What is Cost Audit ?
Meaning of Cost Audit
Cost audit is the audit of cost records. Cost audit is the verification of the cost of production of any product, service or activity on the basis of accounts maintained by an enterprise in accordance with the accepted principles of cost accounting.
The concept and scope of cost audit as defined in India is more specific and lays emphasis on the evaluation of the efficiency of operations and the propriety of management actions as introduced by the Government of India for specified industries. In this sense, cost audit in India appears to be synonymous with efficiency audit mainly as a guide for management policy and decision making besides being a barometer of actual performance.
Definition of Cost Audit
According to ICMA London :
"Cost audit is the verification of cost accounts and a check on the adherence to the cost accounting plan".
According to ICWAI :
"An audit of efficiency, of minute details of expenditures while the work is in progress and not a post-mortem examination. Financial audit is a 'fait accompli'. Cost audit is mainly a preventive measure, a guide for management policy and decision, in addition to being a barometer of performance".
According to Smith and Day :
"By the term "Cost audit' is meant the detailed checking of the costing system, technique and accounts to verify their correctness and to ensure adherence to the objective of cost accounting".
Thus, Cost Audit in India refers to the statutory Cost Audit of the selected companies covered under the relevant provisions of the Companies Act, 1956. These requirements are mandatory and non-compliance may invite penal provisions also.
Features of Cost Audit
The main features of cost audit in India are summarized as follows :
- According to Section 209 of the Companies Act, 1956, as amended, the government has powers to order companies engaged in production, processing, manufacturing or mining activities to maintain in their books of accounts certain particulars relating to utilization of material, labour and other items of cost. This section thus ensures the existence of cost accounts which is a pre-requisite of a cost audit.
- The Government of India has framed Cost Accounting (Records) Rules for the maintenance of cost accounts for certain selected industries. These rules provide guidelines for the companies to maintain cost accounting records. So far Cost Accounting (Records) Rules for 44 industries have been notified by the Government of India, covering more than 2,000 companies.
- According to Section 233-B of the Companies Act, 1956, the government has powers to order for the audit of cost account of a company falling under the purview of the above record rules. Thus statutory cost audit in India has so far been only selective and all companies even within a particular industry may not be covered.
- Statutory cost audit can be conducted only by a qualified Cost Accountant holding a certificate of practice issued by the Institute of Cost and Works Accountants of India.
- The cost auditor is appointed by the Board of Directors of the company with the previous approval of the Central Government.
- Cost Auditor shall submit Cost Audit Report in the form prescribed in Cost Audit (Report) Rules, 2001.
- Cost auditor shall submit a report in triplicate to the Central Government and at the same time forward a copy of the report to the company.
- Time ait prescribed for submission of cost audit report by the cost auditor is one hundred and eighty days from the end of the company's financial year to which the cost audit report relates.
- A copy of cost audit report has to be attached to income tax return of the company.
- A cost audit conducted under Section 233-B shall be in addition to the usual financial audit conducted by another auditor.
- The cost auditor has in his own sphere of work, the same powers and duties as the financial auditor as contained in various provisions of the Companies Act.
- It is necessary that the cost audit of a company when ordered be conducted every year as a regular feature, unless the government directs otherwise.
Objectives of Cost Audit
The main objectives / functions of cost audit are :
1) Protection :
Cost audit protects the business. It ascertains and controls cost by:
- Examining the correctness of cost records.
- Detecting errors, undue wastage or losses and ensuring that cost records are compiled accurately.
- Ascertaining whether the cost accounting plan has been adhered to or not.
2) Constructive Appraisal :
The success of cost audit depends on the outlook of management and scope of cost audit. The cost auditor provides constructive suggestions based on his findings from cost audit for the benefit of management and shareholders as follows:
- Useful information is provided to management for regulating production, selecting economical methods of operation, reducing operations costs and re-formulating plans etc.
- Suggestions for modification of existing procedure, submission of returns, etc., if they are not in conformity with the modern techniques and elimination of unwanted procedures.
- Suggestions for improving the return on capital employed further.
- Information regarding reliability and effectiveness of the existing procedures for taking managerial decisions.
- Suggestions for necessary action if the projected expenditure is found inadequate to produce optimum results.
3) Improved Productivity :
Cost audit creates cost consciousness at different levels within the organization which results in cost reduction and cost control. Moreover, cost audit improves productivity by using efficiently scarce resources, i.e., men, material, machines etc.
4) Pre-Audit :
Cost auditor checks whether the expenditure has been provided for in the budget estimates and the cumulative expenditure has exceeded the budgeted provisions.
Principles of Cost Audit
There are certain principles that the cost auditor has to observe in planning and performing the cost audit. There are also principles that the cost auditor has to see are being observed by the company he is auditing. On the one hand, the cost auditor has to safeguard his independence and professional status in planning and performing the cost audit, ensuring quality and standard of cost audit, as required by his professional body, the ICMAP, as well as by the Companies Ordinance 1984, and the Companies (Audit of Cost Accounts) Rules. 1998, and other rules regulating his audit engagement and reporting. On the other hand, he has also to see that the client unit operates within the legal framework provided for the industry, maintaining cost accounting records, int accordance with the cost accounting records order rules applicable to the industry.
Code of Ethics
Cost Auditor should comply with the "code of ethics for professional accountants." The fundamental principles governing the professional responsibility of the Cost Auditors are enumerated as follows:
1) Independence of Cost Auditor :
The independence of the cost auditor is largely covered by the Companies (Audit of Cost Accounts) Rules 1998, under which a person who has or had specified relationships, which go to mar his independence, cannot be appointed as a cost auditor.
2) Integrity and Objectivity :
Integrity implies not only honesty but fair dealings and truthfulness. The principle of objectivity imposes the obligation on all professional accountants to be fair, intellectually honest and free of conflict of interest. Financial involvement with the client effects independence and may lead a reasonable observer to conclude that it has been impaired.
A professional cost and management accountant should be straightforward and honest in rendering professional services as a cost auditor. He has neither any ulterior motives nor any personal ends to serve. He should be fair and should not allow any prejudice or bias, conflict of interest or any other influence to override objectivity. Cost audit is to meet the management's and the Government's need for credibility in cost information and cost accounting systems.
3) Professional Competence and Due Care :
A professional accountant should not project himself as having expertise or experience which he does not possess. Attainment of professional competence requires a high standard of general education followed by specific education, training and examination in professionally relevant subjects and a period of work experience, with which all ICMAP members are equipped. Professional competence requires to be maintained by a continuing awareness of developments in the accountancy profession, including relevant national and international pronouncements on accounting, auditing and other relevant regulations and statutory requirements. The cost and management accountant has to maintain professional knowledge and skill at a level required to ensure that a client or employer receives the advantage of competent professional service, based on up-to-date developments in practice, legislation and techniques.
4) Confidentiality :
A cost and management accountant should respect the confidentiality of information acquired during the course of performing professional services and should not use or disclose any such information without proper and specific Commission or unless there is a legal or professional right or duty to disclose. The duty of confidentiality continues even after the end of the relationship between the cost auditor and the client or the cost and management accountant and the employer.
5) Professional Behavior :
A professional Cost and Management Accountant, being a member of the Institute of Cost and Management Accountants of Pakistan, should act in a manner consistent with the good reputation or the profession. He should meticulously avoid any such conduct or behavior as may cast unfavorable aspersion on the profession. He has to ensure professional behavior while meeting his responsibilities to clients, third parties, other members of the cost and management accounting profession, staff, employers and the general public.
6) Technical Standards :
A professional Cost and Management Accountant should carry out professional services in accordance with the relevant technical and professional standards. A Cost and Management Accountant has a duty to render professional services with care and skill, in accordance with the instructions of the clients or employers, insofar as they are compatible with the requirements of integrity. objectivity, and in the case of Cost and Management Accountants in public practice, independence. Moreover, they have to conform to the technical and professional standards laid down by the Institute of Cost and Management Accountants of Pakistan, International Federation of Accountants (IFAC), International Accounting Standard Board (IASB) and the relevant laws, orders, rules and regulations.
7) Professional Code of Ethics :
A distinguishing mark of a profession is its acceptance of responsibilities to the society. The Cost Auditor's independence is to be judged by his clients. Government, employers, employees, investors in the business, the financial community and the consumers at large, who all rely on the objectivity and integrity of the Cost and Management Accountant. This reliance imposes a public interest responsibility on the professional cost and management accountant.
8) Engagement in Other Occupation :
A professional accountant in public practice should not concurrently be engaged in any business occupation and activity which might impair his integrity, objectivity or independence or the good reputation of the profession. The code of professional ethics of the Institute of Cost and Management Accountants of Pakistan must be carefully observed.
Aspects of Cost Audit
There are two main aspects of cost audit :
1) Propriety Audit :
It has been defined as "Audit of executive action and plans bearing on the finance and expenditure of the company".
This audit is related to the propriety, i.e., fitness or rightness of the expenditure made. An expenditure may have been sanctioned and it may have been supported by the vouchers, yet the propriety audit has to satisfy whether or not the expenditure made was appropriate to the circumstances of the case and that there could not have been a better alternative. So this audit is concerned with the audit of such actions of the executives as have a bearing on the finances and expenditures of the company or concern.
The cost auditor, under propriety audit, has to ensure that :
- The expenditure has been planned in a way as to give the optimum results.
- There is no other better alternative to the expenditure made and results obtained.
2) Efficiency Audit :
This is also known as 'Performance Audit' and is related to working efficiency of the cost-plan. It has to be seen whether the plan has been executed efficiently or not and for this the results obtained are to be judged. For example, the budget is a plan and the efficiency audit would determine: whether the expenditure is incurred according to the budget and the results obtained are also in accordance with the budget, or not. The emphasis is on the point that:
- Every unit of money invested must give the optimum or the best result, and
- The investment made in different types and areas is balanced and optimum.
"The Management Accounting" defines Efficiency audit as "the audit which ensures the application of the basic economic principle that resources will flow into the most remunerative channels".
The Efficiency audit is based on determining the working efficiency of the enterprise and so it is related to the examination of aspects like inventory control, productivity, utilization of installed capacity, cost control, profitability etc.
Types of Cost Audit
The following are the important types of cost audit :
1) Cost Audit on Behalf of Management :
Audit may be instituted by the management for its own satisfaction. The purpose of this audit is to provide management for its own satisfaction. The purpose of this audit is to provide correct and reliable cost information to management for taking managerial decisions and to ensure that the costing department is functioning according to the plan. In this audit the cost auditor helps the management in several ways by pointing out the drawbacks of the system and suggesting ways and means to control and reduce costs. The errors are corrected and defalcations are prevented. The cost auditor is appointed by the management for this audit.
2) Cost Audit by the Government :
Besides the Statutory audit, the audit can be instituted by any Government - Central or State for the following purposes :
- To ascertain cost of production and marketing in case of industries to whom financial assistance in the form of subsidy, grant-in-aid, lower or free rates of taxes, etc., is to be provided,
- To ascertain costs in order to fix maximum prices of products,
- To ascertain cost of contracts to be given to contractors under Cost-plus contracts, and
- To fix limits of loans to be advanced by financial corporations, small scale industries, and banks to different industries, on the basis of production costs.
3) Cost Audit by Contractees :
Where it is decided by the contractee with the contractor that the contractor would be paid the cost of the contract plus fixed percentage of profit, as in case of 'Cost-plus' contracts, the audit is instituted by the contractee to ascertain correct cost of the contract. Similarly, where a contractor appoints sub-contractors on the basis of cost and profit basis, the contractor institutes cost audit of the accounts of sub-contractors to settle payments.
4) Cost Audit by Tribunals :
To settle labour disputes on wages, bonus, profit-sharing, etc., the Tribunals may ask for cost audit of the concerned businesses. Similarly, Income-tax Tribunals may direct cost audit for assessment of tax based on profits of a manufacturing concern.
5) Cost Audit by Trade Associations :
In the case of concerns of similar nature costs are compared with each other under Uniform Costing or Inter-firm comparison by Trade Associations, Trade Associations want to know costs to seek concessions from the Governments in the gestation or take-off periods of certain concerns, and for that purpose, cost audit is required.
6) Statutory Cost Audit :
This type of audit is conducted in accordance with the provisions of Section 233B of the Companies Act 1956. It is the compulsory audit which required maintaining the related books and accounts of specified establishments. The chief aims of this types of audit is that the government wants to ascertain the relationship of costs and prices.
Techniques and Procedures of Cost Audit
The techniques and procedures used by a cost accountant while conducting cost audit are similar to that used by an auditor of financial accounts. These can be summarized as follows :
1) Ascertain Internal Controls :
The auditor should examine the cost accounting system and ascertain the effectiveness of internal control systems in operation with regard to the cost function. This determines the detail and depth of examination and the extent of reliance on test checking.
2) Vouching :
Vouching refers to establishing correctness of cost records with the help of documentary evidences, called vouchers, supporting and substantiating these records. These vouchers may be internally or externally generated. In case of financial records externally generated vouchers are larger in number, while in case of cost records internally generated vouchers are larger in number. In vouching, the auditor does not merely seek proof that the expenditure has actually been incurred. It examines the soundness of vouchers, and ascertains that the expenditure is properly authorized, appropriately recorded and has resulted in desired value addition. For example, a cost auditor examines that materials are issued against duly authorized Material Requisition Note, used for the purpose for which they have been issued, and surplus materials have been accounted for and supported by Material Return Note or Material Transfer Note.
3) Checking and Ticking :
Cost auditor does tallying, totaling, examination of postings and cost computations. They put check-marks or tick-marks with colored pencils or pens to indicate the work that has done. They may also put checked stamp and his signatures.
4) Test Checking :
In case the cost auditor is satisfied about the soundness of internal cost control system operational in the organization, they may resort to test checking instead of detailed examination of each item. The test checking may be based on random sampling or deliberate sampling.
5) Valuation and Verification :
Under cost audit, this work is particularly significant with reference to calculation of depreciation on productive assets and inventories of raw materials, work-in-progress and finished goods. Valuation and verification of inventories involves examination of records relating to production, sales and those maintained by the store keeper.
6) Working Papers :
Cost auditor should obtain and file with copies of cost manual, relevant decisions, cost codes,audit procedure followed by him and cost audit questionnaire.
7) Audit Notes :
Cost auditor should maintain precise notes of all significant facts discovered by him. important clarifications clarifications with which they could not be satisfied, further clarifications required, defects in the system of internal control, frauds, and policy deficiencies. Working Papers and Audit Notes help cost auditor in carrying out audit work, preparation of Cost Audit Report, and in defending himself subsequently against an allegation, if made, that they failed to discharge his duties with due skill, care and diligence.
8) Questionnaires :
Cost auditor prepares questionnaires for obtaining information regarding procedures and practices relating to various types of costs incurred.
9) Cost Audit Report :
The report is the culmination of cost audit. The Cost Auditor submits the report to the authority at whose order he has been appointed - Central Government or Court or the management, etc. A specimen of statutory cost audit report is given later.
Advantages of Cost Audit
The importance of cost audit / important significance's derived from cost-audit are :
1) Advantages/Benefits to Management :
- It helps to detect errors, frauds, inconsistencies etc. This improves the morale, makes the staff more watchful and helps them to improve the accuracy in their work.
- It ensures a high degree of reliability of cost data, e.g., price fixing, decision-making, etc., which helps the management to improve the quality of cost reports.
- It highlights the weaknesses in the systems and procedures. Inefficiencies in the working of the company are brought to the notice of the management by comparing actual achievements with the target performances for corrective action.
- It improves cost accounting methods and the effectiveness of cost control and cost reduction schemes by pointing out avoidable losses.
- It establishes & reliable check in the valuation of closing stock and WIP.
- Audited cost data is more suitable for inter-firm comparison.
- It makes management by exception possible through allocation of responsibilities to individual managers.
- It reduces wastes by continuous checking and reporting to management.
- Budgetary control and standard costing system will be greatly facilitated.
2) Advantages/Benefits to the Consumers :
- Cost audit helps the Government to fix the fair selling price of consumer goods. Thus the consumers get the benefits of fair price for the products of the company.
- Cost audit does not allow the product to make excess profits by increasing the price at regular intervals. This helps the consumers to maintain a higher standard of living and saves them from unreasonable price hike.
- It helps to reduce and control cost and make proper use of scarce resources.
3) Advantages/Benefits to the Shareholders :
- Cost audit helps to make proper valuation of closing stock and WIP and reveals the true picture of profitability of each product vis-a-vis for the entire company. It also highlights whether the management is making optimum utilization of resources by eliminating inefficiencies.
- It helps the shareholders assess whether they are getting adequate return on their investment.
4) Advantages/Benefits to Government :
- When the Government enters into a cost-plus contract, cost audit helps to fix the price of the contract accurately. This helps the Government to settle the cost claims of bills under cost-plus contract quickly.
- Cost audit helps the Government to fix selling prices of essential commodities accurately and thus prevents undue profiteering.
- Cost audit data is considered more reliable for giving protection to certain industries in public interest.
- Cost audit helps the Government to focus its attention on inefficient units and increase their productivity by taking effective measures. This improves the national income of the country.
- It helps the Government to settle industrial disputes regarding wages, bonus, fringe benefits, etc. through conciliation.
- Accuracy in price fixation generates a healthy competition among the different units in an industry. This checks inflationary trend automatically.
5) Benefits to Statutory Financial Auditor :
- Cost audit generates reliable data by maintaining constant internal check. Costing data, e.g., closing stocks of raw materials, WIP and finished stock, etc., is of great help to the statutory financial auditor.
- It helps to prepare profit and loss account easily.
Disadvantages of Cost Audit
The limitations of cost audit are :
1) Expensive :
One primary disadvantage associated with cost audits is the excessive fees. Auditors are typically independent contractors who can charge relatively high prices for services rendered. In addition to initial charges, auditors may increase fees in the middle of the project if companies fail to prohibit such action in the contract. A person or corporation can essentially go from paying 24,000 to 26,000 for an audit.
2) Lengthy :
Cost audits are also lengthy processes that require employee devotion Although the auditor may be an outside contractor, employees must provide requested information and be accessible in case further explanation of documents is necessary. People must also provide contractors with a proposed schedule. If a company wants an audit to be completed in three months, employees must give the auditor a road map on how to accomplish the goal within the given time-frame. This process requires additional time and effort on an employee's part.
3) Lost Time :
Although thorough, an auditor's report is usually given three to five weeks after the balance sheet is released. This means people who have been stealing from an establishment have nearly a month to form an excuse or leave the company. Regardless of the chosen option, time last between the balance sheet release and auditor's report may cost the company money as evidence against the employee weakens.
4) Uncertainty :
Because a major part of the process involves estimating, there is the possibility of numerical figures being wrong. In addition, if receipts and other forms of record-keeping are skewed, an auditor relying on such documents may produce an inaccurate report. Unorganized companies will not find cost audits helpful, because the process merely lays out information without putting it in order.