Audit of a Firm

The auditor to a firm is usually appointed by the partners either on the basis of a decision taken by them or to comply with a condition in the partnership agreement. His remuneration is also fixed by the partners. It is important that the letter of appointment should clearly state the nature and scope of audit
which is to be carried out and particulars of limitations, if any, under which he would have to function. The Indian Partnership Act, 1932 does not prescribe audit of a partnership firm. Nevertheless, for the verification of adjustment in the accounts of partners made in respect of profits and losses, interest and
remuneration of partners, their contribution to capital, etc. It is necessary that the auditor should have a knowledge of the provisions in this regard under the Act—especially that of powers and audit of partners and their right to profit and capital under different situations and circumstances. The auditor may,
particularly, ensure application of accounting standards prescribed by the Institute. In case the firm is required to get its accounts audited under the requirements of any statute, the auditor will have to qualify the report in case of non-compliance with the accounting standards. Alternatively, only
disclosure of non-compliance with the accounting standards, would be sufficient without making it a subject matter of qualification. Also, before starting the audit, he should examine the partnership agreement and note the provisions therein as regards the following matters :

(1) The name and style under which the business shall be conducted.
(2) The duration of the partnership, if any, that has been agreed upon.
(3) The amount of capital that shall be contributed by each partner—whether it will be fixed or could be varied from year to year.
(4) The period at the end of which the accounts of the partnership will be closed periodically and the proportions in which the profit shall be divided among the partners or losses shall have to be contributed by them; whether the losses shall be borne by the partners or whether any of the partners will not be required to do so.
(5) The provisions as regards maintenance of books of account and the matters which must be taken into account for determining the profits of the firm available for division among the partners e.g., creation of reserves, provision for depreciation, etc. also the period within which accounts can be
reopened for correcting a manifest error.
(6) Borrowing capacity of the partnership (when it is not implied as in the case of non-trading firms).
(7) The rate at which interest will be allowed on the capitals and loans provided by partners and the rate at which it will be charged on their drawings and current accounts.
(8) Whether any salaries are payable to the partners or withdrawals are permitted against shares of profits and, if so, to what extent ?
(9) Duties of the partners as regards the management of business of the firm; also, the partners who shall act as managing partners.
(10) Who shall operate the bank account of the firm ? How will the surplus funds of the partnership be invested ?
(11) Limitations and restrictions that have been agreed upon the rights and powers of partners and on their implied authority to pledge the firm’s credit or to render it liable. In the absence of a partnership agreement, the provisions of the Act which concern the auditor are the
following :

  • Each partner is required to contribute an equal amount of capital.
  • The partners share equally in profits and losses.
  • The partners are not entitled to any interest on capital.
  • Where a partner is entitled to interest on the capital subscribed by him, such interest will be payable only out of profits.
  • A partner is entitled to interest at 6 per cent per annum on his advances and loans over and above the capital.
  •  Every partner can take part in the management of the business. A partner is, however, not entitled to receive any remuneration for taking part in the conduct of the business.
  •  Every partner has the right to inspect and to take a copy of any of the books of the firm.  A partner is entitled to be indemnified for all payments made and liabilities incurred by him in the ordinary course of business or in the preservation of the firm’s property.
  •  The property of the firm must be held and used by the partners exclusively for the purpose of business.
  •  If a partner derives any profit for himself from any transaction of the firm or from the use of the property or business connections of the firm or the firm name, he must account for that profit and pay it to the firm; also the profit from any competing business carried on by a partner without other partners’ consent must also be accounted for and paid to the firm.
  • In the absence of any usage or custom of trade to the contrary, the implied authority of partner does not empower him to :
  1.  submit a dispute relating to the business of the firm to arbitration;
  2. open a bank account on behalf of the firm in his own name;
  3. compromise or relinquish any claim or portion of a claim by the firm;
  4.  withdraw a suit or proceeding filed on behalf of the firm;
  5. admit any liability in a suit or proceeding against the firm;
  6. acquire immovable property on behalf of the firm;
  7. transfer immovable property belonging to the firm; or
  8. enter into partnership on behalf of the firm.
  •  The firm is liable to third parties :
  1.  if a partner, acting within the scope of his apparent authority, receives money and misapplies it, or
  2.  if the firm in the ordinary course of the business receives money, which is misapplied by a partner.
  • No person can be introduced as a partner without the consent of the other partners.
  • Any differences arising as to ordinary matters connected with the business are to be decided by the majority of the partners, but no change can be made in the nature of the business without the consent of all the partners.
  •  If, on the death or retirement of a partner, no final settlement has been effected and the business is carried on by the surviving or continuing partners, the outgoing partner or his estate has the option of claiming :
  1. such share of profits as may be attributable to his share of the assets; or
  2. interest at 6 per cent per annum on his share of partnership assets.
  •  On dissolution of the partnership, every partner has the right to have the goodwill of the business sold for the common benefit of all the partners.
  •  On a dissolution of the firm, the losses, including deficiencies of capital must be made good :
  1. first out of profits;
  2.  next out of capital; and
  3.  lastly, by the partners individually in the proportion in which they share profits.
  • On the dissolution of the firm, assets are to be applied in the following order :
  1.  in paying the firm’s liabilities to third parties;
  2.  in repaying partner’s advances and loans;
  3.  in repaying partner’s capital; and
  4. the residue if any, is to be divided amongst the partners in the proportion in which they share profits.

Advantages – On broad considerations, the advantages of audit of accounts of a partnership could be stated as follows :
(1) Audited accounts provide a convenient and reliable means of settling accounts between the partners and, thereby, the possibility of occurrence of a dispute among them is mitigated. On this consideration, it is usually provided in and accepted by the partners, shall be binding upon them, unless some manifest error is brought to light within a specified period subsequent to the accounts having been signed.
(2) On the retirement or death of a partner, audited accounts, which have been accepted by the partners constitute a reliable evidence for computing the amounts due to the retiring partner or to the representative of the deceased partner in respect of his share of capital, profits and goodwill.
(3) The accounts of a partnership, which have been audited, are generally accepted by the Income Tax Department as the basis for computing the assessable income of the partners and also for the settlement of their liability in respect of Wealth Tax.
(4) Audited statement of accounts are relied upon by the banks when advancing loans, as well as by prospective purchasers of the business, as evidence of the profitability of the concern and its financial position.
(5) Audited statements of account can be helpful in the negotiations to admit a person as a partner, especially when they are available for a number of past years.
(6) An audit is an effective safeguard against any undue advantage being taken by a working partner or partners especially in the case of those partners who are not actively associated with the working of the firm.
Matters which should be specially considered in the audit of accounts of a partnership:

  • Confirming that the letter of appointment, signed by a partner, duly authorised, clearly states the nature and scope of audit contemplated by the partners, specially the limitation, if any, under which the auditor shall have to function.
  • Studying the minute book, if any, maintained to record the policy decision taken by partners specially the minutes relating to authorisation of extraordinary and capital expenditure, raising of loans; purchase of assets extraordinary contracts entered into and other such matters as are not
    of a routine nature.
  • Verifying that the business in which the partnership is engaged is authorised by the partnership agreement; or by any extension or modification thereof agreed to subsequently.
  •  Examining whether books of account appear to be reasonable and are considered adequate in relation to the nature of the business of the partnership.
  • Verifying generally that the interest of no partner has suffered prejudicially by an activity engaged in by the partnership which, it was not authorised to do under the partnership deed or by any violation of a provision in the partnership agreements.
  • Confirming that a provision for the firm’s tax payable by the partnership has been made in the accounts before arriving at the amount of profit divisible among the partners.
  • Verifying that the profits and losses have been divided among the partners in their agreed profitsharing ratio.

From the foregoing steps involved in the audit of a partnership it would be observed that like the audit of every other commercial undertaking, it culminates in the verification of the Balance Sheet and the Profit and Loss Account to ensure that these exhibit a true and fair state of affairs of the firm. The object of examining the partnership agreement, which is an important feature of such an audit, is that the auditor may be able to report to the partners if the interest of any partner has been prejudicially affected, on account of the firm having engaged itself in an activity which it was not authorised to do or violation of any provision of the partnership agreement. Reports on accounts of sole traders and partnerships There is no statutory form of auditor’s report in the case of sole traders and partnerships. Often the auditors of sole traders and firms have nothing to say on the audited accounts except “Audited and found correct” or “Examined and found correct”. This form of reporting is not recommended as it gives no indication of the extent of the examination of accounts that has been carried out. The Guidance Note on Members’ Duties regarding Engagements involving Compilation of Financial Statements to provide guidance on the professional responsibilities of the members of the Institute of Chartered Accountants of India, when an engagement to compile financial statements or other financial information is undertaken and the form and content of the report issued in connection with such a compilation so that the association of the name of the member with the financial statements is not misconstrued by a user of the statements as the same having been audited by him.
For the member, the objective of a compilation engagement is to use accounting expertise, as opposed to auditing expertise, to collect, classify and summarise financial information, This ordinarily entails reducing detailed data to a manageable and understandable form without the requirement to test the assertions underlying that information. The procedures employed are not designed and do not enable the member to express any opinion on the financial information. However, users of the compiled financial information derive some benefit as a result of the member’s involvement because the service has been performed with professional competence and due care.

A compilation engagement would ordinarily include the preparation of financial statements (which may or may not be a complete set of financial statements) but may also include the collection, classification and summarisation of other financial information. Engagements to provide limited assistance to a client in the preparation of financial statements (for example, on the selection of an appropriate accounting policy) do not constitute an engagement to compile financial information. It is essential that the member clearly brings out the nature of association with the financial statements and the nature of the work performed by him. The following recommendations are made in this regard

  2.  The report should be addressed to the appointing authority.
  3. The report should identify the financial information compiled, also stating that it is based on the information provided by the management.
  4. The report should clearly state that the financial statements are not audited.
  5.  In describing the engagement, ambiguous terms such as ‘review’, ‘general review’, ‘check’ etc., should not be used.
  6. Date of the report should be mentioned.
  7. Name and address of the firm of the member appointed for carrying out the compilation engagement should be mentioned.
  8.  Signatures and the designation (sole proprietor/partner) and membership number should appear in the report.
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