Vuching and Verificatin

Chapter 8
Reserves and Provisions
CHAPTER OUTLINE
8.1 Concept of Reserves
8.2 Concept of Provisions
8.3 Difference between Reserves and Provisions
8.4 Classification of Reserves
8.1 CONCEPT OF RESERVES

Reserves are amounts appropriated out of profits, which are not intended to meet any liability,
contingency, commitment or diminution in the value of assets known to exist at the date of the
balance sheet.
According to American Institute of Accountants, the use of the term reserve is limited to
indicate that an undivided portion of the asset is being held or retained for general or specific
purposes.
8.2 CONCEPT OF PROVISIONS

Provisions are amounts charged against revenue to provide for the following:
1. Depreciation, renewals or diminution in the value of assets
2. A known liability, the amount whereof cannot be determined with substantial

accuracy
3. A claim, which is disputed
According to the Penguin Dictionary of Commerce, a provision is the amount written off or
retained by way of providing depreciation, renewals or diminution in the value of assets, or
retained by way of providing for any known liability of which the amount cannot be determined
with substantial accuracy.
8.3 DIFFERENCE BETWEEN RESERVES AND PROVISIONS

Reserves represent that portion of the business profits, which is meant for a use in future, in
situation of emergency or contingencygeneral or specific. On the other hand, provisions are
charges against earnings and must be shown in the profit and loss account. In the balance sheet,
reserves are shown under the heading reserves and surplus irrespective of the nature of
reserves, capital or revenue. But, in case of provisions, that part of the provisions which
represents liabilities will be shown under the heading current liabilities and provisions and that
part of the provisions which represents the diminution in the value of assets, e.g. provisions for
depreciation, provisions for bad and doubtful debts are generally deducted from the balance of
the concerned assets in the asset side of the balance sheet.
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The difference between reserves and provisions is illustrated in Table 8.1.
8.4 CLASSIFICATION OF RESERVES

The net worth of the company consists of capital contribution by the shareholders as well as total
undistributed profits held either to the credit of the profit and loss account or to a reserve. The
reserves can again be segregated as revenue reserves and capital reserves.
As per Part I of Schedule VI, the following items are shown under the heading reserves and
surplus in the liabilities side of the balance sheet:
Capital reserves
Capital redemption reserves
Other reserves specifying the nature of each reserve and the amount in
respect thereof less debit balance in profit and loss account (if any)
Securities premium account
Surplus, i.e. balance in profit and loss account after providing for proposed
allocations, namelydividend, bonus or reserves
Proposed additions to reserves
Sinking fund
TABLE 8.1 Distinction between reserves and provisions
Reserves Provisions
1. It is an appropriation of profit. Hence it is 1. It is a charge against profit. Hence it is
created by debiting profit & loss appropriation debited to profit and loss account.
account.
2. A reserve is created for an unknown liability. 2. A provision is made for a known liability.
3. Creation of reserves depends upon the financial 3. Creation of provisions is a must as these
policy of the firm. are meant for meeting known liabilities.
4. The reserve is shown in the balance sheet of a 4. The provisions are usually deducted from
company under the head Reserves & Surplus. the concerned assets in the asset side of the
balance sheet.
5. Past reserves can be utilised for distribution of 5. Provision can never be utilised for
dividend. dividend payment. Only excess provision
written back can be used for dividend
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distribution.
6. It is possible to create revenue only if the 6. Provisions are possible to be made even if
company earns profit. If there is a loss, no reserve there is loss as it is a charge against profit.
cannot be created as it is an appropriation of profit.
7. Creation of reserves is discretionary and the 7. Creation of provision is a must and the
auditor need not devote much time for the auditor should qualify his report if adequate
verification of reserves. provisions are not made.
8. A reserve is always reserve till it is fully 8. As per Schedule VI of the Companies Act,
utilised. Even if it is more than the requirement, it provision in excess of requirement can be
will not change its nature. treated as reserve.
8.4.1 Revenue Reserve

It represents profits that are available for distribution to shareholders held for the time being for
any one or more purposes, e.g. supplement divisible profits in lean years, to finance an extension
of business or to generally strengthen the financial position of the company.
Since the creation of this reserve is not a must, the auditor has no duty to report on the creation,
adequacy or inadequacy of such a reserve. He may advise the management on the desirability of
creation and maintenance of such reserve in the interest of the business.
8.4.2 Capital Reserve

It represents reserves which are created out of capital profit. Capital profits are those profits,
which do not arise in the normal course of business. So, capital reserve is created out of the
profits of following nature:
1. Profit earned on sale of fixed assets at a price in excess of cost
2. Profit on revaluation of all assets
3. Profit earned prior to incorporation of the company
4. Profit on re-issue of forfeited shares.
According to the definition of capital reserve, as contained in Part-III of Schedule VI to the

Companies Act, it is reserve, which does not include any amount regarded as free for distribution
through the profit and loss account. In the narrowest sense, therefore the description would
include only Securities premium, Capital redemption reserve, Development rebate reserve and
Profit on re-issue of forfeited shares.
A capital reserve can be generally utilised for the following purposes:
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It can be utilised for issuing bonus shares, if the Articles of Association so
provide.
It can also be utilised for writing off various types of intangible and fictitious
assets.
But the amount of securities premium or capital redemption reserves account can be utilised only
for the purposes specified in Section 78 and Section 80 of the Companies Act.
The question whether capital reserve can be made available for the distribution of dividend or
not has not been dealt specifically with by the Companies Act. However, from the decisions of
the two leading cases, i.e. (1) Lubbock vs The British Bank of South America (1892) and (2)
Foster vs. The New Trinidad Lake Asphalte Co. Ltd. (1901) it is learnt that the following
conditions must be fulfilled before distribution of dividend out of capital reserve:
1. The Articles of Association must authorise such distribution.
2. The capital reserve created out of profit on sale of fixed assets should be
realised in cash.
3. The capital profit must exist after revaluation of all the assets and liabilities of
the company.
So, capital reserve created out of the following incomes is not available for dividend payment:
1. Securities premium, the distribution of which as dividend is specifically

prohibited by Section 78 of the Companies Act
2. Capital redemption reserve
3. Profit on re-issue of forfeited shares
4. Profit prior to incorporation
5. Profit on redeeming debentures at a discount
6. Profit on purchase of business.
The auditor should examine that the capital reserve is created out of capital profits only. If the
capital reserves are to be utilised for distribution of dividend, he should ensure that the same is
permitted by the articles of the company.
8.4.3 Capitalisation of Reserve

The term capital reserve should not be confused with the term capitalisation of reserve.
Capitalisation of reserve is the process by which the reserve, whether capital in nature or revenue
nature is permanently retained by the company by way of issuing bonus shares. It is one of the
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methods of financing the growth and expansion of the business and is popularly known as the
ploughing back of profit.
So, capital reserve and capitalisation of reserve are two different terms having the following
differences between them as depicted in Table 8.2.
TABLE 8.2 Distinction between capital reserve and capitalisation of reserves
Capital reserve Capitalisation of reserves

1. Capital reserve is created out of capital 1. Capitalisation of reserve is done either out of
profit only. capital reserve or revenue reserve.
2. Capital reserve does not increase the 2. Capitalisation of reserve increases the amount of
capital of the company. capital of the company.
3. There is no specific provision in the 3. SEBI has introduced detailed guidelines for the
Companies Act regarding creation and capitalisation of reserves.
utilisation of capital reserve.
4. Capital reserve is created by any type 4. Capitalisation of reserve is possible only out of
of capital profit when they arise. some specific reserves.
5. Creation of capital reserve is 5. Capitalisation of reserve does not increase the

accompanied by an increase in asset of the assets of the business. Only there is some
company. reorganisation of capital structure of the company.
Advantages of capitalisation of reserve
Capitalisation of reserve is the process by which reserve is permanently retained by the company
by way of issuing bonus shares. The shareholders as well as the company itself are benefited
from the issue of bonus shares.
Advantages from the point of view of shareholders
1. The shareholders get back their undistributed profit in the shape of shares.
2. Accumulated profit can be distributed without disturbing the liquidity position

of the company.
3. It will increase the number of shares in the hands of the existing shareholders
without any extra payment. Thus it will increase the marketability of shares.
4. They receive profit of the company, though in kind, but in case of necessity,
shares can be converted into cash by selling them in the market.
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Advantages from the point of view of the company
1. The company can keep its shareholders happy without impairing the financial
position and liquidity of the company.
2. Creditors can feel more protected due to increase in share capital.
3. Growth of the company is ensured by permanently keeping the reserve in the

business.
4. By way of capitalisation of reserves, disparity between effective capital and

book capital can be eliminated and the balance sheet can be presented in a
more meaningful way.
Auditors duty in respect of capitalisation of reserves
The auditor will ensure that the following SEBI guidelines have been duly adhered to by the
company at the time of capitalising its reserves.
1. Bonus shares can be issued out of free reserves created out of genuine profits
or securities premium only.
2. Reserves created out of revaluation of assets have not been utilised for the
purpose of capitalisation.
3. The company has not defaulted in payment of interest and principal in

respect of debentures and public deposits.
4. There has been provision in the Articles of Association authorising the

company to issue bonus shares.
5. The extended capital after the issue of bonus shares has been within the limit
of the authorised capital of the company.
6. In addition to the above guidelines, the auditor will also check the accounting
entries to ensure himself that they have been passed properly in the books of
accounts.
8.4.4 Reserve Fund

Reserves can either be retained in the business as a part of working capital or invested outside
the business in marketable securities.
The term reserve fund is used to describe a reserve only when the amount of reserve is invested
outside the business and it is represented by the readily realisable assets.
Again, according to Part-I of Schedule VI to the Companies Act, the word fund in relation to
any reserve should be used only where such reserve is specifically represented by earmarked
investments. So, the term reserve fund should not be used loosely to represent any other fund.
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The auditor should see that the reserve fund has been distinctly shown in the balance sheet and
the fund is represented by readily realisable and earmarked funds.
8.4.5 Sinking Fund

A sinking fund is a specific type of fund, which is created for the redemption of a long-term debt
or for the replacement of an asset. This fund is created by the regular investment of an amount,
which will accumulate along with the compound interest earned thereon to make available a
certain amount of money at the end of a stated period.
Creation of sinking fund
Sinking fund is created by adopting any of the following two methods:
1. Sinking fund investment method Under this method, a pre-determined

amount is debited to the profit and loss account every year crediting sinking
fund account and an equivalent amount should be taken out of business and
invested in readily saleable securities. When the period of the fund expires,
the investments are sold and the amount so realised is utilised for the
concerned purpose.
2. Sinking fund policy method Under this method, a policy for the period is
taken up and the premium on the policy is debited to the profit and loss
account. At the end of the policy period, the amount received is utilised for
the concerned purpose. This method is adopted usually in those situations,
where a certain amount is required to be received at the end of the period.
Auditors duty regarding sinking fund
1. The auditor should ensure that the reserve fund created has been separately
shown in the balance sheet.
2. He has to ensure that the purpose for which the fund is created has been
clearly indicated.
3. He should also see that the creation of sinking fund for any specific purpose
is authorised by the Articles of Association of the company.
4. He should also ensure that proper entries have been passed in the books of
accounts to record the creation and utilisation of the fund.
8.4.6 Secret Reserve

The reserves, which is not disclosed in the balance sheet, is known as secret reserve or hidden
reserve. It is called hidden reserve as this reserve is not apparent on the face of the balance
sheet. Obviously, if secret reserves are created, the balance sheet does not reveal the true and fair
picture of the financial affairs of the company. The actual financial position of the company, in
reality, is better than what is revealed on the face of the balance sheet.
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Creation of secret reserve
Secret reserves can be created by adopting the measures given below.
Charging capital expenditure as revenue expenditure
Providing for more depreciation on fixed assets
Making excessive provision for bad and doubtful debts
Writing down goodwill to a nominal value
Under-valuation of stock-in-trade
Omitting some assets from the balance sheet
Showing contingent liabilities as real liabilities
Showing imaginary liabilities or overvaluing the liabilities
Making an excessive provision for contingencies or by continuing to carry

forward provisions when they are not required
Ignoring the permanent appreciation in the value of assets
Suppression of sales
Inflating purchases.
Objects of creation of secret reserves
Secret reserves are usually created to serve the following purposes.
Meet any extraordinary loss in future without disclosing the fact to the
shareholders.
Strengthen the financial position of the company
Mislead the competitors about the financial position of the organisation
Evade income tax and wealth tax
Manipulate share price for some ulterior motives
Regulate steady payment of dividend
Legal provisions
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Before the Companies Act, 1956 came into force, there were no restrictions on the creation of
secret reserves except that whenever secret reserves were brought back into accounts, it was
necessary to disclose the amount adjusted out of such reserve.
But after the introduction of the Companies Act, 1956 it is no more possible for a company to
create secret reserves. However, a banking company may continue to have secret reserves.
It is not possible to maintain secret reserves at present in a company form of organisation

because of the following reasons:
1. Section 227 of the Companies Act requires the auditor of a company to state
in his opinion whether the balance sheet gives a true and fair view of the
state of affairs of the company as at the end of its financial year. But, if secret
reserves are created, it will either overstate liabilities or understate assets
and as a result financial statement will not reflect a true and fair view.
2. Part I of Schedule VI to the Companies Act requires that the balance sheet will
make full disclosure for reserves and provisions.
3. Part III of Schedule VI to the Companies Act also requires that a provision for
depreciation, renewal or diminution in the value of assets and that in respect
of a known liability, which in the opinion of directors, is in excess of the
amount which is reasonably necessary for the purpose, should be credited to
reserve account. As a result, it is not possible any more for a company to
create secret reserves.
Auditors duty regarding secret reserves
The auditor is required to report on whether the balance sheet reflects a true and fair view of the
state of affairs of the company. If secret reserve is created, the balance sheet will not reflect a
true and fair view of the state of affairs of the company. So the auditor cannot ignore the
existence of secret reserve in the balance sheet. If there is secret reserve, he must find it out. His
position in this respect will not change even if it is created for some good purposes, e.g. for
strengthening the financial position of the business or for meeting any future contingency. The
auditor should, therefore, exercise reasonable skill and care in detecting all cases of secret
reserves. He will advise his client to rectify the accounts to do away with secret reserve if it
exists. If his advice is ignored, he will qualify his report.
There is also some relaxation in case of banking, insurance, electricity and finance companies,
which may continue to have secret reserve. But even the auditor of such companies must not
remain indifferent to the secret reserve. He must ascertain the magnitude of secret reserve
existing in the books and enquire into its necessity. He will allow it to continue if he is satisfied
that it has been created in the best interest of the company and the amount is reasonable.
In the context of the auditors duty while he detects the existence of secret reserve, the decision in
the Royal Mail Steam Packet Company case (1931) is noteworthy.
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[The fact of the case was that a huge amount of secret reserve was created under the head
Taxation Reserve in boom years. Later, when the company suffered heavy losses, this secret
reserve was used to conceal the loss. The shareholders were given to understand through annual
report that the company was running profitably and they were being paid dividend out of current
years profits. The auditor was criminally prosecuted along with the chairman of the company for
deceiving the shareholders. While defending himself, the auditor argued that the purpose of
secret reserve was to augment profit in lean years and had he disclosed the fact of secret reserve,
its purpose would have been defeated. But the auditor was held liable for committing breach of
duty. It was held that a protected utilisation of secret reserve, in order to keep the company
going, is a serious matter which ought to be disclosed to the shareholders of the company.]
Even a provision in the articles of association forbidding the auditor from disclosing the fact of
secret reserve is ultra-vires and invalid as was held in the case of Newton vs Birmingham Small
Arms Co. Ltd. In these judicial pronouncements, it is noted that although creation of secret
reserve was permitted, its disclosure was made obligatory.
Before the Companies Act 1956 came into force, there were no restrictions on the creation of
secret reserves except that whenever it was utilised, it was necessary to disclose the amount
adjusted out of such reserves.
The Companies Act now prohibits the creation of secret reserves. Only the banking, insurance
and electricity companies etc. are allowed to create such reserves. Therefore, the auditor should
state in his report, if he finds that such a reserve has been created. In case of companies, where
creation of secret reserve is permitted, he should carefully enquire into the necessity of creating
such a reserve. He need not qualify his report, if he is satisfied with the purpose of creation of
such a reserve and the amount involved.
Legal views as regards secret reserves
The legal views as discussed in different cases so far taken to courts of law are summarised
below.
Case Study
1. Case: Royal Mail Steam Packet Company (1931)
Fact of the case: A huge amount of secret reserve was created by the company under the
head taxation reserve in boom years. Later, when the company suffered heavy losses,
this secret reserve was used to conceal the loss. The shareholders were given to
understand through annual report that the company was running profitably and they were
being paid dividend out of current years profit.
Legal view: The auditor was criminally prosecuted along with the chairman of the
company for deceiving the shareholders. While defending himself, the auditor argued that
the purpose of secret reserve was to augment profit in lean years and had he disclosed the
fact, its purpose would have been defeated. But the auditor was held liable for
committing breach of duty.
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It was held by Justice Wright, J that a protected utilisation of secret reserve, in order to
keep the company going, is a serious matter, which ought to be disclosed by the
company.
2. Case: Newton vs Birmingham Small Arms Co. Ltd. (1906)
Fact of the case: In this case, the Articles of Association of the company provided that
1. The Directors should have powers to form an internal reserve fund,

which was not to be disclosed in the balance sheet and which should
be utilised in whatever way the directors thought fit.
2. The auditor should have access to the accounts relating to such

reserves, but they should not disclose any information with regard
thereto to the shareholders or otherwise.
Legal view: It was held that these provisions were ultra-vires since they limit the
statutory duty of the auditors.
Justice Buckley opined that, any regulations which precluded the auditors from availing
themselves of all the information to which under the Act they are entitled, as material for
the report which under the act they are to make as to true and correct state of the
companies affairs, are, I think, inconsistent with the Act.
8.4.7 Specific Reserve

A specific reserve is created for some definite purpose, out of the profits of the company. The
purpose may be anything connected with the business, which the articles of association or the
directors want to be provided for, such as dividend equalisation, replacement of fixed assets,
expansion of the organisation, income tax liability for the future etc.
Though the concerned amount is carried under earmarked head, this reserve is available for
distribution as dividend on the recommendation of the directors, but subject to the approval of
the shareholders, since this is created by appropriation of profits.
Normally, specific reserves are created to comply with the terms of the Articles of Association or
in accordance with a decision of the board of directors to meet a particular situation, which may
arise in future.
Also some of the specific reserves may be required to be created under contractual obligations or
legal compulsion. An example of the former would be the fund for redemption of debentures that
of the latter would be the development rebate reserve, which is compulsory to be created, if the
advantages of the development rebate are to be enjoyed from income tax liability. Such specific
reserves take on the character of capital reserve.
Purposes of creation of specific reserve
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The purposes of creation of specific reserve can be anything connected with the business, which
the Articles of Association or the Board of Directors want to be provided for.
Some of the important purposes for which it is created are as follows:
1. Debenture redemption reserve In order to redeem debentures after a

certain period of time, sometime debenture trust deed provides for the
creation of sinking fund or debenture redemption fund. This fund is created
by transferring an equal amount of profit every year to the said fund upto the
specified period from profit and loss account.
2. Capital redemption reserve When preference shares are redeemed out of

profit, i.e. without corresponding fresh issue of shares, an amount equal to
the nominal value of shares redeemed is transferred to capital redemption
reserve account from revenue profit of the company according to the
provision of Section 80 of the Companies Act.
3. Dividend equalisation reserve In order to equalise the rate of dividend

between lean years and boom years sometimes a reserve is created, which is
known as dividend equalisation reserve. This reserve enables the company to
pay dividend at a stable rate in different years irrespective of the amount of
profit earned.
4. Foreign project reserve For availing deductions u/s 80HHB, a foreign

project reserve account is to be created, which is equivalent to a certain
percentage of profit from foreign projects earned during any financial year.
The amount credited to this reserve account has to be utilised within a period
of five years for the purpose of the business itself, and not for distribution of
dividend.
5. Staff welfare reserve fund This reserve is created for conducting different
welfare activities of the workers and employees of the organisation. The
intention of this reserve is to create good image of the company amongst its
employees and workers by undertaking various activities for their benefit.
Auditors duty as regards specific reserve
Specific reserve is created out of revenue profit of the company. So, creation of this type of
reserve in no way distorts the true and fair view of the financial position of the company.
However, this does not mean that the auditor has no duty in respect of specific reserves,
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particularly for those specific reserves, which are to be created to fulfil any legal requirement.
The auditor must verify its adequacy and ensure that it is not used for any purpose other than that
for which it is created. If he fails to do so, he will be held guilty of negligence as was held by the
Chennai High Court in the case of M.S. Krishnaswami (1952).
So, the auditor has to take the following steps in order to justify the existence of specific reserves
in the balance sheet of a company.
1. Examination of the articles of association The auditor should study the

Articles of Associations to examine whether there is any provision for creation
of specific reserve.
2. Examination of the directors meeting minute books He will go

through the minute books of Directors meeting to see whether the
management has taken any decision for the creation of any specific reserve
and if so, whether the reserve has been created according to the decision
taken.
3. Examination of the balance sheet The auditor will satisfy himself that
the specific reserve created has been shown in the balance sheet according
to the requirement of Part I of Schedule VI of the Companies Act.
4. Examination of legal documents He will also examine the related

documents, e.g. the debenture trust deed, the tax audit file etc. to ensure
that adequate provision has been created according to the legal requirements
and the amount credited, if utilised, has been utilised according to the legal
provisions.
POINTS TO PONDER
Reserves are amounts appropriated out of profits, which are not intended to
meet any liability, contingency, commitment or diminution in the value of
assets known to exist at the date of the balance sheet.
Provisions are amounts charged against revenue to provide for depreciation,

renewals or diminution in the value of assets or a known liability, the amount
whereof cannot be determined with substantial accuracy or a claim, which is
disputed.
The reserves can be of either capital reserve or revenue reserve. Revenue

reserve represents profits that are available for distribution to the
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shareholders held for the time being. Capital reserve represents reserves,
which are created out of capital profit.
Capitalisation of reserve is the process by which the reserve is permanently

retained by the company by way of issuing bonus shares. It is also known as
ploughing back of profit.
Reserve can be retained in the business as a part of working capital or

invested outside the business. Reserve fund is that part of reserve which is
invested outside the business.
A sinking fund is a specific type of fund, which is created for the redemption
of a longterm debt or for the replacement of an asset. It is created either by
sinking fund investment method or by sinking fund policy method.
Reserves which are not disclosed in the balance sheet are known as secret
reserves. At present, it is not possible for a company to create secret
reserves, except banking, insurance and electricity companies.
A specific reserve is created for some definite purpose, out of the profits of
the company. The purpose may be anything connected with the business,
which the Articles of Association or the directors want to be provided for.
Examples of specific reserve include debenture redemption reserve, capital
redemption reserve, dividend equalisation reserve etc.
REVIEW QUESTIONS
Short-answer Questions
1. What do you mean by capitalisation of reserve?
2. How do you distinguish between reserve and provision?
3. What is sinking fund? How and why it is created?
4. How is secret reserve created and utilised?
5. What is the difference between capital reserve and revenue reserve?
Essay-type Questions
1. What do you mean by capital reserve? How does the capital reserve differ
from capitalisation of reserve? Can capital reserve or capitalised reserve be
available for distribution of dividend? Discuss with reference to Indian
Companies Act.
2. What is meant by capitalisation of reserves? State the advantages of such

capitalisation to the business and to the shareholders. What is the duty of an
auditor in respect of capitalisation?
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3. What is secret reserve? Why it is created? Discuss the duties of an auditor in
regard to secret reserve with reference to provision of Indian Companies Act.
4. What is meant by special reserve? What are the purposes of creation of such
reserves? What are the duties of the auditor regarding special reserve?
Add Highlight
Add Note
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Lesson 4
Vouching
The act of examining documentary evidence in order to ascertain the accuracy and authenticity of entries
in the books of account is called "Vouching". In other words vouching means a careful examination of all
original evidences that is invoices, statements, receipts, correspondence, minutes, contracts etc. With a
view to ascertain the accuracy of the entries in the books of accounts and also to find out, as far as
possible that no entries have been omitted in the books of accounts. According to Dicksee. "Vouching
consists of comparing entries in books of account with documentary evidence in support thereof.
According to R. B. Bose, "By vouching is meant the verification of the authority and authenticity of
transactions as recorded in the books of account".
From these definitions it is clear that vouching means testing the truth of entries appearing in the primary
books of account, vouching includes routine checking of carry forwards, extentions, posting into the
ledgers, casts, sub-casts and other calculations in the books of original entry. Vouching may be lengthy
process in a big organisation unless there is efficient internal control system iiv existence.
The vouching is an important tool in the hands of auditor provided he handles this work with intelligence,
observation and commonsense. Vouching is a sort of preliminary work which forms an important part of
audit work. Since accounts of a business begin with the passing of entries, hence it becomes a basis for
further scrutiny to be made at a later stage. The auditor, after satisfying himself with regard to the
authority and authenticity of transactions, can only then say specifically that the books of account are
correct and the Balance sheet and Profit and Loss Account exhibit the true and fair state of the financial
affairs of business. This is why vouching is said to be the backbone of auditing.
But all this depends upon the efficiency of the auditor. He, besides checking the arithmetical accuracy of
the books or comparing the entries with the available documentary evidence, should also go to the source
of a transaction. He should also see that the transaction has been properly authorised. Frauds can be
detected only by proper vouching conducted in an intelligent and searching manner. The importance of
proper vouching was emphasised in the case of "Armitage Vs. Brewer and Knott . In this case auditors
were found guilty of negligence because of their failure to detect defalcations committed by manipulating
wage records and petty cash book.
Objects of Vouching
1. To see that all transactions connected with the business have been recorded in the books of account.
2. To establish that no transaction which is not connected with the business has been recorded.
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3. To verify that all recorded entries are genuine.
Vouchers
A voucher is a written paper or document in support of an entry in the books of account. They may be of
two types :
1. Primary:- A written evidence in original is said to be the primary voucher, for example, invoice for a
purchase.
2. Collateral: When the original voucher is not available, copies there of are produced in support or
subsidiary evidence in order to remove doubt from the mind of auditor. Such a voucher is usually known
as a collateral voucher.
A voucher may be a receipt, invoice wage-sheet, an agreement, correspondence, bank paying-in-slip,

minute books recording resolutions of directors or share holders, and so on.
While examining vouchers the following points should be noted by the auditor:
1. All vouchers have been properly filed, serially numbered and arranged in order as it saves time in
finding out a particular voucher in checking.
2. The voucher is properly stamped as normally every receipt for more than five hundred rupees requires
a revenue stamp unless legally exempted.
3. The date and the year of the receipt or the voucher corresponding with the cash book. The name of the
party to whom the voucher is issued, the name of the party issuing voucher and the amount etc. are
correct.
4. Those vouchers which have been inspected by him are stamped so as to avoid the possibility of their
being produced again.
5. Every voucher is passed "as in order" by some responsible person whose signature should be noted.
6. Amount paid appears both in words and figures. If they differ, the matter should be investigated.
7. For missing vouchers, the auditor should satisfy himself with regard to the reasons of their being lost. If
he is not satisfied with the explanations, he should state this fact in his report.
8. No help from any member of the staff of the client has been taken while vouching the entries and
checking the vouchers.
9. Any alteration in the voucher is duly signed by the invoice clerk.
10. In case of vouchers for insurance, rent, rates and taxes etc., the period for which the payment has been
made should be noted.
11. Special attention should be paid to those vouchers which are in the personal name of one of the
partners, Directors, manager, Secretary or any other official of a business and which may or may not
relate to the business itself. In case of purchase, original invoice, inward book and order book etc. should
be examined to ensure that the goods were purchased for the business only.
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Vouching of Cash transactions
Vouching of cash transactions is by far the most important job in every business irrespective of its size
and type of business etc. Before setting the programme for vouching the cash book, an auditor should
examine carefully the whole system of internal check in operation in respect of cash transactions.
(Internal check has already been explained in detail previously).
Vouching of receipts of the debit side of the cash book
It is rather very difficult to vouch the receipt of cash than to vouch payments as some entries might have
been omitted altogether and therefore only an indirect evidence like counterfoils of receipts issued, carbon
copies of receipts, contracts and letter from debtors etc. are available. He should check a few items at
random and if he finds them to be in order, he may assume that the others will be correct but he must not
forget to compare the rough cash book or the diary with the cash book. If he fails to do so and later on a
fraud is detected, he might be held responsible. If he finds that there is a time gap between the two dates,
he should go deeper into the matter as it is possible that money might have been received in between the
two dates and misappropriated.
Some of the important items which usually appear on the debit side of the cash book and the duty of an
auditor in that connection are given below:
1. Opening balance: This can be vouched by comparing it with the balance shown in the duly audited
balance sheet of the previous year. By doing this, it is verified that the actual balance has been brought
down.
2. Cash sales: Under this head, the chances of fraud are comparatively greater, for example the salesman
may sell goods but may not record the same in the cash book thus misappropriating the money. Therefore
the auditor should examine the effectiveness of the internal control system in operation in regard to cash
sales. Assuming an effective internal check system in operation, the auditor should take the following
steps to verify the correctness of the amount of cash sales.
(a) Check the counterfoils of the cash sales books with the salesman's sun maries or
abstracts.
(b) Note that each salesman's abstracts agrees with the analysis of the cash received by the receiving
cashier.
(c) Check the details of cash received with the cash sales counterfoils.
(d) Compare the daily totals of the receiving cashier's memorandum cash books with their corresponding
entries in the main cash book. If the auditor fails to do so and later on fraud is discovered, he will be held
liable.
Cash received from debtors
The cash received from customers to whom good have been sold on credit in the past can be vouched
with the help of the counterfoils of the receipts issued to them. But it is often noted that a smaller amount
than actually received is shown on the counterfoils or receipts are issued to the debtors from old but
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unused counterfoil receipt books, the auditor should take the following steps in vouching receipts from
debtors :
1. Check the internal check system with regard to the sales as a whole.
2. Ensure that the unused counterfoil receipts are kept in safe custody.
3. See that all spoiled receipts are attached to the counterfoils and he has cancelled them.
4. Verify the dates on the counterfoils with those in the cash book.
5. The practice being followed with regard to receipts through cheques should be noted and if no official
receipts are being issued, he should verify the daily lists of such receipts with the entries in the cash book.
6. In respect of discount allowed to debtors, the auditor should ascertain the terms on which discount is
allowed and test check a certain number of entries to ascertain whether the discount allowed is in order.
7. Special attention should also be paid to the amount shown as bad debts written off as cash can be
misappropriated by writing off the whole or a part of the debit balance as bad. He has to ascertain as to
who is responsible for writing off debts as bad. He should, with the permission of the client, establish
direct contracts with the debtors by sending them the statements or verification slips from time to time
and asking them to send their confirmation directly to him.
With regard to receipts from debtors fraud may be committed by the process of "teeming and lading", that
is not entering cash in the cash book received from a debtor and entering it only when a similar amount is
received from another debtor and so on. Of course, no misappropriation is committed but the practice
should be checked because there is the loss of interest for the period money is misappropriated and
the cashier may be tempted to commit such a fraud of bigger amount and may not be able to replace the
same. To detect such a fraud the auditor should :-
1. examine the accounts of those debtors which show part payments from time to time.
2. check the amount and date on the counterfoil receipts to compare it with the date and
amount deposited in the bank.
3. should send verification slips to the debtor requesting them to send the confirmation
directly to him.
4. Bills receivables :
All details about bills receivable can be made available in the Bills receivable book. The auditor should
take the following steps:
(i) Ascertain the due dates of the various bills.
(ii) Note that the amount due on bills was received on maturity. This can be ascertained by comparing the
bills receivable book with the cash book and the pass book.
(iii) Special attention should be given to those bills which have been matured but the amount in respect
thereof has not been received. Such bills might have been dishonoured or retired. But there is a possibility
of their proceeds being misappropriated by the cashier.
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(iv) In case of discounted bills, the cash received should be properly entered in the cash-book and the
discount deducted should be separately shown in the discount account.
(v) He should note that in case of bills discounted but not matured at the date of the balance sheet,
contingent liability has been shown in the balance sheet.
5. Rents Receivable :
The auditor should proceed keeping in view following points:
(i) examine the leases agreement with the tenants and ascertain the exact amount receivable.
(ii) Check the amounts due with the rent-foil.
(iii) Compare the amounts as per rent roll with the cash book.
(iv) Check the counterfoils of rent receipt issued to tenants. If agents are appointed to collect
rent, the accounts or statements submitted by them should be carefully checked.
6. Interest and dividends :
Interest and dividends received from investments should be vouched in the following manner:
(i) receipts on this account should be checked with the counterparts of the interest and dividend warrants
or the letters along with the cheques.
(ii) in case of bearer bonds the bonds themselves should be inspected along with the torn off coupons to
note as to what interest should have been received.
(iii) If the banker is authorised to collect interests or dividends the entries in the bank pass book or
statement should be inspected.
(iv) In case of interest on fixed deposits, the bank pass book has to be checked.
(v) In case of interest received on a loan granted to a borrower, the agreement between the borrower and
the business should be referred to for the rate of interest, date of payment etc.
(vi) The auditor should ensure that all dividends or interest in respect of investments, deposits or lendings
etc. have been received and accounted for.
7. Sale of fixed assets :
The points to be considered are given below :
(i) It is possible in case of sale of fixed assets, the sale deed is not executed for the full purchase
consideration. To detect such a fraud, the auditor should examine the correspondence made with the
parties willing to purchase them.
(ii) In case, sale has been made through a broker, the broker's sold note should be examined,
(iii) He should see that the sale has been duly sansctioned.
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(iv) He should note that the profit earned on the sale of fixed assets should be credited to the capital
reserve account and not to the general profit & loss account.
8. Insurance Claims :
Amounts received under an insurance policy should be verified by means of the correspondence with and
accounts rendered by the insurance companies.
9. Sale of investments :
In this connection, the auditor should consider the following points:
(i) As investments are usually sold through brokers, so the broker's sold note should be examined to note
the date of sale, the amount received and the commission changed.
(ii) In case the sale has been made through the bank, the bank advice should be examined.
(iii) He should note as to whether the sale has been cum-dividend and if so, the dividend has subsequently
been received and the sale proceeds have been proportioned between capital and revenue. If investments
are sold ex-dividend, he has to see that the dividend has been received if declared.
10. Subscriptions :
Subscriptions received by a club or society should be checked with counter-foils of receipt books and
with the published list of subscribers.
11. Commission received :
For this, the agreements between the client and the parties from when it is receivable should be examined
to verify the terms of commission, its rate etc. Counter-foils of receipts should be compared with the
particulars entered in the cash bank. In case of goods received on consignment, the amount of
commission should be vouched with reference to the copy of the account sent to the consignor or the
auditor should calculate the amount himself, if necessary.
12. Receipts from hire purchase :
The hire purchase agreement should be checked in order to ascertain the duration of the agreement, the
amount of instalments, total number of instalments, payment by the close of period the accounts of which
are under audit. He should also note that the instalment includes interest also and also the whole amount
of an instalment is properly apportioned between sales and interest.
Vouching of Cash Payments
The object of vouching the credit side of cash or bank of cash payments is not merely to ascertain that
money has been paid away but to ensure that the payments have been made :
(a) to the proper and right party,
(b) on behalf of the business for a proper purpose,
(c) for the accounting period under audit,
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(d) after proper authorisation,
(e) against a proper voucher, and
(f) correctly recorded in the books of account.
Some of the important items on the credit side of the cash book and the duty of an auditor in that
connection are given below:
(A) Capital Expenditure :
According to Spicer and Pegler "Capital expenditure is all expenditure incurred for the purpose of
acquiring, extending or improving assets of a permanent nature, by means of which the business may be
carried on or for the purpose of increasing the earning capacity of the business". Such expenditure is
normally heavy and therefore require special attention. The type of documents required depends upon the
nature of the payment. Some of the items of capital nature and the duties of an auditor in each case are
given below :
1. Land & Building : The auditor should take the following steps :
(i) The documents of title of the property purchased should be examined.
(ii) The auditor should find out as to whether land or buildings purchased are on freehold or leasehold
basis. In latter case, he should examine the terms of the lease.
(iii) If the properties are purchased through an auctioneer, the account submitted by the auctioneer should
be checked.
(iv) In case the property has been purchased through the broker, the broker's note should be examined.
(v) Where the property is got erected through a contractor, he should examine the receipts issued by the
contractor, for payments made. If the buildings have been constructed by engaging labour, he should
vouch the expenditure on building materials purchased, cartage paid, wages paid to the workers etc. and
also see that the expenditure has been properly capitalised.
(vi) The expenses incurred, for example, auctioneer's commission, brokerage, architect's fee, registration
fee etc. can be vouched with the help of the receipts obtained and it should be seen that they are
capitalised.
2. Plant, Machinery, Furniture, Fixtures etc. :
In this connection, the auditor should take the following steps :
(i) examine the invoices and the receipts obtained from the supplier and see that the items have been
properly authorised.
(ii) In case, machinery has been purchased on hire-purchase basis the auditor should examine the contract
of hire-purchase with the vendors to find out the purchase price, the amount of instalment and interest.
Here, he should note that only the principal amount has been capitalised.
3. Investments :
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Investments should be vouched in the following manner:
(i) In case, these have been purchased though a stock-broker, payments should be vouched with reference
to the brokers sold note.
(ii) In case of a new issue for which application has been made and if the share certificates have not yet
been received, the allotment letter and banker's receipts for the instalments paid should be inspected. But
if share certificates or debentures have been received, they should be examined.
(iii) The actual investments should be examined.
(iv) In case of cum-dividend purchase, he should see that the expenditure has been properly apportioned
between capital and revenue.
(v) He should see that the investments have been made in accordance with the provisions of the
Companies Act and Investments are registered in the name of the company required under section 49 of
the Companies Act.
4. Patents :
The auditor should take the steps as given below :
(i) examine the patent.
(ii) if the patent has been purchased, the assignment should be inspected together with the receipt for the
purchase consideration.
(iii) In case patent has been purchased through some agent, the agent's receipted amounts should be
examined to note the agent's fees and verify the amount so included in the asset account.
(iv) He should note that the patent renewal fees has not been charged to the patent account, as these fees
represent revenue expenditure.
5. Loans :
In order to vouch the figure of loans, the auditor should :
(i) inspect the loan agreement, the security held if any, receipt given by the borrower etc.
(ii) examine that the loan has been properly authorised.
(iii) If the loan has been advanced against mortgage he should examine the receipt mortgage, the receipt
from the borrower, the mortgage, deed, title deeds and other documents.
(iv) In case of loans to directors, the managing directors and other officials of a company, he must see that
the provisions of the companies act are followed.
(B) Revenue Expenditure :
(i) Wages: In case of concerns employing a considerable number of workers, vouching of wages forms a
very important part of the auditor's job. He should first of all satisfy himself in regard to the efficiency of
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internal check system so far as it relates to the maintaining of wage records, preparation of wages sheets
and payment of wages. Besides this, he should note the following points:
(i) the totals and calculations involved in the wage sheets should be checked.
(ii) He should check a few items, for example, deductions in the form of rent, fire insurance, providend
fund, etc. and the method of deducting them should also be examined.
(iii) He should see that the amount of the cheque drawn for payment of wages tallies with the net amount
as shown in the wages sheets.
(iv) Names of workers given in the wages sheets should be well compared with those given in the wages
record like job cards, foremen's register, etc.
(v) He should see that the wages sheets have been properly initialled by those responsible for their
preparation.
(vi) He should carefully check the payments made to the casual labour.
2. Salaries :
For this, salaries book containing the details of the employee's salary should be maintained. The auditor
should take the following steps :
(i) He should compare the cheques drawn with the salaries book.
(ii) Any change in the salary list should be verified with an official source.
(iii) Special attention should be paid to the deductions in respect of provident fund, life insurance
premium, income tax, etc.
(iv) Independent information as regards employees leaving the service of the concern should be obtained
from the staff departments and compared with the salaries book to find out persons already left being
included in the salaries book.
(v) He should ensure that the payment has been made to the correct person. This he can do by comparing
the signature on the salaries book with the specimen signature of the employees.
3. Petty Cash :
Vouching petty cash is another problem for the auditor as normally there are no proper vouchers and
therefore chances of misappropriation of cash exist. As a first step, the auditor should examine the
soundness of internal check system in this regard and in case he finds it to be satisfactory, he should take
the following steps :
(i) He should see that imprest system is being followed and if not he should recommend the same to the
client.
(ii) He should check the payments made to the petty cashier with the entries in the cash book.
(iii) For those expense for which vouchers are not available he should ask the petty cashier to give a
summary which should be duly signed by a responsible officer.
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(iv) He should examine the totals and balances of the petty cash book.
(v) He should see that the petty cash book is periodically checked and initialled by some responsible
official.
(vi) The auditor should, without notice and occasionally, count the cash in hand and agree it with the
balances shown by the petty cash book.
4. Travelling expenses
These are paid for the travel in connection with the business. Where a fixed amount is payable, there is no
difficulty in checking it. But in other cases, the auditor has to check very carefully. His duty in vouching
such payments shall consist of:
(i) Vouching the cheque drawn according to the cash-book with the traveller's receipts.
(ii) Checking the figures in some of the traveller's accounts with the vouchers submitted by them.
(iii) Seeing that all unpaid commissions and expenses have been brought into account at the end of the
financial period.
5. Insurance premiums
In case of new policies, the auditor should inspect the cover note or the receipt from the insurance
company and in case the policy has been received, it should be examined. In case of renewals, the
renewal receipt should be checked. If the number of policies is large, he should require a schedule of
various particulars like number of the policy, the amount, the date of maturity, the amount of the premium
payable etc. He should examine these particulars. In case some policy has lapsed, he should find out as to
under whose authority it has been allowed to lapse.
6. Bank Charges
In order to vouch this item as shown in the cash book the auditor should tally the figures with the bank
pass book and if necessary he should check their calculations.
7. Postage
The auditor should compare the postage book with the cash book and petty cash book and count the
stamps in hand. He should see that postage includes only the postal expenses connected with the business
and not with any private account.
8. Director's Fee :
The auditor should take the following steps in vouching the payments under this head,
(i) Examine the articles to find out the fee payable to the directors.
(ii) The director' s minute book, the attendance register should be examined to ascertain the number of
meetings attended by them.
(iii) Examine the receipts obtained from directors for this payment.
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(iv) Examine the resolutions of the shareholders to calculate the amount payable as director's fee and
compare this figure with the amount actually paid.
9. Cash Purchases
In vouching this item, the auditor should take the following steps :
(i) Test the entries in the cash book with the cash memos.
(ii) See that the goods paid for have actually been received which can be done by checking the entries in
the goods inward book or purchases book.
(iii) See that only net amounts, that is, purchases minus trade discount, has been carried to the books of
account.
10. Payments to Creditors
(i) The receipts issued by the creditors acknowledging the receipt of money should be checked.
(ii) The money paid should be compared with the money due as per the accounts of the
creditors and the invoices received from them.
(iii) He should scrutinize the method of comparing the statement of accounts with their actual accounts.
(iv) Before passing an entry in this regard, he should refer to minutes, contracts and other documentary
evidence in support of it.
11. Bills Payable
In this connection, the auditor should:
(i) Examine the duly cancelled returned bills as an evidence of the amount having been paid.
(ii) Inspect the bills payable book.
(iii) See the bank pass book and the banker's advice in case the payments on certain bills have been made
through the bank.
12. Freight and Carriage
The auditor should vouch the payment on this account with the help of the statements rendered by the
shippers or carriers together with the receipts. He should also see that allowances in respect of rebates
have been properly accounted for. 13. Rents Payable
The agreement with the landlords and receipts from them should be examined.
14. Payment of taxes
In order to vouch this item, the auditor should refer to the copy of the assessment order, assessment form,
notice of demand and the receipted challan etc. The advance payment of income tax and interest allowed
on it should also be verified. Payment of sales tax can be vouched by reference to the return submitted by
the dealer and Treasury or bank receipt every month or quarter.
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15. Commission
The conditions relating to the payment of commission should be examined with reference to the
agreements between the client and the agents. The statements of account submitted by the agents should
also be seen.
Vouching of Trading Transactions
Here, the auditor is concerned with the checking of the Purchases Book and Sales Book in order to
prevent misappropriation of goods.
1. Purcahse Book or Bought Day Book : This book is used for recording the credit purchases of the
business only. First of all, an auditor should satisfy with the internal check system in operation with
regard to purchases. If the system of internal check is efficient and effective, the auditor can conveniently
proceed with the vouching of purchases book in the following manner:
1. He should check the invoices and compare them with entries in the day book. When examining an
invoice, special attention should be paid to the following points :
(a) The name of the creditor agrees with the entry in the day book.
(b) The invoices are made cut in the name of the auditor's client and appear to be of a nature relating to
the business carried on.
(c) Each invoice relating to goods has a memorandum, signed by the gate keeper acknowledging receipt
of the goods attached to it. Alternatively, it may bear a reference to a goods inward book. The auditor
should examine these order to see that the goods stated in the invoice have actually been received.
(d) The date agrees with that in the day book and falls within the period under audit.
(e) The trade discount has been deducted from the amount of the invoice, then only net amount has been
entered.
(f) Any invoice charged to capital is a proper capital charge and is debited to the correct account.
(g) In case the staff member's accounts are passed through the day book, they are charged to their
personal accounts.
2. At the end of the financial period, the auditor should compare the goods inward book and the stock
sheets with the purchases book in order to ensure that all goods taken into stock have been entered in the
purchases book. In case there is no goods inward book, he should check the suppliers advice notes
received with the goods as it is possible that towards the close of the financial year, goods have been
received and included in that closing stock but not recorded in the purchases books which will inflate
profits. 3. The auditor should ask his clients to send notice to every supplier requesting him to furnish a
statement showing the balance due on the balance sheet date. Then he should examine these statements
and compare them with the ledger accounts. If they agree, it will mean that no invoices with regard to
these accounts have been omitted.
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4. The auditor should see that no invoice has been entered twice in the books as fraud may be committed
by such a practice. In order to prevent it, he must compare invoices and the goods inward book in few
cases as test checking.
5. As invoice may be post dated to provide a fictitious period of credit to the purchaser the auditor must
see that entries are made in the purchases book only if the goods have been actually received during the
financial year under audit.
6. In case of duplicate invoices, the auditor should satisfy himself that they were obtained in respect of
only these invoices which have been actually lost.
7. He should check totals, sub-totals, carry-forwards, calculations in the purchase books and postings
from the purchases book to the ledger accounts.
2. Purchases Returns Book
Sometimes goods purchased are rejected or returned to the supplier or seller for various reasons. In this
connection the auditor should satisfy himself with the efficiency of internal check system and if satisfied
should proceed in the following manner.
1. He should compare the credit notes sent by the creditors with the entries in the purchases returns book
and the goods outward book.
2. He should see that proper deduction has been made on account of goods returned before the payment is
made. In case the payment has already been made, he should ensure that full credit has been received
subsequently.
3. He should pay particular attention to the heavy returns made at the close of the year and in the
beginning of the year as the entries might have been passed to adjust fictitions purchases of the previous
months.
4. He should check castings and postings of the purchases returns book to the ledger accounts.
3. Sales Book (Credit Sales)
The vouching of the sales book is a much more difficult task then that of the purchase book because the
only documentary evidence available is in the form of duplicates or invoices which are not completely
reliable. Therefore the auditor has to be very careful in this regard. Firstly, he should examine the system
of internal check in this respect and if satisfied with the system, proceed as follow:
1. He should compare the various particulars like the name, date, amount etc. on the copy of the invoice
with those given in the sales book.
2. In case some distinction is made in granting trade discount to two different customers, he should
enquire into the reasons for the same.
3. The sales book should be vouched with the help of the orders received book and the goods outward
book to ensure that no sales have been omitted from recording.
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4. Where goods have been supplied on àpproval' or `goods on sale or return' basis, he should see that
they are not treated as sales till the letter of acceptance has been received. At the same time he should
ensure that the goods with customers are included in the stock. 5. The auditor should specially examine
the sales relating the sales relating to the periods in the beginning or at the close of the financial year in
order to ensure that no manipulation has been made in accounts. He may check such sales with the goods
outward book.
6. He should see that capital sales have not been treated as revenue sales.
7. He should check the castings of the sales book and the posting to the ledger accounts.
8. He should set that the goods sent on consignment are not included in the figure of sales. They shall be
treated as sales only when they have been actually sold by the consignee and the Àccount Sale' is
received by the consignor. Till then, such goods are to be treated as stock with the agent. So he should
check such entries with the consignment note, account sale, vouchers for the expenses and cash-book.
Entries for sale-proceeds, expenses incurred by the consignee, his commission, etc. should be vouched
with the help of account sale as sent by the consignee. He should also see that the stock remaining unsold
with the consignee is shown in the balance sheet at cost or market price whichever in lower.
Sales Under Hire Purchase Agreements
Such sales can be recorded in the account books under two methods. One is to credit the sales account
with the total cash selling price in the year of sale and to treat the buyer as debtor for the instalments not
yet due at the date of the balance sheet. The other is to credit the sales account with each instalment
payable under the contract as and when it becomes due. When the first method is followed the auditor
should see that a provision for unrealised profits is made at the date of the balance-sheet and credit is
taken in each year only for such interest as has actually accrued during the accounting period. In case the
second method is adopted, the auditor should see that the amount of the unpaid instalments less unearned
profit included therein, is credited to the trading account and shown in the balance sheet as stock-on-hire.
Packages and Empties
There are some cases in which customers are supplied with packages like bags, cans and jars etc. which
they have to return to the suppliers or dealers. The auditor shall see that an effective system should exist
to record such packages and empties. Generally a memorandum system is adopted under which the
customer is debited with the cost of such empties. The cost of empties is not included in the sales. They
are entered in the sales return book under a separate column for this and also in the empties returns
inward book by the gatekeeper. So the auditor must examine these books.
At the date of the balance sheet a list of empties `not returned' by the customer should be prepared and the
value of such empties should be recorded in separate book to be known as "Empties and Packages on
hand" at cost price less depreciation. So the auditor should ensure a proper valuation of empties for the
purpose of balance sheet and see that correct depreciation has been provided for those packages and
empties which are still in the hands of the customers.
5. Bills Receivable Book
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Entries for bills receivable are passed in this book. Auditor's duty in regard to different types of bills is as
follows:
(a) In case of bills matured for which payments have been received, the receipt of money may be checked
by reference to the cash book or bank pass book as the case may be.
(b) For bills discounted, the cash book and the pass book entries should be checked.
(c) There may be bills in-hand which are not matured. If such bills are with the client,, personal
verification should be done by the auditor. If they are deposited with the bank, the auditor should check
the certificate to that effect obtained from the bank.
(d) In case of bills dishonoured, he should see that the proper entries have been passed in the financial
books. He should also check the castings of the bills receivable book and their postings to the ledger
accounts. The liability for bills discounted should be properly shown on the liability side of the balance
sheet.
6. Bills Payable Book
The auditor's duty in connection with bills accepted and entered in this book is as follows :
(a) In case of those bills for which payment has been made by the client on maturity, the auditor should
vouch them with the entries in the cash book or bank pass book and the returned bills.
(b) For those bills which have not yet mature, he should vouch them with the help of counterfoils or
copies of such bills, bills payable book and if necessary, the statements of account submitted by creditors.
(c) He should also examine the castings of this book and their postings into theledger accounts.
7. Journal :
Journal is used to record all extra ordinary transactions for which there are no special books of original
entry. The entries appearing in the Journal will be such as all opening entries, say, for the acquisition of
various assets, the issue and allotment of shares etc., closing entries which are passed" for closing and
transfering balance from the nominal accounts in the Profit and Loss account; adjusting entries such as
provision for outstandings, depreciation and bad debts etc, and miscellaneous items like writing off profits
or losses on the sale of assets. In order to vouch the journal the auditor should take the following steps :
1. In order to vouch opening entries, the auditor should examine them with reference to last year's audited
balance sheet. In case of new business he should verify them with reference to minutes of the board's
meetings, documents of title, purchase agreement, correspondence with the vendors, receipts issued by
the payee, etc.
2. For vouching closing entries, he should see that balances were correctly arrived at and they have been
carried to proper accounts.
3. In case of adjusting entries the auditor should check all the available evidence, for instance, bad and
doubtful debts can be inspected with the help of accounts contained in the sales ledger.
4. He should check the postings to the respective ledger accounts to as certain that they are in order.
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8. Bought Ledger or Purchase Ledger
This ledger contains accounts relating to creditors. The auditor should take the following steps:
1. He should check the opening balances of different accounts with the audited balance sheet of the
previous year.
2. He should examine all supporting books like purchases book, goods inwards book, cash book, discount
register, goods outward book etc.
3. If the self- balancing system is in use, he should ask his client for a schedule of creditors and total of
the schedule should be tallied with the creditor's ledger adjustment account.
4. The auditor should examine all the creditors statements and with their help, the purchase ledger
balances should be checked.
5. He should see that the balances in the purchases ledger whether debit or credit are shown on the proper
side of the balance sheet.
6. He should ensure that provision for reserve for discount on creditors, if made, is not excessive.
9. Sales Ledger or Debtors Ledger
This contains accounts relating to debtors. The following points should be noted while vouching sales
ledger:
1. The auditor should check the opening balances with the audited balance-sheet of the previous year.
2. He should examine supporting book like bills receivable book, cash-book, goods out ward book, sales
returns book etc.
3. Where self-balancing system is in use, the total of the balance as per the schedule of debtors should be
verified with the total of the balance shown in the debtors ledger
adjustment account.
4. He should test check postings to this ledger from various books of first entry. He should give special
attention to credit postings, as any attempt to conceal defalcations will more usually take the form of
fictious credit entries.
5. He should also check the castings and balances with the list of debtors. If there is any credit balance in
the sales ledger, he should see that it is shown on the liabilities side of the balance sheet alongwith sundry
creditors.
6. While examining the accounts the auditor should ascertain the composition of each balance. In
particular he should note whether it represents specific items of goods or is an accumulated balance. In
the latter case, he should ensure that it does not represent doubtful for bad debt.
7. He should call for a list of bad and doubtful debts and verify them thoroughly as there is quite
possibility of the figure being understated and misappropriated.
Vouching of Impersonal Ledger :

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It is an important part of the auditor's, duty to vouch the impersonal ledger which contains accounts from
which trading and profit and loss accounts and the balance sheet are prepared. The impersonal ledger has
two kinds of accounts -Nominal accounts & real accounts. Nominal accounts relate to the trading, profit
account and real accounts record assets. Here, the transactions appearing in the impersonal ledger but
relating to profit & loss account and the auditor's duty in connection with only those items is to be
considered. Whole vouching these transactions, the auditor should consider the following points :
1. He should check the totals of the various books of original entry with the accounts in the impersonal
ledger.
2. He should vouch the Journal carefully and should see that each entry is supported by sufficient
evidence. He should also check their postings to impersonal ledger.
3. He should test the postings from the cash book to the impersonal ledger in order to ensure that the
entries have been posted to the correct accounts.
4. In those cases where direct entries are passed from one account to another in the impersonal ledger, he
must proceed in the same manner as if they had been passed though the journal. Such items are as follows
:
1. Outstanding assets :
Under this head, there may been an expenditure already incurred for which the corresponding benefit
could not be made available for the business during the period or some portion of this relates to the period
subsequent to the date of balance sheet. Such items are usually named payments in advance or pre-
payments and should be shown in the balance sheet.
Beside this, there may be some items accruing or due which may not have been recorded in the books, for
example, prepaid expenses, accrued income items and deferred revenue expenditure. In case of prepaid
expenses like advance payment of rates and commission etc ; the auditor should see that such amount has
been excluded from the profit & loss account and be shown on the asset asset side of the balance sheet.
He should vouch such expenses with the help of nominal accouifrs, demand notes, receipts and the actual
inspection of the original documents. He should also see that the correct amount has been proportioned
between the two periods on the date of the balance sheet. In case of other items also, same procedure can
be following by the auditor.
2. Outstanding liabilities :
It is the duty of an auditor to ascertain that all outstanding liabilities are brought into account before
calculating the net profit or loss for the year under audit. But in practice, it may not be easy for an auditor,
therefore it is better if he obtains a certificate from a responsible official that there are no expenses
incurred in the current year which have not been recorded in the books of account. In spite of this, he
should scrutinise the nominal accounts like interest, rent and salaries and discount etc, to verify that all
expenses accrued up to the date of the balance sheet have been accounted for.
For example in case of unearned income, the auditor should examine the necessary vouchers to ascertain
how much amount of such income is to the credited in the current year's profit and loss account and how
mcuh is to be carried forward to the following year. Another example of outstanding liabilities is unpaid
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expenses such as audit fee wages and salaries, freight & carriage, rent, rates, taxes & electricity etc.
traveller's & agent's commission, interest on loan & debts etc. In order to vouch these expenses, the
auditor should examine nominal accounts demand notes, receipts, invoices & other relevant vouchers &
note the period covered by such payment. He should also ascertain with their help that the expenses
unpaid have been debited to the profit & loss account of the current year and shown separately on the
liability side of the balance sheet.
3. Contingent liabilities :
Contigent Liabilities are those liabilities which are not definite or certain as they may or may not arise
after the preparation of the balance sheet. So it is the duty of an auditor to see that the necessary provision
has been made for contingent liabilities. In order to ascertain the existence of such liabilities, he should
examine the minutes of the meetings of the board of directors and other concerned correspondence. He
should also enquire from the legal officer of the client about possible losses from pending law suits. He
should write to the bank to supply a list of all the bills discounted, also the number of bills which have not
matured as yet. He should also find out the amount of dividend payable to cumulative share holders. The
auditor should divide the contingent liabilities into two main groups according to Part - I of schedule IV
of the companies Act. First come those liabilities in respect of which a provision has been made in the
balance sheet. So in such a case, he shpuld see that they appear under the heading "current liabilities and
provisions". Then there are liabilities in respect of which no provision has been made in the balance sheet.
In this respect, the auditor has to see that these are appearing by way of foot note in the balance sheet.
4. Contingent Assets
There is no practice of showing these in the balance sheet either as a foot note or any other manner and in
Companies Act also there is no provision to show them. It is but fair that if a contigent liability is shown,
a contingent aseet must also be shown at the same time.
Verification
Verification means `proving the truth' or `confirmation'. One of the most important duties of an auditor in
connection with the audit of the accounts of a concern is to verify the assets and liabilities appearing in
the balance sheet. The fact that there is an entry regarding the purchase of an asset and has been be
correctly recorded, is not a proof that the asset is in the possession of the concern at the date of the
balance sheet. It is possible that after purchase and passing the entries, the asset might have been disposed
of or pleadged and no entry has been made concerning this before the closing of thse books. Therefore, he
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has to see whether a particular asset as recorded in the balance sheet on the day of the closing of the
books of account exists or not. If he fails to verify the asset, he will be liable for any damage suffered by
the client as it was decided in the case of London Oil Storage Co. Ltd. Vs. Sear Haslock and Co. (1904).
Thus we can say that verification is a process by which the auditor satisfies himself not only about the
actual existence, possession, ownership and valuation but also ensures that the assets are free from any
charge or lien. The verification of assets involves the following points :
1. Comparing the ledger accounts on the date of the balance sheet.
2. Verifying the existence of the assets on the date of the balance sheet.
3. Satisfying that they are free from any charge of mortgage.
4. Verifying their proper value.
5. Assets were acquired for the business.
Difference between Vouching and Verification
1. Vouching is based only on documentary evidence whereas verification is based on physical inspection
as well as documentary examination.
2. Vouching examines the entries relating to the transaction recorded in the books of account whereas
verification examines the assets and liabilities appearing in the balance sheet.
3. Vouching of books of account is done for the transactions for the whole year. Verification, on the other
hand is done at the end of the year when the balance sheet has been prepared.
4. Vouching indicates though a particular asset must be in possession of the concern whereas verifies
certifies the existence of the asset.
The auditor should as far as possible, inspect the assets personally on the date of the balance sheet like
cash, bills receivable and investments etc.
Verification of assets is important as it will avoid the possibility of the improper inflation of values, or of
the existence in the books of record of an asset which does not exist or which in fact never existed. This
may be done in most of the cases to inflate the profits, and to show a better position of the business than
what is actually is. An example of this is inflation of the value of stock. If the auditor is negligent is
performing his duties in respect of verification, he may not be in a position to detect misappropriation of
assets, inflation of profits and falsification of the balance sheet. In such case he may be held liable for
damages.
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Valuation
Valuation of assets is an important part of their verification. The correct profits can
not be calculated unless the assets are properly valued. Only then the balance
sheet will reveal the true and fair position of the financial affairs of the business.
The valuation as such is to ensure the correct valuation of the assets while in
verification, the auditor has to verify the authority, and the existence of the
property also besides its valuation. Thus valuation means to test the exact value of
an asset on the basis of its utility. Normally, valuation is done after deducting the
depreciation for the value of an asset. If proper depreciation on assets is not
provided for, the profits will be overstated or understated which will have adverse
effect on the company's solvency. The auditor should consider the following points
while valuing the assets:
1. Original cost of the assets.
2. Expected working life of the assets.
3. Wear and tear of the assets.
4. Break-up value of the assets.
5. The chances of the assets becoming obsolete.
Mode of valuation of different types of assets.
The mode of valuation of different types of assets differs depending upon the nature of the business and
the purpose for which the assets are held. The basis of valuation for different types of assets is given as
below :
1. Fixed assets : These assets are of a permanent nature with which the business is carried on and which
are held for earning income and not for re-sale in the ordinary course of the business. For example, land
and building, plant and machinery and furniture etc. These assets are to be valued at cost price less total
depreciation in their value by constant use. Additions and sales should be taken into account.
2. Wasting Assets : These assets are of fixed nature and are depleted gradually lose a part of their value in
the process of working such as mines, quarries and oil wells etc. The common method of valuation in
such a case is that the value of such assets must be shown in the balance sheet at its original cost and
provision is made for depreciation and depletion according to the estimated exhaustion of these assets.
3. Intangible assets : There are the assets which have income producing ability but can not be seen of
touched. For example, goodwill, patents, copyrights, licences etc. They are generally valued in the same
manner in which fixed assets are valued, that is at the cost price.
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4. Current Assets : These are the assets which are acquired in the business held for purposes of
consumption, resale or subsequent conversion into cash. For example, stock-in-trade, book-debts, cash
and bills receivable etc. These assets should be valued at original or the market price whichever is lower.
Auditor's position as regards valuation of assets :
It is not an auditor's duty to determine the values of various assets. It has been judicially held that he is
not a valuer or a technical man to estimate the value of an asset. But he is definitely concerned with
values set against the assets. He has to certify that the profit and loss account shows true profit or loss for
the year and balance sheet shows a true and fair view of the state of affairs of the company at the close of
the year. Therefore he should exercise reasonable care and skill, analyse all the figures critically, inquire
into the basis of valuation from the technical experts and satisfy himself that the different classes of assets
have been valued in accordance with the generally accepted assumptions and accounting principles. If the
market value of the assets are available i.e., in the case of share investment then he should verify the
market value with the stock exchange quotations. If there is any change in the mode of the valuation of an
asset, he should seek proper explanation for it. If he is satisfied with the method of valuation of the assets
he is free from his liability.
Verification and Valuation of assets
1. Property : In order to verify this item, the auditor should distinguish between two types of property.
(a) Freehold Property : Where Freehold property has been purchased, he should
examine the title deeds e.g., the purchase deed, the certificate of registration, the
broker's note and the auctioneer's account etc., in order to verify the correct
position. However, an auditor cannot guarantee that the title is good, all he can do
is to see that the deeds are in client's possession and appear to be in order. In case
of any doubt on any point, he should refer the matter to the client's solicitors.
In case where property has been mortgaged, the auditor should obtain a certificate from the mortgagee
regarding the possession of title deed and outstanding amount of loan. In case the property has been
acquired in the current year the cost may be verified with the help of the bank pass book. He should also
vouch all the payments made in this connection. He should see that the property account should be shown
in the balance sheet at cost price including the legal and registration charges less depreciation up-to-date.
He should also see that a separate account for building and land on which it is constructed is maintained.
It is necessary because depreciation is provided for building and not for the land.
(b) Leasehold Property : The auditor should verify this by inspecting the lease contract to find out value
and duration. He should see that the terms and conditions of lease are properly complied with. In case
property has been mortgaged, the auditor should obtain a certificate from the mortgagee regarding the
possession of title deed. Where the leasehold property has been sub-let, the counter part of the tenant's
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agreement should also be examined. Wherever possible, the auditor should physically inspect the
properties. He should also note that proper provision has been made for depreciation of leases and for any
possible claims arising there under.
2. Furniture, Fixtures and Fittings : In case the assets have been acquired during the current accounting
period, the auditor should examine the invoice of the dealers. It should be noted that adequate
depreciation has been written off, based upon the working life. In the case of fixture and fittings on lease
hold premises, the whole cost should be written off over the period of the lease of their estimated working
life, whichever is shorter. A stock register to record furniture etc., purchased should be maintained. The
old and unserviceable furniture must be discarded by a responsible officer. He should ask the management
to prepare an inventory and reconcile it with the stock register.
3. Plant and Machinery : In case the machines are purchased in the current accounting period, the invoices
and the agreement with the vendors should be verified. The auditor should ` examine the plant register in
which particulars about the cost, records about sales, provision for depreciation, etc., are available. He
should prepare a list of each machine from the plant register and should get the list certified by the works
manager as he is not a technical man and therefore he has to depend upon the advice of the works
manager regarding their valuation, etc. He should see that plant and machinery account is shown in the
balance sheet at cost less depreciation after making proper adjustment regarding purchases and sale of
some parts effected during the year under audit. In case any plant and machinery has been scrapped,
destroyed or sold, he should ascertain that the profit or loss arising thereon has been correctly determined.
4. Goodwill: Goodwill should be shown as an asset in the balance sheet only if it has been purchased. In
such a case goodwill should be shown at cost. But if the price paid for goodwill has not been fixed
specifically in the contract of sale, the amount of goodwill will be the difference between the total
purchase price and the other assets at agreed valuations, less any liabilities taken over from the vendors.
Here it should be noted that the real value of the goodwill of any business can be said to fluctuate almost
daily and it is not part of an auditor's duty to consider whether this value is greater or smaller that its book
value at a balance sheet date. The auditor should see that the goodwill account represent the actual cost
only, that is, improper items should not have been included therein.
Sometimes a question is raised about the depreciation of goodwill. Legally, it is not

binding on a company or a firm to write off goodwill, but, however, it is advisable
from the financial point of view to write it off gradually within a reasonable period
out of current profits or reserves. But it is for the proprietors or directors to decided.
An auditor cannot interfere with this decision, though he may give advice, if asked
for. However the auditor should very carefully look to the reasonableness of
appreciation in its value, if any.
5. Patents : The auditor should first of all examine the patents and verify them with the help of the
certificates which have granted for such patent rights. Where the patent has been purchased, the
assignment as well as the patent should be inspected.
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If the number of patents is considerable, the auditor should call for a schedule thereof from the client
giving particulars of each patent the register number, dates etc. and examine the same.
Here it is important to note that the actual patent should be examined and it must be duly registered. He
should also examine the last renewal fee receipt to satisfy himself that the patents have been renewed at
the prescribed time. He should note that the cost of renewal fee should be debited to profit and loss
account.
6. Trade Marks : The auditor should see that they are registered in the name of the client and this can be
done by examining the certificate issued by the Registrar. In case a trade mark has been purchased he
should also vouch the payment.
Where it is registered by the proprietor of the business himself he should examine the registration
documents and the certificates issued by the office of the registrar of trade marks and the last renewal
payment fee receipt. He should also see that any expense incurred in the acquisition of the trade mark has
been treated as capital expenditure but any renewal charges has been treated as revenue expenditure.
7. Copyrights : This is a right to produce or re-produce some kind of literary works. Its effect is that the
author or the publisher gets an exclusive right to publish or reproduce the work for a certain number of
years of for the life time of the author or the publisher as the case may be the auditor should inspect the
agreement between the author and the publishers. It is after seen that the value of the copyright is not
stable because they lose their value by passage of time. Hence, in this case, the revaluation method of
charging depreciation is considered to be most appropriate. The auditor may rely on the certificates of
experts responsible for revaluation.
If the sale of the publication is very low or nil, the copyright should be written off. Generally, copyright
must be shown at cost less amounts written of from time to time.
8. Loose Tolls : The auditor should obtain a list of loose tools duly authorised by some responsible officer
and examine the same. Revaluation of loose tools is the most appropriate method of valuation. The
difference between the cost price and the current price should be treated as depreciation or loss to be
charged to the profit and loss account.
9. Motor Vehicles : Motor Vehicles account is to be separately maintained. The auditor should compare it
with the balance sheet in which it should be clearly stated under separate head. He should also see that
they are shown in the balance sheet at cost less depreciation.
If the number of vehicles is very large, a separate register maintained should be checked and compared
with a schedule of motor vehicles by the auditor. He should check the registration books and licences to
ascertain that vehicles are registered in the name of client. He should check the premium receipts to
ensure that they are fully insured.
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10. Investments : Investments include government securities, shares, debentures,
etc. When the number of investments is very large, the auditor should ask for a
schedule of investments held by the client containing various particulars like name
of the securities, date of purchase, nominal value, cost price, market price, etc., and
examine the same. He should see that the asset has been shown separately in the
balance sheet.
The auditor should verify the existence of investments by his personal inspection. At the same time, he
should also ensure that the investments are registered in the name of the client and they are free from any
charge. He should rely on the relevant vouchers and certificates to do so.
If the securities are with the trustees on behalf of the concern the auditor should examine the trust deed. In
case they are under the safe custody of the banker then he should obtain the certificate from the banker
and examine the same. If they are with the broker, he should examine the certificate received from the
broker.
Having verified the securities, the auditor has to find out that the investments are properly valued.
Generally, investments are valued at cost price of market price whichever is lower. In case there is a
temporary fall in the price of the shares, it should be ignored. But where such a fall is permanent,
depreciation must be provided. Actually the basis of valuations of investment will depend upon the
purpose for which they are held. For instance, in case of trust company the sole purpose of which is to
earn interest and dividend, then such investment must be treated as fixed asset. In such cases even the
permanent fall in their value should be ignored.
11. Book Debts (Sundry Debtors) : The task of verifying this asset would be reduced to a great extent in
case there is an efficient internal check system regarding sales and writing the sales ledger. The auditor
should, however take the following steps to verify this asset:
1. He should see that the debts as disclosed in the balance sheet are recoverable.
2. He should obtain a certified statement of book debts clearly distinguishing between good debts, secured
debts, unsecured debts, current debts, bad and doubtful debts, debtors outstanding for a period exceeding
six months and other debts.
3. He should check the balances of the sales ledger with the schedule of the book debts by test checking.
4. In case where certain amounts of debt has been written off the auditor should enquire into the details.
He should also examine the correspondence or any documentary evidence or the authority of any
insolvency court regarding the payment of debt.
5. In case of hire purchase debts, the auditor should see that instalment yet to be paid by the customers
should not be treated as book debts because the customer has a right to return the goods.
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6. Debts due by directors or other senior officers of the company jointly of individually should be
separately stated. The maximum amount due by directors and senior officers should be stated by way of a
foot note in the balance sheet.
7. In case of debts from a subsidiary company under the same management,'he should examine the
relevant documents to ascertain the genuineness of the debt and the name of such companies must be
disclosed.
8. He should also write to the parties and get balances confirmed by them which will enable him to know
the accuracy of the amount receivable.
9. He should ensure that book debts in the balance sheet of a company is shown according to schedule VI
of part I of the Companies Act.
12. Bad and Doubtful Debts : The adequacy of the provision for bad and doubtful
debts made by the management can be checked by an auditor by considering the
following points : (a) All time barred debts must be treated as bad. So an auditor
must check up the period of the debt and see that necessary provision has been
made for such bad debts.
(b) He must check the cases of those individual debtors who are not regular in payment of debts
according to the terms of agreement and ascertain the collectivility of the debts in each case. Amounts
that are definitely not collectible should be written off.
(c) In case of those debtors, who have been adjudicated as insolvent or whose cheques or bills have been
dishonoured proper provision must be made.
(d) Provision must also be made for the amounts owing from those debtors against whom suits for
realisation of debts are pending in the law courts.
It is not desirable that debts should be written off until there is no further spoke of recovering any thing.
Bad debts should not be written off without the function of some official which will prevent the
possibility of misappropriations. As regards the amounts of provision to be made in respect of bad and
doubtful debts not written off it is suggested that full provision should be made for those debts actually
regarded as bad while the doubtful debts should be provided for according to their estimated value
depending upon the circumstances of each cash.
Bill Receivable : In order to verify the bills receivable, the auditor should take the following steps:
1. The bills receivable should be compared and counted with the actual bills in hand at the date of balance
sheet by examining the bills receivable book.
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2. In case the bills have matured and honoured subsequent to the date of the balance sheet but prior to the
date of audit, he should vouch the cash received as shown in the cash book or the bank pass book.
Similarly, the bills discounted after the date of balance sheet must be vouched with reference to cash
collection.
3. He should see that the bills are properly drawn, stamped and duly accepted and they are not overdue. In
case of the renewal of any bill, he should examine the new bill with the old bill. Where the part of the
original bill has been paid he should vouch the cash received and see that a new bill of the balance
amount has been obtained.
4. Where the number of bills is large and they are usually kept with bankers or agents for collection he
should obtain a detailed certificate from them and examine the same.
5. In respect of bills discounted or endorsed but remaining outstanding at the time of audit, any contingent
liability in respect of such bills should be mentioned as a foot note in the balance sheet.
6. Bills which have been dishonoured before the date of the balance sheet should not be included in the
balance sheet as bills receivable in hand as they are no longer assets. The acceptor, dishonouring the bill,
should be shown as debtor in the books of accounts.
14. Cash-in-hand : The auditor should carry out cash verification at the end of the
year and or by way of a surprise check any time during the year. In the former case,
he should visit the clients office on the last day of the closing of the financial period
and count the cash-in-hand and compare it with the balance as shown in the cash-
book. He should also count the balances of the petty cash book, stamps and I.O.U's
in hand. In case there is any shortage, he must report it to the accountant and
obtain a certificate to that effect from him. He should insist on the production of all
funds in the same location simultaneously. If the cashier has access to funds
belonging to other entities like associated companies, staff cluBs", etc., the auditor
should seek the cooperation of these entities in ensuring that all funds are checked
simultaneously as there is a danger that shortages in one account may be made up
from the balance in another account. Where the whole or a part of the cash is
maintained either at an upcountry branch or factory and is not therefore
conveniently accessible to the auditor for verification, the client may be advised to
deposit the entire amount of cash in hand on the last day in the bank. The auditor
should carry out a surprise cash verification whenever he visits such an up country
branch or factory during the course of his audit.
15. Cash-at-Bank : The auditor should compare the balance as shown in the pass book with the balance as
shown in the bank column of the cash book. In case of difference, bank reconciliation statement should be
prepared. In order to avoid the presentation of fictitious pass book, he should also obtain a letter of
confirmation from the bankers. Separate certificates should be obtained for fixed deposits, current account
and saving bank account, etc., from the bank.
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16. Stock-in-Trade : The verification and valuation of the stock-in-trade is one of the most important
duties of an auditor in order to arrive at the correct profit and loss of the concern under audit. In various
cases, it has been decided that the auditor cannot be asked to take the stock or value it. Practically also, it
is impossible for the auditor to physically verify every item of the stock-in-hand because of various
reasons i.e. limited time and the lack of technical knowledge etc., still he has to exercise reasonable care
in regard to stock verification and valuation. He should make enquiry into the system of internal check,
the method of stock taking and the basis of valuation.
The auditor should conduct some tests in order to ascertain the effectiveness of these systems. He should
compare the rough stock sheets with fair stock sheets. He should also check the stock books to ascertain
the correct position of the stock-in-hand. He should also obtain a certificate from a responsible officer
stating that the quantities and the valuation of the various stocks are correct and all the items are the
property of the concern. He should also obtain a list duly certified about the obsolete goods which have
been discarded.
Method of Stock Taking
The stock verifier goes to the godown and calls out the number and other relevant particulars of the items
of each class of goods and another clerk enters these particulars in the stock sheet. Then two clerks of
another batch will check the stock-sheet.
The Stock-sheet will then be sent to a responsible officer who fills in the rate of each item of goods at
which they are to be valued. The work of calculation is entrusted to a clerk who will calculate the value of
each class of goods and his work is then checked by a senior clerk. All those connected with the stock-
taking put their initials on the work done by them so that if later on any mistake is found the concerned
official may be held responsible for the mistake. All stock-sheet are stand-by the general manager or
partner as the case may be.
Care should be taken that goods-in-transit are included. Similarly balances of the unsold stocks at the
branches or with the approved agents or `sent on approval' should be included in the stock-sheet. But
goods received by the client on sale or return basis or as a consignee and goods sold but not yet delivered
should not be included. The auditor should obtain a certificate with regard to the accuracy of the stock-
sheet and its valuation from the senior officer of the concern.
Valuation of Stock-in-Trade
The auditor should consider three principles while valuing the closing stock. One is that stock should be
value at cost or market price, whichever is lower at the date of balance sheet. Another principle is that all
anticipated losses should be taken into account but anticipated profits should be ignored. Third principle
is that the method once adopted should be consistently followed.
The following are the different methods of finding out the cost price of the stock-in-
hand : 1. Unit cost or Actual cost: Under this method each article, batch and parcel
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of consignment is valued at its individual cost, but it is not usually capable of
application.
2. Average Cost: Under this method, the average cost per unit is calculated. The average should be
weighted average. The total value of goods (quantity x price) held in stock and those purchased and sold
should be divided by the total number of units. This method is adopted when the goods purchased at
different times have been mixed up and it is not possible to identify the goods.
3. First-in First-out (FIFO) : In this method the whole of the stock is valued at the rate of the latest
consignment purchased. This method assumes that the goods issued out of the stores are those which were
received first. This method is easy to operate if the prices do not fluctuate very frequently.
4. Last-in-Flrst-out (LIFO) : This method is the reverse of FIFO. In this method the whole of the stock is
valued at the rate at which the earliest purchases were made. This method assumes that the latest receipts
of the materials are issued first and the unsold stock represents the earliest purchases and is priced
accordingly.
5. Base Stock : Here it is assumed that certain minimum or basis quantity of material should always
remain in the store. Therefore the stock should be valued at normal long period price, and not on the basis
of dost price or the market price whichever is lower. Excess stock may be valued at cost price or market
price whichever is lower.
6. Standard Cost : In this method the stock is valued at a predetermined cost per unit, known as standard
cost. This method is convenient where goods pass through a number of processes and are manufactured
on large scale basis.
7. Adjusted Setting Price: In this method the unsold stock is valued at the prevailing price out of which
the normal profit plus the estimated cost of disposal i.e., selling expenses and overhead expenses, are
deducted.
Market Value
For the calculation of market price there are two methods in use :
1. Replacement cost method: It is the cost of replacing an asset at the date of the balance sheet. It means
the price at which similar types of goods can be presently purchased from the market.
2. Net Realisable value method: Is means the price at which the goods can be sold in the market after
deducting the necessary selling expenses.
Whether net realisable value be used or replacement cost method be used, it will depend upon the purpose
for which the stock is held. If the purpose is to resale the stock, it may be valued at net realizable value
and if it is retained for use then replacement cost method be applied.
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Valuation of different items of stock
1. Raw Materials : Normally the raw material is purchased for manufacturing goods, hence it should be
valued at cost price plus a reasonable proportion of incidental expenses like carriage and freight and
excise duty etc. If the raw materials were purchased at different times and the lots could not be identified
then average price may be taken. It should be noted that such raw materials should never be used at a
higher price than the market price. But a provision for the write off must be made in respect of damaged
and obsolete raw materials.
Some materials like wine, timber etc., appreciate in value and hence may be valued
at higher price than the cost price. But such value should not be in excess of the
market value. 2. Semi-Finished goods : In case of semi-finished goods which are in
the process of manufacture at the date of balance sheet, they will be valued at the
cost price of the raw materials used, plus the proportionate amount of wages and
other direct expenses and a percentage of overhead expenses. The auditor should
see that the amount in respect of selling and office expenses are not included.
3. Finished goods : These goods may be of two types. Firstly, the goods which have been manufactured
and are in a deliverable state, will be valued at the manufacturing cost, that is, material, labour and a
proportion of factory expenses. If the cost price of the manufactured goods is higher than the market price
and they must be valued at market price.
Secondly, in some trading concerns goods are purchased for the purpose of resale. The cost of such goods
would be the aggregate of the invoice price (including sales tax, excise duty etc.) and other direct
expenses like carriage etc.
4. Stores : These are goods which may be in hand at the date of the balance sheet stores are held for use
and not for sale in the original form. Examples are Coal, Oil, Fuel etc. They should be valued at cost
price. If the market price of such stores have gone down, it has been suggested that they must be written
down.
5. Spare Parts : Spare parts are used in connection with the maintenance of production facilities. The
auditor should get a list of such parts from the works manager. They should be valued at cost price and
are not required to be written down to the market value if that value is lower at the date of the balance
sheet.
6. Goods on Consignment: It may happen that at the date of the balance sheet, the whole of the
consignment or part of it may not have been sold. Such unsold consignment of goods should be valued at
cost price, plus proportionate expenses, etc., but it should not be valued at higher price than market price
of similar goods. The anticipated losses should be considered while valuing such stock of goods.
The Duty of an Auditor as regards Stock-in-Trade
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The duty of an auditor in relation to the stock-in-trade can be understood from the following two points of
view:
(i) Physical Verification of Stock-in-Trade : This part of auditor's duty is subjected to a great amount of
controversy. As a matter of fact an auditor may or may not possess the technical knowledge to verify that
the stock-sheets are correct and even if he possesses the necessary knowledge it is not possible for him to
inspect each and every item of the stock. The first guiding legal cases in this direction are Kingston
Cotton Mills Case and Irish Woollen Co. Ltd. V/s Tyson and others. It was held in these cases it was held
that an auditor is not a valuer and it is not his business to take stock and if there are no suspicious
circumstances, he is entitled to depend upon the representation of officials. He is not guilty of negligence
if he accepts a certificate of such persons as to the value of stock. At the same time it was also stated that
he must exercise reasonable care in regard to stock verification and valuation. For instance, he should
make enquiry into the system of internal check, the method of stock taking and the basis of valuation
compare the rough stock sheets with fair stock sheets etc.
American accountants have not accepted the decision of Kingston Cotton Mills case in view of the
decision taken in the case of Mckesson and Robbins. It was decided in this case that the auditor was
responsible for the physical verification of the stock in-trade.
In India, the accepted practice of the American Accountants has not been accepted.
In India, it is held now that the auditor must present himself when the stock is
counted by the company's staff. He should also examine the effectiveness of the
system of stock control. He should check the stock sheets and if he does not do so,
he will be held responsible. He should also check the calculations, additions and
castings as was held in the case of Henry Squire Ltd.. Vs. Ball Baker and Co. As a
result of these decisions, the practice of sending a representative by the auditor at
the time of stocktaking is growing in India.
(ii) Verifying the Valuation of the Stock-in-Trade : The auditor should apply tests to see that the stock in
trade has been appropriately and correctly valued. If he fails in his duty he will be held responsible. Some
of the duties of the auditor in this connection are given below:
1. He should satisfy himself that the cost figures have been calculated on some acceptable method and are
applied consistently. If the method of valuation has been changed as compared to the previous year, the
auditor should mention this fact in his report and if possible, should show the effect of the changed
method on the financial position of the concern.
2. He should see that the stock sheets are duly signed by the competent authority and ensure that
calculations, additions and castings are correct.
3. He must examine the stock sheets and see that only goods usually dealt in are included. He should also
see that fixed assets are not included. Similarly, goods on consignment or sale or return should be
included at cost.
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4. If the bought and sold books contain quantity columns, the balance shows by them should be compared
with the stock sheets.
5. He should see that proper provision is made for the depreciation of the obsolete or defective stock and
that trade discounts are deducted.
6. He should compare that stock-sheets with those of the previous year and enquire into major differences.
7. He should compare the prices at which finished goods have been sold and at which the unsold stock
has been valued.
8. He should check the percentage of gross profit on sales with that of the last year and find out the causes
of any material change.
9. He should see that the stock-in-trade in the balance sheet of a company is shown according to Schedule
VI, Part I of the Companies Act.
Verification of Liabilities
Verification of liabilities is equally as important as the verification of assets. If liabilities are not properly
verified and valued, the balance sheet will not reveal true and fair view of the state of affairs of a business
concern. Therefore, the auditor should examine that:
(a) all the liabilities have been clearly stated on the liability side of the balance sheet;
(b) all these liabilities relate to the business itself;
(c) they are all correct and authorised, and
(d) they are shown in the balance sheet at their actual figures.
The auditor should also obtain a certificate from some responsible official of the business to the effect
that all the liabilities for purchases or for expenses have ben recorded in the books of account and all the
contingent liabilities have been disclosed by way of footnote in the balance sheet.
The verification and valuation of various liabilities are given as below:
1. Capital : In case of a partnership firm the auditor should examine the partnership
agreement. He must find out the original capital contributed by each partner and
the rate of interest payable on capital. He must see that capital accounts are
correctly maintained and verify all transactions affecting the capital accounts. He
should examine the cash book, pass book, withdrawals of the partners and profits
and loss earned.
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In case of a company while verifying the share capital, the auditor should examine
the Memorandum of Association, Articles of Association, Cash Book, Pass Book,
and the Minute Books of the Board of directors to find out the number and the
different classes of shares issued and the amount received on each type of share.
In case of a newly floated company he should undertake an exhaustive checking. If
shares have been issued to the vendors or to the promoters for consideration other
than cash he should examine the contracts between the vendors or promoters and
the company. He should also check the entries regarding the forfeiture of shares,
reissue if any, calls in arrears. -
2. Loans : Loans may be of two types :
A. Unsecured Loans and Advances : In such a case the auditor should examine the correspondence and
relevant documents, if any. He should study the conditions for interest payable, repayment of loan, refund
by instalments, etc. He should also ensure that the loans are taken for use in the business. He should also
get confirmation from the lenders concerned certifying the balance of principal and interest outstanding at
the date of the balance sheet.
B. Secured Loans and Advances : In order to verify such loans, the auditor should note (a) Actual amount
which has been advanced, and (b) Security for the loan. So far as the actual amount is concerned, the
auditor should examine that this amount has been properly authorised and sanctioned by directors in case
of a company and by partners in case of a partnership firm. He should examine the applications received
and check the receipts which have been given in token of having received the loans. He should also verify
that the payment in form of instalment and interest thereon has been received from the borrower himself.
3. Trade Creditors : The auditor should take a statement of balances of trade creditors duly signed by a
responsible officer and should verify these balances with the bought ledger or the purchase ledger. He
may get confirmatory statements from the creditors. He should also examine the invoices as sent by the
suppliers and an ìnward Goods Book' if it is maintained.
He should carry out test checking of all the purchases made during the year particularly those made at the
end of the year. He should also compare the percentage of the gross profit with that of the previous year.
If there are material deviation, he should enquire into the reasons.
For any purchases returns, he should examine the `Returns Outward Book' and verity them with the help
of the credit notes as sent by the supplier.
4. Outstanding Liabilities for Expenses : The auditor should obtain a certificate from a responsible officer
of the company stating that all outstanding liabilities for goods purchased or for expenses incurred, have
been taken into account.
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He should verify those items of expenses which usually constitute outstanding liabilities like rent, rate,
wages, salary, audit fee, legal expenses etc. He should ascertain the accuracy of the accounting records
and test the calculations of such liabilities.
5. Bills Payable: The auditor should obtain a statement of bills payable and compare
it with the bills payable book and bills payable account. For bills which have been
met after the date of the balance sheet but before the time of audit, he should
examine the cash book and bank pass book. He should ensure that the bills which
have been paid are not recorded as outstanding. He should also obtain
confirmations in respect of amounts due on the bills accepted by the client that are
held by them.
6. Contingent Liabilities: Contingent liabilities are those liabilities which may or may not arise in the
future for payment, for example, the liability for calls on partly paid shares, liability on bills discounted
and the liabilities in respect of arrears of dividend of cumulative preference shares, etc.
Contingent liabilities are divided into two broad categories. One is for those liabilities in respect of which
provision has to be made in the balance sheet, for instance, liability which may arise in connection with a
suit, etc. Another is for liabilities for which no provision has been made in the books but merely a note
has been made at the foot of the balance sheet, for example, bills receivable which have been discounted
but not matured at the date of the balance sheet, arrears of fixed accumulated dividends, etc.
The auditor should examine the director's minute book, correspondence made with the legal advisers and
the information obtained from the officials of the business. He has to ensure that proper provision has
been made for all such liabilities and if he is not satisfied, he should mention the fact in his report.
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Auditing: Principles and Techniques
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Investigation
CHAPTER OUTLINE
14.1 Introduction
14.2 Definition
14.3 Objectives or Purposes of Investigation
14.4 Features of Investigation
14.5 Terms of Reference
14.6 Working Methods
14.7 Duties of an Investigator
14.8 Investigation Report
14.9 Qualities of an Investigator
14.10 Difference between Investigation and Auditing
14.11 Types of Investigations
14.12 Legal Views as Regards Investigation
14.1 INTRODUCTION
In addition to regular audit of the books of accounts of an enterprise, there may be the
requirement of thorough examination of the accounts and records of past several years to fulfill
certain objectives from time to time. In order to carry out thorough examination of books of
accounts and records of an enterprise, investigation is undertaken. Investigation implies an
enquiry into the accounts and business records to attain certain specific objective. In most cases,
the purpose of such enquiry is to ascertain the true financial position of the concern or its normal
profit-earning capacity or the extent of fraud. Thus, investigation is a special type of examination
of accounts and records carried on by an investigator with a pre-determined objective according
to the requirement of the situation and entail something beyond the verification of accuracy of
figures in the financial statements.
14.2 DEFINITION
An investigation may be defined as a special examination of and enquiry into books of accounts
and other related records with a view to establishing a fact or to evaluating a state of affairs or to
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determining causes for a happening in a business. For example, an investigation may be
conducted into the accounts of a firm whose business is to be acquired by a company or
investigation may be required to establish the extent of a suspected fraud.
In the opinion of Taylor and Perry, investigation involves enquiry into facts behind the
accounts, i.e. into the technical, financial and economic position of the business organisation.
So, investigation is a special type of examination of accounts and records carried on by the
investigator with a pre-determined purpose in accordance with the necessity of the situation and
are concerned with something more than the verification of accuracy of the figures of the
financial statements.
14.3 OBJECTIVES OR PURPOSES OF INVESTIGATION

The need of investigation may arise in many cases, but these are some of the circumstances
where investigation is most frequently called for:
1. For purchasing any business
Investigation can be conducted by a person on behalf of his client, when the client intends to
purchase an existing business.
2. For admission of a new partner
Investigation into the affairs of a partnership firm can be made by any person on behalf of the
incoming partner of an existing partnership business.
3. For seeking avenues of investment
In order to measure the financial solvency position of any business, investigation can be done.
The financial solvency is measured through investigation on behalf of a person who seeks
avenues of investment.
4. For granting loan or financial assistance
Investigation can also be undertaken on behalf of a bank or other financial institutions proposing
to extend or grant loans to its client or alter the terms and conditions of the same.
5. For suspected fraud
If the owner or the management suspects fraud, they can appoint an investigator to detect the
fraud activated by the employees.
6. For abnormal fluctuation of profit
Investigation can be conducted on behalf of the owner or the management of a business in order
to ascertain the reason of abnormal fluctuation in profit in the organisation.
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7. For settlement of tax liability
Investigation can be undertaken for the settlement of tax liability or in some cases for the
detection of undisclosed income of the assessee.
8. For settlement of insurance claim
In case of fire or other hazards, the organisations have to submit claim to the insurance company
to recover the loss. The insurance company can appoint an investigator to determine the exact
amount of loss for settlement of claim.
9. For valuation of goodwill and shares
The shares and goodwill of the business are required to be valued on different occasions. In order
to calculate the fair value of shares and goodwill, investigation can be undertaken.
10. For judging sickness of a business unit
Government may consider to take over a sick industrial unit and for this purpose, it may give
appointment to an investigator to investigate into the affairs of the sick unit.
11. For the provisions of the Companies Act
Section 235 to Section 251 of the Companies Act provide regulations for the investigation of any
company under different specific situations.
12. For justifying negligence of the auditor
In some cases, the auditor is held liable for negligence in his duty. But before accusing auditors
for negligence, the case has to be properly investigated.
13. For complaint by the shareholders
Investigation can also be undertaken by the management on the basis of complaints made by the
shareholders.
14. For the affairs of a trust
Investigations are sometimes required to be conducted on behalf of the beneficiaries of any trust
into the affairs of a trust for suspected fraud.
15. For the liquidation of the business
Investigation of suspected fraud or misfeasance against the Directors on behalf of the liquidator
of a company could also be undertaken.
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14.4 FEATURES OF INVESTIGATION
An investigation is an examination of accounting records undertaken for a special purpose; in
effect it is an audit of which the scope is limited or extended in accordance with the requirement
of the particular purpose. Its objective is usually to discover and display the facts in such a
manner as will enable the parties for whom it is undertaken to draw conclusions and make their
decisions accordingly.
On the basis of analysis of the above definition, the following inherent features of investigation
can be identified:
Investigation is normally conducted with certain specific objectives.
It involves critical examination and verification of specific records.
There are no statutory provisions or rules prescribed for investigation except

in case of companies. It is voluntary and contractual in nature.
It is not only confined to examination of financial aspects of an organisation,

but also concerned with the policy matters.
It is undertaken with certain suspicion, depending on the nature of the

objective for which it is undertaken.
In most of the cases, the future courses of action have to be outlined by the
investigator.
In addition to the detailed analysis and study of the books of accounts and
records, personal examination of individuals may also be undertaken.
The scope of investigation may be limited to a certain specific objective or

extended to cover a number of objectives according to the requirements of
the situation.
The investigator reports to the person/s who is/are responsible for his
appointment.
In the report, the factual information has to be given in analytical as well as

descriptive manner.
14.5 TERMS OF REFERENCE

In the case of a private investigation, e.g. one undertaken on behalf of a prospective purchaser of
a business, the investigating accountant must obtain precise instructions from his client as to his
terms of reference the purpose of investigation, the amount of detailed work required etc. These
terms of references must be set out clearly in a letter of engagement.
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In the case of investigation governed by statute, e.g. reports for prospectus, the reporting
accountant must be fully conversant with the statutory regulations and must also obtain
necessary instructions where that would be applicable.
14.6 WORKING METHODS

Having clearly established the purpose of the investigation, the investigator will first make such
preliminary inquiries as are necessary to ascertain the information that is required to enable him
to plan his investigation.
He will then draft an outline report, detailing the headings, which he will use in his final report.
These will vary according to the nature of investigation being undertaken, but if a business were
being investigated on behalf of a prospective purchaser, the headings could be as follows:
The business and its history
Management and the staff
Sales and marketing
Purchasers and suppliers
Trading results as per audited accounts
Future prospects and trends
Assets and liabilities
Conclusions and recommendations
After drafting the outline report, the investigator will undertake the detailed work necessary to
complete the investigation. This will normally be mainly composed of interviews and discussions
with relevant persons and work on the accounts and records, but on every investigation he will
need to exercise his judgment as to exactly understand the work to be undertaken. Detailed
working papers will be prepared and from those working papers the final report will be written.
These working papers must be carefully preserved. In the event of a dispute arising and
negligence being alleged against the investigating accountant, these working papers would be
vital evidence in litigation. When the investigation is completed, the draft report will be finalised.
14.7 DUTIES OF AN INVESTIGATOR

The procedures to be followed in an investigation depend on the nature of investigation, its
purpose and the circumstances of the case in which the investigation was undertaken. In all the
cases of investigation, certain precautionary measures are required to be taken by the
investigator. These measures are considered as the duties of the investigator, which he should
follow in discharging his duties in conducting investigation. These duties are given below.
1. Obtaining written instruction about scope and objectives of investigation
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Before starting an investigation, the investigator should obtain from the client clear written
instruction about the scope of his work and purposes of investigation. If the client is interested to
impose any restriction or limitation to his work, he should also get it in writing so that he may
exactly determine the scope of his work and the nature of his duties.
The period to be covered in the investigation should also be confirmed by the investigator from
his client clearly in writing. The period is very important because the investigator can
accordingly restrict his examination of transactions and records to that period only.
2. Framing investigation programme
Based on the objectives, scope and period to be covered, an effective investigation programme
should be chalked out. The investigation programme should be flexible, so that the investigator
may make required changes in the programme during actual investigation. Such flexibility in the
programme is necessary, since many steps in an investigation depend on the results of the earlier
steps.
3. Collection of information about the business
It is not possible for the investigator to give correct interpretation and reporting of the fact, if he
does not have the detailed knowledge of the activities of the enterprise for which he is to conduct
investigation. So, before starting his work of investigation, the investigator should collect all
relevant information about the activities of the enterprise.
4. Enquiry about the reputation of the enterprise
The investigator should make enquiries and collect information about the reputation of different
individuals working in the organisation. Information should also be obtained about the goodwill
of the enterprise. This information will help the investigator a lot in preparing his report.
5. Taking expert advice
The investigator should take the assistance of experts during the course of his examination, if
required, and consult experts on matters in which his knowledge is not adequate.
6. Reliance on accounts and records
If the books of accounts and required records have been properly maintained and the accounts
have been audited, the work of the investigator becomes simplified as he is entitled to rely upon
the audited accounts and properly maintained records.
So, usually the investigator should avoid duplication of work and concentrate more on such
procedures as will be more purposeful for investigation. But the fact that the investigator has
depended on the audited books of accounts should be included in the investigation report.
7. Preservation of working papers

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It is the duty of the investigator to maintain his working papers properly. A complete record of
work carried out, records examined, relevant information and evidence collected etc. should be
kept in his file together with important statements, schedules and documents. These working
papers will help him at the time of finalisation of report. These working papers can also be
valuable documents in his defense, in case the affected parties subsequently challenge his
findings.
8. Maintenance of secrecy and confinement to purpose
The investigator should always keep in mind the purpose of investigation, as the purpose of
investigation will determine which records and figures should be examined in detail, which need
not be examined, for which cases detailed checking may be avoided, what information he should
seek from sources other than books and records and what procedures should he adopt in his
investigation work. On the other hand, secrecy is the basic necessity of any investigation. So, the
investigator should keep the details of the investigation very secret.
9. Maintenance of minimum standard of work
The investigator must be honest and he should approach his work with reasonable care, skill and
diligence. He should not allow himself to be influenced by others, as total independence is
required in investigation. So, the investigator should always keep himself free from the influence
of interested persons.
10. Proper and correct reporting
The investigation report should be clear and unambiguous. The investigator should analyse the
data and evidence collected by him. He must take great care to see that his report does not
contain any wrong information. So, before signing his report, he should carefully check the
content of his report with preserved working papers and notes. This is very important as incorrect
report may mislead his client and invite legal action against him.
14.8 INVESTIGATION REPORT

The report on the investigation must be carefully prepared. It should be simply worded, very
clear in its meaning and as concise as practicable in the given circumstance. It must, however,
give full consideration to all the factors affecting the decision to be made.
The form of the report will normally be an introduction setting out the terms of reference and the
nature of the enterprise being investigated. A main section will be there setting out the facts
ascertained and detailing the work performed, and a final section setting out the conclusions and
the recommendations. It should be remembered that the main points of the report are not
obscured by details; any voluminous statistics should be relegated to appendices and referenced
to the relevant part of the report.
Investigation report should contain all important and relevant matters. He must present in his
report what is essential, ignoring what is not essential. Facts and only facts should be presented
and nothing based on estimates should be given. The investigator should mention in his report
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the instructions given to him by his client with regard to the investigation. He must mention the
limits, if any, put in the scope of his work.
14.9 QUALITIES OF AN INVESTIGATOR

An investigating accountant should combine sound auditing techniques, considerable experience,
sound judgment and a good understanding of a variety of business enterprises. Because of the
demanding nature of the work, it will usually be found that partners and senior staff will
personally perform a higher proportion of the work on investigation than on audits.
The investigator must approach his work methodically. He must work honestly and diligently. He
must keep the interest of his client at the top and must work with a feeling of some service to the
client. The subject of the investigation is highly technical in nature and usually a senior
accountant with profound knowledge and experience suitable for the job. He need not be a
chartered accountant, but he must have sound knowledge of accounting and auditing and
practical knowledge about the various affairs of different types of enterprises. He must be a man
of competence and ability to understand different critical matters clearly. He must possess the
ability to grasp things easily and express them in clear words. While conducting the
investigation, he must exert utmost care, skill and reasonable diligence keeping in mind all
through the purpose of investigation.
14.10 DIFFERENCE BETWEEN INVESTIGATION AND AUDITING

The difference between audit and investigation is outlined in Table 14.1.
TABLE 14.1 Distinction between audit and investigation
Points of Audit investigation

difference
1. Interested Audit is conducted on behalf of Investigation is usually carried out on behalf
parties the shareholders or proprietors. of outsiders who intend to purchase the
business or who wish to lend money and thus
want to know the earning capacity or the
financial position of the concern.
2. Legal Audit is compulsory for a Investigation is not compulsory.

aspects corporate business according to
the Companies Act.
3. Inter- Audited accounts are not audited Investigation may be conducted even though
dependence again except in case of special the accounts have been audited.
audit u/s 233 A.
4. Duration The audit of accounts is usually Investigation may cover a period extending
for a year or six months. over three to seven years.
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5. Depth of Audit is a kind of test checking. Investigation is a thorough examination of the
work books of accounts.
6. Subject Audit includes an examination of Investigation is not only an examination of

matter the books of accounts. accounts, but also inquiry into other factors,
i.e. it goes beyond the books of accounts.
7. Computation Audit is not concerned with the Net profit or the actual earning capacity of the
of net profit alteration of figures and concern is ascertained by making certain
introduction of adjustments to adjustments in the net profit as calculated.
have net profits from different
points of view.
8. Purpose Audit is conducted to know the Investigation is conducted to know the

true and fair view of the books of financial position and the earning capacity of
accounts. the concern.
14.11 TYPES OF INVESTIGATIONS

There are many types of investigations, but certain main classes can be identified. Following are
some of the areas where the investigation is mostly called for:
1. Investigation on behalf of a person or company who wants to purchase a

running business.
2. Investigation on behalf of a person who is interested to join as a partner in a

partnership firm.
3. Investigation on behalf of a person who wants to lend money to a business or

is interested to know its financial position.
4. Investigation on behalf of the owner/shareholder of the business who

suspects a fraud.
5. Investigation on behalf of the tax authority for assessing actual tax liability.
6. Investigation on behalf of prospective shareholders who wish to make a

valuation of shares of a limited company.
7. Investigation on behalf of government into the affairs of a sick company.
8. Investigation under the Indian Companies Act, i.e. the statutory investigation.
All these cases are discussed separately in detail as follows:
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14.11.1 Investigation on behalf of a Person or Company Wanting to
Purchase a Running Business
The purchaser of an existing running business may be interested to know the earning power and
the future prospects of the business. He would like to know the worth of the business and how
much he should pay for the purchase of that business. Investigation has got a higher
responsibility in this case, as his client would take the decision on the basis of the report of the
investingator.
Therefore, the investigator should pay due attention on the following points:
1. Preliminary matters
1. Letter of engagement The purpose and scope of the investigation would

be agreed with the client. Such matters as who could be approached for
information, the amount of detailed work to be undertaken and the
approximate fee authorised, would be settled. These would be formally
confirmed in a letter of engagement.
2. Outline report Initial discussions would be held with the auditors, if any,
and the management of the business being investigated. The history and the
nature of the business would be considered. The outline report would then be
drafted and the detailed work to be undertaken would be planned.
2. Detailed work of investigation
1. Inquiries The investigator would hold exhaustive discussions of relevant

matters with the management, senior staff and the auditors, if any, of the
business. He would also make any necessary inquiries of third parties.
2. Accounts The accounts of the business for an agreed period would be

obtained and considered. The period selected is often three years, as that
allows trends to be established and comparisons to be made without going
back to periods that are so remote to be irrelevant. The investigator would
form an opinion as to the reliability of the accounts.
The investigator would make the necessary adjustments to the accounts under review.
These adjustments would be of two types:
1. Correctness to accounts: Assets would be adjusted to their true values.

Slow moving or obsolete stocks would be written down. Bad debts
would be written off. Any liabilities omitted would be brought in. Any
other relevant correction would be made.
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2. Adjustment to accounts: When items relating to the past have no
relevance to the future, appropriate adjustments would be made.
Details of all adjustments would be shown in appendices to the
accounts.
Once the accounts for the relevant years has been adjusted, they would be set out in
columnar form so that trends would be clearly shown. To assist the making of
comparisons, the important percentages and ratios would be inserted.
The important percentages and ratios, which are required to be calculated in this respect
may include the following:
o Percentage of gross profit on turnover
o Percentage of net profit on turnover
o Ratio of stock to cost of sales
o Ratio of debtors to turnover
o Ratio of creditors to purchases
o Ratio of current assets to current liabilities
o Ratio of liquid assets to liquid liabilities
2 Consideration apart from the accounts The scope of the investigator

would not normally be confined to the accounts. Therefore, he would consider
all other relevant matters, which include the following:
o The economic prospects for the trade or industry
o The trends and mix of sales
o Any local planning matters affecting the business
o The probable effects of any proposed legislation
o Actual competition of rival businesses, or the threat of future

competition
o Whether there could be difficulty in renewing any important contract
o Whether premises are leasehold, when the leases are due for renewal
and whether they can be renewed and if so, on what terms
o The state of the fixed assets and their potential future life
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o The competence and age of the key staff and
o Any relevant matters concerning the tax position of the business
3. Report
Once the detailed work had been completed, the report would be finalised. The final section on
the result of the investigation and the conclusions to be drawn from them would be written, and
the report would be submitted to the client.
14.11.2 Investigation on Behalf of a Person Who Wants to be the Partner

in a Partnership Firm
A person admitted to the partnership becomes the co-partner and the co-owner of the properties
of the firm. Hence, the incoming partner would like to know the profitability, sound financial
position of the business, efficiency and the extent of the use of the capacity of the fixed capital in
the firm.
Under these circumstances, an investigator is required to take a note of the objective of the firm
and the terms, conditions, provisions of the partnership deed, nature of the business and the
existing partners capital balance and their profit sharing ratio.
In addition to the above noted points, the investigator should pay due attention to the following
points:
1. Quality of the existing partners
Partnership business is basically dependent on the trustworthiness of the partners. Before being
admitted into a partnership firm as a new partner, the character and quality of the existing
partners should be first evaluated.
2. Reason for admission
The investigator should know the reasons for taking new partner in the firm. The reasons for the
admission of a new partner could be that the business is expanding or that an existing partner is
retiring, but it could be that the business is undercapitalised or facing some other trading
difficulty.
3. Examination of the partnership deed
The terms of the partnership agreement or if there is no written agreement, the present
arrangements and effects of the Partnership Act should be examined with regard to the following
matters:
1. The term for admitting the new partner particularly with regard to the
treatment of goodwill and the valuation of asset
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2. The provisions regarding the appropriation of profits, including whether there
are arrangements for the accounts to be audited to establish agreed profits
3. The provisions for dealing with the dissolution of the partnership on the death
or retirement of a partner, particularly with regard to the treatment and the
valuation of assets
4. The rights of the individual partners and the provisions for dealing with
disputes.
4. Analysis of profitability and prospect
The prospects for the partnership firm, given the general economic trends for the profession,
industry or trade in which it is operating and such special factors as its reliance on any large
customers or contracts should also be examined by the investigator.
5. Ascertainment of financial position
The investigator will analyse the financial position of the firm on the basis of different aspects
such as liquidity, solvency, adequacy of working capital, collection from customers and net
worth of the business. He should ensure that all the assets and liabilities as disclosed in the latest
balance sheet have been properly valued.
6. Justification of premium for goodwill to be brought in
The investigator will check the method of valuation of goodwill of the firm. He will ensure that
the method adopted is logical and suitable in the given circumstances and also ensure that
earning capacity (past and expected) is duly considered in the valuation of goodwill.
7. Justification of the amount of capital to be brought in
The investigator will check the basis of computation of capital contribution to be made by the
incoming partner and will ensure that the amount of capital of the incoming partner is consistent
in proportion of the capital of the old partner.
8. Examination of financial position of old partner
As in partnership business, all partners are individually as well as collectively liable for all the
liabilities of the firm, the investigator will also inquire into the financial position of the existing
partners. If the financial positions of the existing partners are not sound, the incoming partner
will be in trouble in the near future.
9. Enquiry into the administration set up of the firm
The investigator will see that the salaries paid to the partners are inconsistent with their duties
and technological skill. If the incoming partner is going to be admitted replacing a partner having
some sort of technical expertise, he will see whether the business will be affected due to the loss
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of expertise of the partner retiring and if so, what actions have been taken by the firm to
compensate it.
10. Ensuring trustworthiness and confidence
The success of the partnership firm depends upon the trustworthiness and confidence among the
partners to a great extent. So, it is the duty of the investigator to verify the relationship among the
partners and ensure that the incoming partner will be able to adjust himself with the existing
partners.
14.11.3 Investigation on Behalf of a Person Who Wants to Lend Money to a

Business or is Interested to Know Its Financial Position
Bank and other non-banking financial institutions are the prime sources from where one can
borrow money. If a person approaches a bank or other financial institutions for money, the
financial agencies would first of all like to examine thoroughly the present financial position of
the customer. In this situation, the audited balance sheets of the customers of the last few years
serve the purpose to a great extent. However, in those cases, where the money to be lent is a big
amount, usually an investigator is appointed to investigate into the financial position of the
customer and to advise whether the money should be lent to the customer or not. Investigation
may also be conducted on behalf of a private moneylender. The investigator will undertake the
following procedures for this purpose:
1. Purpose of the loan
The investigator should know the purpose of the loan and should ensure that the loan amount
applied for is adequate for the purpose for which it is intended to be used. It is obviously foolish
for a loan to be sanctioned where it will not be adequate for the stated purpose.
2. Borrowing power of the customer
The investigator will see whether the required loan is within the legal borrowing power of the
business. This is particularly important where a limited company is involved.
3. Repayment capacity of the borrower
He will also check whether the projected profits and cash flow of the business will enable it to
meet both the interest on the loan and also the capital repayment. It must be remembered that,
while assets may provide security, the lender will only want to invoke the sale of assets as a last
resort. The loan should not be made, even if assets provide adequate security, unless there are
reasonable grounds for anticipating that it can be repaid in the ordinary course of business.
4. Security against the loan
The investigator should check the extent to which the loan can in fact be secured by fixed or
floating charges over the assets of the business. The security offered should be examined with
respect to value, title, and realisability.
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5. Adequacy of insurance coverage
The investigator should verify the adequacy of the insurance cover of the business, with regard to
the assets, loss of profit, indemnity and other relevant matters. The insurance policies should be
checked to see whether all assets have been adequately insured or not and whether up-to-date
premiums have been paid on all policies.
6. Terms of loan and its repayment
The investigator should go through the terms of loan and its repayment schedule and ensure that
the proposed borrower will be able to satisfy the terms of loan and be able to repay the loan
within the stipulated time period.
7. Present loan liabilities of the borrower
The investigator should further verify and collect a complete information regarding the existing
liabilities of the borrower against loan and other borrowings of the business, their duration and
interest rate.
8. Profitability of the business
The ability of the borrower to pay interest and principal in time will largely depend upon the
profitability of the business. So, the profit and loss account of the business for the last few years
should be reviewed and profitability trend should also be assessed.
9. Study of feasibility report
If the loan is required for any capital expenditure of the borrower, the feasibility report should be
studied very carefully. He will check whether the project will be viable and will give adequate
return to the prospective borrower.
10. Cash flow analysis
The borrower should be asked to submit a projected cash flow statement indicating the method
of repayment of loan along with the amount of interest on the basis of time schedule. This
statement should be checked very carefully to assess the justifiability of loan sought.
14.11.4 Investigation on Behalf of the Owner/Shareholder of the Business

Suspecting a Fraud
Investigation is conducted, sometimes, to detect a suspected fraud. Fraud is generally activated
by those employees who handle cash and goods. The investigator should know from his client
the nature of fraud suspected and the names of the suspected persons. There is more possibility
of fraud, if the internal check system is ineffective. The investigator should thoroughly study the
internal check and control system of the organisation.
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Fraud takes two main forms which are manipulation of the accounts and defalcation of money or
goods by employees of a company or other enterprise.
In the case of manipulation of accounts, the classic way in which this is contrived is the inflation
or over-valuation of stock, the suppression of creditors or the inclusion of sales which are either
non-existent or relate to the following accounting period. However, there are numerous
possibilities, such as creation of non-existent assets or the manipulation of accounts with other
companies within a group or with associated companies. The investigator must bring great skill,
experience and thoroughness to ensure that every aspect of the business is both genuine and
properly accounted for.
In case of defalcations, the exact nature of the investigation will depend upon the circumstances
of the case. However, it will always be necessary to evaluate carefully the system of internal
control in the areas affected.
The most frequent asset to be the subject of fraud is of course cash, and where cash has been
misappropriated, the following checks will normally be carried out by the investigator:
1. Nature and duties of suspected employees
The investigator should know the authority exercised by the defaulting employee and the exact
nature and extent of his duties.
2. Checking of cash book
The cash book must be cast and checked fully with the bank statements. It must be ensured that
all receipts were banked promptly. The original pay-in slips retained by the bank should be
obtained and checked with the counterfoils, as discrepancies could indicate teeming and
lading. Certificate of opening and closing bank balances should be obtained direct from the
bank.
3. Vouching of payments
Payments should be vouched with paid cheques and other appropriate evidences, to ensure that
the names on the cheques are the same as those in the cash book. Duplicates of any missing
voucher must be obtained. It must also be considered whether any cash payments are abnormal
and if so, they must be vouched with the utmost care.
4. Vouching of petty cash expenses
Payments, which are not made through banks, are made through petty cash. The investigator
should also vouch the petty cash payments. Cash received on account of unusual receipts such as
sale of waste materials should be thoroughly checked, as these provide good chances of
misappropriation.
5. Checking of payments of wages and salaries

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The correctness of payments for wages and salaries must be checked. With regard to wages,
great care should be taken to ensure that no fictitious names have been included in the payroll.
6. Checking of debtors ledger
Posting to the debtors ledger must be checked, and it must be scrutinised for payments on
account, which could indicate teeming and lading. The validity of write-offs of bad debts and
allowances given to debtors must be established. A positive circularisation of debtors should be
carried out.
7. Vouching of cash sales
Cash sales must be properly vouched. Particular attention should be paid to the adequacy of the
system of control relating to cash sales and any weakness should be reported.
8. Checking of payments to creditors
Payments to creditors should be vouched with purchase invoices to ensure that no invoices have
been paid twice. The genuineness of purchase invoices must be established by checking them
against goods records. It should also be seen that all purchases of goods have been properly
authorised and relate to the business of the client.
9. Checking of personal accounts of employees
The personal accounts of the employees showing unusual amount of debit balance for a long
period of time should be checked. It is usually seen that executives are in the habit of drawing
advances before any tour but do not bother to submit voucher and refund the surplus money after
the tour.
10. Checking of handling of cheques
The investigator should also enquire as to who is authorised to sign the endorsement of the
cheques to avoid any misappropriation.
The investigator should follow step-by-step above mentioned checking procedure. In order to
trace fraud regarding misappropriation of cash, detailed procedure of vouching and verification
should be adopted by the investigator.
14.11.5 Investigation to Find Out the Possible Reasons of Shortfall in

Working Capital of a Company
Working capital is that portion of capital, which is employed in the business for its day-to-day
operations. It is the amount of investment made in various current assets like stock, sundry
debtors, cash etc. Sometimes the net concept of working capital also becomes relevant, which is
the excess of current assets over current liabilities. But when a company speaks of shortfall of
working capital, it generally implies scarcity of cash resources.
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Scarcity of cash resources may arise due to various reasons like lengthy operating cycle,
diversion of working capital for procurement of fixed assets, wrong dividend policy etc. The
investigator will cover the following areas in his investigation to find out the reasons for shortfall
in cash or working capital:
1. Nature of the business
The investigator will verify whether the investment in current assets is consistent with the nature
of the business of the company. For this purpose, he will ascertain the current assets to total
assets ratio of the company and compare it with the average ratio of the industry to which the
company belongs. The industry average may be made available from the publication of Reserve
Bank of India or from the publication of the Chamber of Commerce and Industry. This may
perhaps reveal that the root of the problem lies in the inadequate investment in current assets.
2. Scale of operation
The investigator should see whether scale of operation has increased with corresponding increase
in working capital of the company. This may be found out by analysing the trend of current
assets to sales ratio of the company for the last five to six years. Overtrading, i.e. the situation of
increased scale of operation without matching working capital may increase the profitability in
the short-run but will ultimately disrupt the normal operation of the business.
3. Material storage policy
The investigator will evaluate the material storage policy of the company. For this purpose, he
will find out the average period during which raw materials remain in store and compare it with
the industry average. The average period of material storage can be ascertained by dividing the
average inventory with average daily consumption. He will also examine the store ledger to
locate the slow-moving and obsolete items of materials in which working capital may remain
blocked.
4. Processing period
He will find out the processing period and see whether the processing period is reasonable or not.
The processing period can be found out by dividing the average work-in-progress with daily
average factory cost of production. The processing time may be lengthy due to various reasons
like defective production planning, supervisory incompetence, outdated technology, fall in
demand of the product in the market or shortage of cash required for further inputs. The
investigator may require the help of some technical expert in this area.
5. Finished goods storage period
The investigator should assess the finished goods storage period and try to justify the length of
the period. The average storage period can be found out by dividing the average finished stock
with average daily cost of goods sold. This period may be long due to wrong production policy,
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fall in demand of the product, marketing incompetence etc. The actual reason has to be identified
by the investigator by careful and thorough study.
6. Credit period allowed
He will ascertain the credit period allowed to debtors. The period is found out by dividing
average debtors with average daily credit sales. It indicates how long capital remains blocked in
debtors on an average. He will also conduct age analysis of individual debtor accounts involving
large amounts. This will help him to find out whether working capital shortage is due to
sluggishness in debt collections. It should also be checked whether any fictitious sales has
artificially kept the working capital high.
7. Credit period enjoyed
The investigator will also ascertain the credit period enjoyed by the company from its suppliers.
This will be measured by dividing the average credit balance with daily credit purchase. It may
so happen that credit period enjoyed by the company is much shorter than the credit period
allowed to debtors, thus resulting in scarcity of cash resources.
8. Price level
The investigator will compare the price level of those inputs for last three to five years, which
form significant part of cost of production and see whether there is any significant increase in
price level. Increased cost of production is supposed to be followed by increase in selling price.
But since there is a time gap between purchase of material, and the realisation of cash from sale
will have an impact on working capital, so, further introduction of working capital is required to
cope with the situation.
9. Capital expenditure
He will see whether capital expenditure incurred during last two-three years is more than the
amount of depreciation charged during this period. If there is no introduction of additional long-
term fund, capital expenditure over the amount of depreciation will impair working capital
position of the firm.
10. Cash flow statement
The investigator will prepare cash flow statement and fund flow statement of the company for
last two-three financial years and see whether cash position and working capital position have
been impaired due to payment of dividend and tax out of unrealised profit, repayment of loan,
purchase of assets etc. Both these statements prepared simultaneously for an in-depth analysis of
change in cash and working capital position of the company.
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14.11.6 Investigation on Behalf of Tax-authority for Assessing Actual Tax
Liability
Such investigations are carried out where the tax authority suspects that the taxpayer has
understated his income in his returns. The tax authority may have various grounds for suspicion,
for example, they may have discovered sources of income, which have not been disclosed; they
may know that the tax-payer is living in a style, which exceeds his known income; or they may
have been given some information about the tax-payers affairs by an informer.
These types of investigation have no set rules. The investigator must use his initiative and
experience with regard to the circumstances of the particular case. All potential sources of
information relating to both the clients business at private affairs must be used. In relation to the
business, the investigator will use his auditing experience to test for possible manipulations. In
relation to the clients private affairs, the investigator must do his utmost to ensure that he
establishes the clients income from all sources as accurately as possible.
The investigator must obtain all the relevant documents relating to the whole period of
investigation. These would include the following:
All business records and accounts audited or un-audited
Copies of the clients tax return for the period, if available
Bank passbooks for all the accounts of the client and the clients spouse and
dependents
All records of the clients income for the period
Schedules of investments and income thereon and details of rights at bonus

issue
Schedules of all other assets and liabilities, with details of acquisition and
disposals during the period
Details of all legacies and gifts received, and any other non-recurring receipts
and expenditure
Details of insurance and premiums paid
Estimates of the living and personal expenses of the client and his family for
the whole period of the investigation
Once the investigator has assembled and shifted all the relevant documents and has received all
the available information and explanations from the client, he must prepare the appropriate
accounts to show his clients true total and taxable income for the period. If there is no sufficient
information available to prepare proper accounts, it will be necessary to rely on statements
reconciling the clients total wealth at the commencement of the period with his total wealth at
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the end of the period, and treating any unexplained increase in wealth as additional taxable
income.
The investigator should ensure that the client approves and signs the statement before it is
submitted to the tax authority. If he feels that the client is being less than honest, he should warn
the client of the possible consequences of misleading the income. The report should be
exhaustive, and should indicate the evidence relied on by the investigator, including the
assumptions made and any deficiencies in the information available.
14.11.7 Investigation on Behalf of Prospective Shareholder Who Wishes to

Make a Valuation of Shares of a Limited Company
Sometimes professional accountants are required to investigate the value of shares of private
limited companies and the shares of public limited companies, which are not quoted in the stock
exchange. The valuation of the shares of a public limited company listed on the stock exchange
is easy, but the shares of a private limited company or of a public limited company not quoted in
the exchange cannot be purchased and sold in the open market, hence its valuation is quite
difficult.
Where the client is proposing to purchase a minority shareholding in an unquoted company, the
same consideration will apply as where a business is being purchased in deciding whether the
company is a basically sound vehicle for investment.
However, as the shares are not readily marketable and the holding is to be a minority one, certain
additional factors must be taken into consideration by the investigator, which are stated as
follows:
1. State of control
The investigator should see whether the company is absolutely under the control of certain
Directors and their associates. There are obvious risks in being a minority shareholder in a
company, which is under the absolute control of a small group of people.
2. Right to transfer the shares
The investigator should go through the Articles of Association of the company to know the
provisions as contained therein regarding the right of the shareholders to transfer shares.
Otherwise, should the purchaser later wish to sell the shares, it may be found that there are
restrictions on the right of the shareholder to transfer shares freely to the highest bidder.
3. Influence to hold a particular size of the shares
The investigator will also check whether there are provisions in the Articles of Association
giving influence to holding of a particular size. For instance, powers to block certain actions by
the majority could be conferred on holders of, say, more than 25% of the voting shares.
4. Prices of shares recently transferred

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In valuing the shares, the investigator will of course take into account the price of any shares
recently transferred, but it must be recognised that such transfers do not establish the value of the
shares. Moreover, little weight should be attached to them unless they were arms length
transactions between unassociated persons. The size of the holding being transferred must of
course also be considered.
5. Past dividend policy
Past dividend policy must be taken into account in deciding what return on the investment is
likely to be received, as any indications that have been given by the Directors for future dividend
policy.
6. Possibility for quotation of shares
Enquiries should be made as to whether there is any possibility that the company might seek
quoted company status. A quotation would almost certainly increase the value of the shares,
because shares in unquoted companies are usually at a substantial discount as against similar
quoted shares because of their lack of marketability.
7. Fair valuation of shares
The fair value of shares may be calculated by one of the following two methods:
1. Net asset value method In this method, the gross value of assets of the
company is ascertained. From the gross asset value, all the external liabilities
are subtracted to get the net asset value. If this net asset value figure is
divided by the number of shares of the company, value per share is obtained.
2. Yield method Under this method, the value of shares is obtained by

comparing the rate of return of the company with the average rate of return
of the industry to which this particular company belongs. If the rate of return
is more than the normal rate of return of the industry, the paid up value of
shares increases proportionately and the resulting value is regarded as the
market value of shares.
14.11.8 Investigation on Behalf of Government into the Affairs of a Sick

Company
A state government or central government may be considering the takeover of a sick company
and for this purpose, it may give appointment to an investigator to investigate into the affairs of
the sick company. Investigation in such a case involves detailed examination of records for
several years, collection of information from different sources and analysis of facts and figures.
An investigation into the affairs of such a company will involve the following major steps:
1. Investigation of documents, books and records

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The investigator should examine the different documents, books and records including the books
of accounts in order to know the existing position of the business along with different aspects of
the business including legal, financial, social, economical and other aspects, which directly or
indirectly influenced the functioning of the organisation. The important documents, books and
records mainly include the following:
The Memorandum and the Articles of Association
Audited financial statements
Different budgets including cash budget
Stock records
Debtors and creditors ledger
Bank statements
Records for working capital requirement
Records of cost structure of different products
2. Collection of information from different sources
The investigator should collect information for his proper investigation from different sources
including the management of the organisation. He should gather information about the
weaknesses and threats of the business from the management. He should also meet the bankers
and other financial institutions to know the financial position of the organisation as reflected in
its dealings with those institutions. The investigator should also meet with the trade union leaders
to identify the basic problems of the organisation. He should visit the Chamber of Commerce and
Industry to know the prospects of the organisation and the industry to which it belongs.
3. Measurement of the degree of sickness
The investigator should then measure the degree of sickness of the company with the help of
some standard accounting ratios on the basis of last few years financial statement. Following are
the most accepted ratios for the measurement of sickness:
EBIT to Sales Ratio
OCF to Sales Ratio
EBIT to Total Assets Ratio
OCF to Total Assets Ratio
OCF to Net Worth

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(EBIT = Earning before interest and taxes, OCF = Operating Cash Flow)
4. Identification of the causes of sickness
After measuring the degree of sickness, the investigator must try to find out the reasons for
sickness of the company. Sickness of a company may be due to various reasons, out of which
some of the reasons are inborn in nature. The company under investigation may be born sick for
reasons as given below.
Selection of wrong technology
Selection of improper place of business
Selection of wrong product-mix
Adoption of defective production policy.
Again, the company may be started healthy but subsequently may become sick due to a
number of reasons, which include the following
Change in the government policy of the country
Change in the economic scenario of the country
Change of market condition of the product
Lack of management effectiveness
Adoption of wrong market strategy.
A company may become sick because of innumerable reasons and the investigator will have to
identify the actual causes of sickness.
5. Possible remedies
The investigator will then find out the possible remedies for the survival of the sick company.
These remedial measures can be of long-term and short-term basis. He will also ascertain the
fund requirement for the implementation of the revival programme. The requirement of fund can
again be for working capital purpose or for the purpose of acquiring fixed assets. Usually the
revival measures include the following suggestions:
Modernisation and technology upgradation
Sound financial management and policy
Deployment of surplus worker
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Re-organisation of capital structure
Change of product-mix and design.
6. Socio-economic justification for the continuation of the business
Before taking over any sick industrial unit, the government should consider the aspects of socio-
economic factors for the continuation of the business. Socio-economic factors include the
following:
Development of the local economy
Employment of workers
Tax revenue of the government
Economic aspects of persons related to the business and
Environment effect of the business activities.
7. Reporting
On the basis of the above study and evaluation of the position of the sick business unit, the
investigator should write his report. The report should be written carefully stating all the relevant
information including the symptoms of sickness, the causes of sickness, the suggested
programme of revival and socio-economic justification for the continuation of the business.
Finally, he should offer his opinion as to whether the government should take over the unit or
whether the revival of the sick unit is possible in other ways without taking over it.
14.11.9 Investigation under the Indian Companies Act, i.e. the Statutory
Investigation
Section 235 to Section 251 of the Companies Act, 1956 deals with the Statutory Investigation.
Under Section 235, the central government may appoint one or more competent persons as
inspectors or investigators to investigate into the affairs of any company and to report to the
central government in the prescribed manner.
The central government may direct for investigation under the following situations:
1. On application by members of the company
According to Section 236, when members apply for investigation, they must support their
application by evidence and give a security not exceeding Rs. 1000 towards the cost of
investigation. Investigation is possible only in the following cases:
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1. In case of a company having share capital, on the application of 2,000
members holding not less than one-tenth of the total voting power (Section
235(a))
2. In the case of a company without share capital, on application of not less

than one-fifth of the members (Section 235(b))
2. On the report by the Registrar of companies
If the Registrar of companies finds the following:
1. That the company has not furnished the required information or explanation
asked for
2. The information or explanations supplied by the company to him is

unsatisfactory
3. The company has not made a full disclosure of facts
4. The business of the company is carried on for a fraudulent or unlawful

purpose
3. Investigation of companys affairs in other cases
According to Section 237 without prejudice to its power under Section 235, the central
government
1. shall appoint one or more competent persons as inspectors to investigate the

affairs of a company and to report thereon in such manner as the central
government may direct, if the company by special resolution or by the court
order declares that the affairs of the company ought to be investigated by an
inspector appointed by the central government, and
2. may do so if, in the opinion of the supervising authority, there are

circumstances suggesting:
1. that the business of the company is being conducted with an intention

to defraud its creditors, members or any other persons, or otherwise
for a fraudulent or unlawful purpose or in a manner oppressive of any
of its members or that the company was formed for any fraudulent or
unlawful purpose.
2. that persons concerned in the formation of the company or the

management of its affairs have in connection therewith been guilty of
fraud, misfeasance or other misconduct towards the company or
towards any of its members, or
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3. that the members of the company have not been given all the
information with respect to its affairs which they might reasonably
expect, including information relating to the calculation of the
commission payable to a managing or other directors or the manager
of the company.
Restrictions on appointment No firm, body corporate or other association shall be appointed as

an inspector under Section 235 or 237 (Section 238).
Investigation on ownership of company Under Section 247, the central government may
appoint one or more inspector to investigate and report on the membership of a company for the
purpose of determining the true persons:
1. Who are or have been financially interested in the success or failure, whether
real or apparent, of the company
2. Who are or have been able to control or materially influence the policy of the
company
The expenses of this type of investigation will be borne by the central government out of money
provided by parliament unless the government may order the recovery of the expenses from
persons on whose application the investigation was ordered.
Power of the inspector According to the provision as contained in Section 240 of the
Companies Act, the inspector enjoys the following powers:
1. The inspector can demand the production of any book, papers etc. from any
officer, employees or the agents of the company or the related bodies
corporate.
2. He can examine on oath from an officer, employee or the agent of a related

body corporate.
3. The inspector has the power with the prior approval of the central
government, summon any other person and examine him on oath.
4. The inspector can even seize, if so authorised by a magistrate, the books and
papers of the company or of any related body corporate and retain them if he
is of opinion that these books, papers etc. will be destroyed, altered,
mutilated or removed. He can retain them till the conclusion of the
investigation.
Inspectors report According to Section 241 of the Companies Act, every inspector has to
prepare and submit an interim report if necessary and a final report to the central government. He
has to submit his report also to the following:
1. The members of the company, where he was appointed on their application
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2. The court, if he was appointed on its order
The central government may publish the report and the interested parties may get the copy of the
report on the payment of the prescribed fee.
Sections 242 to 244 state that if the inspectors report shows that if any person has committed
any offence for which he is criminally liable, the government may take steps to prosecute him for
the offence.
Section 246 states that the inspectors report shall be admissible in any legal proceedings as
evidence of the opinion of the inspector in relation to any matter contained in the report.
Section 250A states that an investigation can be initiated even if the company has passed a
special resolution for voluntary winding up or if an application has been made for an order under
Section 397 and 398 of the Act.
14.12 LEGAL VIEWS AS REGARDS INVESTIGATION
Case Study
1. Case: Colmer vs Merrett, Son and Street (1914)
Fact of the case: Mr. Colmer, an engineer, claimed damages from the defendant, the
auditor, for the losses sustained by him by investing heavy sum of money on the reliance
of his report.
In fact, the auditor was given only three days time to prepare the annual accounts.
Therefore, he did not undertake the complete audit or investigation. The report was based
on approximation.
Legal view: It was held that assessment of financial position along with the preparation
of annual accounts for the purpose of investigation was not possible within a period of
two or three days. The investigating auditor had taken only the readymade information
into consideration. He had not checked the truth and fairness of the accounting records.
So, he was held liable for gross negligence in his duty.
2. Case: Regina vs Wake and Stone (1954)
Fact of the case: The prospectus of the defendant company Wake and Stone contained
the figures for stock and work-in-progress which was duly certified by the auditor of the
company, and the figure was subsequently proved to be false, deceptive and misleading.
A case was filed by the plaintiff against the company and its auditor for inflating the
stocks and work-in-progress figure. It was pleaded on behalf of the auditor that he relied
on the statement given by the managing director.
Legal view: Both the managing director and the auditor were found guilty. But the nature
of punishment in two cases was different. Because the managing director was sentenced
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to imprisonment and the auditor was fined 200 or in the alternative six months
imprisonment for having signed the report for the prospectus recklessly.
3. Case: Short & Compton vs Brackett (1904)
Fact of the case: The plaintiff sued for the fees for having investigated the books of the
defendant firm in respect of the proposed admission of partner in the firm. It was
subsequently revealed that an employee of the firm defrauded the firm by defalcation of
wage sheet. The important point to be noted in this case is that a part of the fraud was
made by an employee during the period of investigation. A counter sue was made by the
defendant against the plaintiff to the original case for alleged negligence in failure to
discover the fraud.
Legal view: It was proved by the court that when the plaintiff checked the wage sheet, it
was correct at that time. Therefore, the counter claim was dismissed by the court.
POINTS TO PONDER
An investigation may be defined as a special examination of and enquiry into

books of accounts and other related records with a view to establishing a fact
or to evaluating a state of affairs or to determining causes for a happening in
a business.
The need for investigation may arise in many cases including cases for
purchasing a business, for admission of a business, for seeking avenues of
investment, for granting loans, for suspected fraud, for settlement of tax
liability, for judging sickness of a business unit and for many other purposes.
Investigation is normally conducted with certain specific purposes. There are

no statutory provisions prescribed for investigation except in case of
companies. Investigation is not confined to examination of financial aspects
of an organisation, but also concerned with the policy matters.
The procedures to be followed in an investigation depend on the nature of the

investigation, its purpose and the circumstances of the case in which the
investigation was undertaken.
In all the cases of investigation, certain precautionary measures are required

to be taken by the investigator, which are considered as the duties of the
investigator. These duties include obtaining written instruction about scope
and objectives of investigation, framing investigation programme, collection
of information about the business, taking expert advice, preservation of
working papers and proper and correct reporting.
The report on the investigation must be carefully prepared. It should be

simply worded, very clear in its meaning and as concise as practicable. It
should contain all important and relevant matters. The investigator must
mention the limits, if any, put in the scope of his work.
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An investigator should combine sound auditing techniques, considerable
experience, sound judgment and a good understanding of a variety of
business enterprises. He should be methodical. Honest and diligent.
Audit and investigation are not same. Audit is conducted to know the true
and fair view of the books of accounts. But investigation is conducted to know
the financial position and earning capacity of the concern.
Investigation can be of different types. But whatever may be the type of

investigation, an investigator has to consider certain points in conducting
investigation, which include preliminary matters, detailed work of
investigation and reporting.
Preliminary matters include letter of engagement and outline report. Detailed

work of investigation includes inquiries and accounts and other
considerations apart from the accounts. After completion of detailed work,
the report would be finalised. The final section on the result of the
investigation and the conclusions to be drawn from them would be written
and the report would be submitted to the client.
REVIEW QUESTIONS
Short-answer Questions
1. What is investigation?
2. Are investigation and audit the same?
3. How can misappropriation of cash and goods be checked?
4. Discuss in brief the powers of inspector.
5. What are the important purposes of investigation?
Essay-type Questions
1. What is investigation? Distinguish investigation from audit.
2. What do you understand by investigation? Explain the general procedure

followed in an investigation.
3. A fraud is suspected in a business house and you are asked to carry out an
investigation. Explain briefly how you would proceed in this matter.
4. What special points should be borne in mind by you in carrying out an

investigation on behalf of a person who wants to purchase business as a
going concern?
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5. What are the points to be borne in mind in carrying out an investigation on
behalf of a banker who wants to lend money to a borrower, which is a
company?
6. Mention the circumstances under which an investigation of a company can be

ordered by the central government? What should be the procedure of
investigation in such a case?
7. The Directors of a private limited company of which you are an auditor ask
you to fix the value of its equity shares. Discuss the factors you would
consider to evaluate the shares.
8. What are the general powers and duties of an investigator appointed by the
central government? Discuss the investigators report according to the
Companies Act.
9. A going concern having become sick has approached the state government
for taking over the undertaking. You have been asked to investigate into the
affairs of the concern. Chalk out the procedure of this investigation as an
investigator.
10.You are appointed to find out the possible reasons of shortfall in the working
capital of a company. Discuss how you would investigate the matter.
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Chapter 8

Reserves and Provisions

8.2 Concept of Provisions

8.3 Difference between Reserves and Provisions

8.4 Classification of Reserves

8.1 CONCEPT OF RESERVES

8.2 CONCEPT OF PROVISIONS

1. Depreciation, renewals or diminution in the value of assets

2. A known liability, the amount whereof cannot be determined with substantial

3. A claim, which is disputed

8.3 DIFFERENCE BETWEEN RESERVES AND PROVISIONS

8.4 CLASSIFICATION OF RESERVES

Capital redemption reserves

Securities premium account

Proposed additions to reserves

TABLE 8.1 Distinction between reserves and provisions

8.4.1 Revenue Reserve

8.4.2 Capital Reserve

1. Profit earned on sale of fixed assets at a price in excess of cost

2. Profit on revaluation of all assets

3. Profit earned prior to incorporation of the company

4. Profit on re-issue of forfeited shares.

According to the definition of capital reserve, as contained in Part-III of Schedule VI to the

A capital reserve can be generally utilised for the following purposes:

1. The Articles of Association must authorise such distribution.

1. Securities premium, the distribution of which as dividend is specifically

2. Capital redemption reserve

3. Profit on re-issue of forfeited shares

4. Profit prior to incorporation

5. Profit on redeeming debentures at a discount

6. Profit on purchase of business.

8.4.3 Capitalisation of Reserve

TABLE 8.2 Distinction between capital reserve and capitalisation of reserves

Capital reserve Capitalisation of reserves

5. Creation of capital reserve is 5. Capitalisation of reserve does not increase the

Advantages of capitalisation of reserve

Advantages from the point of view of shareholders

2. Accumulated profit can be distributed without disturbing the liquidity position

2. Creditors can feel more protected due to increase in share capital.

3. Growth of the company is ensured by permanently keeping the reserve in the

4. By way of capitalisation of reserves, disparity between effective capital and

Auditors duty in respect of capitalisation of reserves

3. The company has not defaulted in payment of interest and principal in

4. There has been provision in the Articles of Association authorising the

8.4.4 Reserve Fund

8.4.5 Sinking Fund

Creation of sinking fund

Sinking fund is created by adopting any of the following two methods:

1. Sinking fund investment method Under this method, a pre-determined

Auditors duty regarding sinking fund

8.4.6 Secret Reserve

Secret reserves can be created by adopting the measures given below.

Charging capital expenditure as revenue expenditure

Providing for more depreciation on fixed assets

Making excessive provision for bad and doubtful debts

Writing down goodwill to a nominal value

Omitting some assets from the balance sheet

Showing contingent liabilities as real liabilities

Showing imaginary liabilities or overvaluing the liabilities

Making an excessive provision for contingencies or by continuing to carry

Ignoring the permanent appreciation in the value of assets

Objects of creation of secret reserves

Secret reserves are usually created to serve the following purposes.

Strengthen the financial position of the company