IGNOU Solved Question Papers: ECO - 12 (December' 2011)

Term-End Examination December, 2011
Time: 2 hours
Maximum Marks: 50 (Weightage 70%)
Note: Attempt any five questions. All questions carry equal marks.
1. Define Continuous Audit. Explain its advantages and disadvantages. 2+4+4
Ans: CONTINUOUS AUDIT: Continuous audit: Continuous audit is a system of audit where the auditor and his staff Examines all the transactions and books of accounts in details continuously throughout the year at regular intervals i.e. weekly or fortnightly or monthly etc.
According to Spicer and Pegler, “a continuous audit is one where the auditor’s staff is occupied continuously on the accounts the whole year round, or where the auditor attends at intervals, fixed or otherwise, during the currency of the financial year and performs an interim audit; such audits are adopted where the work involved is considerable and have many points in their favour although they are subject to certain disadvantages.”

Advantages of continuous audit: Following are the advantage of continuous audit in an organization. These are discussed below:
(i) Extensive checking: As the auditor regularly visits the client’s office, he should get time for extensive checking of small transactions and the audit work can ne smoothly conducted.
(ii) Early detection of errors and frauds: As continuous audit is conducted throughout the whole year, errors and frauds can be quickly detected. The accounting staff should not get sufficient time to manipulate accounts.
(iii) Early Preparation of Final accounts: AS this audit is conducted throughout the whole year, it is possible to prepare final accounts i.e. Profit and Loss account and Balance Sheet just at the end of the financial year. The management and the owners can know the financial results without delay.
(iv) Declaration of interim dividend: Those companies who want to declare interim dividend at the middle of the year is to prepare interim accounts. Continuous audit helps to get interim account in time.
(v) More reliability on audited accounts: If continuous audit is done throughout the year, all the interested parties can rely much on the audited accounts.
Disadvantage of continuous audit: The following are the disadvantages of continuous audit:
(i) High Cost: As continuous audit is conducted throughout the year the organization has to give huge remuneration to the auditor. Therefore, a small concern cannot afford the high cost of conducting such audit.
(ii) Difficulties in accounting work. As a result of frequent visits of the auditor often it is seen that the books of accounts are checked by the audit staff and for this audit work is hampered.
(iii) Change of figures: It may so happen that the portion of accounts which have already examined by the auditor may alter the figures by the dishonest employees to achieve some personal interest.
(iv) Loss of continuity of work: As continuous audit is conducted at regular intervals, the auditor may left unchecked same audit work which was pending during his last audit work.
(v) Adverse effect on employee’s morale:
(vi) monotony in Work
(vii) Chances of collusion between organization’s staff and auditor’s staff
2. What is Internal Audit? How does it differ from Statutory Audit? 4, 6
Ans: Definition of Internal Auditing: Internal auditing may be defined as a service to the management regarding independent evaluation of various activities of organization. More clearly, Internal auditing is an independent appraisal activity within an organization for the review of operations as a service to the management.
Internal audit is a regular activity performed by the employees of the organization, to ensure correctness of accounting data and to detect fraud by way of periodical review of organization system, procedures and policies. Internal audit is systematic and continuous process of examining and reporting the operations and records of a firm by its employees.
Difference between Internal audit and Statutory audit: An internal audit is conducted by the permanent staff of the same office to detect weakness in system, procedures and for the improvement. But statutory audit is the act of checking books of accounts as per the provision of company act. Both of them check books of account; detect errors and frauds even though they have certain differences which are as follows:
1. Appointment: An internal auditor is generally appointed by the management but statutory auditor is appointed by the shareholders or Annual General Meeting.
2. Legal Requirement: Internal audit is the need of management but it is not legal obligation but statutory audit is the legal requirement.
3. Qualification: An internal auditor does not required specific qualification as per the provision of law but qualification of statutory auditor is specified.
4. Conducting Of Audit: Internal audit is of regular nature but final audit is conducted after the preparation of final account.
5. Status: An internal auditor is a staff who is appointed by the management but statutory auditor is an independent person appointed by the shareholders.
6. Scope Of Work: Internal audit is related to the examination of books of accounts and other activities of an organization but statutory audit checks the books of accounts and related evidential documents. So, scope of internal audit is vague but scope of statutory audit is limited.
7. Removal: Internal auditor can be removed by the management but statutory auditor can be removed by the annual general meeting only.
8. Remuneration: Internal auditor is appointed by the management; so remuneration is fixed by the management but remuneration of statutory auditor is fixed by the shareholders.
3. What is Vouching? How do you Vouch cash receipts debtors? 2, 8
Ans: Vouching: The act of examining vouchers is referred to as vouching.  It is the practice followed in an audit, with the objective of establishing the authenticity of the transaction recorded in the primary books of account.  It essentially consists of verifying a transaction recorded in the books of account with the relevant documentary evidence and the authority on the basis of which the entry has been made; also confirming that the amount mentioned in the voucher has been posted to an appropriate account which would disclose the nature of transaction on its inclusion in the final statements of account.  After examination, each voucher is marked in a manner to ensure that it may not be presented again in support of another entry.
Vouching of Receipts from Debtors
Auditor can vouch receipts from debtors by the carbon copy receipts or counterfoil receipts in support of the entries appearing in the receipt of the cash book should be examined. The method of allowing the discount to a customer against prompt payment should also be inquired into. Any unusual discount should be noted and satisfactory explanation should be obtained from the responsible official. The following are the audit steps to audit/vouch/verify the preliminary expenses:
  1. RECEIPTS ISSUED: The auditor can vouch the receipt issued to debtors for collection of money. The counter foil or carbon copies can be compared with entries made in cash book. The amount of receipt must tally with cash book.
  2. RECEIPT DATE: The auditor can note the date of receipt. The date can be compared with date in cash book. There should be no difference in date on receipt and cash book. The chance of fraud can be checked.
  3. DAILY LIST: The auditor can vouch the daily list of cash collected from debtors in case of large-scale business. The receipt and amount can be recorded in it. The total must be shifted to the cash book on daily basis. 
  4. SALESMEN COLLECTION: The salesmen may collect cash through sale of goods. They-must not be allowed to keep cash. The cash must be collected by responsible person and .deposited with the cashier.
  5. SALES RETURN: The sales returns must be deducted from debtors but in case of cash sales the amount of cash should be given to them. Anyhow credit sales can reduce the amount of debtors.
  6. DISCOUNT ALLOWED: Discount allowed is a deduction from debtors account. It must be deducted in order to find out the net amount receivable from debtors.
  7. SALESMEN COMMISSION: The salesman commission is deducted from cash collected by them. The commission on monthly basis should be paid to the salesmen. But total amount of cash sales should be collected from them.
  8. BAD DEBTS RECOVERED: The auditor can vouch the bad debt recovered. The cash is debited and bad debt recovered is credited. The amount collected is checked with cash book entry. The bad debt recovered as income can be transferred to profit and loss account.

4. Explain the method of valuation of (a) goodwill and (b) copy right & trade mark. 6, 4
Ans: (a) Valuation and verification of Goodwill:
Goodwill is an intangible assets representing the value of the reputation of the firm which enables it to earn more than normal profit. The value of goodwill varies with the earning capacity of the business. When a business has been purchase and goodwill is paid for the auditor should verify the agreement with the vendors. Whenever a business is acquired, goodwill is the difference between the value of acquisition and cost of acquisition.
Sometimes, goodwill may also be created by spending huge amounts to innovate new products. Such goodwill is known as Deferred Goodwill. Its capitalized over a period of time. Goodwill is shown in the books at cost less the written off amount.
(b) Valuation and verification of Copy right and Trade mark:
Copy Rights: Copy rights are those rights to produce or reproduce any creative work. The auditor should verify the agreement between the holder of the copy right and his client. Copy right is shown is BS at cost price less written off amount.
Trademarks: They are registered brands. It gives the holder exclusive right to own the brand and protect it from imitation. An auditor should verify the certificate issued by the concerned authority, the fees paid for renewal etc trademarks are valued at cost price less written off amount.

5. Describe briefly the main provisions of company law regarding the appointment and removal of an Auditor. 5+5
Ans: Appointment of a Company Auditor: According to Section 224 of the Companies Act, every company whether private or public must appoint an Auditor or auditors to audit the final accounts. The provisions relating to the appointment of auditor are as follows:
  1. Appointment by Board of Directors: The first auditor of the company is to be appointed by BOD within 30 days from the date of incorporation of company. If BOD fails to appoint the first auditor, the auditor can be appointed in first general meeting. If no auditor is appointed in general meeting, the CG will appoint the first auditor.
  2. Appointment in Annual General Meeting: The auditor or auditors are appointed in the annual general meeting if the board of directors fails to appoint an auditor, the shareholders shall make an appointment in the annual general meeting. Every company shall at each annual general meeting appoint an auditor to hold office from the conclusion of that meeting until the conclusion of the next annual general meeting. The company has to give intimation to the auditor so appointed within seven days of his appointment.
  3. Appointment by Central Government: According to section 224 (3), if the auditor has not been appointed in the annual general meeting, the company has to inform within seven days to the Regional Director to whom the Central Government’s power to appoint an auditor in such an event has been delegated under section 637.
  4. Appointment of Auditor by Special Resolution: In case of a company, in which not less than 25% of the subscribed share capital is singly or jointly held by:
  1. A public financial institution or a government company or the central government or any state government or
  2. Any financial or other institution established by any provincial or state Act in which a state government holds not less than 51% of the subscribed share capital or
  3. A nationalized bank or an insurance company carrying on general insurance business.
  4. In the above mentioned circumstances, the appointment of an auditor shall me made by passing a special resolution (that is 75% or more of the members present should agree for the resolution).
  1. Compulsory Reappointment: Section 619 of the Companies Act specifies that in the case of government companies, the appointment or reappointment of an auditor by the central government can be made only on the advice of the comptroller and Auditor General of India.
  2. Filling of Casual Vacancies: A vacancy caused by the resignation of an auditor shall only be filled by the members in the annual general meeting. If a casual arises for any other reason (that is, death, insanity or insolvency) it can only be filled by the board of directors.
Removal of Company Auditor
The removal of auditor shall be authorized only by the shareholders in the General Meeting (GM). Ordinary resolution is sufficient to remove an auditor. The removal may be of the following types:
  1. Removal of first auditor
  2. Removal of regular auditor other than the first auditor
In case of removal of auditor of first auditor, there is no need for central govt’s prior permission. The removal of auditor other than first auditor can be further classified as:
  1. Before the expiry of term of office
  2. On the expiry of term of office
Where the Co. wishes to remove the auditor before the expiry of term of office the following procedure shall be followed:
  1. The co. shall receive a notice from any member proposing to remove the auditor.
  2. The notice shall be considered as a special notice for 14 days and circulated to all the shareholders to consider the removal in the ensuring GM.
  3. On receipt of the copy of the notice, the outgoing auditor shall have right of submitting a written representation mentioning therein reasons as to why he should not be removed.
  4. The representation shall be submitted at least 7 days prior to the date of GM.
  5. In case representation is received too late by co., the auditor may request to get it read in the Annual General Meeting (AGM)
  6. The outgoing auditor should not make any derogatory remarks about the directors.
  7. It is left to the shareholders whether the auditor should be removed or reappointed.
In the case of removal on term of expiry of office, it shall arise when outgoing auditor vacates his office and is not reappointed. In such case also, all the above procedure shall apply except the prior permission of central Govt. is not required.
6. What is divisible profit of a company? Can dividend be distributed out of capital profits? Explain. 3+7
Ans: DIVISIBLE PROFITS: Divisible profit is that part of actual profit of the company which has been earned and really exists for the distribution to the shareholders as dividends.  The actual amount of divisible profits is determined in accordance with the provision of:
  1. Memorandum and Articles of Association
  2. Companies Act
  3. Principal of Accountancy
a) Memorandum and Articles of Association: The provision of these important documents of the company has to be considered for the ascertainment of divisible profits.  These provisions have important bearing on the determination of the divisible profits.
b) Provisions of the Companies Act: For calculating divisible profits following items has to be considered:
  • Depreciation: It is compulsory to debit depreciation before having divisible profits. However, Central Government may allow any company to pay dividend out of profits without providing for depreciation.
  • Past Losses: A company may face such a situation to know whether current profits can be distributed without writing off the past losses.  The Companies Act does not make it compulsory to provide for the past losses before distributing the current year profits for dividends.  Of course, sound principles of accounting require that the past losses should be provided first in order to ascertain the divisible profits.
  • Capital Losses: Such loss arises when an asset is sold for a value less than the Book value of the asset.  Under such a situation, can the company declare dividend out of current year profits without writing off the capital loss. The Companies Act does not make it compulsory to provide for the capital losses before distributions of the current year profits as dividends.  Of course sound principles of accounting require that the capital losses should be provided first to ascertain the divisible profits.
  • Capital Profits: Such profits arise when an asset is sold for a value more than the Book value of the asset.  Can a company distribute dividends from the capital profits?  Companies Act does not prohibit the distribution of such capital profits as dividends though it has made provision to distribute in the form of bonus shares.  But generally capital profits are not distributed as dividends for up keeping the sound principles of accounting.
Payment of dividend out of capital profits
Dividends can be declared and paid only out of current or accumulated profits of the company. Dividend Normally dividends are declared only out of revenue profits.  Where there are certain compelling forces to declare dividend out of capital profits, the directors must ensure:
  1. Articles of Association authorities to distribute such profits as dividend.
  2. The capital profits have been realized in cash.
  3. It is real surplus after revaluation of all assets and liabilities of the company.
  4. All capital losses has been written off
  5. The company is financially sound to pay off all its debts
  6. The capital profit has not been transferred to Capital Reserve Account.

7. Define Auditors’ Report. Explain in brief the requisites of good auditor's report. 3, 7
Ans: Audit Report: Audit report is a statement on financial position of the company which is issued after the conclusion of audit. It is a medium through which an auditor expresses his opinion on the financial statements under audit.  It generally shows the nature and scope of audit conducted by the auditor and his opinion on the final accounts of the company. It is an important part of audit because it provides the results of the audit conducted by the auditor. The audit report is the final and ultimate report of audit process.
Essentials of Audit Report
1. Title: An auditor report must have appropriate title, such as "Auditor's Report". It is helpful for the reader to identify the auditor's report. It is easy to distinguish it from other reports. The management can issue any report about the business performance. The title o the report is essential. 
2. Addressee: The addressee may be shareholder or board of director of a company. The auditor can audit financial statements of any business unit as per agreement. The report should be appropriately addressed as required by engagement letter and legal requirements. The report is usually addresses to the shareholders or the board of directors. 
3. Identification: The audit report should identify the financial statement that have audited. The financial statement may include trading profit and loss accounts, balance sheet and statement of changes in financial position and sources and application of frauds statement. The report should include the name of the entity. Moreover the data and period covered by the financial statement are also stated in it. 
4. Reference to Auditing Standards: The audit report should indicate the auditing standard or practice followed in conducting the audit. The international auditing guidelines need assurance that the audit has been conducted as per set standards. 
5. Opinion: The auditor's report should clearly state the auditor's opinion on the presentation in the financial statement of the entity's financial position and the result of its operations. The statement give a true and fair view is an auditor's opinion. This opinion is usually based on national standard or international accounting standards. 
6. Signature: The audit report should be signed in the name of the audit firm, the personal name of the auditor or both as appropriate. 
7. Auditor's Address: The address of auditor is stated in the audit report. The name of city is stated in the report for information of the readers. 
8. Date of Report: The report should be dated. It informs the reader that the auditor considered the effect on the financial statements and in his report of events or transactions about which he become aware the occurred up to that date.

8. What is meant by cost Audit? Distinguish between cost audit and financial audit. 2, 8
Ans: It is an audit process for verifying the cost of manufacture or production of any article, on the basis of accounts as regards utilisation of material or labour or other items of costs, maintained by the company. In simple words the term cost audit means a systematic and accurate verification of the cost accounts and records and checking of adherence to the objectives of the cost accounting.
As per ICWA London’ “cost audit is the verification of the correctness of cost accounts and of the adherence to the cost accounting plan.”
The ICWAI defines cost audit as “system of audit introduced by the government of India for the review, examination and appraisal of the cost accounting records and attendant information required to be maintained by specified industries"
From above definition of cost audit, it is clear that cost audit is a systematic examination of cost accounts to verify correctness of cost accounting records.
Difference between Financial Audit and cost Audit
Financial Audit
Cost Audit
Financial audit is the audit of financial accounts of an organization, at the end of the financial year to reflect true and fair view of accounts.
Cost audit is the audit of cost accounting records of an organization to reflect true cost of a product or service and pricing.
Financial audit is compulsory for every company as per company's act, 1956.

Cost audit is not compulsory except in certain' cases i.e. companies' carrying. on business of manufacturing or mining and where the Central government has directed to maintain cost accounts in certain industries under Section 209(d) and compulsory cost audit under Section 233B.
The purpose of financial audit are to find out whether financial accounts are properly maintained and whether reflects true and fair view of the state of affairs of the company.
The objects of cost audit are to examine the cost accounting records, verify it and to give report regarding efficiency or inefficiency in cost of production and detailed analysis of cost data's.
In this audit all types of financial transactions are examined.
In case of cost audit, only expenses related to costs i.e. material, labour, overheads, and stores are thoroughly checked.
Financial audit is primarily conducted to protect the interest of the shareholders.
Cost audit is primarily conducted to protect the interest of the management, customers, government and of the society.
The first auditor of a company is appointed by the board of directors and subsequent auditors are appointed by' the shareholders in the annual general meeting except in certain cases.
Cost auditors are always appointed by the board of directors with the previous approval of the Central government.
A financial auditor does not check the cost records in detail where manipulation can be mad
A cost auditor examines the cost records in detail to find the errors and also to find manipulations in the cost accounts.
At the end of audit work the financial auditor sends his audit report to the management of the company.
At the end of cost audit the cost auditor sends his audit report to the company as well as to the Company Law Board.

9. How would you verify the following? 5+5
(a)Stock in trade
Ans: VERIFICATION OF STOCK IN TRADE: Auditor can verify the stock by taking the following steps:
1. Auditor should ensure that issue of stock sheets has been properly controlled.
2. He should verify that all the stock sheets have been signed and counter signed.
3. Auditor should test the stock sheets with the record if continuous stock records are maintained.
4. Auditor should take the copy of those instructions which are given to the staff about the method of stock taking.
5. Auditor should demand the originals if final stock shares are supplied. These can be tested by the auditor to find the differences.
6. Auditor should also ensure that a physical check has been made at least once during the year.
7. He should verify that stock in transit is received before the closing date.
8. Cut off should also be checked by the auditor.
(b)Trade creditors
Ans: VERIFICATION OF TRADE CREDITORS: Auditor shall verify the trade creditors of the following way:
1. The auditor will check the accounts of the creditors and will compare the it with the purchase ledger.
2. He will compare the accounts with the invoices, receipts, credit notes and the statements.
3. He will verify their balances and will trace them to the list of creditors.
4. Auditor will check the addition in list.
5. He will find the differences if any between figures of the creditors statement and the balance of ledger.
6. For the confirmation of balances auditor may send the balance statements to the creditors.
7. Auditor will also check the entries of the goods inward book and compare it with the purchase ledger.