Cost Audit

Cost audit is the verification of the correctness of cost accounts and of the adherence to proper cost accounting procedures. Its purpose is to check that the various systems can be relied upon to operate in an integrated manner.

Cost audit is of a recent origin. It is an effective tool of control for the management. It keeps a check and safeguards the interests of all, who are connected with the concern.

ICMA defines cost audit as “The verification of cost records and accounts and a check on the adherence to the prescribed cost accounting procedures and the continuation of relevance of such procedures.”

Contents

1. Overview of Cost Audit
2. Introduction to Cost Audit
3. Meaning and Definition of Cost Audit
4. Scope of Cost Audit
5. Features of Cost Audit
6. Phases of Cost Audit
7. Functions of Cost Audit
8. Circumstances under which a Cost Audit is Ordered
9. Types of Cost Audit
10. Cost Audit Programme
11. Difference Between Financial Audit and Cost Audit
12. Benefits of Cost Audit

What is Cost Audit: Introduction, Meaning, Report, Objectives, Advantages, Scope, Features, Phases, Functions, Circumstances, Types, Difference, Benefits and More

Cost Audit – Introduction

Audit is an instrument of financial control. It consists in the inspection or critical examination of the records, assets and activities to verify and validate their existence and accuracy. It is a review exercise to establish that procedures and instructions are being followed, and the activity is operating satisfactorily.

In fact, it is the process by which an independent professional accumulates and evaluates evidence for the purpose of determining and reporting the degree of correspondence between the accounting facts and figures.

By now, there are several types of audit- financial, cost, internal, efficiency, management, operational, etc. Financial or statutory audit tries to show a “true and fair view” of the affairs of the business, and of its operating results.

Opinion is sought from an independent auditor whether the accounts are correct, and fully and fairly disclose the position of affairs, and in what respect they fail to do so. Its objects are threefold- detection of errors, detection of frauds, and prevention of errors and frauds in future.

Cost audit is the verification of the correctness of cost accounts and of the adherence to proper cost accounting procedures. Its purpose is to check that the various systems can be relied upon to operate in an integrated manner.

This involves ensuring that:

1. The figures themselves are correct.

2. The cost accounts, cost centres, and cost units are correctly charged.

Audit of cost accounting is no different, and it generally follows the same procedure as normal financial audits. An audit programme is laid down with regard to the vouching and verification of items of materials, labour, and overheads. A random check of employees is made to satisfy that all hours clocked by and payments made to individuals were being correctly entered.

However, only a sample (representative proportion) of the day-to-day transactions are closely checked. Full checking is undertaken only when amounts are large or correct analysis is of considerable importance.

Audit note sheets are compiled. Unusual items are examined and queries followed up until the auditor is certain that he has full information. A careful appraisal of cost profit and loss account, and closing stocks is important.

India has the distinction of being the first country to introduce compulsory audit of cost accounts. The Companies (Amendment) Act, 1965 empowered the Government of India to enforce cost audit on any company, it deemed fit. This amending Act incorporated the provisions for the maintenance of cost accounting records and audit.

Then, the Cost Audit (Report) Rules were framed in 1968 as amended from time to time, the latest in November 1996. The cost auditor is required to submit a report in triplicate to the Central Government in the prescribed form along with its copy to the company. The overall objective has been to bring about an improvement in general industrial efficiency by drawing attention to weaknesses and taking remedial action.

More than 30 years have passed but so far these rules are applicable only in respect of 43 products in about 2,500 companies. It should be remembered that the number of companies in India, at present, is over 3,50,000.

Cost Audit – Summary

Auditing begins where accounting ends. We have seen that the work of an accountant ends with the preparation of final accounts—Profit and Loss Account and Balance Sheet. In order to verify the accuracy of the accounts an auditor examines the books of accounts and vouchers. This type of examination is known as Financial Audit.

From this, it is clear that the financial audit is mainly concerned with checking the correctness of past transactions through the records and the final accounts.

Cost audit is of a recent origin. It is an effective tool of control for the management. It keeps a check and safeguards the interests of all, who are connected with the concern. ICMA defines cost audit as “The verification of cost records and accounts and a check on the adherence to the prescribed cost accounting procedures and the continuation of relevance of such procedures.”

I.C.W.A. India defines cost audit as “It is an audit of efficiency of minute details of expenditure, while the work is in progress and not as a post-mortem examination. Financial audit is a “fait accompli”. Cost audit is mainly a preventive measure, guide for management policy and decision, in addition to being a barometer of performance”.

Cost Audit – Meaning and Definition

The term ‘audit’ means examination of books of accounts and vouchers so as to find out their accuracy. Cost audit has been defined as the verification of the correctness of cost accounts and of adherence to the cost accounting plan. Cost audit tries to ascertain the profitability of a concern and also attempts to improve it through a thorough scrutiny of costing procedures and techniques.

Verification of accounts is known as audit. It is the process of checking the accounts with a view to find out the correctness of the entries as well as of the accounts.

“The identification of cost accounts and the check on the adherence to the cost accounting plan is called cost audit.” – C.I.M.A. London

Cost Audit Scope – Materials, Wages, Overheads, Capital Expenditure and Capacity Utilisation

As a cost control and cost presentation, cost audit has a wide field. Cost audit may be undertaken by an organisation or Government, trade associations, labour tribunals etc.

In brief this scope is outlined below:

(i) Materials:

The auditor will examine the following:

a. Procedure in purchase of raw materials, receipts and issues,

b. Whether purchase of materials is in economic order of quantity,

c. Procedure of protection in the store against loss or deterioration of materials,

d. Rate of scrap, waste in the manufacturing process,

e. Surplus materials issued and their disposal through records,

f. To verify the proper maintenance of inventory records,

g. To verify stock at different levels,

h. Pricing of materials in accordance with the methods laid down,

i. Analysis of material cost variances,

j. The standards of materials and accounting system.

(ii) Wages:

The important points to be considered are:

a. System of labour requirement and training,

b. Verification of job time with gate time and finding idle time,

c. The system of labour classification into direct and indirect,

d. Labour cost and checking as to its accuracy,

e. Verification of overtime cost, its calculation and its authorisation by competent authority and its reasonableness,

f. Suggesting ways to reduce idle time,

g. Analysis of labour turnover cost,

h. Labour variance analysis,

i. Checking the internal control to prevent fraud in wage payments.

(iii) Overheads:

The auditor should examine:

a. Classification of overheads, and accumulation of overheads,

b. Basis of allocation and apportionment overheads to cost units or cost centers,

c. Method of overhead absorption,

d. Treatment of under or over-absorption of overheads,

e. Checking of actual expenses,

f. Policy regarding inclusion of overheads in stock or work-in-progress,

g. The preparation of budgets.

(iv) Capital Expenditure:

The points to be borne in mind are:

a. Propriety and authority for a capital expenditure,

b. Accounting method expenses of acquisition of assets,

c. Maintenance of proper asset-register,

d. Depreciation methods and rates,

e. Physical checkup and valuation of assets,

(v) Capacity Utilisation:

It relates to plant:

a. To check and verify the idle capacity,

b. Cost of repairs, maintenance, replacement etc.

c. Optimum utilisation.

Top 3 Features of Cost Audit

a) Cost books, cost records and cost accounts are maintained as per costing system adopted.

b) Verification of the cost plan. The prescribed forms and procedures have been adhered to.

c) Detecting errors and preventing frauds.

Cost Audit – 2 Important Phases: Efficiency and Propriety Audit

Two important phases of cost audit are:

Phase # (1) Efficiency Audit:

It is the appraisal of performance to assess whether the corporate plans have been executed efficiently, e.g., the effective utilisation of capital in a concern can be assessed by determining the return on capital employed. It must ensure that the resources flow into the optimum remunerative channels.

It compares actual performance with the planned performance and investigates the reasons of variances, if any, to take remedial action.

The purpose of conducting such audit is to ensure that –

(i) Each rupee invested gives the optimum return.

(ii) The balancing of investment between various functions, of the organisation is designed to yield optimum return.

Phase # (2) Propriety Audit:

It is the audit of actions and plans of executives which have a bearing on the finance and profitability of the organisation.

 A cost auditor has to judge –

(i) Whether the planned expenditure is designed to yield maximum results;

(ii) Whether better results could have been obtained from expenditure on capital as well as current operations by any other alternative plan of action; and

(iii) Whether the size and channels of expenditure were designed to yield optimum results. It gives constructive suggestions for improving efficiency and profitability.

Cost audit is conducted under Sec. 233-B in addition to financial audit under Sec. 224 of the Companies Act, 1956. Hence cost audit is complementary to financial audit.

Cost Audit – 3 Basic Functions

Cost audit performs three basic functions as:

(1) Verification –

Cost audit verifies the cost accounts, in order to maintain them properly.

(2) Checking –

The second function is to check their adherence to cost accounting plan.

(3) Detecting Error –

The third function of cost audit is to detect errors and to prevent frauds.

5 Circumstances under Which a Cost Audit is Ordered

The following are the circumstances under, which a cost audit is ordered:

1. Inefficient management.

2. Tax assessment.

3. Trade disputes.

4. Cost variation from one unit to another unit within the same industry.

5. Price fixation to avoid undue profits.

Cost Audit Types – Statutory and Voluntary

Type # 1. Statutory Cost Audit:

Statutory cost audit is conducted under the orders of the government.

The government can order for cost audit:

(i) When there are reasons to believe that the organisation or industry is indulging in profiteering or production is hampered due to inefficient or dishonest management.

(ii) When the industry requires protection.

(iii) When orders are placed under cost plus contract system e.g., in the case of defence sub-contracts or civil works contracts, etc.

(iv) When fair prices of some basic materials are to be determined, the cost records of units producing petroleum products, cloth, paper, sugar, ferrous and non-ferrous metals, etc., can be examined by the cost accounts officers of the Tariff Commission to determine their cost price.

Type # 2. Voluntary Cost Audit:

Voluntary cost audit can be conducted under the following situations:

i. Labour Tribunals:

An industrial tribunal may demand cost audit for some special purposes, e.g., to fix bonus, share in profits and fair wages, etc.

ii. Management:

Internal cost audit may be followed as a continuing means of controlling managerial performance.

There are three objectives of such an audit:

(a) To check the reliability of cost data.

(b) To measure the performance of different departments, divisions and units of the enterprise,

(c) To prepare future plans.

iii. Trade Associations:

If uniform costing has been adopted by firms in an industry, the concerned trade association may ask for cost audit of member firms to determine whether the costing procedure is followed as decided previously.

Cost Audit Programme – Meaning and Areas to be Verified by a Cost Auditor

Before commencing an audit, a programme of work (i.e., the areas to be examined) is finalised. There is no standard form of audit programme. The audit programme is drawn up after considering the nature and size of the business, type of audit (i.e., partial or complete), existing internal control systems, outlook of management, etc. An audit programme should cover areas like production, sales and other functions.

Some of the areas which a cost auditor should verify are given below:

(A) Materials:

The following points should be examined:

(1) Check all documents used in connection of materials, i.e., purchase order, GRN, material requisition slip, material transfer slip, etc.

(2) Check whether materials are ordered according to E.O.Q. and whether maximum, minimum, re-order levels of each item of stock are maintained.

(3) Check whether the quantity received as per GRN agree with that of the supplier’s challan.

(4) Check whether defective material returned to suppliers have been properly recorded.

(5) Check whether separate records are being maintained for components produced inside the factory.

(6) Check whether the quantity entered and balance in the bin card agree with the stores ledger.

(7) Check whether the method of pricing issues adopted is in accordance with that specified and whether it is being adopted consistently.

(8) Check whether the issue rates are correct.

(9) Check whether the different losses of materials, e.g., scrap, spoilage, wastage, etc., are within reasonable limits.

(10) Check the authority of the issue of materials.

(11) Check whether stocks have been valued as per the prescribed procedure.

(12) Check the calculation of material variances where standard costing system is adopted.

(13) Check whether there is any scope for reduction of inventory cost without disturbing the production.

(B) Labour:

The following points should be examined:

(1) Check the attendance time and job time cards.

(2) Check whether the workers are physically present by surprise visit in departments.

(3) Check whether the wage calculations are correct.

(4) Reconcile the amount of wages paid with the attendance and/or job cards to detect dummy workers.

(5) Check whether classification of labour cost into direct and indirect is correct.

(6) Compare actual labour performance efficiency with the standard performance to take corrective action without delay.

(7) Check the overtime work records, whether overtime is sanctioned by appropriate authority.

(8) Check whether the system of wage payments and handling of cash are satisfactory.

(C) Work-in-Progress (WIP):

The following points should be covered:

(1) Check work-in-progress physically, whether it agrees with the quantity shown in job-cards of unfinished work.

(2) Check whether the valuation of WIP is correct with reference to the stage of completion of each job or process.

(3) Check whether there is any over-valuation or under-valuation of opening WIP or closing WIP distorting net profits or net assets.

(4) Check whether the volume and value of WIP is disproportionate compared to finished production.

(D) Overheads and Indirect Expenses:

The following points must be checked:

(1) Check whether Classification, allocation and apportionment of overhead expenditure (both production and sales) are correct.

(2) Check whether overhead absorption rates and the amounts absorbed by different jobs are correct.

(3) Check whether allocation of overheads between finished and unfinished products is in accordance with correct principles.

(4) Check the booking of overhead to standing order numbers and to departments.

(5) Check whether overhead charges are excessive compared to the value of production in a production shop.

(6) Check the amount of under – and over-absorbed overheads and the method of their disposal.

(7) Check whether the selling and distribution overheads are within reasonable limits and they are justified.

(8) Check the variances of actual production, administration, selling and distribution overheads with the standards and the explanations offered. Also check how these variances have been removed.

(9) Investigate the reasons of over – or under- absorbed overheads.

(10) Check the items excluded in cost and reconciliation of cost and financial accounts.

(11) Check whether the allocation of indirect expenditure of production, sales and distribution is logical and correct.

(12) Check whether actual indirect expenditure has exceeded budgeted or standard expenditure significantly and variations have been satisfactorily explained and accounted for.

Difference Between Financial Audit and Cost Audit

Difference # Financial Audit:

1. Scope – Covers financial books.

2. Aim – Verification of accuracy of accounting records.

3. Approach – Deals with a post mortem examination of records to find out whether the amounts have been really incurred or not.

4. Responsibility – Financial auditor is answerable to the shareholders.

Difference # Cost Audit:

1. Scope – Covers only cost records

2. Aim – Efficiency of performance in terms of cost elements.

3. Approach – Has a forward looking approach. Offers valuable guidance in ensuring control over various items in future.

4. Responsibility – Cost auditor is answerable to the management except in the case of statutory audit where the reports to the Government.

The main points of distinction between cost audit and financial audit are as under:

(1) Statutory Requirement –

Financial audit is compulsory in companies, while cost audit is not compulsory in the companies.

(2) Objective –

Financial audit serves the objective of securing the correctness of accounts while under cost audit such correctness is not possible.

(3) Qualification of Auditor –

A financial auditor must be a Chartered Accountant. A cost auditor may not be a Cost Accountant.

(4) Complementary Audit –

Cost audit is complementary and not supplementary to financial audit.

(5) Audit Report –

A financial audit report is to be submitted to the shareholders, while cost audit report need not to be submitted to the shareholders.

(6) Time Limit –

Cost books must be completed within 90 days and cost audit report must be completed within 180 days. But these time limits are not applicable in case of financial audit.

(7) Appointment of Auditor –

Financial auditor is appointed by the members of the company. While cost auditor is appointed by the Board of Directors of the company.

(8) Scope –

Financial audit covers the entire organisation, while cost audit emphasises mainly on operations relating to product under reference only.

Cost Audit Benefits – To Management, Shareholders, Government and Society

The very purpose of cost audit is to ensure that the cost accounting records adhere to cost accounting principles and procedures and produce reliable and accurate cost data. Accordingly, the chief advantage of cost audit is that management is enabled to get accurate and reliable cost data so that it can fix prices for its products, formulate policies and make decisions.

Besides being advantageous to management, cost audit is of immense benefit to other groups also. It is, therefore, necessary to trace the advantages of cost audit to different groups of persons.

1. Benefit to Management:

(a) Cost audit ensures that the cost accounting plan is in accordance with the firm’s objectives as well as the system of cost accounting that is adopted.

(b) It also ensures reliability of cost data for price fixation, formulation of policy, decision making and control.

(c) By ensuring an effective system of management reporting, cost audit brings to light all forms of waste, idle capacity and profitable and unprofitable lines of activity.

(d) Cost audit helps determine efficiency of operations.

(e) It facilitates inventory valuation.

(f) Enables inter-firm comparison.

2. Benefit to Shareholders:

Safety of investment and reasonable return on investment being the prime factors of interest to shareholders, cost audit secures the following benefits to shareholders:

(a) Cost audit ensures the maintenance of proper cost accounting records to reflect reliable cost information with regard to every element of cost.

(b) Cost audit distinguishes profitable activities from unprofitable ones.

(c) It enables shareholders to assess and evaluate the performance of their concern.

(d) It also ensures that there is no wastage or inefficiency of any kind.

(e) Cost audit ensures a fair return on shareholders’ investment.

3. Benefit to Government:

A modern Government being called a welfare state has to interfere with the economic activities of people and regulate the same for the benefit of all people. Cost audit helps the Government in this task of promoting the welfare of the masses.

(a) Cost audit facilitates fixation of price which is profitable to producers and reasonable to consumers. This is obviously because of reliable cost data furnished to it by producers whenever needed or demanded by Government.

(b) Besides fixing or regulating prices of essential commodities on the basis of cost data furnished, a modern Government is also enabled to effect equitable distribution of any commodity the production of which is not commensurate with demand for the same.

Data with regard to production furnished by concerns producing a particular commodity enables the government to accomplish this task.

(c) In case a particular firm or industry requiring protection through bounty or subsidy, identification by the Government is possible on the basis of cost information provided by cost accounting records duly audited by the cost auditor.

(d) Cost audit is of immense help to the Government in making distinction between efficient and inefficient units in an industry. Such a distinction enables Government to concentrate on improving the efficiency of the inefficient units.

(e) Where Government is a party to cost-plus contracts, cost audit helps it to fix reasonable price for a contract entered into by it.

4. Benefit to Society:

Cost audit is also beneficial to the society at large. Besides promoting cost consciousness amongst the various units in an industry, cost audit promotes overall efficiency.

In particular, cost audit:

(a) Leads to the fullest utilisation of the available economic resources.

(b) Reasonable prices of goods and services fixed on the basis of accurate and reliable cost data prevents price-cutting and other questionable devices which exploit consumers.

(c) Increased labour efficiency is duly rewarded in the form of higher wages and bonus to workers.

(d) Society is benefited to a large extent when the government fixes prices of scarce commodities on the basis of reliable cost data.

(e) Cost audit promotes all round industrial efficiency and thus contributes to industrial development. This, in turn, results in development of the national economy.

(f) Cost audit makes business concerns recognise their social responsibility in matters of quality and price of goods and services they produce and sell.

(g) By enabling business units to make optimum use of the available economic resources, cost audit ensures safety of shareholders’ investment. It thus protects the savings of the members of the society and also directs the same to profitable channels.