Auditing

Unit-2
Internal Check System

Meaning of Internal Check System

An internal check is a part of an organization’s system of internal control that aims to prevent
errors and fraud in the day-to-day transactions and record-keeping activities of the business.
This system is designed such that the work of one employee is automatically checked by
another, reducing the chance of mistakes or manipulation.

Internal checks involve a division of responsibility in the various transactions processing

stages. It’s a method where the work is arranged so that the work done by one person is
automatically checked by another in the ordinary course of business.

Definition Internal Check System

An internal check has been defined by The Institute of Chartered Accountants of England
and Wales (ICAEW) as; “the checks on -a day to day transactions which operate
continuously as part of the routine system, where the work of one person is proved
independently or in complementary to the work of another, the object is the prevention or
early detection of errors or frauds.”

An internal check is a continuous process and part of the daily routine. It relates to all the
transactions that take place every day. An internal check is achieved by a complimentary
allocation of duties and by independent verification of the work of one person by another.

Characterstics of Internal Check System

1. Division of Work: Division of work refers to dividing the total work among various staffs
is such a way that no single person is allowed to perform the work from the beginning to the
end. The work should be allocated to the employee based on the capacity and capability of
each person.
2. Authority and Responsibility: Authority, duties and responsibilities of each person
should be clearly defined and there should not be any overlapping or duplication of duties
and responsibilities of any person.
3. Automatic Check: Work allocated to the staff should be in such a way that the
work performed by one person is automatically checked by another person.
4. Rotation of Employees: A good system of internal check should provide for transfer or
rotation of employees from performing one work to another at frequent intervals.
5. Proper Training to Employees: An effective system of internal check should carefully
select the employees to the organization. The employees should be properly trained and clear
instructions should be given to them to perform their work in an effective and efficient
manner.
6. Proper system of Filling: Internal check system should provide for proper system of
filling vouchers, correspondences etc. in a systematic manner.
7. Periodical Review: The system of internal check should at frequent intervals (be
reviewed) and suitable changes should be introduced.
8. Usage of Electronic Equipment: The system of internal check should provide for usage
of labour saving electronic devices such as calculating machines, personal computers, time
recording clocks, book-keeping machines etc. The proper training should also be given to the
employees for using these devices.
Objectives of Internal Check System
1. To protect business from carelessness, inefficiency and fraud.
2. To ensure and produce adequate and reliable accounting information.
3. To keep moral pressure over staff.
4. To minimize the chances of error and frauds and to detect them easily on early stage
if it is committed.
5. To divide the work in such a way that no business transaction should be left
unrecorded.
6. To fix the responsibility of every clerk according to the division of work.
Principles of Internal Check System
1. Responsibility
2. Automatic check
3. Rotation
4. Supervision
5. Safeguard
6. Formal Sanction
7. Reliance
8. Review
Advantages of Internal Check System

1. It helps in putting moral check on the members of staff and helps in increasing
integrity.
2. It helps in fixation of responsibilities of employees. The member of the staff
may be held responsible for the irregularity caused by him.
3. The chances of frauds are less under the system of internal check as it helps in
detecting errors and frauds at initial stages.
4. The concept of internal check is based on division of work, therefore, it helps
in increasing efficiency.
 5. Any irregularity in the system can be detected at an early stage without doing
much damage to the system.
6. It automatically helps in making correct and complete record of all the
transactions on each balancing of the books of account.
7. It helps in speeding up the audit task because it facilitates test checking.
8. In internal check system, the financial statements are prepared without any
loss of time.

Disadvantages of Internal Check System

1. It is costly for small business units.

2. If Internal Check System is not properly organized, there are chances of
disorder in the working of the business.
3. There might be the instances when the quality of the product and the work is
compromised with by the staff members due to greater importance to faster
results.
4. An Auditor cannot be relied on if he does not conduct test with procedures of
his own.

Internal Control
Meaning of Internal Control

Internal controls are policies and procedures put in place by management to ensure that,
among other things, the company’s financial statements are reliable. Some internal controls
relevant to an audit include bank reconciliations, password control systems for accounting
software, and inventory observations.
Internal control is a process that involves everyone in an organization, from the board of
directors to the front-line employees. It is not a one-time event, but rather an ongoing process
that is constantly being monitored and updated.
Features of Internal Control

1. Control Environment: This is the foundation. It sets the tone and culture,
emphasizing ethical values, integrity, and competence. Think "tone at the top" -
leadership's commitment to control.
2. Risk Assessment: Identifying and analyzing potential threats (internal and external)
that could prevent the organization from achieving its objectives. This is about
understanding what could go wrong.
3. Control Activities: The actual policies and procedures designed to mitigate those
risks. These are the actions taken to ensure things are done correctly (e.g., approvals,
segregation of duties, reconciliations).
4. Information and Communication: Ensuring relevant information is captured and
communicated effectively, both internally and externally, to support decision-making
and control. This is about having the right information in the right hands at the right
time.
5. Monitoring: Regularly evaluating the effectiveness of the internal control system.
This can be ongoing (day-to-day checks) or separate evaluations (periodic reviews).
It's about making sure the controls are working as intended.
Advantages of Internal Control

1. Safeguarding Assets:

i. Preventing Fraud: Reduces the risk of theft, embezzlement, and other fraudulent
activities.
ii. Protecting Resources: Ensures that company assets (physical and intellectual) are
used responsibly and efficiently.

2. Ensuring Accuracy and Reliability:

i. Financial Reporting: Improves the accuracy and reliability of financial statements,

leading to better decision-making.
ii. Data Integrity: Enhances the accuracy and completeness of data used for operations
and reporting.

3. Promoting Operational Efficiency:

i. Streamlined Processes: Helps to standardize and streamline business processes,

reducing waste and improving productivity.
ii. Resource Optimization: Enables better allocation and utilization of resources.

4. Enhancing Compliance:

i. Laws and Regulations: Facilitates compliance with relevant laws, regulations, and
industry standards.
ii. Ethical Conduct: Supports ethical behavior and a culture of integrity within the
organization.

5. Improving Decision-Making:

i. Reliable Information: Provides management with timely and reliable information for
making informed decisions.
ii. Risk Management: Helps in identifying and managing risks effectively.

6. Boosting Stakeholder Confidence:

i. Transparency: Demonstrates a commitment to good governance and transparency,

increasing trust among investors, customers, and other stakeholders.
ii. Accountability: Establishes clear lines of accountability and responsibility.

Disadvantages of Internal Control

1. Weak Organizational Structure: A poorly designed organizational structure can

severely hamper the effectiveness of internal controls.
2. Small Organization Limitations: Smaller organizations often have limited internal
controls due to close owner/management involvement, which can sometimes bypass
established procedures.
 3. Unusual Transactions: Internal control systems may struggle to effectively handle
unusual or non-routine transactions.
4. Cost Factor: Implementing and maintaining internal controls requires investments in
time, effort, and financial resources.
5. Management Override: Top-level management can sometimes override controls,
potentially weakening the system.
6. Collusion: Two or more individuals working together can circumvent even well-
designed controls.
7. Obsolescence: Internal control systems can become outdated and ineffective if not
regularly updated to reflect changes in the business.
8. Human Error: Human error is always a possibility, and even the best controls can be
compromised by mistakes.
9. Monitoring Burden: Effective internal control requires frequent follow-up and
monitoring, which can be time-consuming.

Components of Internal Control

Auditor’s Role in Internal Control

The auditor's role in internal control is multifaceted and crucial for ensuring the reliability of
financial reporting. Here's a breakdown of their key responsibilities:

1. Understanding and Evaluating Internal Control:

 Risk Assessment:

a. Auditors must understand the entity's internal control to assess the risks of
material misstatement in the financial statements. This involves identifying
and evaluating the risks that could lead to errors or fraud.
b. They assess how the organization identifies and responds to business risks.

 Control Evaluation:

a. Auditors evaluate the design and operating effectiveness of internal controls.

This means determining whether the controls are properly designed to prevent
or detect material misstatements and whether they are operating as intended.
b. They test the controls to gather evidence about their effectiveness.

2. Determining the Nature, Timing, and Extent of Audit Procedures:

 Audit Planning:

a. The auditor's evaluation of internal control influences the nature, timing, and
extent of substantive audit procedures.
b. If internal controls are deemed effective, auditors may perform fewer
substantive tests. Conversely, if controls are weak, they may need to perform
more extensive tests.

 Substantive Testing:
 a. Even with strong internal controls, auditors still perform substantive tests to gather
evidence about the accuracy of account balances and transactions.

3. Reporting on Internal Control:

 Communication of Deficiencies:

a. Auditors are responsible for communicating any significant deficiencies or

material weaknesses in internal control to management and those charged with
governance (e.g., the audit committee).
b. This communication helps the organization improve its internal control
system.

 Specific Reporting Requirements:

a. In some jurisdictions, auditors may be required to provide a formal opinion on

the effectiveness of the entity's internal control over financial reporting. This
is notably the case with public companies in the U.S. under the Sarbanes-
Oxley Act.

Key Aspects of the Auditors role:

1. Independence: Auditors must maintain independence to provide an objective

assessment of internal control.
2. Professional Skepticism: Auditors must exercise professional skepticism, which
means having a questioning mind and critically evaluating evidence.
3. Professional Judgement: Auditors use professional judgment to assess the risks of
material misstatement and to evaluate the effectiveness of internal controls.

Audit Procedure
Meaning of Audit Procedure
An audit procedure refers to the specific steps, methods, or techniques used by an auditor to gather
evidence and evaluate the accuracy, completeness, and reliability of financial statements or other
information being audited. These procedures are designed to help the auditor form an opinion on
whether the financial statements are free from material misstatement, whether due to fraud or error.
An audit is a procedure in which a group of independent auditors evaluates a corporation’s or
company’s financial accounts.

Principal Procedures of Auditing:

An all-inclusive list of audit procedures is difficult to prepare. Judgment, with a tempering of
experience, remains the basis for the determination of the type and extent of audit procedures.
However, the following may be cited as the principal audit procedures:
 1. Reviewing, testing and evaluating the internal accounting controls relating to
inventories, purchases, payroll, sales invoice preparation, stock valuation, depreciation
accounting and analysis, routing of invoices, etc.
2. Inspecting, counting and calculating the different assets relating to cash, stocks,
investment, plant and equipment, furniture; and determining that the inventory is calculated
properly at the lower of cost or market price in accordance with generally accepted
accounting principles consistently applied; and obtaining confirmation in regard to the
validity of debtors and creditors balances, etc.
3. Obtaining the proof of accuracy - A copy of final inventory listing can be obtained and
its clerical accuracy checked and tested; obtaining the earnings records of employees and
checking the same for accuracy with the original copies of appointment-cum-increment
letters; Similarly, appropriation of profit and the board's resolutions.
4. Reconciling, comparing and confirming - Sales invoices may be reconciled with the total
charges to customers. The reconciliation between the cost account records and the books of
financial accounts is an illustration. The Bank reconciliation statement provides a good
measure of confirmation. The fact that the inventory belongs to the client and that any lien on
the inventory is disclosed properly can be compared and confirmed from the minutes of the
board of directors for indications of pledges or assignments.
5. Observation and inquiry about any excess, slow-moving, obsolete, or unassailable
inventory. 6. Accounting of all pre-numbered inventories tags before and after the physical
stock-taking.
6. Verification as to the evidences relating to the ownership of assets and existence of assets
and liabilities, as a part of auditing practices and procedures, is the principal duty of the
auditor before he certifies that the assets and liabilities that appear in the balance sheet exhibit
'true and fair view' of the state of affairs of the business.
Types of Audit Procedures
1. Inquiry
2. Confirmation
3. Inspection of records or documents
4. Inspection of tangible assets
5. Observation
6. Recalculation
7. Re-performance
8. Analytical procedures
1. Inquiry: Inquiry is the process of asking the clients for an explanation of the process or
transactions related to financial statements. This type of audit procedure usually involves
collecting verbal evidence. Likewise, auditors use inquiry procedure for a wide range in the
audit process.
For example, auditors may inquire clients to understand the business and control
environment; or they may inquire about transactions or balances of financial statement line
items. Evidence gathered by formal or informal inquiry generally cannot stand alone as
convincing. Hence, auditors usually perform other procedures together with the inquiry such
as inspecting the supporting documents to ensure that the explanation provided by clients can
be relied upon.
2.Confirmation: Confirmation is similar to the inquiry as it is also the procedure of asking
for the information. However, confirmation is usually done by asking the third party, instead
of the client, to confirm transactions and balances. This type of audit procedures is usually
done through formal written letters. Auditors usually perform the confirmation procedure for
testing account balances such as accounts receivable, accounts payable, and bank balances,
etc.
For example, auditors usually perform confirmation on the client’s bank balances in order to
obtain evidence about its existence as well as rights and obligations assertion.
3. Inspection of records or documents: Inspection of records or documents is the process of
gathering evidence by examining the records or documents. This type of audit procedures
may be done by vouching the transaction records to the supporting documents or tracing the
supporting documents to transaction records.
For example, auditor may use the inspection procedure to test the occurrence assertion of
expense transactions by vouching them to receiving reports, supplier’s invoice and purchase
orders. Audit assertions such as occurrence, accuracy, and cut-off are usually tested by
inspecting the documents to support the accounting transactions in the company’s records
(vouching). And completeness assertion is usually tested by selecting documents and trace
them back to the company’s records (tracing).
4.Inspection of tangible assets: Inspection of tangible assets is the process of physical
examination of the company’s tangible assets such as property, plant and equipment. This
type of audit procedures can provide the evidence of tangible assets’ existence.
For example, auditors may test the existence assertion of fixed assets by performing physical
inspection of assets that are recorded in the fixed assets register. Also, it is useful to note that
the inspection alone will not provide evidence about the rights and obligations. For this audit
assertion, auditors may need to inspect the legal documents of the assets.
5.Observation: Observation is different from physical examination of assets as the physical
examination of assets is actually the same as counting assets while observation focuses only
on the client’s activities.
For example, the auditor may perform an observation procedure by witnessing the counting
of inventories by the client. This observation procedure is to test the existence of the client’s
inventories counting procedures, not the accuracy of the client’s inventory.
6.Recalculation: Recalculation is the process of re-compute the work that the client has
already done to see if there are different results between auditor’s work and the client’s work.
This type of audit procedures is usually used to test the valuation and allocation assertion of
the financial statements. For example, auditors may perform recalculation on the depreciation
of fixed assets to test their valuation assertion.
7.Re-performance: Re-performance is the process that auditors independently perform the
control procedures that were originally done as part of the internal control system by the
client. This type of audit procedures is used to test the client’s control procedures.
8.Analytical procedures: Analytical procedures are the processes of evaluating financial
information through analysis of trend, ratio or relationship between data including both
financial and non-financial data. Auditors usually perform this type of audit procedures by
building their expectations about typical transactions or account balances and comparing
them to the client’s record. If auditors find that the client’s record is inconsistent with their
expectations, they will investigate further on the variance that exists. The investigation might
involve performing more substantive tests.
For example, auditor may perform the analytical procedure on interest expense account by
multiplying the average interest rate with the average outstanding balance of the borrowings.
Then, the auditor will use the result to compare with the amount recorded by the client. Any
significant difference will be investigated further.

Purpose of Audit Procedures

Audit procedures are designed to:

1. Gather Evidence: Obtain sufficient and appropriate evidence to support the auditor’s
opinion on the financial statements.
2. Assess Risks: Identify and evaluate risks of material misstatement, whether due to
error or fraud.
3. Test Controls: Evaluate the effectiveness of internal controls in preventing or
detecting misstatements.
4. Verify Accuracy: Ensure that financial statement amounts and disclosures are
accurate, complete, and in compliance with accounting standards.
5. Support Conclusions: Provide a basis for the auditor’s opinion on whether the
financial statements are presented fairly, in all material respects.

Key Considerations for Audit Procedures

1. Materiality: Procedures are designed to detect misstatements that could be material

to the financial statements.

2. Audit Risk: The risk of issuing an incorrect opinion influences the nature and extent
of procedures.

3. Professional Judgment: Auditors use judgment to determine which procedures are

most appropriate in each situation.

4. Documentation: All procedures performed, and evidence obtained, must be

documented in the audit working papers.

Vouching
Meaning:
Vouching means the examination of documentary evidence in support of entries to establish
the arithmetic accuracy. When the auditor checks the entries with some documents it is called
vouching. Vouching is the acid test of audit. It tests the truth of the transaction recorded in
the books of accounts. It is an act of examining documentary evidence in order to ascertain
the accuracy and authenticity of the entries in the books of accounts
According to Joseph Lancaster "it is often thought that vouching consists of the mere
examination of the vouchers or documentary evidence with the book entries. This is,
however, quite wrong, for vouching comprises such an examination of the ledger entries as
will satisfy the auditor, not only that the entry is supported by the documentary evidence but
it has been properly made upon the books of accounts."
Voucher: Any documentary evidence supporting the entries in the records is termed as a
voucher. Any document, which supports the entries in the books of accounts and establishes
the arithmetical accuracy, is called a voucher.
Examples of Vouchers: A bill, a receipt, an invoice, goods received note, salaries and
wages sheets, goods inward and outward register, stores records, counterfoil of a cheque
book, counterfoil of pay-in-slip book, bank statement, bank pass book, delivery challans,
agreements, a material requisition slip, copy of purchase order, minute book, memorandum
and articles of association, partnership deed, trust deed, prospectus etc. are the examples of
vouchers.
Importance of Vouching
1. Ensures genuineness of the transactions
2. Enables to know transactions
3. Helps to know relevance of the transaction
4. Facilitates proper allocation of capital & revenue, expenditure
5. Detects frauds and errors
6. Decides authenticity of transactions
7. Ensures proper accounting
8. Compliance with law
9. Ensures proper disclosure
Factors to be considered in Vouching
1. Date of the voucher
2. The name of the party
3. Tick and audit rubber stamp
4. Authorisation by the authorised person
5. Revenue stamp of Re. 1 if it exceeds Rs.5000/-
6. Transaction relates to business
7. Revenue and capital
8. Amounts in words and figure
9. Account head
10. No assistance of member of clients staff to be taken for checking receipts
11. Not to accept receipted invoice
12. Missing vouchers 115
13. Important documents
14. Vouching of cash transaction
15. Proper filing
 16. Signature of payee
17. Nature of payment
18. Noting in the audit note book
19. Alteration
20. Voucher control number

Objectives of Vouching
The basic objectives of vouching are as under:
1. To ensure that all the transactions are properly recorded in the books of accounts.
2. To see the proper evidence supports all the entries of the transactions.
3. 3 To make it sure that fraudulent transactions are not recorded in the books of
accounts.
4. 4 To see that all transactions relating to business are recorded in the books of
accounts.
5. To see that all transactions are properly authenticated by a responsible person.
Types of Vouchers
1. Primary voucher: It is an original copy of any supporting written document known as a
primary voucher. Like a bill, cash memo, etc. It means it is an original copy of any document
which is given to the customer for any goods purchase.

2. Collateral voucher: It is a duplicate copy of any supporting written document known as a

collateral voucher. Like carbon copy of any bill, duplicate, etc. It means it is a duplicate copy of
any document which has been given to the customer. In the collateral voucher, one of the original
copies has to be kept at the owner while another one which is a duplicate of it, has been given to
the buyer.

Verification of Assets and Liabilities

Introduction:
Verification is a method of auditing in which the auditor confirms the truth of all assets and
liabilities shown in the balance sheet. It is not proper on the part of the auditor to give his
report without proper checking. He is able to give his report regarding the truth of the balance
sheet only on the basis of his faith in the truth of assets and liabilities. Mere examination of
the books of accounts to ascertain their arithmetical accuracy is not enough. The auditor must
verify that the assets appearing in the balance sheet were in existence in the concern on the
balance sheet date. Their ownership was also with the concern. Their valuation was correct
and proper.
Meaning of Verification:
Verification means a process to check the assets and liabilities present in the balance sheet. It
means verification inspect the assets and liabilities that appear in the balance sheet.

Verification of assets and liabilities is done to confirm the following things:

 1. It checks whether the existence of those assets and liabilities is present in the
balance sheet or not.
2. To check that it has business ownership or not. This means the assets or liabilities
entered in the balance sheet are registered for business or not.
3. To check the proper evaluation of assets and liabilities. It means to evaluate the
assets and liabilities present in entered in the balance sheet.
4. It checks whether the business has possession or not.
5. Also it uses to check whether it has freedom from encumbrances or not.
6. It inspects the proper recording of assets and liabilities.

The auditor in his report substantiates the accuracy of the Assets side (the right hand side) of
the balance sheet. The basis of this confirmation by the auditor is called the Verification of
Assets and Liabilities.
In this connection, the judgement of Chief Justice Lord Alverstone in London Oil Storage
Co. Ltd, Vs. Seear Hasluck and Co., 1904 is very significant. The learned judge held that "it
is the duty of the auditor of a company to take proper steps to verify the existence of assets
stated in the balance sheet" In this case, the auditor was found guilty of not verifying the
petty cash in hand and was fined five guineas (guinea is a gold coin worth 21 shillings).
The following definitions should make clear the meaning of verification:
1. "The verification of assets should include not only the verification of their existence, but
also of the values at which they appear in the books, as far as it is possible for the auditor to
satisfy himself of this." -Spicer and Pegler
2. "The verification of assets is a process by which the auditor substantiates the accuracy of
the right hand side of the balance sheet and must be considered as having three distinct
objects: (i) the verification of the existence of assets, (ii) the valuation of assets, (iii) the
authority of their acquisition." –Lancaster
Objectives of Verification of Assets and Liabilities
1. Existence- To ensure that the assets and liabilities exists on the balance sheet.
2. Ownership- To certify the ownership of assets by examining the title deed.
3. Possession- To ascertain that assets are in possession of the client.
4. Purpose and Authority- To ensure that the assets have been acquired or liabilities
have been incurred for the purpose and under proper authority.
5. Lien of Charge- To ensure that assets are free from any charge/lien and if there is any
charge, to ensure its adequate disclosure.
6. Completeness- To ensure that all assets and liabilities are shown in the balance sheet.
7. Valuation- To ensure assets and liabilities are correctly valued and shown at their
appropriate value in the balance sheet.
8. Disclosure- To ensure that the assets and liabilities are disclosed in the balance sheet
as per the statutory requirements and accounting principles.
Difference between Vouching and Verification

Valuation of Assets
Meaning:
Valuation means finding the correct value of assets and liabilities. This helps to keep
financial records true and fair. It also prevents mistakes and fraud. Businesses must check
their assets and liabilities regularly. Valuation of assets in auditing is an important process
that ensures the accuracy and fairness of financial statements by establishing the true value of
a company's assets.

Asset valuation is the process of determining the worth of an asset at a specific point in time.
This process involves assessing various factors such as market conditions, the asset’s
condition, and its potential for generating future economic benefits. In the context of financial
audits, asset valuation is crucial because it directly affects the accuracy of financial
statements and the overall assessment of an organization’s financial health.
Role of Asset Valuation in Financial Audits
1. Accuracy of Financial Statements: Financial statements provide a snapshot of an
organization’s financial position, performance, and cash flow. Accurate asset
valuation ensures that these statements reflect the true value of the company’s assets.
For instance, overvaluing assets can lead to inflated earnings and misleading
investors, while undervaluing assets can result in a distorted view of the company’s
financial health.
2. Compliance with Accounting Standards: Auditors must ensure that an
organization’s financial statements comply with relevant accounting standards and
regulations. Asset valuation is a critical component of this compliance process.
Standards such as International Financial Reporting Standards (IFRS) and Generally
Accepted Accounting Principles (GAAP) require accurate and consistent asset
valuation practices. Deviations from these standards can lead to audit adjustments
and potential legal ramifications.
3. Risk Assessment and Mitigation: During an audit, the valuation of assets in
auditing helps auditors assess the risk associated with financial reporting.
Accurate asset valuation can reveal potential risks, such as impairment or
obsolescence, which may impact the company’s financial performance. Identifying
these risks early allows auditors to address them and provide recommendations for
mitigating potential issues.
4. Impact on Internal Controls: Asset valuation affects an organization’s internal
control systems. Proper valuation practices contribute to vigorous internal controls,
ensuring that asset management processes are effective and reliable. Auditors evaluate
these controls to determine if they are adequate for safeguarding assets and ensuring
accurate financial reporting.

Key Considerations for Asset Valuation

1. Valuation Methods: Various methods can be used to value assets, including cost,
market, and income approaches. Each method has its strengths and is suited to
different types of assets. For example, the cost approach is often used for tangible
assets, while the income approach is suitable for intangible assets. Understanding and
applying the appropriate valuation method is crucial for accurate financial reporting
and audit outcomes.
2. External Factors: External factors such as market conditions, economic trends, and
regulatory changes can impact asset valuation. Auditors must consider these factors
when evaluating the accuracy of asset valuations. For example, a decline in market
conditions may affect the fair value of assets, leading to potential adjustments in
financial statements.
3. Documentation and Evidence: Proper documentation and evidence support asset
valuations. Auditors review documentation such as valuation reports, appraisals, and
historical data to verify the accuracy of asset valuations. Ensuring this documentation
is thorough and reliable is vital for a successful audit process.
4. Regular Revaluations: Asset values can fluctuate over time, making regular
revaluations necessary to maintain accurate financial statements. Periodic re-
evaluations help ensure that asset values reflect current market conditions and
 economic realities. Auditors assess the frequency and appropriateness of these
revaluations during the audit process.

Asset Valuation – Valuing Tangible Assets

Tangible assets refer to a company’s assets that have a physical form, which have been
purchased by an organization to produce its products or goods or to provide the services that
it offers. Tangible assets can be categorized as either fixed asset, such as structures, land, and
machinery, or as a current asset, such as cash.

Other examples of assets are company vehicles, IT equipment, investments, payments, and
on-hand stocks.

To compute the net tangible assets of a company:

 The company needs to look at its balance sheet and identify tangible and intangible
assets.
 From the total assets, deduct the total value of the intangible assets.
 From what is left, deduct the total value of the liabilities. What is left are the net
tangible assets or net asset value.

Asset Valuation – Valuing Intangible Assets

Intangible assets are assets that take no physical form, but still provide a future benefit to the
company. They may include patents, logos, franchises, and trademarks.

Say, for example, a multinational company with assets of $15 billion goes bankrupt one day,
and none of its tangible assets are left. It can still have value because of its intangible assets,
such as its logo and patents, that many investors and other companies may be interested in
acquiring.

Verification of fixed assets, intangible assets and current assets:

Verification of fixed assets, intangible assets, and current assets is a critical process in
financial auditing and accounting. It ensures the accuracy, existence, and proper valuation of
these assets in an organization's financial statements. Below is an overview of the verification
process for each type of asset:

1. Verification of Fixed Assets

Fixed assets are long-term tangible assets used in operations, such as property, plant, and
equipment (PP&E).

Key Steps:
1. Existence and Ownership:
a. Physically inspect the assets to confirm their existence.
 b. Verify ownership by reviewing purchase documents, titles, or lease
agreements.

2. Valuation:
a. Check the purchase cost, depreciation, and net book value.

b. Ensure depreciation methods and rates are consistent with accounting policies.

3. Condition and Usage:

a. Assess the physical condition of the assets.

b. Confirm the assets are in use and not obsolete.

4. Additions and Disposals:

a. Verify additions (purchases or capital expenditures) and disposals (sales or
write-offs) during the period.

5. Impairment:
a. Review for any indicators of impairment and ensure proper impairment testing
is performed.

6. Documentation:
a. Review fixed asset registers, invoices, and maintenance records.

2. Verification of Intangible Assets

Intangible assets are non-physical assets, such as patents, trademarks, copyrights, and
goodwill.

Key Steps:
1. Existence and Ownership:
2. Verify legal documents, such as patents, trademarks, or licenses, to confirm
ownership.

3. Valuation:
4. Review the cost of acquisition or development.

5. Ensure amortization is calculated correctly and consistently.

6. Useful Life:
7. Assess the estimated useful life of the asset for amortization purposes.

8. Impairment:
9. Perform impairment testing, especially for assets like goodwill.

10. Additions and Disposals:

11. Verify any additions or disposals during the period.

12. Documentation:
13. Review contracts, registration certificates, and valuation reports.
3. Verification of Current Assets

Current assets are short-term assets expected to be converted into cash within one year, such
as cash, inventory, and accounts receivable.

Key Steps:
1. Cash and Cash Equivalents:
a. Reconcile bank statements with the general ledger.

b. Confirm bank balances through bank confirmation letters.

2. Accounts Receivable:
a. Verify the existence of receivables by confirming balances with customers.

b. Assess the adequacy of the allowance for doubtful accounts.

3. Inventory:
a. Physically count inventory and reconcile with records.

b. Verify valuation methods (e.g., FIFO, weighted average) and ensure

compliance with accounting standards.

4. Prepaid Expenses:
a. Confirm the nature and timing of the expenses.

b. Ensure proper amortization over the relevant period.

5. Documentation:
a. Review invoices, receipts, and reconciliation statements.

General Considerations for Verification

1. Internal Controls:
a. Evaluate the effectiveness of internal controls over asset management.

2. Third-Party Confirmations:
a. Use external confirmations (e.g., bank confirmations, customer confirmations)
to validate balances.

3. Cut-Off Procedures:
a. Ensure transactions are recorded in the correct accounting period.

4. Compliance:
a. Verify compliance with relevant accounting standards (e.g., IFRS, GAAP).

By following these steps, auditors and accountants can ensure the accuracy and reliability of
the financial statements regarding fixed, intangible, and current assets.

Duty of an Auditor in relation to Verification rules of Verification of Assets 143

The auditor should give his attention to the following while verifying assets:
(i) whether all the assets have been included in the balance sheet.
(ii) whether valuation has been made properly.
(iii) whether assets
(a) existed on the date of balance sheet
(b) were under the ownership of the concern.
(c) were free from other encumbrances or charges than shown in the balance sheet
(iv) whether depreciation applied at each asset is adequate and proper.
(v) whether increase in the property, if any, has been shown in the balance sheet.
(vi) whether expenses on repairs and renewal of assets have been debited to income
expenditure account.
(vii) whether sale deed has been checked if assets have been purchased from a seller.
(viii) whether assets concerning investments (securities, cheques, bills, hundis, etc.) have
been kept safe under lock and key till verification is completed.
(ix) whether fictitious assets have been written off properly.

Verification of Liabilities
Concept:
Liabilities are legal obligations of the organization to third parties. It is in the form of Capital,
Debentures, Long term loans, payment to suppliers against goods and expenses, contingent
liabilities etc. Verification of liabilities is as important as verification of assets. If liabilities
are not properly verified and valued, the Balance Sheet will not reveal a true and fair view of
the state of affairs of a business concern. The main objective of verifying liabilities is to
ensure that all the liabilities are properly disclosed, valued, classified and presented in the
Balance Sheet. The diagram given below shows the various types and classifications of
liabilities.
Verification of Capital
The amount invested by the owner in a business concern is called as Capital. The owner may
be a sole proprietor or partner or shareholder. It is an internal liability of the business concern
and the auditor is required to verify the genuiness and correctness of it in the Balance Sheet.

1. Verification of Capital in a Partnership Firm

The auditor should take into consideration the following while verifying capital of a
partnership firm.
Verify Partnership Deed:
The auditor should verify the partnership deed to find out the original capital contributed by
each partner and the rate of interest payable on capital.
Verify Capital Accounts:
He should verify all the transactions affecting the capital accounts of the partner.
Examine Books of Accounts:
He should examine the cash book, pass book and withdrawals of the partner.
2. Verification of Capital in a Company
While verifying the capital of a company, the auditor should verify the share capital and the
level of reserves and surplus maintained by the company.

Meaning of Share Capital

Share capital means the capital raised by issue of shares. It is the amount invested by
shareholders towards the face value of shares are collectively known as Share Capital.
3. Verification of Reserves and Surplus

Meaning
Reserves and Surplus is that portion of current profits or of accumulated profits which is not
distributed as dividend, but is kept separate for purposes of meeting some known or unknown
liabilities or for fulfillment of future needs.

Auditor's Duty
Reserves and surplus are appropriation out of profits. The auditor should verify that the
reserves and surplus are shown on the liability side of Balance Sheet with footnotes and
verify entries in the Profit and Loss Appropriation Account.
Verification of Debentures

Debentures – Meaning
Debenture means a document issued by a company to raise finance. It is an acknowledgement
of a debt which is given under the common seal of the company.

Auditor's Duty in Verification of Debentures

The auditor should note the following points while verifying debentures:

Verification of Long Term Loans

Loans or Borrowings of a concern may be either secured or unsecured or may be for a short
or long period.
Auditor’s Duty
The auditor while verifying loan in general has the following duties:
1. Verify Loan Agreement: The auditor should verify the loan agreement and refer to the
correspondence for getting the loan.
2. Enquire Purpose of Loan: He should enquire the purpose or purposes for which loan has
been raised and also confirm that the loan raised are being utilized for the specific purpose for
which it is being obtained.
3. Examine Borrowing Powers: He should examine the borrowing powers of the company
by referring to the Memorandum and Articles of Association of the company.
4. Disclosure in Balance Sheet: He should verify that secured loans are shown separately
from unsecured loans and any interest due but not paid is treated as a current liability in the
Balance Sheet.
5. Obtain Confirmation Letter: He should obtain confirmation letter from the parties who
have advanced loans and should verify the balances with the books.

Verification of Current Liabilities

Current liabilities are those liabilities which are payable within one year. This includes bank
overdraft, sundry creditors, bills payable and outstanding expenses.

1. Sundry Creditors: A person who gives a benefit without receiving money or money’s
worth immediately but to claim in future is a creditor. The creditors are shown as a current
liability in the Balance Sheet.

2. Bills Payable: Bill refers to bill of exchange. Bills payable means bills acccepted for the
credit purchases made. The amounts on bills are payable at the due dates. It is a current
liability.

3. Bank Overdraft: It is a line of credit extended by a bank to its account holder to withdraw
money in excess of the balance in his account up to a specified limit. It is a current liability as
the business concern, i.e., being an account holder is liable to repay the amount to the bank.

4. Outstanding Expenses: Expenses which have been incurred but not yet paid during the
accounting period for which the final accounts are being prepared are called as Outstanding
Expenses.
Verification of Contingent Liabilities
Meaning
Contingent liabilities are those liabilities, which may or may not arise in the future for
payment. The auditor should ensure that all known and unknown liabilities have been
accounted in the books of accounts and have been shown in the Balance Sheet.
The following are the examples of Contingent Liabilities:
a) Liabilities on Bills Receivable discounted and not matured.
b) Liability on account of partly paid calls.
c) Liability on arrears of dividend on Cumulative Preference Shares.
d) Liability under a guarantee.
e) Liability for penalties under forward contracts
f) Liability that arises on account of litigation in respect of labour suits, trademarks,
copyrights etc.
Depreciation – Meaning
The word depreciation has been derived from a Latin word ‘Depretium’. The words ‘De’
means decline and ‘pretium’ means ‘price’. Thus, the word ‘Depretium’ stands for decline in
the value or price of an asset. The gradual diminition, loss or shrinkage in the utility value of
an asset due to wear and tear in use, effluxion of time or obsolescence is called as
Depreciation.
Depreciation accounting is a system which aims at distributing the cost or basic value of
tangible capital assets less salvage over the estimated useful life of the asset in a systematic
and rational manner.
Only assets like building, plant, machinery, furniture etc. are subject to depreciation. It refers
to the gradual diminition or loss in the utility value of an asset on account of wear and tear in
use, efflux of time or obsolescence.
Definition

R.G.Williams, “Depreciation may be defined as a gradual deterioration in value due to use”.

Spicer and Pegler, “Depreciation may be defined as the measure of exhaustion of the
effective life of an asset from any cause during a given period”.
The Institute of Chartered Accountants of India defines it as, “depreciation is a measure
of wearing out, consumption or other loss of value of a depreciable asset arising from use,
effluxion of time or obsolescence through technology and market changes”.
Causes For Depreciation
The causes of depreciation can be classified as – (1) Internal causes, and (2) External causes.
Reserves

Meaning
Reserve is a part of the profits which are set aside for any known or unknown contingency,
liability or diminution in the value of an asset etc. It is that portion of the current profits or of
accumulated profits which is not distributed as dividend, but is kept separate for the purpose
of meeting some known or unknown liabilities which might arise in the future.

Definition
Companies Act, defines Reserve as, “shall not include any amount written off or retained by
way of providing for depreciation, renewals or diminution in value of assets or retained by
way of providing for any known liability”.
The American Institute of Accountant defines a reserve as, “the use of the term be limited
to indicate that an undivided portion of the assets is being held or retained for general or
specific purpose.”

Auditor's Duty
1. Verify Articles of Association: It is the duty of the auditor to verify the Articles of
Association to check whether the amount appropriated from profit to specific reserve is duly
complied.
2. Verifying Minute Book of Board meeting: The auditor should ensure that profits are
appropriated according to the board of directors decision by verifying the Minutes book of
the Board meeting.
3. Verify Adequacy of Provision: Auditor should ensure that adequate provision has been
created. In case if the amount created is not adequate, he should insist the management to
increase the provision. Otherwise, he should disclose the same in the audit report.
4. Disclosure in Balance Sheet: The auditor should see whether provisions are properly
shown on the liabilities side of the Balance Sheet.
5. Utilization of Reserve: Lastly, the auditor has to ensure that reserve is utilized for the
special purpose for which they are created.

5. RESERVE FUND
It is a reserve created out of the surplus of the company and is invested in outside securities.
It is similar to general reserve, which is created out of surplus but is retained in the business.
In other words, reserve fund is appropriations of profits which is invested in safe securities
and are easily realizable.

Auditor's Duty
1. Examine Directors meeting Minutes Book: Auditor should examine the Minutes of
Board of Directors meeting to verify that all investments are made with the consent of the
Board.
2. Verify Investment Register: The auditor should physically verify the securities with the
Investment Register.
3. Investment in Securities: The auditor should ensure that the reserve fund is invested in
easily realizable securities.
4. Disclosure in Balance Sheet: He should verify that the reserve fund is shown distinctly on
the liabilities side of the Balance Sheet.
Provisions

Meaning
Provision is an amount which is set aside as a charge against earnings to meet a loss which
may arise on the sale or realization of certain asset or diminution in the value of an asset or to
meet heavy depreciation, repairs and renewals or to meet a known liability. Provisions are
created for a specific known liability or contingency and they can be used to meet only the
specific liability for which they are created.
Examples of Provisions: (1) Provision for Depreciation, (2) Provision for Taxation, (3)
Provision for Doubtful Debts, (4) Provision for discount on Debtors, (5) Provision for
Repairs and Renewals.

Definition
Companies Act defines the term Provision as, “any amount written off or retained by way of
providing for depreciation, renewal or diminution in the value of assets or retain by way of
providing for any known liability of which the amount cannot be determined with substantial
accuracy”.

Objectives of Verification of Liabilities:

1. Existence: Confirm that recorded liabilities are valid obligations.

2. Completeness: Ensure all liabilities are recorded with no omissions.

3. Accuracy: Verify that liability amounts are correct and free from errors.

4. Valuation: Ensure liabilities are recorded at appropriate amounts (e.g., including

interest or discounts).

5. Classification: Confirm proper classification as current or non-current.

6. Cut-off: Ensure liabilities are recorded in the correct accounting period.

7. Rights and Obligations: Verify liabilities belong to the entity, not third parties.

8. Disclosure: Ensure all required disclosures are made in financial statements.

9. Compliance: Check adherence to legal and contractual requirements.

10. Internal Controls: Evaluate controls over recording and authorization of liabilities.

11. Fraud/Error Detection: Identify any misstatements, fraud, or errors.

12. Contingent Liabilities: Assess and disclose potential obligations (e.g., lawsuits,
guarantees).

Audit Procedures for Verification of Liabilities:

1. Obtain Liabilities Schedule: Request a detailed schedule of liabilities from the client
and reconcile it to the general ledger.

2. Confirm Balances: Send confirmation requests to third parties (e.g., suppliers,

lenders) to verify outstanding balances.

3. Examine Supporting Documents: Review invoices, contracts, loan agreements, and

tax records for validity.

4. Test Cut-off: Ensure liabilities are recorded in the correct accounting period.

5. Reconcile Balances: Reconcile liabilities to third-party statements (e.g., supplier

statements, lender confirmations).
 6. Review Subsequent Payments: Check post-year-end payments to confirm liabilities
existed at the reporting date.

7. Analytical Procedures: Compare liabilities to prior periods and investigate

significant fluctuations.

8. Search for Unrecorded Liabilities: Review unmatched invoices and post-year-end

transactions for omissions.

9. Assess Compliance with Standards: Ensure liabilities are measured and disclosed
per accounting standards (e.g., IFRS, GAAP).

10. Test Internal Controls: Evaluate controls over recording, authorization, and
payment of liabilities.

11. Review Disclosures: Verify all required disclosures (e.g., terms, interest rates,
contingent liabilities) are included.

12. Investigate Unusual Items: Inquire about significant or unusual liabilities that
deviate from normal operations.

Rules of Verification of Liabilities

Verification of liabilities is as important as that of assets. The auditor should take into
consideration the following points for the verification of liabilities:
(i) Whether all the liabilities have been included in the balance sheet.
(ii) Whether all liabilities have been included at correct value.
(iii) Whether personal liabilities have been mixed up with the liabilities of the concern.
(iv) Whether doubtful liabilities have been included in the real liabilities.
(v) Whether liabilities shown in the balance sheet actually existed on date.
(vi) Whether all the liabilities are of the concern and not of the employees.
(vii) Whether liabilities have been shown after taking into account increase or decrease, if
any, in liabilities.
(vii) Whether every liability has been explained clearly in the balance sheet.