Auditing and corporate governance, Study notes of Auditing

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AUDITING

AND

CORPORATE GOVERNANCE

Dr. Biswa Mohana Jena

M.Com., M.Phil., Ph.D., UGC-NET

Head, Department of Commerce & Economics, Netaji Subhas Chandra Bose (Govt. Lead) College, Sambhalpur, Odisha.

[As per New CBCS Syllabus, w.e.f. 2018-19]

Dr. Braja Kishore Das

M.Com., M.Phil., Ph.D. Senior Faculty in Commerce, Nimapara Autonomous College, Nimapara, Odisha.

PREFACE

Audits are first and foremost intended to give comfort to shareholders or

investors on the integrity and quality of a company’s financial statements. However,

in principle, auditors also work hand in hand with regulators to provide prudential

oversight over the financial markets. This alignment of interests requires a far broader

perspective from the accountancy profession than it did 20 years ago. External auditing

has evolved from a routine checking of the books of account to a vital part of the

governance process of companies. Factors such as the volume of transactions,

information technology, globalization and the constant increase in the complexity and

number of laws, regulations and standards governing entities and their auditors have

all impacted drastically on the evolving role of the registered auditing profession. The

corporate collapses, business failures and fraudulent financial reporting scandals of

the late 1990s and early 2000s led to a very turbulent time and resulted in a credibility

crisis for the auditing profession. One of the consequences of this was the demise of

Arthur Andersen and the resultant decrease in the number of big audit firms from

five to four. A further consequence was the drastic intervention by governments,

regulators and the auditing profession itself, which have given rise to various and

onerous new laws, regulations and standards that govern financial reporting and the

auditing thereof.

This book is an adventure into the world of auditing, business ethics, corporate

governance and corporate social responsibility. Only I have made humble attempt to

fill up the gap and help the students and teachers community giving them a suitable

textbook catering to their special needs. The subject matter of the textbook has been

presented in a logical order. The language is simple, lucid, convincing and easy to

understand. I wish to express my gratitude to Mr Bijay Ojha, Himalaya Publishing

House Pvt. Ltd. for his cooperation and making resources available to complete this

book. Constructive suggestions for the improvements in the quality and utility of the

book from teachers, students and other readers will be greatly appreciated.

Dr. Biswa Mohana Jena Dr. Braja Kishore Das

UNIT – III SPECIAL AREAS OF AUDITING

Chapter 9 Special Areas of Auditing 131- 9.0 Introduction 9.1 Audit of Clubs 9.2 Audit of Cinema Halls 9.3 Audit of the Charitable Societies 9.4 Audit of Cooperative Societies 9.5 Audit of Hotels 9.6 Audit of Educational Institutions 9.7 Audit of Hospitals 9.8 Audit of Nursing Homes 9.9 Introduction on Cost Audit 9.10 Importance of Management Audit 9.11 Concept of Social Audit 9.12 Definition of Tax Audit 9.13 Environmental Audit 9.14 Trends and Ideas in Accounting and Auditing 9.15 Review Auestions Chapter 10 Auditing using Computer Tool 166- 10.0 Introduction 10.1 Auditing around the Computer 10.2 Auditing with the Computer 10.3 Auditing through the Computer 10.4 Characteristics of Auditing through the Computer 10.5 Internal Controls in an Auditing through the Environment 10.6 Classification of Control Procedure 10.7 Computer Assisted Audit Techniques 10.8 Review Questions Chapter 11 Auditing Standards 176- 11.0 Glimpses of Standards 11.1 Auditing and Assurance Standards 11.2 New Auditing Standards 11.3 Accounting Standards 11.4 Standards on Auditing

12.0 Introduction 12.1 Meaning 12.2 Definition 12.3 Why Corporate Governance? 12.4 Need for Corporate Governance 12.5 Features of Corporate Governance 12.6 Objectives of Corporate Governance 12.7 Importance of Corporate Governance 12.8 Factors influencing quality of Corporate Governance 12.9 Elements of Corporate Governance 12.10 Mechanism of Corporate Governance 12.11 Principles of good Corporate Governance 12.12 Role of SEBI in Corporate Governance 12.13 Secretarial Standards 12.14 Good Corporate Governance companies in India 12.15 Models of Corporate Governance 12.16 Theories of Corporate Governance 12.17 Review Questions Chapter 13 Reforms, Committee and Scandals 230- 13.0 Corporate Governance Reforms in India 13.1 Types of Committee Reports on Corporate Governance 13.2 Whistle Blower Policy 13.3 Indian Experiences 13.4 Composition of Committee of Corporate Governance 13.5 Codes and Standards on Corporate Governance 13.6 Corporate Scandals 13.7 List of Scandals without Insolvency 13.8 Corporate Governance Failure at Enron 13.9 Corporate Governance Failure at WAL-MART 13.10 Corporate Governance Failure at SATYAM 13.11 Corporate Governance Failure at CADBURY 13.12 Major Scandals in India/abroad 13.13 Review Questions

Chapter 8 Liabilities of Company Auditor 121- 8.0 Introduction 8.1 Professional Negligence 8.2 Civil Liabilities 8.3 Liability under Consumer Protection Act 8.4 Liability for Unaudited Statement 8.5 Liability for negligence of Assistants 8.6 Criminal Liability 8.7 Liabilities under Income Act. 1961 8.8 Punitive provisions relating to Statutory 8.9 Review Questions

UNIT – IV CORPORATE GOVERNANCE

Chapter 12 Corporate Governance: Concept, Theory and Models 216-

UNIT – V Coporate Social Responsibility

Chapter 14 Concept of Corporate Social Responsibility 244- 14.0 Introduction 14.1 Relationship of CSR with Corporate Sustainability 14.2 Components of Strategic Planning and CSR 14.3 Corporate Governance vs. Corporate Social Responsibility 14.4 CSR and Business Ethics 14.5 Corporate Philanthropy 14.6 Companies doing Corporate Philanthropy 14.7 Types of Corporate Philanthropy 14.8 Companies having highest Corporate Social Responsibility 14.9 Environmental aspects of Corporate Social Responsibility 14.10 Review Questions Chapter 15 Provisions, Models and Standards 263- 15.0 Introduction 15.1 The Pyramid of CSR 15.2 Theoretical Assumptions 15.3 Scope of Responsibilities 15.4 Total CSR 15.5 Order of Importance 15.6 The role of Philanthropy 15.7 The Intersecting Circle Model of CSR 15.8 The Concentric Circle Model of CSR 15.9 Provision of CSR Rules under Companies act, 2013 15.10 Strategic Corporate Social Responsibility 15.11 International Standard for CSR 15.12 ISO 26000

• Social Responsibility 15.13 ISO 26000:2010 15.14 Corporate Codes 15.15 Committees on Corporate Social Responsibility 15.16 Review Questions Multiple Choice Questions 278- Interview Questions and Answers 285- Big 4 Accounting Firms 292 Test Your Knowledge 293-

Concept of Auditing 1

LEARNING OUTCOME

Going through the chapter carefully, we could

• •••• Understand the origin and concept of audit planning
• •••• Be aware with the different objectives of auditing

CHAPTER OVERVIEW

EVOLUTION-DEFINITION-ADVANATGES OF AUDITING –

AUDIT PLANNING – OBJECTIVES OF AUDITING

1.0 EVOLUTION OF AUDITING

Historically the word “Auditing” has been derived from the Latin word “Audire” which means “to hear”. Such an expression conveys the steps of evolution of auditing in ancient days. However, in the post-ancient period auditing has explored dramatic changes. According to Dixie, traditional auditing can be understood as an examination of accounting records undertaken with a view to establishing whether they completely reflect the transaction correctly for the related purpose but this is not the end of the story. In addition to it, the auditor also expresses his opinion on the financial character of the statements of accounts prepared from the accounting records so as to examine whether they portray true and fair view of financial statements. The term audit is used in this sense ever since the days when public accounts were accepted and approved on the basis of leaving the accounts read. It was Luco pacilo who introduced double entry book keeping .He defined and described the duties and responsibilities of an auditor. Since then, there have been

CONCEPT OF AUDITING

Chapter (^) 1

Unit - I AUDITING

2 Auditing and Corporate Governance

far reaching changes in the scope and definition of audit. Further, the industrial revolution in England compelled the necessity of auditing. When first companies act of 1913 came in to force, made it obligatory on the part of every company registered under it, to have the accounts audited at least in every year.

1.1 DEFINITION OF AUDIT

Concept of Auditing dates back to ancient Egyptian, Roman and Greek Civilizations, where commercial transactions were systematically checked and counter checked by financial administrators. In India, Pre-Vedic literature makes references to the existence of well developed system of accountancy. In ancient times, auditing was coupled with the levy of tax. Whenever taxes were levied on commercial transactions, auditing became inevitable. When a person was appointed to administer finance, the amount received and payments made by him were checked by another official either periodically or at the time of expiry of his term of office. The objective, technique and approach of today’s audit are entirely different from that of the past. One can say that the change in the technology, expansion of business organization, diversification of activities have influenced and altered the auditing scope and techniques. Present day Auditing has come a long way from traditional auditing Traditional auditing involved vouching of all transactions, verification of posting to ledgers, detailed verification of documents, subsidiary books and the principal books of entries. This was possible because the business entities were small, the transactions were not many, the activities were localized and traditional method of book keeping was followed.

In the contemporary world, businesses organizations have expanded and diversified their activities .The transactions have become numerous. The fast developing communication technology has shrunk the earth into a global village. Transactions are made through internet across the world. Rates are fixed over telephone. Receipts and payments are made on line. Use of paper work has been reduced greatly .in these circumstances, it is impossible to apply the traditional methods of auditing.

Auditing is concerned with the verification of accounting data, with determining the accuracy and reliability of accounting statements and reports. - R.R. Moutz

Auditing is an intelligent and a critical scrutiny of the books of accounts of a business with the documents and vouchers from which they are written up, for the purpose of ascertaining whether the working results for a particular period, as shown by the profit and loss account, as also the exact financial condition of the business, as reflected in the balance sheet are truly determined and presented by those responsible for their compilation. - J.R.Batiboi

An audit is an exploratory, critical review by a public accountant of the underlying internal controls and accounting records of a business enterprise or other economic unit, precedent to the

expression by him of an opinion of the propriety of its financial statements. - Eric L. Kohler

According to the INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA, general guidelines in internal auditing 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 examination is conducted with a view to expressing an opinion thereon “In brief, auditing involves testing the reliability, competency and adequacy of evidence in support of monetary transactions. It has its principal roots in accounting with it reviews, on which it leans heavily for idea and methods.

4 Auditing and Corporate Governance

‹ The audited account serves as a basis to determine action in bankruptcy and insolvency cases. ‹ Comparison can be made between the accounts of the current year and other years. ‹ Audited accounts are helpful in claiming reasonable compensation from the insurance company in respect of loss by fire or burglary etc. ‹ Errors and frauds are detected and rectified. ‹ Audited accounts are more reliably accepted as a correct and authentic record of the transaction

1.3 AUDIT PLANNING

‹ Audit planning is one of the basic principles governing an audit. ‹ Auditor should plan his work to enable him to conduct an audit in an effective, efficient and timely manner. ‹ Planning should be based on knowledge of the organization. ‹ Whatever may be the type of audit? The auditor should know what preparatory steps are to be taken before the commencement of the work of audit. However the different steps to be taken before the commencement of a new audit are discussed below: ‹ Receiving the appointment letter or letter of engagement to verify the objectives, scope and coverage of the audit. ‹ Enquiring into the reasons for not appointing the previous auditor. ‹ Acceptance of appointment. ‹ Nature and scope of the work of audit, e.g I case of a statutory audit, the audit must be conducted as per the provisions of the statute concerned. In case of tax audit it must be according to the tax act and for others audits the auditor must know exact scope, coverage and objective of his audit. ‹ Nature and characteristics of the organizations under audit. ‹ Verification of important documents like constitutional document(e.g memorandum and articles in case of a company, partnership deed in case of a partnership firm etc. ‹ Complete list of the books of account and registers maintained by the company. ‹ Concepts of methods of maintaining accounts. ‹ A list of containing the names and signatures of the key personnel. ‹ Understanding the nature and extent of the internal control / internal check system working in the organization. ‹ Framing of audit program.

Concept of Auditing 5

1.4 OBJECTIVE OF AUDITING

The main object of auditing is to verify the accounts and to report whether the Balance Sheet and Profit and Loss account have been prepared as per the Companies Act and whether they show true and fair view of the state of affairs of the concern. Besides, there are certain subsidiary objects also to conduct an audit. They are as follows: (A) Detection and prevention of errors. (B) Detection and Prevention of Frauds. The various objects of an audit as shown in fig. 1.4 are detailed below.

1.4.1 Primary Objects There are two objectives, which are considered as chief objective of auditing. They are as below-

Objectives of Audit

Prim ary Ob jectives

Confirmity with Law

True and Fair view of state o f affairs of business

Detection and Prevention of Fraud

Clerical Errors

Errors of Duplication

Secondary Objectives

Detection and Prevention of Errors

Em bezzlement o f Cash

Misappropriatio n of goods

Manipulation of Accounts

Error of principle

Compen sating errors

Errors of Ommission

Error of Commission

Complete Ommission

Partial Ommission

1.4.1 PRIMARY OBJECTS

There are two objectives, which are considered as chief objective of auditing. They are as below-

(A) To see whether the Financial Statements are Prepared in Conformity with law-

‹ Business concerns prepare Balance Sheet to portray their financial position. ‹ They also prepare Profit and Loss account to disclose the operating results of the period covered in the statement. ‹ These statements are submitted to the Auditor for checking and comment. ‹ He checks the accounts with utmost diligence and care and also with professional competence. ‹ He verifies the accounts to whether they are prepared as per the recognized accounting policies and practices, and also in conformity with the relevant statue.

Concept of Auditing 7

‹ In all these cases, as only one aspect has been omitted it will affect the Trial and the omission will easily be detectable. Some of the errors omission is easily detectable. For example, if the number of rent or salary entries for a year is less than 12, the auditor can easily locate the omission. The errors of omission whether intentional or otherwise, will affect the profit or loss of the year.

(ii) Errors of Commission-

‹ Sometimes, entries are made in the books of original entry or ledger incorrectly either partially or wholly, such errors are called error of commission. ‹ Usually these errors arise due to negligence in recording of transactions in the books of accounts. ‹ Such errors may or may not affect the Trial Balance, Profit & Loss account and Balance Sheet. ‹ They may be intentional or otherwise. Following are the errors examples of errors of commission: ‹ A sale of 500 is entered in the sales book as 50 (i.e. Incorrect Recording). It does not affect the Trial Balance. ‹ Sale of 100 may be written as 10 to the debit of the customer’s account, thus debiting 90 less than the real figure (i.e. Incorrect Posting). The effect of this erroneous posting on the Trial Balance would be that the debit side would be short by 90 and it would show the difference. ‹ The balance of 125 on the debit of an account may be carried forward to the debit column of thee Trial Balance as 115 or 250, and even 125 may be written to the credit column of the Trial Balance, thus entering the correct figure against this account but in the column (i.e. Errors in Carrying Forward Totals to Trial Balance). (b) Errors of Principle ‹ Errors of principle arise when the entries are recorded against the fundamental principles of accountancy. ‹ Wrong allocation of expenditure between capital and revenue, valuation of assets against the principles of Book-keeping, providing inadequate depreciation, wrong provision for doubtful debts, ignoring the outstanding assets and liabilities, posting the transactions to wrong class of accounts, etc. can be cited as examples for errors of principle. ‹ Such errors can be committed either intentionally or unintentionally. ‹ If they are committed intentionally, the object here is to manipulate the accounts with an ultimate purpose either inflating or deflating the profits. ‹ As they affect the Profit & Loss account and Balance Sheet, the auditor must pay particular attention towards this kind of error. ‹ They are not disclosed by Trial balance or by Routine Checking.

8 Auditing and Corporate Governance

‹ In order to detect them, auditor has to carry out independent searching and exhaustive scrutiny, as these are very serious mistake affecting business to a great extent.

(c) Compensating Errors

‹ Compensating errors are also known as offsetting errors. ‹ An error compensated or counter balanced by another error is called as Compensating errors. ‹ In case of compensating errors, the adverse effect of one on debit side or credit side is neutralized by that of another on credit or debit side. Following are the examples of such errors: ‹ A’s account is debited with 100 shorts and credit side of his account is under cast by ‘ 100. ‹ Sales ledger is under cast by ‘ 1000 and purchase ledger also under cast by ‘ 1000. ‹ Compensating errors will not affect the Trial Balance and as such, will not be detected easily. These errors may or may not affect the Profit & Loss account. These errors can be detected by checking the totals, posting and casting. Ü A thorough and exhaustive preparation on the part of the auditor will help to detect such errors.

(d) Errors of Duplication

‹ Errors of duplication arise when an entry in a book of original entry has been made twice and has also been posted twice. ‹ These errors so not affect the agreement of Trial Balance, hence can’t be located easily. ‹ For example, invoice sent in duplicate entered twice in the books and posted twice in the Ledger. ‹ Only thorough checking and comparing vouchers with entries in the books of original entry will reveal such errors.

(B) Detection and Prevention of Frauds

‹ Various terms like fraud, embezzlement, and defalcation misappropriations are often used in a confused way. Hence it is desirable to understand the exact meaning of cache term. ‹ Fraud may be referred to intentional misrepresentation of financial information by one or more individuals among management, employees, or third parties. It may involve- ‹ Manipulation, falsification, or alteration of records of documents. ‹ Misappropriation of assets. ‹ Suppression or omission of effect of transactions from records or documents. ‹ Recording of transactions without substance. ‹ Misapplication of accounting policies.

1 0 Auditing and Corporate Governance

‹ Misappropriating money recorded as wages in the wages sheet by entering dummy names of worker therein.

(b) Misappropriation of Goods

‹ Sometimes, an employee may take away the goods of the company for his personal use. It is known as misappropriation of goods. ‹ Goods are generally misappropriated by actual theft of valuable goods and issuing of fictitious credit notes to customers. ‹ Misappropriation of goods is very difficult to detect when the goods are less bulky and are of higher value. ‹ Only the efficient system of record keeping, periodical checking, internal check, and adequate security arrangements will be helpful to avoid misappropriation of goods. ‹ Hence the auditor has to check thoroughly the inward and outward register, invoice, sales memo, audit notes, etc to detect this kind of fraud.

(c) Fraudulent Manipulation of Accounts

‹ Generally, upper level management commits this type of fraud in order to mislead certain parties both internal and external to the organization. ‹ Such frauds normally involve large amounts. ‹ They are committed intentionally .So they are difficult to be detected. ‹ There are two types of motives behind such manipulations They are as follows: (i) INFLATING THE PROFITS: If profit is inflated, it benefits the company, higher official etc, in the following ways: ‹ The manager may get more commission if it is calculated on the basis of profits earned ‹ To sell the shares he holds in the company at a high price by declaring higher dividend. ‹ The confidence of shareholders is maintained on the manager. ‹ To declare higher rate of dividend. ‹ The financial position of the business is shown better than what actually it is. ‹ To show credit worthiness to creditors, bankers etc (ii) DEFLATING THE PROFIT: showing less profit benefits the company as well as the executives in the following ways: ‹ To give a wrong impression about success of the business to competitors. ‹ To reduce / avoid payment of income tax. ‹ To purchase shares at a lower price in the market. Usually, the following devices are resorted to for falsification of accounts. ‹ Inflating or suppressing expenses or purchases. ‹ Inflating or suppressing sales or other incomes ‹ Over or under valuation of stocks.

Concept of Auditing 1 1

‹ Under or over valuation of assets and liabilities. ‹ Providing less depreciation or more depreciation or not providing for any depreciation.

1.5 REVIEW QUESTIONS

Short questions:

1. Define auditing?
2. Define Errors of commission and omission with examples?
3. State the characteristics of fraud?
4. State the circumstances where misappropriation of cash takes place?
5. What are the objectives of an independent audit? (Madurai b.com)
6. “Auditor is a watchdog and not a bloodhound”-Explain?
7. (a) Can a fraud is committed through an accounting procedure? (b) Is auditing a guarantee that there is no undisclosed fraud? (c) What are commonly used measures for prevention of frauds?
8. State the objectives of auditing (Utkal University, B.com.Pass.2009)
9. Distinguish between fraud and eroor (GM University, B.Com 2018)

Long Questions:

1. Define auditing. Discuss its scope and nature or features.
2. “Accounting is a necessity while auditing is a luxury for a business enterprise”. Do you agree? Give reasons for your opinion and examine critically the role of auditing in the efficient , honest ad economical conduct of a business? (University of Jodhpur, B.Com. 1998), Govt. (A) College, Bhavani Patna B.Com (H), 2018
3. (a) Describe briefly the main classes of errors and frauds. Is the auditor expected to detect all errors and frauds? (Delhi University, B.com hons. 2000), (B.com pass 2003) (Bombay University, B.com, 2003) (b) Can the auditor prevent such errors and frauds? or “Detection and prevention of errors are the main objects of auditing.” Discuss it fully and explain the duties of an auditor in this regard.
4. Auditing is a dynamic social science- comment.
5. ”Fraud doesn’t necessarily mean misappropriation of cash or goods.” Discuss giving illustrations.
6. Define an audit and state the various objects of an audit? (Osmania , Cal, Gauhati B.com)
7. “Teeming and landing is a process of misappropriating cash”- Explain the statement with example.
8. “Auditing can be termed as accounting control.” Explain the statment.
9. “Accounting begins where book-keeping ends and where accounting ends auditing begins”. Discuss. ( Lucknow B.com), (Ravenshaw University, B.Com(H) 2017)
10. Evaluate the following statements :

a) Every business entity should have an annual audit by a qualified auditor. To forgo an audit because of its cost is false economy .(Delhi University, B.com.Hons, 2004)