ca-rubneet-kaurCA Rubneet Kaur

B.Com, M.Com, MBA

The evolution of auditing is a complicated history that has always changed through historical events. Since the beginning of human civilization, auditing has been around. It has its genesis in the era of Maurya dynasty where Kautilya, a 4th century B.C.E. economist, recognized the importance of accounting methods in economic enterprises. Internal audit specifically was first made mandatory for a particular set of companies vide the Manufacturing and Other Companies (Auditor Report) Order, (MAOCARO, 1975). With the advent of Companies Act 2013 and regulations being undergoing dynamic changes on daily basis, the demand for professionalism, knowledge and integrity has increased manifold.

Source- research papers of scholars and publications of IIA and various other sources from online publications

Introduction

Richard Brown has described the roots of auditing even prior to the existence of the concept of accounting.

“The origin of auditing goes back to times scarcely less remote than that of accounting…Whenever the advance of civilization brought about the necessity of one man being intrusted to some extent with the property of another, the advisability of some kind of check upon the fidelity of the former would become apparent.” (1905, quoted in Mautz & Sharaf, 1961)

The era of 4000 BC marks the first step in the process of keeping formal record-keeping systems which were firstly introduced by organized businesses and governments in the Near East to ensure the correct accounting, followed by the similar developments in the Zhao dynasty in China (1122-256 B.C.). Lawrence Sawyer (1911-2002), is called as “the father of modern internal auditing” who perceived the theory of Internal Auditing. Presently the philosophy, theory and practice is defined by the International Professional Practices Framework (IPPF) of the Institute of Internal Auditors. Infact the first major book on Internal Auditing was authored by Victor Z. Brink, a former auditor and Columbia University educator.

Need for Audit-Globally

The evolution of auditing is a complicated history that has always changed through historical events. Since the beginning of human civilization, auditing has been around.

(Even the Bible (between 1800 B.C. and A.D. 95) explains the basic rationale for instituting controls rather straight forwardly: “…if employees have an opportunity to steal they may take advantage of it.”)

Investments started flowing in the corporations during late 1800’s and early1900’s. Followed by the series of the events like the stock market crash of 1929 and Great Depression clearly emphasized the fact of various problems with the functioning of capital markets, business practices, and apparent deficiencies in accounting practices prevalent at that time. When industrial expansion started in 1930s, it became difficult for organizations to maintain control and operational efficiency. The need of independent audits can also be traced back to the requirements of the Government of Babylonia, Greece, the Roman Empire, the City States of Italy, etc., which were worried about incompetent officials prone to making bookkeeping errors and inaccuracies as well as corrupt officials who were motivated to perpetrate fraud whenever the opportunity arose. They wanted to develop a detailed system of checks and counter checks to address such fallacies.

To the worst, the World War further enhanced and aroused the concern for the officials of the organizations’ for scheduling and managing the limited resources complying with regulations in order to control cost. It was decided to appoint a special staff to report on happenings in the company who later came to be known as“Internal Auditors”.

In 1958, the Institute of Chartered Accountants of England and Wales issued a statement entitled Accounting by Electronic Methods. This statement referred to E.P.D.as “…the method of analyzing, marshaling, recording and reporting business information by means of equipment, the central feature of which is an electronic digital computer.

Factors contributing to the emergence of Internal Audit function in the organizations as Eyes and Ears of the management

  • Complexity involved in transactions
  • Volume of transactions
  • Disconnect between masters of business and source of transactions
  • Potential bias of reporting parties towards factually correct reporting
  • Requirement of technical accounting expertise
  • Reviewing and summarizing business activities in a meaningful way
  • Ensuring procedural discipline
“Necessity created internal auditing and is making it an integral part of modern business. No large business can escape it. If they haven’t got it now, they will have to have it sooner or later, and, if events keep developing as they do at present, they will have to have it sooner.” (Arthur E. Hald, 1944)

It is evident form the history that a series of frauds and misappropriations including South Sea Bubble, Tulip Scandal took place throughout the European era. Henceforth, in 1494 AD, critical need for exercising stewardship and control arose. Managers were required to justify their acts and control was to be exercised on their working.

After influencing the European working culture, the systems of book keeping and auditing were introduced to United States as well.A formal internal audit function was developed around the turn of the 20th century.

Initial responsibility Changed within couple of centuries to
– Careful collection and interpretive reporting of selected business facts

– Protection against payroll fraud, loss of cash, and other assets

– Audit for Management

 

– Enabling managements to keep track of significant business developments, activities and results from diverse and voluminous transactions (Mautz, 1964)

– Furnishing reliable operating reports containing non financial data such as “quantities of parts in short supply, adherence to schedules, and quality of the product” (Whittington & Pany, 1998)

– Audit of Management

 

Evolution of Audit and Emergence in India

It has been very long since ‘Internal Audit’ was introduced in India by some enlightened companies. But before that it has its genesis in the era of Maurya dynasty where Kautilya, a 4thcentury B.C.E. economist, recognized the importance of accounting methods in economic enterprises.

He not only developed bookkeeping rules to record and classify economic data, but also emphasized the critical role of independent periodic audits. It was during this time also that two different offices were proposed in order to increase accountability of the operations and reducing the scope for conflicts of interest. The offices constituted were the Treasurer and Comptroller-Audi-tor for linking the successful enforcement of rules and regulations to their clarity, consistency and completeness. The concept of fraud was also referred in his work when his beliefs were propounded in the form that all such measures were necessary but not sufficient to eliminate fraudulent accounting.

Kautilya on creating the necessary conditions for reducing fraud

The ruler should avoid appointing persons who are fraudulent, dishonest, cruel, without enthusiasm, incompetent and cowardly [Kautilya’s Rajanitisastra, Subramanian]
“Just as it is impossible to know when a fish moving in water is drinking it, so it is impossible to find out when government servants in charge of undertakings misappropriate money.It is possible to know even the path of birds flying in the sky but not the ways of government servants who hide their (dishonest) income”
  • Appropriate format for bookkeeping and codification
  • compliance with financial rules
  • recording data systematically
  • advocating frequent periodic reporting
  • adoption of independent audits to reduce system failure
Auditor’s concern -KautaliyaAuditor’s concern-Current Practice
Inadvertent recording errors

Deliberate Deceptive Accounting

Collusion among employees to misappropriate revenue

Loss in productivity due to in fighting among employees

Organisation governance

Risk Management

Effectiveness and efficiency of operations

Reliability of financial reporting

Compliance of statutory regulations

The era of developments- Auditing

The historical development of auditing can be reviewed into the following chronological periods:

Prior to 1840

Detailed verification of every transaction

•Development of auditing not well documented.

•Auditing had little commercial application prior to the industrial revolution because industries during this period were mainly concerned with cottages and small mills which were individually owned and managed.

•Testing or sampling was not part of the auditing procedure.

•Existence of internal control was unknown.

1840s-1920s

Time was ripe for the profession of auditing to emerge

• Large factories and machine-based production were established.

• Share market was unregulated and highly speculative.

• Rate of financial failure was high and liability was not limited.

• The accountant particularly in the early years of this period, was normally the company manager and his duties were to ensure proper use of the funds entrusted to him.

• The auditors during this period were merely shareholders chosen by their fellow members.

• The auditors during this period were required to perform complete checking of transactions and the preparation of correct accounts and financial statements.

• Little attention was paid to internal control of the company.

1920s-1960s

Social economic development influenced the emergence of auditing

• Years of recovery ensuing depression,

• Investment in business entities grew rapidly.

• Advancement of the securities markets and credit-granting institutions.

• The separation of the ownership and management functions became more evident.

• Voluminous transactions emerged

• Materiality and sampling techniques were used.

1960s-1990s

Development in technological advancement

• Credibility of financial information and furthering the operations of an effective capital market.

• Duties of auditors were to affirm the truthfulness of financial statements and to ensure that financial statements were fairly presented.

• Auditors placed much higher reliance on companies’ internal control in their audit procedures.

• Auditors were required to ascertain and document the accounting system with particular consideration to information flows and identification of internal controls.

1990s–2000’s

Substantial and rapid change

• Business risk perspective.

• Increased responsibility to detect and report fraud and to assess

• Reporting more explicitly doubts about an auditee’s ability to continue in conformance with society’s and regulators’ increasing concern about corporate governance matters.

• Audit firms started providing consultancy services to businesses.

• Key reform activities included:(1) The Sarbanes-Oxley Act (2) Ramsay report (Australia)

Present Enhanced Scope• Efficacy of operations, the reliability of financial reporting, deterring and investigating fraud, safeguarding assets, and compliance with laws and regulations
Corporate GovernanceFinancial AuditRevenue Audit
Business strategy processDue DiligenceSpecial Audit
Human resources functionsSocial AuditConcurrent Audit
Marketing strategyEnvironmental AuditIncome & Expenditure Audit
Production processCorporate Social Responsibility (CSR) AuditGrants Audit
Stock Audit/Credit AuditCyber AuditProjects Audi
Compliance with Commercial LawsIndustry Specific Internal AuditInvestigative Audit
ERM AuditAssurance On Sustainability ReportingCAG Audit for PSUs

Recognition as a Statutory Process

With the companies Act 1913 audit of company accounts was made compulsory in India. The qualification of the auditors was also prescribed first time in the Companies Act 1913. Later on,the International Accounting Standards Committee and the Accounting Standard board of the Institute of Chartered Accountants of India have developed standards on accounting and auditing practices to provide the guidance on the day to day work being undertaken by auditors and accountants.

However Internal audit specifically was first made mandatory for a particular set of companies vide the Manufacturing and Other Companies (Auditor Report) Order, (MAOCARO, 1975). With the MAOCARO, 1988 and CARO 2003 the need for internal audit was emphasized and focused. Section 581ZF of the Companies (Amendment)Act, 2002 also stipulated that ‘Every Producer Company shall have internal audit of its accounts carried out, at such interval and in such manner as may be specified in articles, by a chartered accountant’.

Preface to the Standards on Internal Audit, issued by the Institute of Chartered Accountants of India: “Internal audit is an independent management function, which involves a continuous and critical appraisal of the functioning of an entity with a view to suggest improvements thereto and add value to and strengthen the overall governance mechanism of the entity, including the entity’s strategic risk management and internal control system.Till date standards issued by IASB ,ICAI. Standards on Internal Audit are recommendatory in nature in the initial period and shall become mandatory from such date as notified by the Council

COMPANIES ACT 1956

Sec 292 A- Every Public Company having a paid up capital of not less than five crores of rupees shall constitute a committee of the Board known as “Audit Committee”. The auditors , the internal auditors, if any, and the director in charge of finance shall attend and participates at the meetings of the Audit Committee…..

MAOCARO 1975 & 1988

in the case of companies having a paid-up capital exceeding Rs. 25 lakhs as at the commencement of the financial year concerned, or having an average annual turnover exceeding Rs. 2 crores for a period of three consecutive financial years immediately preceding the financial year concerned, whether the company has an internal audit system commensurate with its size and nature of its business ;

COMPANIES AMENDMENT ACT 2002

Every Producer Company shall have internal audit of its accounts carried out, at such interval and in such manner as may be specified in articles, by a chartered accountant

CARO 2003

in the case of listed companies and/or other companies having a paid-up capital and reserves exceeding Rs.50 lakhs as at the commencement of the financial year concerned, or having an average annual turnover exceeding five crore rupees for a period of three consecutive financial years immediately preceding the financial year concerned, whether the company has an internal audit system commensurate with its size and nature of its business;

CLAUSE 49 OF LISTING AGREEMENT 2005

The audit committee shall mandatorily review the following

d. Internal Audit reports relating to internal control weaknesses and the appointment………of Chief Internal Auditor shall be subject to review by the Audit Committee.

COMPANIES ACT 2013

Sec 138-Such class or classes of companies as may be prescribed shall be required to appoint an internal auditor, who shall either be a chartered accountant or a cost accountant, or such other professional as may be decided by the Board to conduct internal audit of the functions and activities of the company.

CARO 2015

Is there an adequate internal control system commensurate with the size of the company and the nature of its business, for the purchase of inventory and fixed assets and for the sale of goods and services. Whether there is a continuing failure to correct major weaknesses in internal control system.

 

CARO 2016

Is there an adequate internal control system commensurate with the size of the company and the nature of its business, for the purchase of inventory and fixed assets and for the sale of goods and services. Whether there is a continuing failure to correct major weaknesses in internal control system.

 

Creation of Auditor’s Independence

Considering the importance of independence of auditor’s work and having unbiased opinions from the professional, it was decided to take following steps to ensure the independence

  • Including a statement in the Corporations Act that auditors are to be independent
  • Requiring auditors to declare to the Board of Directors that their independence is maintained
  • Prohibiting special relationships between the auditor and client
  • Establishing an auditor independence supervisory board
  • Establishing an audit committee to oversee the issue of non-audit services, audit fees, scope disagreements and auditor-client relationships.

Internal Audit Functions/Requirements under various Laws

  1. Risk Based Internal Audit (RBIA) in Banks under RBI Guidance
  2. Compliance of Internal Audit requirements under Companies (Auditors Report) Order, 2003/2015/2016
  3. Internal audit of Operations of Depositary Participants
  4. Internal Audit requirements mandated by SEBI on a half yearly basis for stock brokers/trading members/ clearing members
  5. System Audit of Investment functions of Insurance Companies
  6. Concurrent audit in Banks
  7. Internal audit to be undertaken in respect of Credit Rating Companies Operations
  8. Internal audit of Mutual Funds
  9. Internal Audit of Custodians
  10. Internal audit of Registrar & Share Transfer Agents
  11. Internal audit mandatory for multiple banking or consortium RBI
  12. Internal Audit requirement every quarterly required for insurers under IRDA (Investment) (Fourth Amendment) Regulations

The Paradigm Shift and Emerging fields in Internal Audit

With the advent of Companies Act 2013 and regulations being undergoing dynamic changes on daily basis, the demand for professionalism, knowledge and integrity has increased manifold. Thus the expectations from the professional watchdogs have also increased. The owners of the business houses like Board of Directors and the audit committee require an auditor’s assurance for fulfilling their statutory requirements of being aware of all the operations being carried out in the organizations in an efficient and effective manner.They want the internal auditors to evaluate risk and advise the management on risk identification,risk tolerance and risk management.

  1. Review of Internal Financial Controls-Companies Act 2013 has mandatorily placed an onus on the directors to report on the efficacy of the internal financial controls in their annual declaration regarding the affairs of the company. Effective financial controls, including the maintenance of proper accounting records, are an important element of internal control. The auditor gives an assurance that the company is not unnecessarily exposed to avoidable financial risks.
  2. Review of IFRS/Ind AS Convergence-With the mandatory requirement of applicability of these standards, internal audit can and should play a key role in assessing organizational readiness by identifying project risks in the planning stages, focusing on control over the change management process and the impact on internal control over financial reporting and disclosure controls and procedures.
  3. Forensic Audit– On of the emerging field’s in today’s scenario is forensic auditing which is required with the objective of protecting the business against financial crimes. It can help with the detection and recording of potential conflicts of interest for executives by improving transparency
  4. Fraud Detection-The Internal Auditor can involve himself in the detection, prevention of fraudulent activities occurring at various levels and at various domains such as Banking Frauds, Insurance Frauds, Stock market frauds, Internet frauds, Investment Frauds, Cyber crimes ,Corporate Frauds etc.

Conclusion-Auditing is seen to be evolving at all times

The constantly changing role of auditors and auditing is quite apparent from the detailed review of historical developments stated above. Various factors such as critical historical events (e.g. the collapsed of big corporations), the verdict of the courts, and technological developments (e.g.advancement of computing systems and CAATs) have directly or indirectly had an impact in making the present shape of this discipline which we call as auditing and more specifically the extended version of statutory audit i.e. Internal Audit. Any major changes in these factors are likely to cause a change in the audit function and the role of auditors.

It would not be wrong to say that with growing complexities and inter-relation of activities between various agencies,industries allover the world have realised an immense need to have Internal Audit to help the Management at all levels in controlling the activities in the right direction.

(Author may be contacted at rubneet@gmail.com)

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  • PRAVEEN KASHYAP

    A very well research, compiled and drafted article – a must read for all auditing professionals specially the one beginning their career. Many congratulations.

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