietor has a lot of assets, and upon his death taxes are to be paid upon his wealth, audited accounts prove very helpful.
(5) Helpful in Assessment of Income Tax and Sales Tax: While determining the liability for income tax and sales tax the concerned officers lay much greater reliance upon audited accounts.
(B) To Partnership Firms: Audit has the following advantages in case of a Partnership firm:
(1) Mutual Confidence among Parties: Normally, all the partners do not participate in the day-to-day running of the business of the firm. If the accounts of the partnership firm have been audited, it helps in building mutual confidence among the partners. In case the firm also has sleeping partners, the audit of the accounts of the firm becomes even more necessary since the sleeping partners do not have complete information about the business of the firm. Hence, audited accounts reduce the chances of disputes at the time of division of profits among the partners, and the work of the firm can proceed without any hindrance.
(2) Helpful in Valuation of Business and Goodwill: In case of admitting a new partner into the business of the firm, or at the time of retirement or death of a partner, the valuation of the business, and the valuation of its assets and liabilities and the goodwill of the firm, is greatly facilitated if the accounts have been audited.
(3) Peaceful Settlement of Accounts: At the time of dissolution of the firm, the assets and liabilities of the firm can be divided among the partners in a peaceful manner on the basis of audited accounts.
(C) To a Joint Stock Company: The advantages of audit to a joint stock company, apart from the general advantages mentioned above, are as follows:
(1) Confidence among Shareholders in Management: A company has a system of representative management. The management of the company is in the hands of a few selected shareholders (the directors). The remaining shareholders do not participate in the management of the company. Hence, the managers of the company with the help of getting the accounts audited assure the shareholders that they have been working properly and that they have not misused their position in the company in any manner.
(2) Easy Availability of Investment: A company accumulates capital by issuing shares and debentures to the public. The public has faith on audited accounts and it is on the basis of the same that it invests capital in the company.
(3) Helpful in Declaration of Dividends: Since audit certifies the profits of the company, hence at the time of declaration and distribution of dividends no suspicious are aroused. The auditor certifies in his report that the dividend has been declared and distributed at an appropriate rate.
(4) Facilitates Amalgamation, Absorption and Reconstruction of Companies: Whenever, companies are amalgamated, absorbed or reconstructed, then deciding the purchase consideration is greatly facilitated by audited accounts. In such situations, audited accounts are considered to be more reliable.
(D) To other Parties: Audit has the following advantages for other parties:
(1) When any property is placed in a trust for the benefit of a particular person then the trustee, in order to present in front of others that he has done the work of the trust honestly, gets the accounts of the trust audited.
(2) Audited accounts of a business are helpful for an insurance company when the amount of loss is to be estimated in case of a fire. The insurance companies on the basis of the audited accounts of the organisation can find out whether the claim filed by the organisation is correct or not. This becomes very difficult in case the accounts have not been audited.
(3) Banks and other money lending institutions can take decisions as to whether or not to lend money to a particular organisation on the basis of audited accounts.
(4) If any external person wants to purchase an organisation, then audited accounts a very helpful in deciding the purchase consideration. In case the accounts have bee audited and certified they serve as a basis for the purchasers to decide upon t purchase consideration.
(5) Audited accounts are very helpful for government employees. While levying sales tax, income tax, wealth tax and expenditure tax.
(6) The court, in any case, can also rely upon audited accounts as evidence. One can present one’s case better in front of courts by providing audited accounts as evidence.
LIMITATIONS OF AUDITING: Despite the exercise of utmost diligence, caution and competence on the part of the auditor some frauds and errors in the books of accounts may escape getting detected. Hence, before reaching any conclusions on the basis of the auditor’s report, the following limitations of audit must be kept in mind:
(1) Auditing is not a Conclusive Proof of the Honesty of Employees: If the organisation has a system of internal check and the auditor is satisfied with the working of the same, then he may certify the accuracy of the accounts by resorting to test checking. In a system of internal check also, two or more people can team up and commit fraud, and such frauds may not come to light during the audit. Hence, getting the accounts audited doesn’t certify that the employees of the organisation have worked honestly throughout the period under review.
(2) Auditing doesn’t Guarantee cent-per-cent Accuracy: Normally, large organisations have a very large number of transactions during the financial year. Hence, it is not possible for the auditor to examine each and every transaction in detail, nor it is viable in terms of wastage of time, effort and money. In such cases the auditor resorts to test checking and hence it is only natural that some frauds and errors may remain undetected.
(3) Minor things are not paid attention: The auditor, during the course of his examination, gives full attention only to matters related to Profit and Loss Account and Balance Sheet. He does not pay much attention to small transactions or transactions entered into by the lower staff of the organisation. Hence, it is possible that a few irregularities may remain undetected at the lower levels, despite the audit.
(4) Certain Frauds may Remain Undetected: Despite the exercise of due diligence, competency and efficiency on the part of the auditor, intentional and pre-planned frauds committed by the top managers or other responsible employees of the organisation may escape getting detected.
(5) Auditor does not understand the Nature of all Business Transactions: Even though the auditor examines the accounts of organisation in a variety of fields, it is not necessary for him to understand the nature of each and every transaction. Hence, it is not possible for the auditor to certify as to whether a particular transaction makes business sense or not. During the course of audit, transactions are examined from the legal point of view and not from the point of view of appropriateness.
(6) Auditor merely expresses his Opinion: The auditor merely expresses his opinion on the accounts of the organisation. By expressing his opinion that the Profit and Loss Account and Balance Sheet are correct does not mean that there can be no irregularity in the books of accounts. Even though he gives his opinion after due examination, he is also human, and human beings make mistakes.
(7) Auditor does not Enjoy Practical Freedom: Even though an auditor is considered to be an independent person, since his rights, duties and responsibilities have been specified by the Companies Act, 2013, in practice the managers of the company appoint their own persons as auditors of the company. The auditor is influenced by the management of the company, and hence is not able to conduct a completely independent examination of the books of accounts and give his report on the same.
