This article has been written by Apeksha Choubey, pursuing Diploma in US Corporate Law for Company Secretaries and Chartered Accountants ( MAR-02-2023 ) and has been edited by Oishika Banerji (Team Lawsikho).
This article has been published by Sneha Mahawar.​​
Table of Contents
Introduction
In general terms, auditing refers to independent examination of primary financial statements of a company. Primary financial statements consist of a profit & loss statement, balance sheet and cash flow statement. Auditing refers to the process of checking and analysing the financial statements of any company with the purpose to provide opinion whether the financial information is providing a true and fair view and prepared in accordance with applicable accounting standards. Financial information is very crucial as these represent the performance of a company for a specific period of time. These provide useful information to many users such as shareholders, creditors/suppliers, customers, investors, government and tax authorities. This article discusses the general idea about auditing for its readers.
What is auditing
Auditing can be defined as an on-site verification process which involves either inspection or examination of any process or system functioning, in order to ensure abidance of set-out compliances or requisites. The process of auditing can be applicable to either the entire firm or a particular functioning of that firm. Validity or reliability of any kind of information, irrespective of the source of such information, is a necessity. This becomes one of the prime grounds for effective functioning of the firm or individual associated with such information.
How does auditing work
Although the process by means of which auditing works is complex, the same can be understood simply as well. An independent Certified Public Accountant (CPA) firm or internal staff of the organisation may conduct the audit. The financial statements of almost every company, including the income statement, balance sheet, and cash flow statement, are annually audited. Borrowers also agree to annually accept the results of an external audit as part of their debt covenants. Due to the compelling arguments for purposeful misinterpretation of financial information to commit fraud, audits are a legal requirement for specific businesses.
Auditor and objectives of auditing
The person who performs this process is termed as “auditor” who can be internal or external to the company depending on the type of audit being conducted by him. A report published by the Auditor on the basis of his examination and scrutiny of financial accounts is referred to as an “Audit report” in which he expresses his independent opinion.
Here, it is important to highlight main objectives of auditing as under:-
- To obtain reasonable assurance that financial statements are free from material misstatement whether due to fraud and error.
- To report on the financial statements are prepared and presented as per applicable laws and fulfilled statutory requirements.
Audit opinion
There are different types of audit reports/opinion, types of audit, aspects to be covered and basic principles governing audit which each auditor should comply with by applying to the best of his knowledge and discretion. 4 types of audit report/opinion:-
- Unqualified opinion: It is also considered as a clean report where the auditor is satisfied with financial reporting and is free from material misstatements and the company is conducting its operations as applicable laws and governance principles. It does not contain any adverse comment.
- Qualified opinion: When the auditor is not satisfied with any specific process or transaction, he will issue a qualified report. Proper explanation needs to be provided in the report for the same qualification for users to understand its impact.
3. Disclaimer opinion: When an auditor is not allowed to analyse and review any procedure or not find any satisfactory reply on his queries raised during audit, then he will issue a disclaimer report which creates adverse goodwill of the company.
4. Adverse opinion: This type of report is published when the auditor observed a high level of material misstatements and major deviations in company’s internal control in conducting operations and maintaining financial records. It is considered a red flag for the company.
Basic principles governing an audit
The auditor is responsible to comply with these basic principles while performing any audit assignments.
1. Integrity, independence, and objectivity: The auditor should exercise his full independence while reviewing financial statements and internal control of the company. He shall be free from any type of undue pressure and influence by company officials in any manner. Further, he should be honest, truthful and operate with due diligence in all his acts while performing his duties.
2. Confidentiality: Auditors should maintain utmost confidentiality of its client information during the course of the audit. He must not disclose any information to third and external parties unless there is legal or professional duty binding on him.
3. Skill and competence: Auditors must have adequate knowledge, professional experience and good interpersonal skills which are required to perform audit assignments. He should develop professional expertise to understand the business and operations of the company in order to perform audit procedures in an accurate manner.
4. Work performed by others: It is obvious that the auditor will have a team to perform different types of work relating to audit work. He may use expert opinion if required during the course of audit such as technical report of valuation, litigation reports of lawyers, actuary report. However, the auditor will remain responsible for work done by others. So, he should exercise professional expertise and experience while relying on the work done by others and review their work carefully.
5. Documentation: Auditor is required to maintain all working papers related to audit work properly and safely right from the beginning stage of audit till end of period such as appointment letter, scope of audit, audit plan, other working papers, report and records collected from client during the course of audit. These are important documents considered as audit evidence for the work done by the auditor.
6. Planning: Auditor prepares and documents audit plans for each and every audit basis which he will initiate and complete audit in a timely and efficient manner. This will be discussed with team members and well communicated to clients. It may differ as per size of the company, nature of business, geographical area, scope of audit and effectiveness of internal control of the company.
7. Audit evidence: As part of the documentation process during the course of audit, the auditor will collect sufficient and appropriate audit evidence as per his discretion to support his observations and as a proof for future purpose. He can rely on both internal and external sources of audit evidence. Internal sources refers to evidence collected within the company such as internal control manuals, company policies etc. whereas statements and confirmation collected from outside sources from third parties such as bank statements, creditors confirmations.
8. Accounting systems and internal controls: It is very crucial for auditor to first understand and evaluate the accounting and internal control system of the client company at the beginning of the audit work as it gives assurance that that company financial statements represents true and fair view, all material information have been recorded in the books of accounts, internal control system is robust enough to detect fraud and error. All these aspects are important to draw audit plans and procedures accordingly for every audit undertaken and deciding further sampling and testing techniques.
9. Audit conclusions and reporting: At the end of audit work, the auditor will express his opinion in the form of an audit report based on audit performed and evidence collected. This is communicated to the company. He will evaluate internal control and accounting system, compliance of all regulatory and statutory requirements, applicability accounting system and whether all material information has been disclosed or not.
Types of audit
On the basis of organisation
In this category, audit is divided into two types on the basis of company for audit task undertaken:-
- Audit enforced by law: There are many governing bodies which require audit such as companies registered under Companies Act, banks governed by Banking Act, Tax authorities direct various types of audit etc.
- Audit under voluntary class: These consist of accounts of proprietorship concern, HUF (Hindu undivided Family) business, and partnership firms. Audits for these are performed on a voluntary basis or under any special circumstances such as sanction of loan, government directives.etc.
On the basis of functions
In this category, again audit is divided into two types on the basis of function:-
- External Audit: When audit is performed by independent and separate auditors outside to company affairs, this is termed as external audit such statutory audit and government audit, tax audit.
- Internal Audit: When audit is performed by a separate division within a company, this is termed as internal audit.
In the end, we will see few aspects which need to be covered by auditor while performing any type of audit of financial statements of a company:
- An independent examination of the accounting and internal control system is the key to confirm whether all material transactions are recorded correctly in the books of accounts.
- Review of system and procedures is required to confirm whether internal controls placed in the system are working fine and adequate to avoid any fraud and errors.
- Arithmetical accuracy checking of books of accounts ensures proper accounting system by verification of postings and balances.
- Verification of authenticity and validity of material transactions can be done by examination of supporting relevant documents.
- Proper segregation of capital and revenue transactions is required to reflect a true and fair view of financial statements.
- Comparison of Balance Sheet and Profit & Loss items with previous periods for trends analysis which predict unexpected movements and their reason thereof.
- Verification of the title, physical existence and valuation of assets and liabilities reflecting in the Balance sheet.
- Evaluate the profit and loss figure derived showing true and correct view in line with industry trend.
- Ensure compliance with applicable laws and statutory requirements.
- Reporting audit results to the governing body as terms of audit assignments applicable.
Conclusion
Auditing is one of the fundamental processes that ensures transparency in the functioning of a firm. It is based on the book-keeping methodology that keeps record if every transactions taken place in the firm with the outside world thereby helping the same to function progressively well.
References
- https://www.diligent.com/insights/audit-reporting/understanding-four-types-audit-reports/#:~:text=Unqualified%20opinion%2Dclean%20report,Adverse%20opinion%2Dadverse%20audit%20report
- https://www.vedantu.com/commerce/concept-of-auditing
- https://byjus.com/commerce/principles-of-auditing/
Students of Lawsikho courses regularly produce writing assignments and work on practical exercises as a part of their coursework and develop themselves in real-life practical skills.
LawSikho has created a telegram group for exchanging legal knowledge, referrals, and various opportunities. You can click on this link and join:
Follow us on Instagram and subscribe to our YouTube channel for more amazing legal content.
