IGNOU Solved Question Papers: ECO - 12 (December' 2013)

Term-End Examination December, 2013
Time: 2 hours
Maximum Marks: 50 (Weightage 70%)
Time: 2 hours Maximum Marks: 50 Weightage 70%
Note: Attempt any five questions. All questions carry equal marks.
1. What is meant by Auditing? Explain its advantages. 3, 7
Ans: Auditing: The word audit is derived from the Latin word “AUDIRE” which means to hear. Initially auditor was a person appointed by the owners to check account whenever the suspected fraud, he was to hear explanation given by the person responsible for financial transactions. Emergence of joint stock companies changed the approach of auditing as ownership was pestered from management. The emphasis now is clearly on the verification of accounting date with a view on the reliability of accounting statement.
In the words of Montgomery, “Auditing is a systematic examination of the books and records of a business or other organization, in order to ascertain or verify and report upon the facts regarding its financial operation and the result thereof”. 

In the words A.W. Hanson, “An audit is an examination of such records to establish their reliability and the reliability of statement drawn from them”. 
From the above definitions it is clear that the auditor’s basic duty is to examine the accounts and its arithmetical accuracy. He must ensure than the financial statements depicts true and fair view of the state of affairs of the business. Since, Auditing is a full and critical examination of the books of accounts to find out their accuracy.
Adavantages of Auditing
A. Benefits of Business: Business may get many advantages of conducting audit by a qualified auditor. The advantages are discussed below:
(a) True and Fair view: With the help of audit of accounts, it is possible get a true and fair view of the financial position of the business.
(b) Detection of errors and frauds: If books of accounts are audited, errors and frauds can be detected and necessary action can be taken to prevent it.
(c) Moral pressure on the employees: If audit is conducted by the organization, employees should be cautions and there should be a moral pressure on them. As a result, chances of errors and frauds will be minimized.
(d) Proper accounting control: A system of regular audit helps the organization to maintain proper books of accounts regularly and books of accounts are kept up to date.
B. To the Owner: The owners of the business are also interested to know the financial position of the business. There are discussed below:
(a) Benefit to the sole proprietor: In case of large business, the proprietor can get a true and fair view of the accounts maintained by his employees and also able to know the state of affairs and profit made by him. The proprietor is also benefited for getting loan from financial institutions, to pay income tax etc.
(b) Benefits to the partners: With the help of audited accounts help to the partners to settle their unsettled disputed, for taking loan from financial institutions, to get off the books of accounts maintained by the employees etc.
(c) Benefits to the shareholders: Shareholders are the owners of a company. With the help of audited accounts they get a real picture of the financial position of The company and they can assure that business is running efficiently.
C. To the third parties: Besides business and the owners, there are different outside interested parties who required audited accounts for different purposes: These are:
(a) Government may be interested to get the audited accounts to show the deficiency of the business for giving grant and subsidy.
(b) Financial institutions sections loan to the organization on the basis of verification of financial soundness form the audited accounts.
(c) Tax authorities may depend on audited accounts for determination of income tax, sales tax, excise duty etc.
(d) For settlement of insurance claim, insurance companies can barely on audited accounts.
2. Define internal control. Differentiate between 'internal control' and 'internal audit'. 3, 7
Internal Control is a Systematic measures such as reviews, checks and balances, methods and procedures) instituted by an organization to conduct its business in an orderly and efficient manner, safeguard its assets and resources, determine and detect errors, fraud, and theft, ensure accuracy and completeness of its accounting data, produce reliable and timely financial and management information, and ensure adherence to its policies and plans.

According to W.W.BIGG: “Internal Control is best regarded as indicating the whole system of controls, financial
and otherwise, established by the management in the conduct of a business, including internal check, internal
audit and other forms of control.”
Internal control is the process, affected by an entity's Board of Trustees, management, and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in the following categories:
Reliability of financial reporting,
Effectiveness and efficiency of operations, and
Compliance with applicable laws and regulations.
Types of Internal Controls:
Detective: Designed to detect errors or irregularities that may have occurred.
Corrective: Designed to correct errors or irregularities that have been detected.
Preventive: Designed to keep errors or irregularities from occurring in the first place.
 3. What is Test Checking? What precautions must be taken by an auditor while conducting test checking? 2, 8
Ans: If the organization is large enough and there are huge transactions, it is very much impracticable and hard job for the auditor to examine and verify each transaction one by one. Detailed checking of transactions required time, effort and money. To overcome this situation, the technique of test checking is applied.
Test checking is a technique of intensive checking of some selected transactions on random basis out of huge transactions to avoid waste of time, Labour inaccuracy and costs.
According to professor Meigs, “Testing and test checking means to select and examine a representative sample from a large number of similar items.”
In the opinion of L.R,. Dicksee,, “the theoretical responsibility of the auditor extends ultimately to every entry in the books of accounts, but it does not follow that it is likely necessary possible to examine every entry in details.”
In case of large organizations, if there is a sound system of internal control system, the auditor can take help of test checking.
Precautions while conducting test checking
(i) The transactions of the concern should be classified under appropriate heads and may be stratified if wide variations are there between transactions of the same kind.
(ii) Systems and procedures for entering into and processing a transaction right from the beginning to the end should be studied in a sequential order.
(iii) The whole of the system of internal control in the areas of accounts and finance should be studied and evaluated for its efficiency, soundness and capability for producing reliable accounting and financial data. This can be done by studying the controls and internal checks.
(iv) A properly thought-out test check plan should be prepared and the objective of each check should be clearly understood by the auditing staff.
(v) The transactions falling under each test-check plan should be selected in a manner so that bias cannot enter in the selection. For the purpose, selection should be made by reference to the random number tables.
(vi) Identification of the areas where test check may not be done. For example, if there are only 20 overseas sales in the year, it would be preferable to have them all thoroughly checked.
(vii) The number of transactions to be selected for each test-check plan should be predetermined. This can be done by deciding upon the degree of reliance that should be placed on the test-check result.
(viii) Errors that may be found may be material or immaterial in the context of the particular audit. Investigation of immaterial error may be avoided and only the material errors may be properly and thoroughly investigated.
4. State the various methods of valuation of goodwill, and explain one of these with an example. 3, 7
Ans: Methods of Valuation of Goodwill:
  1. Average profits method
  2. Weighted average profit method
  3. Super profit method
  4. Capitalisation method
Average Profits Method: In this method, normal profits of business of a number of years are taken into account. Such profits are totaled up and their average is arrived at. The average profits are multiplied by the number year’s purchases to arrive at the value of goodwill.
For calculation of goodwill following steps are to be followed
  1. Calculate past normal profit. Past Normal Profit = Net Profit + Abnormal loss – Abnormal Gain
  2. Calculate Average normal Profit = Total Past normal profit/no of years
  3. Calculate goodwill = Average normal profit x no. of year’s purchase

For Example:
The profit for the last five years of a firm were as follows Year 2001 Rs. 1,20,000: Year 2002 Rs.1,50,000: Year 2003 Rs.1,70,000: Year 2004 Rs.1,90,000: Year 2005 Rs.2,00,000. Calculate goodwill of the firm on the basis of 3 years purchases of 5 years average profits.
Average profit  = Total Profits/No. of Years
= Rs.8,30,000/5 = Rs.1,66,000
Goodwill = Average Profits × No. of years purchased
= Rs.1,66,000 × 3 = Rs.4,98,000
Weighted average method: This method is a modified version of average profit method. In this method each year profit is assigned a weight i.e. 1, 2, 3, 4 etc. Thereafter each year profit is multiplied by the weight and find product. The total of products is divided by the total of weight. As a result we find the weighted average profit. After this the value of goodwill is calculated by multiplying the weighted average profit with the agreed number of year’s purchase. Thus the goodwill is calculated as follows
Weighted average profit =

Value of goodwill   = Weighted average profit × number of year of purchase

Super Profit Method: Super Profits means profits earned in excess of the normal Profit, i.e., Actual Profit –Normal. Normal profits mean the profit which the firms could normally earns in a particular business.
Under this method, the following steps are to be followed for calculation of goodwill:
  1. Calculate average normal profit of business as mentioned above
  2. Calculate normal profit
  3. Calculate super profit. Super profit is the excess of average normal profit over normal profit
  4. Calculate goodwill = super profit x no. of year’s purchase
Capitalization Method: Under this method, the value of goodwill is obtained by capitalizing the average profit or super profit of the basis of normal rate.
Value of goodwill under capitalization of average profit is
Goodwill = (Average normal profit of the business/ rate of return) – capital employed
Value of goodwill under capitalization of super profit is
Goodwill = Super profit/ rate of return

5. Distinguish between company audit and partnership audit. 10
6. How would you verify the following? 5, 5
(a) Stock
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) Investment
Ans: VERIFICATION of investments: Auditor can verify the stock by taking the following steps:
  1. Insist on a schedule of investments, when number of investments held by the auditee is very large.
  2. Examine the investment schedule with reference to the relevant ledger accounts.
  3. See that the investments have been shown properly in the Balance Sheet
  4. He should verify the existence of investments by inspecting the certificate, deposit receipts etc.
  5. Obtain a certificate from bank of certain securities given to the bank for safe custody.
  6. Examine the transfer deed, broker’s contract note if certificate of investments is not received upto the date of audit of the securities purchased during the year under audit.
  7. Verify the Sales proceeds from pass book of the sale of any securities made after the date of Balance Sheet but before the audit.
  8. Verify relevant vouchers and certificates whether securities are free from any charge or not

7. Explain the preliminaries before commencement of the audit of a company. 10

8. Differentiate between: 5, 5
(a) Clean and qualified report
Ans: Clean Report: It is also known as Unqualified Report. It is given by the auditor if he is satisfied with the fairness of Balance Sheet and Profit and Loss account with all the contents of the financial statements and he is satisfied with evidences, documents and explanation given by his clients.
Qualified Report: When the auditor is not satisfied with the accounts presented to him if he finds any discrepancy in the recording of the transaction, if he thinks that the Balance Sheet and P&L account do not exhibit true and fair view of the business then he submits Qualified Report.
(b) Auditor's report and Auditor's certificate
Ans: Difference between Audit Report and Audit Certificate:
Audit Certificate
Audit Report
It is a written confirmation of the accuracy of the information given in it.
It is a written statement of collected and considered information so as to give a clear picture of the state of affairs of the business.
It does not contain any opinion. It confirms the accuracy of the figures with the books of accounts. Different auditors will give same certificate.
It is based on opinion of the auditor. Different auditors may give different opinion.
On the basis of data which can be measured.
On the basis of books of accounts and information obtained.
It guarantees the correctness of data in absolute terms and can be checked.
Does not guarantee the correctness of statement and data in absolute terms
It does not cover all accounts but part of accounts for which certificate is required.
It covers all accounts of the concern.
Auditor is directly responsible if anything is found wrong in the certificate given by him.
Auditor does not guarantee the correctness of books of accounts hence he is not responsible if anything is found wrong in the books.
It is not suggestive in nature.
It is suggestive in nature.
It is fact oriented hence objective.
It is opinion oriented hence subjective
Particular format is not required.
Format is required.

9. Write short notes on the following: 5, 5
(a) Management audit
Ans: Ans: Management Audit: Management audit is a method of independent and systematic evaluation of the management activities at .all levels of management to ascertain the functions, efficiency and achievement of' the management (i.e. policies) as compared to standards set by the company.
According to L. R. Howard, "Management audit is an investigation of business from the highest level downward in order to ascertain whether sound management prevails throughout, thus facilitating the most effective relationship with outside world and smooth running of internal organization."
As per Taylor and Perry; "Management auditing is a method to evaluate the efficiency of management at all levels throughout the organization, or more specifically, it comprises the investigation of a business by an independent body from the highest executive level downwards, in order to ascertain whether sound management prevails through and to report as to its efficiency or otherwise with recommendations to ensure its effectiveness where such is not the case."
Thus, Management audit is the total audit of the management i.e. reviews how the policies of the management have been implemented and its efficiency to execute the policy. Therefore, the scope is much greater than financial audit, as it examines the all aspects of the management.
(b) Cost audit
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.