First let us understand the basic concepts of ‘Audit’.

AAS – 1 defines Audit as an Independent Examination of the financial information, including financial statements, of an enterprise, irrespective of its size and legal form, with a view to expressing an opinion thereon.

We come across 3 phrases in the above definition that answer 3 basic question?

The Concept of “Independent Examination”

In any audit, our work is to examine various aspects of the Financial Information, that we are auditing.

Examination implies reviewing, analyzing and testing the accuracy of something.

Independent Examination implies that we are in no way related to the subject that is being examined, i.e., the outcome of the examination should not affect our interests in any way and also that at the time of conducting the examination, we should be free from all kinds of bias and prejudices.

For example, suppose, you have been asked to examine whether a dish prepared by your close relative is tasty or not. Here, even if the food is not tasty, there is a risk that you may say that the food is tasty just to make your relative feel good.

However, if the same food had been prepared by a person, with whom you are not concerned in any way, you would have said the truth that the food is not good, without any glitches.

Independence also implies that we should not audit any information that has been prepared by us.

In the above example, if you yourself had prepared the dish, you would have always felt that the food is good, no matter how bad it really is.

In the field of audit too, the above example holds good. If we conduct the audit of an entity with whom we are related, we may overlook certain important issues to preserve the interests of the entity. Hence there is a risk of issuing a wrong audit opinion. This risk can be overcome by ensuring independence.

Independence in built in the laws:

Section 224 of the Companies Act, together with the Chartered Accountants Act, 1949 and the various notifications issued by the ICAI, ensure the independence of the auditors.

What to audit?

The kinds of audit Chartered Accountants do are related only to Financial Information. Common examples financial information audited by Chartered Accountants are:

1.    Financial statements, i.e., Balance sheet, Profit and loss account, Cash Flow Statements, etc.

 2. Quarterly Results of listed Companies

 3. Financial Information relating to Taxes, both direct and indirect.

 4. Specific financial information relating to certain areas.

 5. Over all financial performance of the Company (performed more in the field of Internal Audit.

What is the objective of an audit?

The ultimate objective of any audit is to express an opinion on the Financial Information audited.

What is the opinion?

The opinion that we issue takes the form of an audit report in which we state, whether in our opinion the information audited by us reflect a true and fair view of the state of affairs.

Additionally, various statutes require us to report on certain specific matters. In such cases, there is additional onus on the auditors to do the same. Examples of such statutory requirements are CARO by the Companies Act, Form 3CD by the Income Tax Audit, relevant forms of VAT Act, etc.

Statutes may also require us to issue an opinion as to whether the financial information are true and correct. In such cases, the responsibility of the auditor increases as he has to vouch for the accuracy of the information. An example of such an audit is tax audit conducted under section 44AB of the Income Tax Act.

What is the difference between ‘true and fair’ and ‘true and correct’?

It is very difficult for an auditor to vouch for the accuracy of any financial information, mainly because we cannot check 100% information and we have to rely on test checks and there is always a possibility that we may miss out on possible cases of errors and frauds. Also, compilation of financial information involves the use of estimates in certain areas and estimates can never be accurate.

Hence, if we were to say that the financial information audited by us is ‘true and correct’, it would not be entirely justified, as the inherent limitations of audit do not allow us form such an accurate opinion.

However, it is our duty to ensure that our audit procedures are designed in such a way so that no major errors and frauds go undetected and we get a reasonable assurance that there are no ‘material misstatements’ in the financial information audited by us. We also have to ensure that the estimates used are reasonable and not absurd. When we achieve the above mentioned objectives, we are in a position to express an opinion that what we have audited does give a reasonably correct picture of the real scenario, though it may not be 100% accurate. The words ‘true and fair’ are used to express such an opinion.

What is material misstatement?

A misstatement means a mistake contained in the financial information caused either due to fraud (intentional) or due to error (non intentional). When such mistakes, individually or in aggregate with other mistakes, assumes such proportion that the picture presented by the financial information no longer gives a reasonably correct view of the real scenario, we say that the financial information is materially misstated.

Materiality is a relative term. What may be material for one entity may not be material for another entity. For example, let us consider a Company like Reliance having an annual turnover in excess of 1 lakh crores. On the other hand, let us consider a smaller Company X, having a turnover of 500 crores. In the given scenario a mistake of 10 crores shall be immaterial for RIL but shall be quite material for Company X.

It is essential that before we start any audit, we define the materiality limits for the audit, so that we know what matters to ignore and what matters to lay emphasis on.

The various details about materiality shall be discussed later.

Why Audit?

We audit because the people who use the financial information need an assurance that the financial information being used by them is reliable and not misleading and since it is not possible for each user to check the validity of the financial information separately, the onus is placed upon us to do the same on behalf of the all the users.  

Who are the users of the financial information?

1. Shareholders : In corporate environment, the management and the ownership functions are separate. The funds of the owners of the Company (Shareholders) are placed in the hands of the Management (Directors and other officers of the Company), for efficient and profitable utilization. The shareholders need an assurance that their money is being managed properly and is not being siphoned away by the management. They use the financial information in the capacity of owners to find out how the funds have been utilized by the management.

2.    Lenders : Whenever any person (banks, FI’s, other lenders) lends money to an entity, he uses the financial information to ensure the credibility of the Company before extending the loan. Even after sanctioning the loan, he uses the financial information to ensure that the funds provided by him are being used for correct purposes, and to ensure that the entity is in a position to service and repay the debt.

 3.Government : The Government uses the Financial Information mainly for collection of various levies and taxes and also for ensuring compliance of various other stipulations. The Government also needs such information to compile statistical data for analysis purposes.

 4. Public, at large : Any entity is a social system, being a part of the society. Hence, various other people are interested in the working of the Company for various other reasons and they can know about it by perusal  of Financial Information. Eg; A prospective shareholder deciding whether to buy a share or not.

In order to protect the interests of all the above mentioned users, it is our duty to conduct the audit diligently and properly.

What are the consequences if we do not carry out the audit properly?

The Institute of Chartered Accountants of India requires all its members to be very careful and diligent in performing audits. If a member is found guilty of being negligent, he shall be liable to punishment, which may take the form temporary suspension of the membership and if it is an extreme case of negligence, then his membership can be terminated for life as well. The Companies Act also lays down certain liabilities of members who are grossly negligent in the performance of the audit function.

Even members, who are not signing the audit report, but who have been involved in the audit are liable to punishment, if negligence is proved on their part.