Unit 2: Accounting and Auditing mind map

The concepts behind every entry, the accounting process, capital and revenue items, and the Indian Accounting Standards that questions pair with their subjects.

Concepts and conventions

The accounting process

Accounting is a process. A transaction is identified, recorded, classified, summarised and then interpreted.

• Identify and measure the transaction in money.
• Record it in the journal, then classify it in the ledger.
• Summarise: trial balance and final accounts.
• Interpret the results for decisions.

The order never changes. A transaction first goes to the book of original entry, then to the ledger, then to the trial balance, then to the annual statements. Interpretation comes last, because it needs the statements.

Business entity and money measurement concepts

The business entity concept treats the business as separate from its owner. The money measurement concept records only facts that can be stated in money.

• Personal transactions of the owner are not recorded in the firm's books.
• Skills and loyalty of staff are not recorded, because no reliable money value exists.

Because the firm is a separate unit, an owner's home expenses have no place in its books. Because only money values count, a valuable team or a good brand that was never bought does not appear in the balance sheet.

Going concern, cost and accounting period concepts

The going concern concept assumes the business will continue. It supports historical cost and depreciation.

• Assets are kept at cost, not at their selling price.
• Depreciation spreads cost over the useful life.
• The accounting period concept cuts the life of the business into equal periods.

If the firm will keep using a machine, its sale price today does not matter. So the machine stays at cost less depreciation. The accounting period concept lets the firm report results every year, usually on 31 March.

Matching, consistency and materiality

Matching puts expenses against the revenue they helped earn. Consistency means using the same method each period. Materiality means size matters.

• Matching: expenses go in the period of the related revenue.
• Consistency: the same method period after period, so results can be compared.
• Materiality: an item matters when its size could change a decision.

If a firm sells goods in March, the cost of those goods belongs to March, even if the payment is later. Consistency lets readers compare one year with the next. Tiny items need not be shown separately.

Conservatism and prudence

Conservatism means playing safe. Do not anticipate profit. Provide for all likely losses.

• Stock is valued at cost or market value, whichever is lower.
• A provision is made for bad and doubtful debts.
• A profit is counted only when it is realised.
• It keeps profit from being overstated.

Prudence guards the firm from being too hopeful. An accountant who plays safe will record a likely loss now and wait for the profit. The same attitude stops the owner from withdrawing too much.

Capital and revenue expenditure

Capital expenditure gives a long-lasting benefit and creates an asset. Revenue expenditure serves the current year.

• Buying a machine is capital.
• Wages for installing a new machine are capital, added to the machine's cost.
• Heavy advertising to launch a product is deferred revenue expenditure.
• Goodwill purchased is capital.

A cost needed to bring an asset into use is part of its cost. So installation wages go to the machine account, not to wages. A big launch advertisement helps several years, so it is spread over those years.

Accounting equation and the capital equation

The capital equation links opening capital, profit, additional capital and drawings to closing capital.

• Closing capital = Opening capital + Profit + Additional capital - Drawings.
• So Opening capital = Closing capital - Additional capital + Drawings - Profit.
• It is used in the statement of affairs method.

When a small business keeps no full books, profit can be found by comparing closing and opening capital. Add back drawings and remove additional capital, because neither is profit.

Classification of accounts and balance sheet items

Accounts are personal, real or nominal. A company's balance sheet groups items under Schedule III headings.

• Personal: people and firms. Real: assets. Nominal: income and expenses.
• Prepaid insurance is treated as a representative personal account in the key.
• Bank overdraft is a current liability.
• Interest accrued on investment is another current asset.

Prepaid insurance stands for the insurer who owes cover for the unexpired period. A trade mark is a non-current asset. Stores and spares are inventory under current assets.

Accounting standards

AS and Ind AS: who issues them and what they mean

Accounting standards set the rules of recording and reporting. Ind AS are India's standards, converged with IFRS.

• Ind AS contain some carve-outs from IFRS.
• So accounts under Ind AS are not fully IFRS compliant.
• XBRL is the open standard for digital business reporting.

India did not adopt IFRS word for word. It kept a few departures to suit local needs. Because of those carve-outs, a statement prepared under Ind AS is not automatically IFRS compliant. XBRL tags each item so that machines can read it.

Ind AS and their subjects

Match questions pair each Ind AS number with its subject. Learn the numbers in the table below.

• Ind AS 1: presentation of financial statements. Ind AS 2: inventories.
• Ind AS 7: cash flows. Ind AS 8: policies, estimates and errors.
• Ind AS 12: income taxes. Ind AS 16: property, plant and equipment.

The same numbers return every year. The easiest memory trick is to learn them in groups. This concept holds the first group. The next concept holds the rest.

Ind AS and their subjects: the second group

More Ind AS numbers appear in match questions. Keep this list together with the first.

• 19 employee benefits, 21 foreign exchange rates, 23 borrowing costs.
• 24 related parties, 28 associates and joint ventures, 34 interim reporting.
• 37 provisions and contingencies, 38 intangible assets.

Ind AS 17 on leases is now replaced by Ind AS 116. Ind AS 18 on revenue is now replaced by Ind AS 115. Exams still use the old numbers in some options.

Ind AS: business combinations, consolidation and others

Another group of Ind AS covers combinations, consolidation, fair value and revenue.

• Ind AS 103: business combinations.
• Ind AS 110: consolidated financial statements.
• Ind AS 113: fair value measurement.
• Ind AS 115 and 18: revenue.

Ind AS 29 covers hyperinflationary economies. Ind AS 101 covers first-time adoption. Ind AS 104 covers insurance contracts. Ind AS 116 deals with leases, and Ind AS 41 with agriculture.

Earlier Accounting Standards (AS)

The older AS numbers also appear in match questions. A few are worth knowing.

• AS-1: disclosure of accounting policies.
• AS-2: valuation of inventories. AS-3: cash flow statements.
• AS-4: events after the balance sheet date.
• AS-10: fixed assets. AS-14: amalgamations. AS-19: leases.

AS-2 says inventory is valued at cost. Cost includes freight in and factory depreciation. Carriage outwards and general administrative overheads are excluded. AS-4 treats an event as adjusting when it gives more evidence of a condition that existed on the balance sheet date.

Inventory cost, adjusting events and deferred tax

These three areas have tricky details. AS-2 sets the cost of inventory, AS-4 splits events, and deferred tax arises from timing differences.

• Inventory cost includes inward freight and factory depreciation.
• A customer's insolvency at the balance sheet date is an adjusting event.
• A deferred tax liability arises when accounting income exceeds taxable income.

Depreciation under the Income-tax Act can be higher than book depreciation. Taxable income is then lower now, but the tax will fall due later. That gap creates a deferred tax liability.

Leases

A lease transfers the right to use an asset. A finance lease transfers nearly all risks and rewards. An operating lease does not.

• Finance lease: lessor transfers substantially all risks and rewards.
• Operating lease: ownership risk stays with the lessor.
• Sale and leaseback: sell an asset and lease it back.
• Ind AS 116 now replaces Ind AS 17.

A finance lease works like a loan with a purchase. The lessee records the asset and the liability. In an operating lease the lessee pays rent and the lessor keeps the asset on its books.

How to read accounts: key ratios and their formulas, worked calculations, the cash flow statement and the funds flow statement.

Ratio analysis

Liquidity ratios: current and quick

The current ratio and quick ratio test whether a firm can pay its short-term debts.

• Current ratio = current assets / current liabilities.
• Quick (liquid) ratio = liquid assets / current liabilities.
• Liquid assets exclude inventory.
• Working capital = current assets - current liabilities.

The quick ratio is a tougher test, because stock is the slowest current asset to turn into cash. A high quick ratio can still hide trouble, for example slow debtors. Work backwards from working capital when the question gives only that.

How changes move the current ratio

Equal changes in current assets and liabilities pull the current ratio toward 1. Paying a liability when the ratio is above 1 raises it.

• Equal rise in both lowers a ratio above 1.
• Paying a current liability raises a ratio above 1.
• Buying stock for cash does not change current assets in total.

Take Rs 200 of current assets and Rs 100 of liabilities, a ratio of 2. Add Rs 100 to both: 300 over 200 is 1.5, lower. Pay Rs 50 of the liability from cash: 150 over 50 is 3, higher.

Turnover and operating ratios

Turnover ratios show how fast assets move. The operating ratio shows how much of sales is eaten by costs.

• Inventory turnover = cost of goods sold / average inventory.
• Cost of sales is the better numerator than sales.
• Operating ratio = operating cost / net sales x 100.
• A high operating ratio is unfavourable.

A faster turnover means the same sales need less stock. A high operating ratio leaves a thin margin, so it is bad. Exams often flip this into 'higher operating ratio means higher profit', which is false.

Coverage, EPS and return ratios

Coverage ratios test debt safety. EPS shows earnings per equity share. Return ratios show profit on capital.

• Interest coverage = profit before interest and tax / interest.
• EPS = (profit after tax - preference dividend) / number of equity shares.
• ROCE = profit before interest and tax / capital employed.

Always start from the right profit. Coverage uses profit before interest and tax. If the question gives profit after tax, gross it up with the tax rate. ROCE removes income from investments, because it is not operating income.

Ratios and the problem they reveal

Each problem shows up in a particular ratio. A match question pairs them.

• Inability to pay interest: interest coverage ratio.
• Liquidity crisis: current ratio.
• Slow collection from customers: debtors turnover ratio.
• Investors check debt-equity, price-earning and dividend yield.

Think of what each ratio measures. Interest coverage measures how safely interest is paid. Debtors turnover measures how fast customers pay. For an investor, the key ratios are those of risk, price and return.

Altman's Z-score

Altman's Z-score of 1966 predicts industrial sickness by combining five ratios, each with a weight.

• Working capital / total assets: weight 1.2.
• Retained earnings / total assets: weight 1.4.
• EBIT / total assets: weight 3.3, the highest.
• Market value of equity / total debt: 0.6. Sales / total assets: 1.0.

A higher weight means the ratio matters more in the prediction. EBIT over total assets matters most. Market value of equity over debt matters least. Exams ask you to arrange the ratios by weight.

Cash flow and funds flow

Classifying cash flow activities

A cash flow statement sorts cash movements into operating, investing and financing activities.

• Operating: the main revenue-producing activity.
• Investing: buying and selling long-term assets and investments.
• Financing: changes in equity capital and borrowings.

Share issue, debenture redemption, loan repayment and dividends paid are financing. Sale of a fixed asset or a patent purchase is investing. Provision for depreciation is a non-cash item, so it is not an activity at all.

Net cash from operating activities: the indirect method

The indirect method starts from profit before tax and adjusts it step by step to reach cash from operations.

• Add back non-cash items, such as depreciation.
• Adjust for changes in current assets and liabilities.
• Subtract tax paid.

The order matters. Profit before tax and extraordinary items comes first. Then operating profit before working capital changes, then cash generated from operations, then cash flow before extraordinary items, then net cash.

Cash flow rules for finance companies and non-cash items

Finance companies treat lending as their main business. Non-cash transactions are left out of the statement.

• Loans advanced by a finance company are operating activities.
• Dividends paid are financing activities.
• Non-cash transactions: assets bought by taking over liabilities, debt converted to equity.
• A bank overdraft payable on demand counts as cash equivalent under Ind AS 7.

Because lending is their business, loans advanced by a finance firm go under operating. Their investing section holds fixed assets, patents and debentures purchased. Interest or dividend received from investing is a normal cash flow, not a non-cash one.

Funds flow statement

A funds flow statement shows where funds came from and where they went in a year. It is a management tool.

• A flow of funds needs a change in both a current and a non-current item.
• A change within current items alone is not a flow.
• It is not mainly for outsiders.

Paying a trade creditor by selling land affects both a current liability and a non-current asset, so it is a funds flow. Collecting from debtors only moves current items, so it is not. Dividend received is a source of funds.

Admission, retirement and dissolution of a partner, goodwill, and the share accounts of a company: forfeiture, premium and redemption.

Partnership accounts

Rights of partners and appropriation of profit

The Partnership Act and the deed decide how partners share profit. Without a deed, profits are shared equally.

• Interest on capital and salary are paid only if the deed says so.
• Interest on a partner's loan to the firm is payable at 6 per cent a year.
• A firm earning only normal profit has no goodwill.

Appropriation follows an order: interest on capital, salary and then the balance shared in the profit ratio. Do each partner's total at the end.

New profit-sharing ratio on admission

When a partner is admitted, the old partners give up part of their share. Work out the new ratio in shares of a common whole.

• Old partners share the remaining part in their old ratio, unless told otherwise.
• New ratio of all partners adds up to the whole.
• Sacrificing ratio = old share - new share.

First write each partner's share as a fraction. Then take the new partner's share off the top. Share the rest among the old partners. Check that the total is the whole.

Sacrificing and gaining ratio

The sacrificing ratio is the old share minus the new share. The gaining ratio is the new share minus the old share.

• Sacrificing ratio applies on admission.
• Gaining ratio applies on retirement or death.
• If the question is silent, old partners sacrifice in the old ratio.

On admission the old partners lose and are paid for goodwill in the sacrificing ratio. On retirement the remaining partners gain and pay the retiring partner in the gaining ratio.

Valuation of goodwill

Goodwill is the value of a firm's good name. It exists only when profit exceeds the normal profit.

• Super profit = average profit - normal profit.
• Normal profit = normal rate x capital employed.
• Methods: average profit, super profit, capitalisation and annuity.

In the annuity method, the super profit is treated as an annuity and multiplied by its present value factor. For five years at 10 per cent, the factor is about 3.79.

Goodwill adjustment, revaluation and death or retirement

When a new partner cannot bring cash for goodwill, the adjustment goes through capital accounts. A revaluation is done on retirement or admission.

• New partner's capital account is debited.
• Old partners' capital accounts are credited in the sacrificing ratio.
• Revaluation profit or loss goes to old partners' capitals.

Assets and liabilities are revalued so that the retiring or admitted partner gets a fair share of unrecorded gains and losses. When a partner dies, the rest continue. Unless told otherwise, they share the dead partner's part in their old ratio.

Dissolution of a partnership

On dissolution, assets are sold, liabilities are paid and the balance is returned to partners. The realisation account finds the profit or loss.

• Assets are transferred to the realisation account.
• Loss on realisation is shared by partners.
• Final cash is paid back against capital.

Say partners put in Rs 90,000 in all. Only Rs 80,000 is left after paying all liabilities. The shortfall of Rs 10,000 is a loss on realisation. It is shared in the profit ratio.

Company accounts

Forfeiture and reissue of shares

A company forfeits shares when a shareholder does not pay a call. The amount already paid goes to the forfeiture account.

• Forfeited amount is the amount actually received.
• On reissue at a discount, the discount cannot exceed the forfeited amount.
• The gain left over goes to capital reserve.

A share reissued as fully paid for less than its face value gives a discount. The discount is charged against the forfeited amount of those shares. Whatever balance remains is capital reserve.

Calls in advance, subscription and securities premium

Calls in advance are amounts paid before they are due. Securities premium is the amount above face value.

• Calls in advance: paid in excess of what is due.
• Over-subscription: applications exceed shares offered.
• Securities premium: excess of issue price over face value.
• A share forfeiture account is credited with money actually received.

When applications exceed the shares offered, the issue is over-subscribed. Under-subscription is the reverse. Mixing the two is a common trap.

Securities premium and redemption of preference shares

The securities premium account may be used only for purposes listed in Section 52 of the Companies Act. Preference shares are redeemed out of profits or a fresh issue.

• Premium can fund bonus shares, preliminary expenses and issue expenses or discount.
• It can pay the premium on redemption of preference shares or debentures.
• It cannot be used to pay dividend.
• Profits used to redeem need a capital redemption reserve.

If profits are used for redemption, the same amount is moved to the Capital Redemption Reserve. Only the part paid out of profits needs this transfer. The fresh issue proceeds are subtracted first.

When companies combine or reorganise: merger and purchase, purchase consideration, internal reconstruction, and consolidation with a subsidiary.

Amalgamation and reconstruction

Amalgamation: merger and purchase

In an amalgamation, a transferee company takes over the business of a transferor company. It is either in the nature of a merger or in the nature of a purchase.

• Merger: pooling of interests, with all five conditions met.
• Purchase: any amalgamation that fails a merger condition.
• Merger conditions: all assets and liabilities taken over.
• At least 90 per cent of transferor equity holders become equity holders of the transferee.

In a merger the business is meant to continue. The consideration is wholly in equity shares of the transferee, except for cash paid for fractional shares. Book values are not changed. A statement that says shareholders 'need not' become equity holders is incorrect.

Purchase consideration

Purchase consideration is what the transferee pays for the business taken over. Four methods work it out.

• Lump sum payment method: one agreed amount.
• Net assets method: agreed value of assets taken less liabilities taken.
• Net payment method: add up the cash and shares paid to shareholders.
• Share exchange method: shares given by a swap ratio.

Gross receipts is not a method. A sum paid for a business is the consideration, whatever way it is worked out. In the exam, if a method is not on the list of four, it is the odd one out.

Vendor's debtors and amalgamation adjustment account

Two special entries appear in questions. They deal with debtors collected on behalf of the vendor and statutory reserves.

• If the buyer collects debtors only as agent, it credits Vendor's Suspense account.
• Statutory reserves of the transferor are kept alive in a merger.
• They are carried in the Amalgamation Adjustment account.

When the buyer does not buy the debtors, it records what it will collect for the vendor. The statutory reserve must continue because the law required it. The adjustment account keeps the books balanced.

Internal reconstruction

Internal reconstruction reorganises a company's capital without winding it up. No new company is formed.

• Share capital is reduced under Section 66 of the Companies Act, 2013.
• Liabilities are sometimes reduced.
• The existing company continues.

The company writes off accumulated losses against capital. It is different from external reconstruction, in which the old company is wound up and a new one takes over.

Holding company accounts

Goodwill and capital reserve on consolidation

When a holding company buys shares in a subsidiary, it compares cost with its share of net assets at that date.

• Cost higher than net assets acquired: goodwill on consolidation.
• Cost lower than net assets acquired: capital reserve on consolidation.
• Net assets = share capital plus reserves and profits at acquisition.

Goodwill shows the extra price paid for earning power. A capital reserve shows a bargain buy. Both are found on the date control is gained.

Pre- and post-acquisition profits

Profits are split at the date the holding company acquires control. The two parts are treated differently.

• Pre-acquisition profits are capital profits.
• Post-acquisition profits are revenue profits.
• Capital profits are set against the cost of investment.
• Revenue profits go to the holding company's reserves.

Profits earned before control passed were already part of what the holding company paid for, so they cannot be treated as the parent's income. Profits earned after control belong to the group.

Minority interest and cross holding

Minority interest is the outsiders' share in a subsidiary. A cross holding is when parent and subsidiary hold each other's shares.

• Minority exists when the holding company owns more than 50 per cent but not all.
• Minority interest is calculated on the subsidiary's capital and reserves, not on the holding company's.
• It is shown separately in the consolidated balance sheet, not as part of the parent's equity.

The outsiders own their share of the subsidiary's net assets. In the group balance sheet it is a separate line. A cross holding makes consolidation harder, because each company's investment must be adjusted.

Cost behaviour, break-even and marginal costing, standard costing and variances, process and job costing, and activity-based costing.

Costing methods and techniques

Standard cost, estimated cost and cost behaviour

A standard cost is a scientific target. An estimated cost is a forecast. Cost behaviour describes how a cost moves with activity.

• Standard cost: what the cost should be, from engineering studies.
• Estimated cost: what the cost will be, from past data.
• Methods to find cost behaviour: high-low point, least squares regression, accounting (analytical) approach.

Standard costs are set for control and are revised from time to time. Estimated costs are used for quotes and forecasting. To split a mixed cost into fixed and variable parts, use the high and low points or a regression line.

Costing techniques and their uses

Each technique serves a purpose. A match question pairs them.

• Standard costing: management by exception.
• Margin of safety: sales minus break-even sales.
• Ratio analysis: forecasting and planning.
• JIT: control of inventory.

In standard costing, only large variances are looked into, so management gives attention by exception. Margin of safety shows how far sales can fall before a loss arises.

Marginal costing: assumptions and uses

Marginal costing separates fixed and variable costs and looks at contribution.

• Total fixed cost stays constant over the range.
• Variable cost per unit stays constant.
• Selling price per unit stays unchanged.
• Fixed cost per unit is not constant. It falls as output rises.

Marginal costing helps short-term decisions: special orders, make or buy, choosing between options. The assumptions are simplifications, so real life may differ.

Cost-volume-profit: P/V ratio and break-even

Contribution is sales minus variable cost. The P/V ratio is contribution divided by sales. Break-even is where profit is zero.

• P/V ratio = contribution / sales x 100.
• Break-even sales = fixed cost / P/V ratio.
• Break-even units = fixed cost / contribution per unit.
• At break-even, contribution equals fixed cost.

Variable cost ratio is 100 minus the P/V ratio. If the P/V ratio is 25 per cent, variable cost is 75 per cent of sales. The break-even point does not depend on how many units were sold. It depends on fixed cost, price and variable cost.

Margin of safety and target profit

The margin of safety is actual sales less break-even sales. A target profit needs fixed cost plus profit covered by contribution.

• Margin of safety = actual sales - break-even sales.
• Margin of safety = profit / P/V ratio.
• Units for target profit = (fixed cost + target profit) / contribution per unit.

If the margin of safety is Rs 8,000 on sales of Rs 48,000, break-even sales are Rs 40,000. With fixed cost of Rs 12,000, the P/V ratio is 12,000 / 40,000 = 30 per cent.

Raising contribution and limits of CVP

Contribution per unit rises when the price rises, when variable cost falls, or when the sales mix shifts to better products. CVP analysis rests on simple assumptions.

• Raise the selling price or lower variable cost.
• Sell more of products with a higher P/V ratio.
• CVP limits: constant selling price, linear costs and constant efficiency.
• Sales mix and inventory are assumed constant.

CVP gives quick answers but real prices drop with volume, and costs are not always linear. So it is a rough guide.

Variances, process costing and ABC

Material variances

Material variances compare standard and actual cost. Price and usage explain the total.

• Cost variance = standard cost of actual output - actual cost.
• Price variance = (standard price - actual price) x actual quantity.
• Usage variance = (standard quantity - actual quantity) x standard price.
• Yield variance = (actual yield - standard yield) x standard cost per output unit.

A negative figure means unfavourable or adverse. Usage reasons include waste, poor machine handling and design changes. A rise in basic price is a price reason, not a usage reason.

Fixed overhead and sales variances

Fixed overhead variances explain the gap between absorbed and actual overhead. Sales variances split price and volume effects.

• Total = absorbed - actual overhead.
• Expenditure = budgeted - actual overhead.
• Volume = absorbed - budgeted overhead.
• Calendar = (actual days - budgeted days) x budgeted overhead per day.

Volume variance splits into capacity, calendar and efficiency parts. Working more days than budgeted gives a favourable calendar variance. Cutting the sales price makes the price variance adverse. Selling more units makes the volume variance favourable.

Standard costing process and the three ratios

Standard costing is a cycle. Activity, capacity and efficiency ratios measure production performance.

• Set standards, measure actual, compare, find variances, then dispose of them.
• Activity ratio = standard hours produced / budgeted hours.
• Capacity ratio = actual hours worked / budgeted hours.
• Efficiency ratio = standard hours produced / actual hours worked.

Efficiency equals activity divided by capacity. If activity is 80 per cent and capacity is 120 per cent, efficiency is 80 / 120 = 66.67 per cent. The firm used more hours than planned and made less than planned.

Job and process costing

Job costing suits custom work. Process costing suits continuous mass production of identical units.

• Job costing: wedding invitations, repairs.
• Process costing: oil refining, chemicals.
• Process costing steps: physical units, equivalent units, total costs, cost per equivalent unit, assignment.

In a print shop, each order has its own design and cost, so costs are collected job by job. In an oil refinery, each litre is like the next, so costs are averaged. Process costing with work in progress uses equivalent units.

Joint products and target costing

Joint products come from one process and cannot be told apart until the split-off point. Target costing starts from the price.

• Split-off point: where joint products become separate.
• Separable costs: costs after split-off.
• Target cost = target selling price - desired profit.

Costs up to the split-off point are joint costs and must be shared. Costs after it are separable and belong to one product. Target costing designs the product to meet a cost the market will allow.

Activity-based costing

Activity-based costing traces cost to activities and then to products using cost drivers.

• Steps: identify activities, pool costs, find drivers, compute rates, charge products.
• Drivers: transaction, duration and intensity.
• Levels: unit, batch, product and facility.

A transaction driver counts how often an activity happens. A duration driver measures time. An intensity driver measures resources used each time. Limitations are high set-up cost and that not every cost has a clear activity.

How accounts are checked: vouching and verification, the auditor's appointment, rights and duties, reports, and the special audits.

Audit techniques and evidence

Vouching and verification

Vouching checks entries in the books against documents. Verification confirms the existence, ownership and value of assets and liabilities.

• Vouching is called the backbone of auditing.
• It covers all transactions, including profit and loss items.
• Verification applies to balance sheet items.
• Vouching of sales uses the sales book and dispatch records.

Take a cash book entry of Rs 5,000. The auditor traces it to the invoice and receipt. That is vouching. Checking that a machine on the books really exists and belongs to the firm is verification.

Verification of fixed assets

The auditor verifies fixed assets for ownership, possession and valuation. Physical verification is mainly management's job.

• Check the fixed asset register.
• Examine title deeds for ownership.
• Ascertain that assets are in the client's possession.
• Check that valuation and disclosure are right.

Management carries out the physical count of fixed assets. The auditor reviews that record. For furniture, the auditor checks purchase invoices, the stock register, depreciation rates and where repairs were charged.

Audit programme and audit assertions

An audit programme is a written plan for a particular audit. Assertions are claims in the accounts that the auditor tests.

• Audit programme lists the procedures, who does them and when.
• Occurrence: transactions did happen.
• Cut-off: recorded in the right period. Classification: recorded in the right account.
• Existence: balances exist at the end of the period.

Each procedure is signed off when done. The auditor checks assertions by design. The match question gives meanings, and you find the assertion name.

Appointment, rights and reports

Appointment of auditors: sections of the Companies Act

The Companies Act 2013 has separate sections for the appointment, qualification, remuneration and powers of auditors.

• Section 139: appointment.
• Section 141: qualifications and disqualifications.
• Section 142: remuneration.
• Section 143: powers and duties.

Sub-sections matter. Section 139(5) lets the CAG appoint the auditor of a government company. Section 139(6) lets the Board appoint the first auditor within one month of registration. Section 148 provides for cost audit.

Rights, duties and liabilities of an auditor

A statutory auditor has rights to do the work, duties to report, and liabilities if he or she fails.

• Rights: remuneration, attend general meetings, visit branches, access records.
• Duties: examine valuation and disclosure.
• Report: qualified or unqualified opinion.
• Liability: for a misstatement in a prospectus.

The auditor can attend the general meeting and speak on audit matters. He receives all notices of the meeting. He can visit branch offices or have branch accounts audited by another auditor. The auditor does not have a right to attend board meetings as a rule.

Types of audit report

The auditor's opinion is either unmodified or modified. SA 705 covers three kinds of modified opinion.

• Unmodified: statements are true and fair in all material respects.
• Modified: qualified, adverse and disclaimer.
• An Emphasis of Matter paragraph is not a modification. It comes under SA 706.

A qualified opinion says the statements are fine except for one issue. An adverse opinion says they are materially wrong. A disclaimer says the auditor could not form an opinion.

Types of audit by intensity

Audits differ in depth. The order from lighter to deeper runs from internal check to special audit.

• Internal check, internal audit, interim audit, annual audit, special audit.
• Internal check is built into daily routine.
• Internal audit is a continuing review by the company's staff.

Internal check works inside daily work. Internal audit reviews it by staff. An interim audit is done part-way through the year, and the annual audit covers the whole year. A special audit is the deepest.

Management, cost and other audits

Management audit

A management audit is a structured review of systems and procedures to judge whether they run efficiently and effectively.

• It appraises both policies and actions.
• It is dynamic and result oriented.
• It is not a statutory requirement.
• It may be appointed by the board or shareholders.

A management audit looks at the whole management process, not only the accounts. Its process begins with business objectives. Then it reviews structure, responsibility centres and performance, and ends with reporting. Depreciation checks belong to a financial audit.

Cost audit, energy audit and environmental audit

Special audits check cost records, energy use and environmental impact.

• Section 148 makes cost audit mandatory for certain companies.
• Cost audit of materials covers goods inward and scrap accounting.
• Energy audit aims to cut energy cost, waste and environmental damage.
• Environmental audit covers management system, compliance and site audits.

A cost audit of materials checks how the firm buys, stores and handles scrap. Energy audit objectives are lower cost, less waste and less environmental harm. Environmental audit has operational parts such as the environment management system audit, compliance audit and site audit.

Computer-assisted audit techniques

Computer-assisted audit tools help an information systems auditor test data and systems.

• Benefits build up: check threats, evaluate the system, data security, stronger controls, IT governance.
• Cloud and online accounting increases the exposure.

The order runs from risk to remedy. First the auditor checks how exposed the system is. Then the system is evaluated, data is secured, controls are strengthened and IT governance is developed.

Accounting for decisions and for what the balance sheet misses: management accounting, transfer pricing, human assets and price-level changes.

Management accounting and transfer pricing

Purposes of management accounting

Management accounting gives managers information for planning, control and decisions.

• Measurement of performance and cost.
• Control, by comparing results with plans.
• Choosing between alternatives.
• Recording transactions is the job of financial accounting.

Management accounting looks forward. It is not bound by the legal formats of financial accounts. Its distinctive purposes are measurement, control and alternative choices.

Transfer pricing

A transfer price is the price at which divisions or group companies sell to each other.

• Multinationals can use transfer prices to shift profit.
• They show profit in a low-tax country and loss in a high-tax one.
• Common bases: market price, cost-plus and negotiated price.

Inside one group, no outsider fixes the price. So the group can set it to suit its tax plan. Tax authorities watch for this, which is why transfer pricing rules exist.

Human resource and inflation accounting

Human resource accounting: meaning and origins

Human resource accounting treats people as assets. It measures their cost and value to the firm.

• Punctuality and team spirit raise profit but do not appear as assets.
• The basic method is to capitalise the cost and amortise it over the working life.
• Sir William Petty called labour the father of wealth.
• William Farr valued human capital in 1853.

Financial statements show only costs that can be measured in money. So skills are missing from the balance sheet. HR accounting tries to fill that gap by capitalising the cost of recruiting and training and writing it off over the service life.

HR valuation approaches and their authors

Cost approaches value people by cost. Each approach is linked to its authors.

• Historical cost: Brummet, Flamholtz and Pyle.
• Replacement cost: Rensis Likert and Eric Flamholtz.
• Opportunity cost: Hekimian and Jones.
• Standard cost: David Watson.

Historical cost counts what was actually spent. Replacement cost counts what it would cost to replace the person. Opportunity cost counts the value of the next best use. The net benefit model counts the present value of future services less future pay.

Net benefit model and intellectual capital

The net benefit model values people by the present value of future services less future payments. Intellectual capital covers all intangible assets of a firm.

• Net benefit steps start with the gross value of future services.
• Intellectual capital includes processes, designs, customer relations, domain names and copyrights.
• Management process: identify, capture, index, store and replicate.

The model starts with the gross value of future services. It deducts the value of future payments to get the net benefit. Then it discounts that to present value. For intellectual capital, every item in the exam list counts.

Inflation accounting

Inflation accounting adjusts accounts for price changes. Two methods are generally accepted.

• Current purchasing power (CPP) method restates cost using a general price index.
• Current cost accounting (CCA) values assets at current cost.
• Sandilands Committee (UK, 1975) recommended CCA.
• In CPP, cash, debtors and debentures are monetary items. Inventories are non-monetary.

CPP restated value = historical cost x current index / index at purchase. Holding monetary items during inflation causes a loss of purchasing power. Non-monetary items like stock move with prices.