Elective Course in Commerce
ECO – 12: Elements of Auditing
Elective Course in Commerce

Dear Students,

As explained in the Programme Guide, you have to do one Tutor Marked Assignment in this Course.

Assignment is given 30% weightage in the final assessment. To be eligible to appear in the Term-end examination, it is compulsory for you to submit the assignment as per the schedule. Before attempting the assignments, you should carefully read the instructions given in the Programme Guide.

This assignment is valid for two admission cycles (July 2019 and January 2020). The validity is given below:

1)         Those who are enrolled in July 2019, it is valid up to June 2020.

2)         Those who are enrolled in January 2020, it is valid up to December 2020.

You have to submit the assignment of all the courses to The Coordinator of your Study Centre. For appearing in June Term-End Examination, you must submit assignment to the Coordinator of your study centre latest by 15th March. Similarly for appearing in December Term-End Examination, you must submit assignments to the Coordinator of your study centre latest by 15th September.


Course Code : ECO - 12

Course Title : Elements of Auditing

Assignment Code : ECO - 12/TMA/2019-20

Coverage : All Blocks

Maximum Marks: 100

Attempt all the questions

1. Distinguish between Internal Audit and Statutory Audit. Can the statutory auditor rely upon the internal audit in carrying out his functions as a statutory auditor?                                              (20)

Ans: Difference between Internal audit and Statutory/External 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.

Reliability of Internal Audit

Internal audit is an independent appraisal activity within the organization by the staff of the entity or by an independent professional appointed for that purpose, for review of accounting, financial and other operations and controls established within an organization as a service to the organization. The objective of internal audit is to furnish the analysis, appraisals, suggestions and information concerning the activities reviewed to the management for promoting effective control at reasonable cost.

 According to the Institute of Internal Auditors New York, “Internal audit is an independent appraisal activity within the organization for the review of financial, accounting and other operations done as a basis of service to the management. It is a managerial control which functions by measuring and evaluating the effectiveness of other controls”.

Internal Audit under section 138 of Companies Act, 2013: Internal Audit is required by:

(1) Such class or classes of companies as may be prescribed shall be required to appoint an internal auditor, who shall either be a chartered accountant or a cost accountant, or such other professional as may be decided by the Board to conduct internal audit of the functions and activities of the company.

(2) The Central Government may, by rules, prescribe the manner and the intervals in which the internal audit shall be conducted and reported to the Board.

According to the Institute of Internal Auditors, internal audit involves five areas of operations:

i. Reliability and integrity of financial and operating information: Internal auditors should review the reliability and integrity of financial and operating information and the means used to identify, measures, classify and report such information.

ii. Compliance with laws, policies, plans, procedures and regulations: Internal auditor should review the systems established to ensure compliance with those policies, plan and procedures, law and regulations which could have a significant impact on operations and reports and should determine whether the organization is in compliance thereof.

iii. Safeguarding of Assets: Internal auditors should verify the existence of assets and should review the means of safeguarding assets.

iv. Economic and efficient use of resources: Internal auditor should ensure the economic and efficient use of resources available.

v. Accomplishing of established objectives and goals for operations: Internal auditor should review operation or programmes to ascertain whether results are consistent with established objectives and goals and whether the operations or programmes are being carried out as planned.

From the above discussion, we can say that internal audit is an important tool in the hands of statutory auditor. It helps the statutory auditor in the following ways:

i. It evaluates the internal control system, so the statutory auditor can reduce the number of tests that he may have had to conduct in case there was no internal audit

ii. It carries out physical stock taking procedures, so reliance on stock valuation is increased.

iii. It helps in timely completion of accounts and accuracy of records.

iv. It evaluates the contingent liability existing at the year end.

v. It ensures correctness of financial statements through a system of pre-audit or continuous audit.

2. What do you understand by “outstanding assets” and “outstanding liabilities”? What are the duties of an auditor in relation to outstanding liabilities?                                          (20)

Ans: Outstanding assets and auditors duties

Outstanding assets are those which are receivable at the end of the accounting year. These assets are short term in nature and shown as current assets in the balance sheet. Example of outstanding assets are rent receivable, prepaid expenses, accrued interest.

Auditor’s duties in case of outstanding liabilities:

1. The auditors should check that all the outstanding assets are included in current year’s balance sheet.

2. The auditor should see that necessary adjustments of all accrued income are made in income statement.

3. The auditor should check entries for some weeks after the balance sheet date to ensure that they are not related to the under audit period.

4. The auditors should ensure that all outstanding assets have been duly realised.

5. He should compare the expenses shown as unpaid during the current year with those of the last year and if he finds any difference, the same should be enquired into.

Outstanding liabilities and auditors duties:

Outstanding liabilities are those which are remain unpaid at the end of the accounting year. These liabilities are short term in nature and shown as current liabilities in the balance sheet. Example of outstanding expenses are rent unpaid, salaries payable, unpaid electricity bill etc.

Auditor’s duties in case of outstanding Liabilities:

1.       The auditor should obtain a certificate from a responsible official to the effect that all outstanding expenses have been included in the current year’s accounts. Examples of expenses which should be debited to the current year are rent of twelfth month or salaries payable or electricity charges for the last month, etc. Further,

2.       The auditor should check entries for some weeks after the Balance Sheet date to ensure that they are not related to the under audit.

3.       The auditor should ensure that outstanding expenses have been subsequently paid.

4.       He should see whether necessary provision for all the outstanding expenses have been made by checking receipts and other vouchers.

5.       He should compare the expenses shown as unpaid during the current year with those of the last year and if he finds any difference, the same should be enquired into.

3. What is the status of the auditor in a company? How can he protect the rights of the shareholders of the company? (20)

Ans: Status of a Company auditor: A company auditor is a central figure in the overall scheme of work. Different people may view him differently. The shareholders may regard a company auditor as their trustee or agent. The general public may think of him as an officer of the company. To many he may mean a mere employee of the company. His status should be viewed from the standard of responsibilities taking into consideration his appointing authorities, his accountability and his role as an auditor in the day to day affairs of the company.

1.                   As an Officer of the company. In London and General Bank (1895) Lindley said, “It seems impossible to deny that for some purposes, and to some extent, an auditor is an officer of the company. He is appointed by the company and his position is described in the section as that of an officer of the company. He is not a servant of the directors, on the contrary, he is appointed by the company to check the directors and for some purposes and to some extent, and it seems to be quite impossible to say that he is not an officer of the company”.

In Connell v. Himalaya Bank, it was held that auditors, if appointed at a general meeting of the company and if also paid by the company were officers of the company. However, a casual auditor may fail to qualify as an officer of the company. Lord Lindley specified in the case of the Western Countries Steam Bakeries and Milling Company Ltd. “If all persons who did auditor’s work of a company were officers of the company, the case would be easy but no decision has yet gone into this length. An auditor need not be an officer of a company. So may anybody else, e.g. a banker or a solicitor. Prima facie such persons are not offices. To be an officer there must be an office and office imparts a recognised position with rights and duties annexed to it, and it would be abuse of words to call a person an officer who fills no position either de jure or de facto, but who happens to do some of the work which he would have to do if he were officer in the proper sense of the word.”

Thus casual auditors appointed by a company to do a particular accounting work are not officers. In Lindley V. Waddell it was held that an accountant to whom books have been handed over to prepare a balance sheet is not an officer. The case Hudson V. Official Liquidating Dehradun Mussoorie Electric Tramway Company 1989, held that auditors were not officers except for the purpose of sections mentioned therein.

According to Sec. 2(60) of the Indian Companies Act the definition of the term “Officer includes an auditor for the purposes of Sec. 299, 300, 447, 305, 342, 439 and 463.

a)         Section 299 refers to the Court’s power in winding up, to summon persons suspected of having property or books or papers of the company.

b)         Section 300 deals with Court’s power to order public examinations of the promoters, directors or persons guilty of frauds, etc.

c)          Section 447 stipulated penalties for the falsification of accounts and other books.

d)         Section 305 deals with the power of the Court. In the coursed winding up, to assess damages against delinquent officers.

e)         Section 342 deals with the prosecution of delinquent officers and members of the company.

f)          Section 439 takes cognizance of offences under the Act.

g)         Section 463 empowers the Court to grant relief in certain cases, i.e., in proceedings for negligence, default, breach of duty, misfeasance, etc.

Thus, except for the above quoted provisions a company auditor is not one of the officers.

2.          As Agent of the Shareholder. A company auditor works for and on behalf of the shareholders. Thus, it is but natural that he is treated as the agent of shareholders. Barring first auditors and shareholders have the exclusive right to appoint auditors. It is only when they fail to do so under special but specified reasons that the central government intervene and appoints them. An auditor has to safeguard the interests of the shareholders. Accordingly, he must be considered as an agent of the shareholders.

In Spockman v. Evans said Lord Cranworth, “the auditor may be agents of the shareholders so far as it relates to the audit of the accounts. For the purposes of audit the auditors will bind the shareholders.”

In the same case Lord Chemsford clarified the extent of the agency though agreeing that the auditor is the agent of the shareholders. He opined that although auditors may be the agents of the shareholders, the latter could not be deemed to be precluded from objecting to any actions of the directors or others merely on the grounds that the auditors were aware of such actions. The mutuality between principal and agent as applied to shareholders and the auditor works only when the auditor informs them through the Report. In Nicls case re. Royal British Bank Turner L. J. said, “There were auditors of the company appointed by the shareholders. These auditors were within the scope of their duty, at least as much the agent of the shareholders as the directors were, and the false and fraudulent representations were discoverable by them.”

An auditor can protect the interest of the shareholders by performing his duties efficiently. Duties of auditor are stated below:

a)      Duty to Enquire: It is the duty of auditor to inquire into the following matters:

i.        Whether loans and advances made by the company on the basis of security have been properly secured and whether the terms on which they have been made are prejudicial to the interests of the company or its members.

ii.      Whether transactions of the company which are represented merely by book entries are prejudicial to the interests of the company.

iii.    Whether loans and advances made by the company have been shown as  deposits.

iv.     Whether personal expenses have been charged to revenue accounts.

v.       Whether or not cash has actually been received from allotment of shares.

vi.     Where the company not being an investment company or a banking company, whether so such of the assets of the company as consist of shares, debentures and other securities have been sold at a price less than at which they were purchased by the company.

b)      Duty to make report: The auditor shall make a report to the members of the company. In his report, the auditor shall report on:

                    i.            Whether he has sought and obtained all the information and explanations which to the best of his knowledge and belief necessary for the purpose of his audit and if not, the details thereof and the effect of such information on financial statements.

                  ii.            Whether in his opinion, proper books of account are required by law have been kept by the company so far as appears from his examination.

                iii.            Whether the company’s balance sheet and profit and loss account dealt with in the report are in agreement with the books of accounts and returns.

                 iv.            Whether in his opinion, the financial statements comply with the accounting standards.

                   v.            Whether any director is disqualified from being appointed as a director.

                 vi.            Whether the company has adequate internal financial control system in place and the operating effectiveness of such control.

               vii.            Such other matters as may be prescribed under rule 11: The auditor’s report shall also include views and comments on the following matters.

1)      Whether the company has disclosed the impact, if any, of pending litigations on its financial position in its financial statement.

2)      Whether the company has made provisions, as required under any law or accounting standards, for material losses, if any on long term contracts including derivative contracts.

3)      Whether there has been any delay in transferring amounts, required to be transferred, to the investor education and protection fund by the company.

c)       Duty to report on frauds u/s 143 and rules 13: If an auditor of a company, in the course of the performance of his duties as auditor, has reason to believe that an offense involving fraud is being or has been committed against the company by officers or employees of the company, he shall immediately report the matter to the central government within such time and in such manner prescribed in rule 13. 

4. What do you understand by management audit? How does it help management in improvement of its effectiveness? (20)

Ans: 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."

Significance of Management Audit for the management

Objectives of management audit: 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. Management audit has some objectives. These are discussed below:

(i) Verifying the efficiency: Management audit aims at to asses the efficiency at all levels of management and implementation of policies.

(ii) Gives suggestion for increase in efficiency: Management audit highlights the inefficiencies in different areas of management and gives his valuable suggestions and means to improve the efficiencies.

(iii) Asses the effectiveness of Planning and policies: Management audit examine and evaluates the plans and policies and judge whether planning and policies are properly implemented.

(iv) Helps to increase profitability: Management audit helps the management to increase profitability by giving remedies to maximize the organization's resources in an efficient way.

(v) Helps to co-ordinate activities: Management audit detects the interrelationship among the activities, evaluates the authority and responsibility and gives valuable suggestions for improvement of co- ordination among the activities and the employees. .

(vi) Gives valuable advice: By scanning the management efficiency and detecting the weak spots of different levels of management, the management auditor gives valuable advice to the top management regarding different policies and future course of action


There are several advantages of conducting management audit of an organization. When an organization grows in its volume and activities, there is a need for management audit for evaluating efficiency and effectiveness of the management at all levels of the organization. The advantages and importance of management audit are discussed below:

(i) Evaluates efficiency of the management: 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.

(ii) Scrutiny of the plans, policies and procedure: Management audit helps to determine how the management has implemented their plans, policies and procedure to reach the organizations goal.

(iii) Helps for correction of plans, policies and procedure: Through management audit, it is possible to change or revise the plans, policies and procedure as per needs of the company.

(iv) Aids for decision making: Management audit asses the ability of the managers to take important decisions and helps them to rectify the defects.

(v) Helps to get loan: Financial institutions who gives huge loan to the organizations are interested to know the efficiency of the management and the profitability. Management audit certainly gives a guide to them.

(vi) Helps to get subsidy: Before granting subsidy by the government, to any entity they are interested to know the efficiency and functioning of the management. Management audit helps in this matter.

(vii) Helps to increase profitability: Management audit helps the management to increase profitability by giving remedies to maximize the organization's resources in an efficient way. 

5. Write short notes on the following :                  (4x5)

a)      Errors of Commission

Ans: Errors of Commission: These errors arise at the time of recording transactions in the journal, ledger and / or subsidiary books. Agreement of trial balance may or may not be affected by these errors. Some of the errors of commission affect the two sides of trial balance, while others do not affect. Few examples are given below when the trial balance does not agree due to errors of commission:

Examples of errors of commission:

a)         Wrong totaling of subsidiary books.

b)         Posting the same amount on wrong side.

c)          Errors in balancing at the time of balancing the ledger accounts.

d)         Posting the wrong amount. If a wrong amount is posted in the ledger account, the two sides of trial balance will not reconcile.

e)         Errors in carrying forward of total. Errors may be committed while carrying forward the total of one page to another page.

f)          Errors of duplication. Such errors arise when a transaction is recorded twice in the original books and posted twice in ledger accounts. These errors do not affect the agreement of trial balance.


b)      Contingent Liabilities

Ans: Certain liabilities may or may not arise after the preparation of the Balance Sheet. These are called contingent liabilities. In the words of Montgomery, “The term ‘contingent liability’ should be used in the accounting sense to designate a possible liability of presently determinable or indeterminable or indeterminable amount which arise from past circumstances or action which may or may not become a legal obligation in the future, and which, if paid, gives rise ot cost or an expenses or an asset of doubtful value” A contingent liability is different from an actual liability.

Types of Contingent Liabilities

1.       Liabilities on Bills Receivable Discounted and not Matured.

2.       Liability for Calls on Partly Paid Shares

3.       Liability under a Guarantee.

4.       Liability for Cases against the Company not Acknowledged as Debts.

5.       Liability for Penalties under Forward Contracts.

6.       Liability in respect of Arrears of Dividend on Cumulative Preference Shares.

Auditor’s Duties

1.       Check the various contingent liabilities named above.

2.       Some liabilities may have no provision made in the books but merely a note made at the foot of the Balance Sheet, e.g., bills receivable which have been discounted and which have not matured at the date of the balance Sheet, arrears of fixed accumulated dividends, etc. In case for liabilities in respect of which provision has to be made on the Balance Sheet, e.g., liability which may arise in connection with a suit, etc., the auditor should examine such cases and ascertain the amount to be specifically reserved for the purpose.

3.       Examine the Directors Minute Book, correspondence made with the legal advisers and the information obtained from the officials of the business. Ensure that proper provision has been made for all such liabilities and if he is not satisfied mention the fact in the report. The requirements of the Companies Act regarding the contingent liability should be complied with in the Balance Sheet on the liabilities side.


c)       Divisible Profits

Ans: The term “Divisible Profit” is a very complicated term because all profits are not divisible profits. Only those profits are divisible profits which are legally available for dividend to shareholders. Dividends cannot be declared except out of profits, i.e. excess of income over expenditure; ordinarily capital profits are not available for distribution amongst shareholders because such profits are not trading profits. Thus, profits arising from revaluation or sale of fixed assets or redemption of fixed liabilities should not be available for distribution as dividend amongst shareholders. The principles of determination of the divisible profit are given below:

1)      According to Section 123 of the Companies Act, 2013 no dividends can be declared unless:

Ø  Depreciation has been provided for in respect of the current financial years for which dividend is to be declared;

Ø  Arrears of depreciation in respect of previous years have been deducted from the profits; and

Ø  Losses incurred by the company in the previous years.

2)      Section 123 of the Companies Act, 2013 provides that before any dividend is declared or paid a certain percentage of profits for that financial year depending upon the rate of dividend to be paid or declared should be transferred to the reserves of the company.

Provided that nothing in this sub-section shall be deemed to prohibit the voluntary transfer by a company of a higher percentage of its profits to the reserves in accordance with such rules as may be made by the Central Government in this behalf.

3)      No dividend shall be payable except in cash;

4)      There is no prohibition on the company for the capitalization of profits or reserves of a company for the purpose of issuing fully paid-up bonus shares or paying up any amount for the time unpaid on any shares held by the members of the company.


d)      Audit report

Ans: 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.

Elements of Audit Report or Essentials of Good Audit Report

1. Title: An auditor report must have appropriate title, such as "Auditor's Report".

2. Addressee: The addressee may be shareholder or board of director of a company.

3. Date of Report: The report should be dated.

4. Identification: The audit report should identify the financial statement that have audited.

5. Reference to Auditing Standards: The audit report should indicate the auditing standard or practice followed in conducting the audit.

6. 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.

7. Signature: The audit report should be signed in the name of the audit firm, the personal name of the auditor or both as appropriate. 

8. 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. 

Importance of Audit Report       

In case of a company management is separated from the ownership share holders appoint the auditor to check the accounts and submit a report to them. However, the report doesn’t guarantee accuracy of the accounts. The auditor is neither a guarantor nor an insurer. In one of the cases it was held that “the auditor must not be held liable for not tracing fraud, when there is nothing to arouse their suspicion and when those frauds are perpetrated by the trusted servants of the company”.

The auditor is expected to act honestly with reasonable skill and care. Audit report is an extremely significant document as share holders rely upon it. The auditor will be guilty of professional misconduct if he deliberately fails to disclose material facts known to him. Conceals misstatements and fails to obtain necessary information to complete his audit.


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