General Considerations
In addition to matters which are listed in the audit of cash transactions, certain other principal matters that should be taken into account while vouching trading transactions are :
- Correctness of book-keeping record : The auditor should also take steps to verify that the amount of profit has not been overstated, e.g., by the inflation of sales or closing stock, by the understatement of purchase and expenses or by omission to credit customers accounts with the value of goods returned by them, etc. The figure of profit can also be inflated by the failure to provide for losses and depreciation or reduction in their value for instance, by not making an adequate provision for bad debts, for discounts payable on the recovery of book debt, for any fall that has taken place in the value of investments or stock. In such a case, the final accounts would not disclose a ‘true and fair’ stage of affairs of the business. Likewise, it should be verified that profits have not been understated. In the case of companies, there is a specific restraint in this regard contained in Part III of Schedule VI to the Companies Act, 1956. It prescribes that a provision, which is in excess of the amount considered reasonable by directors must be treated as a reserve. In consequence, any provision of bad debts, depreciation, expenses, or liabilities which is in excess of the sum considered reasonable, must be treated as a reserve.
- Observance of accounting principles : Students are already aware of the implications of all these requirements; nevertheless, there is a necessity for a fresh look into these with a view to knowing how trading results can be upset if any of these are not properly followed. If the distinction between capital and revenue is not kept in mind in recording transactions, the profit or loss would be wrongly stated; as a consequence, there would not be a true statement of assets in the balance sheet. For example, if an amount representing installation cost of a machine, has been wrongly treated as a revenue expense charged off in the year’s account, the profit for the year would be understated to the extent of the charge and the value of machine also would be understated. If the benefit of an expense incurred in a given period is not fully realised within that period, it would be proper to carry forward the appropriate proportion of the expense in the books of account without charging that amount wholly to revenue. For example, if annual insurance premium is paid at the end of third quarter of the financial year of the concern, it would be appropriate that only 1/4th of the total premium should be charged in that year’s account and the rest carried forward to be charged off in the next year when the benefit from the premium would be exhausted.
Similarly, if commission has been earned by salesmen for effecting sale within the year, the same should be provided in the accounts irrespective of whether a bill for commission has been received or not within the year. It is a common knowledge that the value of fixed assets depreciates due to efflux of time, use and obsolescence. The diminution of the value represents an item of cost to the concern for earning revenue during a given period. Unless this cost is charged to the accounts, the profit or loss would not be correctly ascertained and the values of fixed assets would be shown at higher amounts. Likewise, current assets, if they are stated at more than the realisable value, the year’s profit or loss would not be fairly stated. For example, if the figure of sundry debtors, includes some accounts which are not realisable, this is a loss to the concern and it should be provided as soon as it is known. Also, fictitious assets like a worthless patent, trade mark or developmental expense should be written off at the earliest so that the net value of the business can be really known and the infructuous expenses are absorbed by the revenue earned by the business and the true surplus is reflected in the books as profits. Stock-in-trade stands on a slightly different footing in as much as no running account in the financial record is generally maintained for stock. At the year end, the physical quantities of the stocks in hand are noted and values are applied to them to arrive at the value of the closing stock. Often the stock records also provide the basis for ascertaining quantities in hand on the closing day. This being an asset, representing a part of the stock purchased or acquired in the year or earlier needs to be brought into books of account for a fair ascertainment of the profit or loss.
Closing stock account is debited and trading account is credited for giving effect to the adjustment required in the revenue account and for bringing the stock as an item in the accounts. It is therefore obvious that any mistake, error or fraud in the aforesaid process of bringing stock into financial books will have considerable impact on the year’s trading results and assets position. To obtain a true and fair view of the accounts, the correctness, appropriateness and consistency of the verification and valuation bases and methods are of great significance. Students, no doubt, are aware that except for any physical losses that the goods may suffer, during the manufacturing process or due to some extra-ordinary factors, e.g., fire or pilferage, there should be no difference in the total of the quantities of goods entered on either side of the Trading Account i.e., the quantities of opening stock and the quantities purchased or produced should be equal to the quantities of goods sold and those held in stock at the close of the year. It is the duty of the auditor to verify that there has not been any loss or leakage of goods in the process of trading. He should, therefore, reconcile the closing stock with the opening stock on taking into account the quantities of goods purchased and sold. If there is a discrepancy, he must locate the cause thereof. Some of the factors which give rise to discrepancy in the stock are stated below :
- Inclusion in the closing stock of goods that should have been returned to suppliers and noninclusion of goods returned by customers.
- Inclusion in the closing stock of goods received for sale on approval or on a consignment basis and, conversely, non-inclusion in the closing stock of goods sent out for sale on approval or on consignment basis.
- Failure to adjust the quantities of stocks lost by fire or given away as samples.
- Failure to adjust any sales, the proceeds whereof have been misappropriated, or purchases, the bills in respect of which had not been received from the suppliers.
- Failure to include goods purchased that were in transit at the close of the year and to exclude goods which had been sold but not delivered.
- Non-adjustment of the losses in weight of material in the process. In this connection, it is necessary to mention that since the closing stock of one period becomes the opening stock of the next, it is essential that the stock should be valued consistently from year to year; otherwise a part of profit or loss of one period will be transferred to the next.
On this consideration, it is provided under clause (3)(xv) of Part II of Schedule VI to the Companies Act, 1956 that the effect of any change in the basis of accounting, of any item shown in the Profit and Loss Account, should be disclosed. In such a case both the particulars of the change in the basis of valuation of stock, as compared to that in the previous year and the amount by which the profit or loss has increased or has reduced as a consequence should be disclosed. Students may also refer to AS-2 on Valuation of Inventories. As a matter of general principle, AS-1 “Disclosure of Accounting Policies” states that consistency is one of the fundamental accounting assumptions. The change in accounting policy, if any, requires appropriate disclosure.
3. Checking of stock and record : The stock accounts are an integral part of the financial accounts. Therefore, any inaccuracy in one affects the other. It is necessary, therefore, that while checking entries of purchases and sales in the financial books, corresponding entries in the stock accounts also should be checked. In a large concern, this is a stupendous task, on account of the large volume and variety of stocks purchased and sold. In the circumstances, it is practicable for the auditor to only test check the stock entries. In case no mistakes are found, he can accept the correctness of entries not checked provided there exists an efficient system of internal check. He must, however, reconcile the quantities of goods purchased and sold with the balance at the close of the year.