Auditing basics

In short

Auditing is the independent examination of an entity's financial statements and supporting records so the auditor can express an opinion on whether they give a true and fair view. It protects shareholders, lenders, regulators and tax authorities who cannot verify the books themselves. In India it is governed by the Companies Act, 2013 and the Standards on Auditing (SAs) issued by ICAI, and it is examined heavily in B.Com Auditing papers, CA/CS/CMA exams and audit-firm placement interviews (Deloitte, EY, PwC, KPMG, Grant Thornton, BDO and mid-size Indian firms).

Explained

Meaning, objectives and types

• Definition: a systematic, independent examination of books, accounts, vouchers and records to verify that the financial statements present a true and fair view and comply with law.
• Primary objective: expressing an opinion on the financial statements. Secondary / incidental: detection and prevention of errors and frauds.
• Errors: error of omission, commission, principle (e.g. capital expenditure charged to revenue), and compensating errors. Frauds involve intent — misappropriation of cash or goods, or manipulation of accounts (window dressing, secret reserves).
• Audit is not a guarantee against fraud — it gives *reasonable*, not absolute, assurance (SA 200).
• Classification by law: *statutory* (compulsory — companies, banks, insurance, co-operative societies, trusts) versus *voluntary* (sole proprietor, partnership firm).
• Classification by scope/approach: complete, partial, interim, final, continuous, balance-sheet audit, cost audit, secretarial audit, tax audit, management audit, performance audit (CAG).
• Internal vs statutory: internal audit is management's own appraisal tool, continuous and wide in scope; statutory audit is an external legal requirement reporting to members.

The audit process

1. Engagement acceptance: check eligibility and disqualifications (Section 141), independence, prior auditor's NOC, and issue an engagement letter (SA 210).
2. Planning (SA 300): understand the entity and its environment (SA 315), assess risk, set materiality (SA 320), prepare the audit programme — a written plan of work allocated to staff.
3. Internal control evaluation: study the system, test controls; weak controls mean more substantive testing.
4. Gathering evidence (SA 500): vouching of transactions, verification and valuation of assets and liabilities, physical verification, third-party confirmation, analytical procedures (SA 520), audit sampling (SA 530).
5. Documentation (SA 230): working papers — permanent file (MOA/AOA, deeds) and current file (year's evidence).
6. Conclusion and reporting: subsequent events, going concern, written representations, then the audit report.
7. Audit techniques include inspection, observation, inquiry, confirmation, recomputation, re-performance and analytical review.

Key Companies Act, 2013 provisions

• Section 139 — appointment: first auditor by the Board within 30 days of incorporation; thereafter at AGM for 5 years. Rotation (Sec 139(2)) applies to listed and prescribed companies — an individual for 5 years, a firm for 10 years, with a 5-year cooling-off.
• Section 140 — removal/resignation: removal before term needs prior Central Government approval (application in Form ADT-2, powers delegated to the Regional Director) followed by a special resolution; a resigning auditor files Form ADT-3.
• Section 141 — qualification: only a practising Chartered Accountant; disqualified if holding securities in, indebted to, or in business relationship with the company (limits are prescribed by the Rules and may be revised).
• Section 143 — powers and duties: right of access to books and vouchers at all times, right to information from officers, and the duty to report fraud to the Central Government (above the prescribed threshold) or to the Board/audit committee below it.
• Section 144 — prohibited services: accounting, internal audit, actuarial, investment advisory, management services, etc.
• Section 147 — penalties for contravention; Section 177 — audit committee; NFRA (Sec 132) oversees auditors of large and listed companies.
• CARO 2020 adds a long list of reporting clauses (fixed assets, inventory, loans, statutory dues, default, whistle-blower complaints, etc.) for companies other than those exempted (small companies, OPCs, certain private companies).

Audit report and opinions (SA 700 series)

• Elements: title, addressee (members), Opinion paragraph, Basis for Opinion, going concern, Key Audit Matters (listed entities, SA 701), responsibilities of management and auditor, report on other legal requirements, signature, UDIN, place and date.
• Unmodified (clean) opinion — true and fair view.
• Modified (SA 705): qualified ("except for" — material but not pervasive), adverse (material *and* pervasive misstatement), disclaimer (unable to obtain sufficient evidence, material and pervasive).
• Emphasis of Matter / Other Matter paragraphs (SA 706) do not modify the opinion.
• Advantages: credibility to accounts, deterrent to fraud, easier credit and valuation, moral check on staff, statutory compliance.
• Limitations: test checking and sampling, reliance on management representations and judgement, collusive fraud hard to detect, cost and time constraints, no comment on future viability or business efficiency.

Key points

• True and fair view - the accounts are free from material misstatement and disclose what law requires; not "exactly correct".
• Reasonable assurance - high but not absolute level of assurance (SA 200).
• Materiality - an item is material if its misstatement could influence a user's economic decisions.
• Audit risk = risk of giving a wrong opinion = inherent risk × control risk × detection risk.
• Vouching - examining documentary evidence of transactions; the "backbone of auditing".
• Verification - confirming existence, ownership, valuation and presentation of assets and liabilities.
• Audit programme - written plan of procedures and staff allocation; working papers are the auditor's property.
• Routine checking vs test checking - full arithmetical check versus examination of a representative sample.
• Section 139 - appointment for 5 years at AGM; rotation for listed/prescribed companies.
• Section 143 - auditor's powers (access to books) and fraud-reporting duty.
• SA 700/705/706 - form of report, modified opinions, and emphasis paragraphs.
• Auditor is a watchdog, not a bloodhound - but modern standards require professional scepticism and fraud risk assessment (SA 240).

Formulas and examples

• Example 1 — materiality and detection risk. A company has revenue ₹80 crore, total assets ₹50 crore and profit before tax ₹4 crore. The auditor uses 5% of PBT.
  • Overall materiality = 5% × ₹4,00,00,000 = ₹20,00,000.
  • Performance materiality at 60% = 0.60 × ₹20,00,000 = ₹12,00,000.
  • The auditor assesses IR = 0.8, CR = 0.5 and wants AR = 0.05.
  • DR = 0.05 / (0.8 × 0.5) = 0.05 / 0.40 = 0.125 (12.5%) — low, so more substantive testing is needed.
  • An unadjusted error of ₹25,00,000 found in sundry debtors exceeds materiality → the auditor asks for correction, and if refused issues a qualified opinion (material but confined to one head, not pervasive).

• Example 2 — sample size and projected misstatement. Trade receivables total ₹5 crore. Tolerable misstatement is ₹20 lakh and the reliability factor for 95% confidence (expecting no errors) is 3.0.
  • Sample size = ₹5,00,00,000 × 3.0 / ₹20,00,000 = 15,00,00,000 / 20,00,000 = 75 items.
  • The auditor circularises 75 balances worth ₹1.25 crore and finds overstatement of ₹3,00,000.
  • Projected misstatement = ₹3,00,000 × (₹5,00,00,000 / ₹1,25,00,000) = ₹3,00,000 × 4 = ₹12,00,000.
  • ₹12,00,000 is below the ₹20,00,000 tolerable misstatement, so the balance is accepted — but it is close, so the auditor extends testing before concluding.

Where it is used

• Audit and assurance firms: Big Four and Indian firms recruit B.Com graduates as audit assistants for statutory audit, tax audit and bank branch audits.
• Banking and NBFCs: concurrent audit, revenue audit and stock audit of borrowers; RBI-mandated audits of banks and co-operative societies.
• Corporate finance and compliance teams: preparing audit schedules, handling queries, ensuring CARO and Ind AS disclosures; internal audit and SOX/IFC testing in listed companies and MNC shared-service centres.
• Government: CAG audits of Union and State departments and PSUs (propriety and performance audit); GST and income-tax departmental audits.

Interview questions

• Q: What does "true and fair view" mean? A: The financial statements are free from material misstatement and disclose all information required by law — it does not mean arithmetically exact.
• Q: Who can be appointed as a company auditor in India? A: Only a practising Chartered Accountant (individual or firm), subject to the disqualifications in Section 141 of the Companies Act, 2013.
• Q: Difference between vouching and verification? A: Vouching examines documentary evidence for transactions in the books; verification confirms existence, ownership, valuation and disclosure of assets and liabilities at the year end.
• Q: When is a qualified opinion given rather than an adverse one? A: Qualified when the misstatement or lack of evidence is material but confined to specific items; adverse when it is material *and* pervasive to the statements as a whole.
• Q: What is audit risk and how is it managed? A: The risk of an inappropriate opinion on materially misstated statements; it is managed by assessing inherent and control risk and reducing detection risk through more extensive substantive procedures.
• Q: Is the auditor responsible for detecting all frauds? A: No — the primary responsibility is management's; the auditor gives reasonable assurance and must report frauds noticed under Section 143(12).
• Q: What are working papers and who owns them? A: Documentation of evidence, procedures and conclusions (SA 230); they are the auditor's property and must be kept confidential and retained for the prescribed period.

Common mistakes

• Saying the auditor's main objective is to detect fraud — it is to express an opinion; fraud detection is incidental.
• Confusing vouching with verification, or routine checking with test checking.
• Mixing up qualified and adverse opinions, or treating an Emphasis of Matter paragraph as a qualification.
• Quoting old Companies Act, 1956 sections (224, 227) instead of the 2013 Act (139, 141, 143), or AAS numbers instead of current SAs.
• Writing that internal audit can replace statutory audit, or that an internal auditor may also be the statutory auditor (prohibited by Section 144).

Related topics

• Internal control and internal audit · Companies Act basics · Forensic accounting and fraud detection · Financial statements and Ind AS · Cost and management audit