INTERNAL AUDITING “The Journey so far”

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 4^th 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.

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.

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”.

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

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.

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 4^thcentury 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

• 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

The era of developments- Auditing

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

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

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.