IGNOU Solved Question Papers: ECO - 12 (December' 2012)

byKumar Nirmal Prasad -
BACHELOR'S DEGREE PROGRAMME
Term-End Examination December, 2012
ELECTIVE COURSE: COMMERCE
ECO-12: ELEMENTS OF AUDITING
Time: 2 hours
Maximum Marks: 50 (Weightage 70%)
Note: Attempt any five questions. All question carry equal marks.
1. What is continuous audit? State its merits and demerits. 2, 5, 3
Ans: 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. Explain any two of the following: 5, 5
(a) Audit programme
Ans: Before commencing the audit he should plan his work so that is over without delay. For this purpose the auditor chalks out a detailed programme explaining the procedure to be followed for audit. It explains the work to be done by the audit staff. an audit programme is defined as “a detailed plan of the auditing work to be performed, specifying the procedure to be followed in verification of each item in the financial statements, and giving the estimated time required’. Hence an audit programme is a statement giving instructions and guidance to the audit staff as to the audit procedure. It arranges and distributes the work among the audit staff.
Advantages of Audit Programme
  1. It provides the audit staff clear instructions about their duties.
  2. It promotes division of work in a well organized manner.
  3. It helps the auditor to monitor the progress of the work.
  4. It will be easier to fix responsibilities for omissions and commissions.
  5. It serves as a valuable evidence for the work done.
Disadvantages of Audit Programme
  1. The audit work becomes mechanical.
  2. It kills the creativity of the audit staff.
  3. Chances of work not done properly are high as the scope is to be completed within a scheduled time.
  4. A rigid programme may not be suitable for all kinds of business.
(b) Audit Note Book
Ans: The audit clerk maintains the audit notebook.  He keeps therein a record of his observations during the course of any audit work as also the points to be discussed with his senior clerk or the auditor.  It is a written record of the queries made by him and the replies thereto.  It is part of permanent record of the audit office, which is used by the auditor while preparing his report. Some of the important matters recorded in the Audit Note Book are as follows:
  1. Name of the business.
  2. Instructions from the management having relevance to the audit.
  3. List of book of account maintained by the enterprise.
  4. Accounting methods followed in the enterprise, and their defects.
  5. Any irregularities in the observance of laws and notifications applicable to the enterprise.
  6. List of missing vouchers and receipts.
  7. Matters requiring explanation or clarification.
It should be noted that an audit notebook is meant to record only important and strategic items.  Matters, which are, or can be sorted out on the spot, or those of a trivial nature, need not be entered therein.
(c) Audit working papers
Ans: Audit working papers constitute the basic records for the auditor in respect of the audit carried out by him. They constitute the link between the auditor's report and clients' record.
These include retention of permanent record in the nature of a document to show the actual audit work executed the nature of the, work, the extent of the work and important points, facts, dates and decisions having bearing on the audit of the accounts audited. The working papers, if properly maintained, can be used as defense in case of need. The audit working papers are found very useful in the following aspects as they:
  1. aid in the planning and performance of the audit;
  2. aid in the supervision and review of the audit work;
  3. provide evidence of the audit work performed to support the auditor's opinion; and
  4. act as evidence in the Court of law when a charge of negligence is brought against the auditor.

3. "Vouching is regarded as the essence of auditing."  Discuss. 10
Ans: Meaning of Voucher: Voucher is the original document in support of any payment or receipt of money pertaining to a transaction in a business.  It forms the basis of accuracy of any entry in the books of accounts.
According to J.P. Batliboi “A voucher may be defined as documentary evidence in support of an entry appearing in the books of accounts.”
Meaning of Vouching: `Vouching’ means a careful examination of the original documentary evidence such as invoices, receipts, statements, correspondence, minutes, contracts etc. in order the check the accuracy of records in the books of accounts.  Thus, it is a mode of verifying the authenticity and correctness of entries in the books of accounts.  Merely by checking the arithmetical accuracy of posting is no proof that all the transactions are correctly recorded.  For instance, as entry may be recorded about a purchase from A but just this entry does not prove that the goods were actually received or misappropriate or the entry is entirely fictitious.  Hence vouching is an important tool of auditing.  It is indispensable as it helps to ascertain whether:
  1. The transaction in within the general nature of the business.
  2. The transaction has been duly authorized.
  3. The transaction has been correctly recorded in the books of accounts.
Importance of vouching: Vouching of transactions is the most important audit step in any type of auditing. Voucher is the document which describes any transaction and whole building of accounting stands on vouchers. Such is the importance of voucher and vouching. The importance and objectives of vouching are given below:
  1. Back bone of auditing: Vouching is first step in detailed auditing. It gives grounds and reasons for further investigation. It is primary activity to know the worth of any business.
  2. Careful vouching helps the auditor to detect fraud, misappropriation of money, errors, falsification etc.
  3. Detailed vouching acts as a moral check on employees.
  4. Vouching helps in separation of revenue with capital items.
  5. Vouching helps in ascertaining whether the transaction is in relation to business or some other activity outside the business.
  6. It is the foundation stone for any accounting process.
  7. Effective vouching makes the rest of audit easy and fast.
  8. Vouching helps the auditor to determine whether the voucher belongs to the period of audit.
From the above discussion, it is clear that vouching is the essence of audit.
4. Explain the process of verification and valuation of: 5, 5
(a) Cash in hand, and
(b) Contingent liabilities

5. State the auditor's duties in relation to: 5, 5
(a) shares issued at a discount
Ans: Auditor’s Duty regarding issue of share at a discount
  1. The auditor should examine the Prospectus, the Articles and the Minutes of the Directors to see whether the issue of shares at a discount is duly authorized or not.
  2. He should confirm the rate of discount. Rate of discount normally does not exceed 10%.
  3. He should also confirm that at least one year has been elapsed since the date for which the company became entitled to commence business.
  4. The cash receipt on issue of shares at a discount is vouched with the entries in the Cash Book and the supporting documents.
  5. He should see that the provisions of section 79 have been complied with.
  6. The auditor should also confirm that the discount on issue of shares is properly disclosed in the company’s balance sheet.

(b) issue of bonus shares
Ans: Auditor’s Duties regarding issue of bonus shares
  1. The auditor should examine the Articles of Association to ascertain that the issue of Bonus shares is duly authorized.
  2. It is to be noted that Bonus Shares can only be issued out of the premium received on issue of shares, heavy accumulated reserves, undistributed profits, capital redemption etc., if such an issue is permitted by Articles.
  3. He should inspect the Minute Book of Shareholders for the resolution declaring the bonus and also the Director’s Minute Book to examine the resolution under which profits have been appropriated.
  4. He should ensure that sanction of Controller of Capital Issues has been obtained.
  5. He should check the Allotment Book, Share Register and Reserve Account to ensure that proper entries have been made wherever necessary and the allotments are regular.
  6. If to increase the Share Capital, alterations are effected in the Memorandum and Articles of Association, it should be seen that the requirements of law in this respect have been duly complied with.
  7. He should vouch the entries passed in connection with the issue of Bonus Shares.
  8. Lastly, he should examine the Balance Sheet of the company to note the change made by the issue of shares.
6. Explain the status of an auditor in a company and his rights in protecting shareholders interests in the company.    10
7. What do you understand by 'divisible profits’? When can the dividends be paid out of the past accumulated profits reserves? 5, 5
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.
Declaration of dividends out of past accumulated profits
Where in any year there is a loss, or the profits are inadequate to declare a dividend, the dividend can be declared, out of the accumulated profits earned by the company in previous years and transferred to reserves, subject to certain rules. The following conditions have to be fulfilled before declaring dividend out of reserves:
  1. Rate of dividend shall not exceed average of rates of dividend declared in preceding 5 years subject to a max. Of 10%.
  2. The total amount to be withdrawn out of reserves shall not exceed 10% of the aggregate of paid-up capital and free reserves and this amount shall first be utilised to set off the losses incurred in the financial year and the balance only may be utilised to distribute dividend.
  3. The balance in the Reserves shall not fall below 15% of paid-up share capital after the amount withdrawn necessary for the purpose of dividend and set off of losses of the current year.

8. What do you mean by the term 'management audit’? Explain its importance. 4, 6
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."
ADVANTAGES OR IMPORTANCE OF MANAGEMENT AUDIT:
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.

9. Write short notes on any two of the following: 5, 5
(a) Internal control
Ans: 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.”
Thus, 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:
  1. Reliability of financial reporting,
  2. Effectiveness and efficiency of operations, and
  3. Compliance with applicable laws and regulations.
Types of Internal Controls:
  1. Detective: Designed to detect errors or irregularities that may have occurred.
  2. Corrective: Designed to correct errors or irregularities that have been detected.
  3. Preventive: Designed to keep errors or irregularities from occurring in the first place.

(b) Routine checking
Ans: Routine checking is a checking of books of original entry and ledgers as a matter of routine work to determine the arithmetical accuracy and to detect errors and frauds and ensures the reliability of final accounts.
Objective of routine checking: The objectives of routine checking are discussed below:
(i) Checking of primary books
(ii) Examining arithmetical accuracy
(iii) Examination of pointing
(iv) Helps to detect errors and frauds
(v) Prevent to alter errors and frauds
Advantage or importance of Routine Checking: There are many advantages of routine checking. These are discusses below:
(i) Examination of arithmetical accuracy
(ii) Through checking of books of accounts
(iii) Detection and prevention of frauds
(iv) Reliability of final accounts
Disadvantages or Limitations of Routines Checking: The following are the limitations of routine checking.
(i) All errors cannot be detected
(ii) All frauds cannot be detected
(iii) Highly mechanical
(c) Objectives of Auditing
Ans: Objectives of Auditing:
  1. Reporting: The objective of an audit of financial statement is to enable the auditor to express an opinion whether the financial statements are prepared, in all material respects in accordance with an identified financial reporting frame work. The phrases used to express the auditor's opinion are given a true and fair view or present fair in all material respects, which are equivalent terms.
  2. Purpose of Audit: The purpose of audit is to check the proper accounting to policies. For the better accounting system it is necessary to follow the accounting policies. Only by this way we can get the effective result.
  3. Opinion: The purpose of the audit is to get the correct opinion about the business so for this the auditor should be honest, confident and he must have the ethical standard for his work.
  4. True and Fair View: The purpose of the auditing is to determine the correctness of statement. After auditing the financial statement has the correct and true view about the business.
  5. Detection and Prevention of Errors: The audit is committed for the detection and prevention of errors. These errors can be prevented through internal check also.
  6. Detection and Prevention of Fraud: The detection and prevention of fraud is another purpose of auditing. It consists of the omission of the effect of transaction, recording or transaction without substance etc.
  7. Profit Verification: Audit is concern to check the profit verification in a business concern. Profit has to main position in any type of business, only the expert auditors can check the fluctuation of the Profit.
  8. Admission of Partners: For the admission of the new partner the audit plays an important role. It provides information to new as well as old partner for the settlement of the new terms according to the volume of assets and liabilities.
  9. Purchasing Price: For the buyers and sellers of a certain business concern it is necessary to know the real value of the business assets and liabilities. The audit is helpful in finding out the real value of the business.

(d) Qualified Audit Report
Ans: Qualified Audit Report: A qualified report means an audit report which is not clean. In case auditor has any reservation in respect of certain methods mentioned in the financial statements he may qualify his report. A qualified opinion shall be expressed as being subject of or except for the effects of the matter to which the qualification matters. If the accounting standards issued by Institute of Chartered Accounts of India is not followed by the company the auditor may qualify his report.
Circumstances for Qualification of Audit Report: In following circumstances the auditor has to qualify his report.
(a) He cannot conduct audit satisfactorily due to non availability of certain books of accounts or records, information or explanations necessary for conduct of his audit.
(b) He finds that the Balance Sheet and Profit & loss Account have not been prepared in accordance with accepted accounting principles.
(c) He detects that provisions for Bad & Doubtful Debts, Depreciation etc. are not adequate.
(d) He detects that the company has created certain secret reserve.
(e) The stock in trade has been valued at market price which is more than cost price.
(f) He finds that the contingent liability for bills discounted has not been disclosed.
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