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AUDITING AND CORPORATE GOVERNANCE

B.COM

INTRODUCTION

"Auditing is an important professional task carrying heavy responsibility and calling

for commensurate skill and judgment."

In the early stages of civilization, the methods of maintaining accounts were very

crude. The size of business-houses was very small and with little amount of capital, the

number of transactions to be recorded was so small that each individual was in a position to

maintain his accounts and check for himself all his transactions. Hence, it was thought to be a

sheer waste of time and money to get the accounts checked by someone from outside.

ORIGIN OF AUDITING

The origin of auditing may be traced back to the 18th century when the practice of

large-scale production was developed as a result of Industrial Revolution. It is found that

some systems of checks and counterchecks were applied for the purpose of maintaining

public accounts, rather accounts of public institutions, as early as the days of the ancient

Egyptians, the Greeks and the Romans.

The word 'audit' is derived from the Latin word, audire, which means to hear'.

Originally, it was customary for persons responsible for maintenance of accounts to go to

some impartial and experienced persons, ordinarily judges, who used to hear these accounts

and express their opinion about their correctness or otherwise. Such persons were known as

auditors'. Thus, the term 'auditor' means literally 'hearer', i.e., 'one who hears' and is used ever

since the days when public accounts were accepted and approved on the basis of hearing the

accounts read.

The last decade of the 15th century was an important period during which a great

impetus was given to trade and commerce by the Renaissance in Italy and the principles of

double-entry book-keeping were evolved and published in 1494 at Venice (in Italy) by Luca

Paciolo. This system of accounts was quite capable of recording all kinds of mercantile

transactions. Thus, the scope of audit automatically increased thereafter. Luca Paciolo also

defined and described the duties and responsibilities of an auditor and since then, there have

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been various changes in the scope and definition of audit, and subsequently, the duties and

responsibilities of an auditor have enormously increased.

The Industrial Revolution of England was another landmark in the history of trade

and commerce. This led to a great increase in the volume of trading operations which

necessitated the use of more capital and the average trader was compelled to combine in

partnership with others. Consequently, big enterprises in the form of partnership firms and

joint stock companies were formed. The growth of business enterprises before and after the

Revolution was accompanied by improved accounting system. Besides this, the separation of

ownership from management in British Companies made stock-holders realise that their

interests could be well-protected by an independent and impartial audit.

Such developments had a direct effect on the evolution of the practice of auditing, but

the audit of business accounts could not be common until the 19th century. The enormous

increase in the trade, commercial and industrial activities further necessitated the use of

proper devices of checking the accounts of big business-houses. Under these conditions, the

commercial public became perfectly aware of the advantages of the services of auditors and

the importance of audit increased to such an extent in those days that the accounts were

thought to be misleading and incorrect unless they were audited by professional and qualified

auditors.

The Institute of Chartered Accountants in England and Wales was incorporated by

Royal Charter on May 11, 1880 with the sole purpose of preparing auditors. Usually, auditors

in India were also prepared by this Institute. In January 1923, the British Association of

Accountants and Auditors was established and a person after passing his examination from

this Association could be fully competent to work as professional auditor in India.

Auditing in India

From 1914 to 1932. The history of auditing in India dates back to April 1, 1914 when

the Indian Companies Act, 1913 came into force. The growth of the accountancy profession

in this country was actually an outcome of this Act, which made it obligatory on the part of

every company registered under it to have the accounts audited at least once every year. The

Act for the first time prescribed the qualifications for an auditor.

Initially, the Government of Bombay was first to arrange for conducting the courses

of study in this direction. The qualification of being an auditor was obtained by passing the

examination of the Government Diploma in Accountancy (G.D.A) conducted by the Bombay

Government.

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From 1932 to 1949. Till 1932, it was the concern of the Provincial (now State}

Governments to arrange for the education of and to prepare qualified auditors. Thereafter, the

Central Government established an Indian Accountancy Board under the Auditors' Certificate

Rules, 1932. Under these Rules, Registered Accountants (R.A.) were prepared to work as

qualified auditors.

From 1949 to 1956. The Chartered Accountants Act was passed in 1949 and it came

into force on July 1, 1949. On the passing of this Act, the autonomy was granted to the

accountancy profession and as a result, the regulation, control and management of the

profession passed from the Central Government to the Profession, i.e., in the hands of the

Indian Institute of Chartered Accountants which was formed under the provisions of the said

Act. Now, a person has to pass the examinations conducted by it. Only then he can obtain his

certificate of Chartered Accountants (C.A.).

The Institute also maintains a register of its members. The members ire of two types :

(i) Associates of the Institute of Chartered Accountants (A.C.A.). As-- dates are ordinary

members of the Institute and their names appear in the register kept by it for the purpose.

Such members can write the abbreviation, A.C.A.' after their names.

(ii) Fellows of the Institute of Chartered Accountants (F.C.A.). Fellows are also members of

the Institute. Associates become fellows after they have fulfilled certain prescribed

conditions, e.g., at least 5 years' practice,

i\-ment of the prescribed fee, etc. Such members can write the abbreviation, 'F.C.A.' after

their names.

From 1956 onwards. In 1960, some important amendments were made In the

Companies Act, 1956 and the Companies (Amendment) Act, 2000 is the last one in the series

of such amendments. The Companies (Amendment) Act, 1965 has inserted a new section

233B under which the Central Government has been empowered to order audit of cost

accounts in the case of specified companies by a cost and works accountant within the

meaning of the Cost and Works Accountant Act of 1959.

The Income-tax Act, 1961 has made the audit of accounts of some individuals

compulsory which is an important landmark in the history of the profession'

DEFINITION OF AUDITING

The word 'audit' has a wide usage and it now means a thorough scrutiny of the books

of accounts and its ultimate aim is to verify the financial position disclosed by the Balance

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Sheet and the Profit and Loss Account of a Company. The following are some of the

definitions of audit :

(i) Spicer and Pegler: "An audit may be said to be such an examination f the books,

accounts and vouchers of a business as will enable the auditor ) satisfy that the Balance Sheet

is properly drawn up, so as to give a true and fair view of the state of affairs of the business

and whether the Profit and Loss Account gives a true and fair view of the profit or loss for the

.nancial period according to the best of his information and the explanations given to him and

as shown by the books, and if not, in what respects he isriot satisfied."

(2) F.R.M. De Paula : "An audit denotes the examination of a Balance Sheet and

Profit and Loss Account prepared by others together with the rooks, accounts and vouchers

relating thereto in such a manner that the auditor may be able to satisfy himself and honestly

report that, in his union, such Balance Sheet is properly drawn up so as to exhibit a true and

correct view of the state of affairs of a particular concern according to :he information and

explanations given to him and as shown by the books."

(3) R.B. Bose : "Audit may be said to be the verification of the accuracy and

correctness of the books of accounts by an independent person qualified for the job and not in

any way connected with the preparation of such accounts."

Thus, audit is the systematic and scientific examination of the accounts of a business.

The fundamental question is how an auditor should perform this scrutiny to his satisfaction

and according to the wishes and instructions of his client. For this, the following definition

gives a clue :

(4) M.L. Shandilya: "Auditing maybe defined as inspecting, comparing, checking,

reviewing, vouching, ascertaining, scrutinising, examining and verifying the books of

accounts of a business concern with a view to have a correct and true idea of its financial

state of affairs."

Briefly speaking, an audit is an intelligent and critical examination of the accounts of

a business as is evident from the various definitions given above, but progressive writers, like

Sri A.K. Chanda, former Comptroller and Auditor-General of India, have now gone still

further in expressing their point of view on audit.

(5) A.K. Chanda : "Audit is not an inquisition and its mission is not one of fault-

finding. Its purpose is to bring to the notice of the administration lacunae in the rules,

regulations and lapses, and to suggest possible ways and means for the execution of plans and

projects with greater expedition, efficiency and economy."

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This is entirely a new approach in which Sri Chanda clarifies the purpose for which

audit is conducted. According to him, an auditor is required to point out to the authorities the

lacunae and shortcomings and also to suggest remedial measures with a view to bringing

about greater expedition and more efficiency and economy. This is a pragmatic approach to

the subject.

(6) Taylor and Perry : "An audit is an investigation by an auditor into the evidence

from which the final Revenue Accounts and Balance Sheet or other statements of an

organisation have been prepared, in order to ascertain that they present a true and fair view of

the summarised transactions for the period under review and of the financial state of the

organisation at the end date, so enabling the auditor to report thereon."

This definition contains four important elements viz., (1) An audit is, first of all, an

investigation; (2) Such investigation is necessarily of some statement of figures, but not

necessarily of a Balance Sheet; (3) The investigation involves the examination of certain

evidences; and (4) The primary object of the investigation is to enable the auditor to make a

report on the statement. Thus, the definition appears to be more exhaustive and clear.

From a close scrutiny of the definitions given above, it would be evident that there are

different methods of saying a particular thing but still, there is a lot of similarity therein.

However, audit may be defined as :

(1) an intelligent and a critical examination of the books of accounts of a business, which

(2) is done by an independent person or body of persons qualified for the job,

(3) with the help of vouchers, documents, information and explanations received from the

authorities, so that

(4) the auditor may satisfy himself with the authenticity of financial accounts prepared for

a fixed term and ultimately report that

(i) the Balance Sheet exhibits a true and fair view of the state of affairs of the concern;

(ii) the Profit and Loss Account reveals the true and fair view of the profit or loss for the

financial period; and

(iii) the accounts have been prepared in conformity with the Law.

Thus, it will be seen that the duty of an auditor is much more than mere comparison of

the Balance Sheet and accounts with the books. But, cart from doing this, he has to satisfy

himself that, according to his ormation and the explanations given to him, the books have a

proper ord of the transactions entered into. How he will do it and how much r.ount of skill

and care will be reasonable under the individual cir-.mstances of a particular case are some of

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the questions which he can : irectly and independently answer. Much will, of course, depend

upon the -.ructions of the Law.

In short, an audit implies an investigation and a report. The process : checking and

vouching continues until the investigation is completed n d the auditor enables himself to

report in accordance with the terms of his appointment.

SCOPE OF AUDIT

The scope and dimensions of auditing have greatly increased in the - . enties and the

evolution of new concepts such as Tax Audit, Management Audit and Operations Audit has

further laid emphasis on its adoption n a wider scale. Actually, the primary audit objective of

detection of fraud in the beginning has now shifted to the determination of the fairness and -

Authenticity of reported financial position together with the detection and : re\ ention of

errors and fraud. This has vastly enhanced the scope of diting and to meet with, exhaustive

rules and regulations are being framed in all the countries of the world for conduct of

independent and ~ r fessional audit.

An auditor has to certify the correctness of the books of accounts and : detect errors

committed by the clerks and accountants in the preparation financial records. It is, of course,

true that if this verification is not nducted in a proper and satisfactory manner, the results thus

obtained auld be wholly unreliable. There may be various ways and reasons due hich the

financial books may be incorrect and inaccurate. It is the duty : an auditor to bring them to

light and to report them to the owners of the business.

In a well-known English case, viz., London and General Bank (1895) se, it was

indicated that the auditor should not only check the accuracy : the accounts but should also

satisfy himself whether the books of ounts show a true position. Hence, the duties of an

auditor become :

(1) to check the arithmetical accuracy of the accounts;

(2) to check the books of accounts with the help of all the relevant vouchers, invoices,

correspondence, minute books, etc.;

(3) to verify the assets and liabilities shown in the Balance Sheet; and

(4) to report to the client on the basis of his findings.

The following points should, however, be noted in this connection : (1) The auditor of

a limited company is expected to submit his report annual accounts (i.e., Profit and Loss

Account and Balance Sheet) which re placed before an Annual General Meeting. In other

cases, however, such iitors submit some sort of certificate or report on the accounts. The

work audit should invariably justify such report or certificate.

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(2) The work of audit usually depends upon the amount of discretion exercised by an

auditor in his work. As such, it is not at all possible to lay down any hard and fast rules in this

regard.

(3) It is not possible for an auditor to check every item or conduct audit in detail in big

business concerns and as such, he has to rely much on the system of internal check in vogue.

Test checking, therefore, has to be exercised by him during the course of audit.

(4) An auditor should satisfy himself and ensure that the entries passed in the books

are correct. For this, he has to exercise reasonable care and skill during the course of his

work.

(5) An auditor is not a technical man and, therefore, he has to rely upon the statements

and explanations of responsible officials.

(6) He should investigate properly and thoroughly such matters which arouse

suspicion and doubt.

Thus, it can be observed that the duties of an auditor provide a guideline towards the

scope and subject-matter of auditing. The scope of auditing is what an auditor does, or in

other words, the scope of auditing depends mainly upon the extent of the work done by the

auditor.

The scope and dimensions of duties of an auditor have been further extended due to

the following factors :

1. Expansion of business and separation of management from ownership. With the

advent of Industrial Resolution, the business has expanded from sole trader organisation to

partnership and to company form of organisation in which there has been complete separation

of ownership from management. The owners of company (shareholders) from within the

country and outside are interested in the financial statements of the company which provide

them the information about the affairs of the company. Hence, there has been growing

importance of audit conducted by an impartial and competent person.

2. Statutory Control The supervision and control exercised by the Government

through the provisions of legislative measures such as Companies Act, 1956 have led to the

need for exhaustive scrutiny of accounts under the norms and procedures laid down by such

legislation. It has extended further the scope of audit.

3. Legal Decisions. The courts have also given decisions from time to time and have

laid down statutory obligations for presentation of financial statements and for reporting

norms. This has greatly enlarged the scope of duties and liabilities of auditors.

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4. Standards set by Professional Institutes. There are institutes of accountants in

different countries which have laid down definite standards for preparation and audit of

financial statements. The Institute of Chartered Accountants of India is an example in India

which has issued statements on Standard Auditing Practices (S.A.P.) and Accounting Stand-

ards which the auditors are required to follow.

4. EDP Based Accounts. It is now a common practice for big business undertakings to

use electronic computers for processing transactions, maintaining data files and preparing

final accounts. Very often an auditor has to rely upon the EDP application of the client for

determination of the extent of audit tests. This has given rise to new techniques to assess and

prepare a proper audit plan.

BOOK-KEEPING, ACCOUNTANCY AND AUDITING

Some of the writers on the subject are of the opinion that Book-keeping, Accountancy

and Auditing are the three aspects of the term Accountancy' itself in its widest sense, namely:

(i) the aspect of recording transactions, i.e., the practical part (known as 'Book-keeping');

(ii) the constructive aspect, le., the theoretical part (commonly known as Accountancy

Proper'); and

(iii) the critical aspect, i.e., the analytical part (known as Auditing').

This is probably the briefest and the simplest distinction that can be made between

these three terms. There was a time when no proper demarcation could be made between the

duties of a book-keeper and an accountant. But in the present industrial age, Book-keeping

and Accountancy have become separate functions. The following table makes this distinction

clear:

(a) Recording and

Balanceing (Book-keeping)

(b) Summary and Analysis

(Accountancy)

(c) Examination of Records

(Auditing)

1. Journalizing,

2. Posting into Ledger,

3. Totalling of different accounts in the Ledger, and

4. Balancing.

5. Checking the work of the Book-keeper,

6. Preparation of Trial Balance,

7. Preparation of Trading and Profit & Loss Account,

8. Preparation of Balance Sheet, and

9. Passing entries for rectification' of errors and making adjustments.

10. Checking the work done by Accountant.

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Book-keeping. As is evident from the above table, book-keeping is the art of recording

the daily transactions in a set of financial books. The elementary part of the work in the

whole process is performed by a book-keeper who is mainly concerned with journalizing,

posting, totalling and balancing the various accounts in the ledger. The entire work of a book-

keeper is more or less mechanical for which it is not necessary to be familiar with the

accounting principles. A person with the knowledge of rules of journalizing and posting can

very easily do the job. In Western countries like England and America, this work is done by

machines.

Accountancy. "Accountancy begins where Book-keeping ends." It means that an

accountant comes into the picture only when the bookkeeper has done his job. He has to go

behind the work of a book-keeper and to satisfy himself that the transactions have been

properly recorded and posted in the books of accounts. His duty lies in making the Trial

Balance agree and then to prepare the Profit and Loss Account and the Balance Sheet after

making the necessary adjustments and the rectification of errors. In short, it can be said that

he has to prepare summary in the form of Trial Balance and make analysis after preparing the

Balance Sheet and Profit and Loss Account. An accountant is expected to be an expert in the

accounting procedures as he has to examine analytically the final accounts.

Despite all this, it is not necessary for him to pass the Chartered Accountant's

examination. He is not required to submit his report after the completion of his work. jQ

S^Auditing. "Where accountancy ends, auditing begins." An auditor has J^fo verify the

entries passed by the accountant and the final accounts prepared by him. Auditing is,

therefore, the scrutiny of the accounts of a business with the help of vouchers, documents and

the information given to him and also the explanations submitted to him. Unlike an

accountant, an auditor has to satisfy himself after due verification and thorough scrutiny of

accounts as to whether the transactions entered into the books are bona fide. It is to be noted

that an auditor is required to submit his report to the effect whether or not the Balance Sheet

is a true and fair representation of the existing state of affairs of a business concern.

Hence, an auditor must be well-versed in the accounting principles. This is why he

should be a Chartered Accountant. He has to express his impartial opinion in his report which

he cannot give unless he satisfies himself completely with the proper recording of

transactions. No auditor can dream of certifying a Balance Sheet as true and fair by simply

acting as an accountant. As such, auditing is based on accountancy and not accountancy on

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auditing. An auditor must be well familiar with the principles and practical aspects of

accountancy but it is not necessary for an accountant to be an expert in the audit work.

Sometimes an auditor is requested to write up the books of accounts of his client from

the records and documents as are produced to him. If he acts that way, he is not an auditor but

an accountant as he plays the role of an accountant. In two cases viz., Apfell vs. Annan Dexter

& Co. (1926) and Leach vs. Stocks (1937) and others, the learned judge did not hold a firm of

accountants liable for negligence in tracing out the fraud on the ground that the firm has

appointed an accountant whose duty was to prepare final accounts for purposes of Income-

tax. It was not part of his duty to audit the Balance Sheet. An auditor has, therefore, nothing

to do with the preparation of accounts whatsoever but his work is totally different. An

accountant is to put his signature as a token of his having drafted the Balance Sheet and Profit

and Loss Account while an auditor has no duty to prepare such accounts but to certify that

they are correct, properly drawn up and that they reveal true and fair view of the state of

affairs of the concern.

Some people agree that auditing is a luxury as :

(a) The remuneration paid to the auditor is a charge on the profits of a concern and it is a

sheer wastage of funds;

(b) An average businessman finds it difficult to observe formalities necessary for the

purpose of auditing;

(c) The work of audit involves a lot of obstructions in the daily routine of work of the

office staff and as such, it is an unnecessary waste of time; and

(d) An auditor cannot detect and prevent all the errors and fraud and hence, it is of no use.

The above arguments are not sound and are based on illusory grounds. To sum up, if

accounting is a necessity, auditing is still more impor-ot. It might be the case in small

business-houses where only small mounts of capital are invested and accounts are maintained

in a very rude form that auditing may not be a necessity and legally compulsory. E ut for

every business, auditing has a great practical utility. An individual, t . nature, wants to attain

the maximum utility of his money and to earn maximum profits and if so, he must maintain

proper accounts and get hem audited by some independent and qualified auditor. Hence, the

notion bat some businessmen are of the opinion that auditing is a luxury, while accounting is

a necessity," no longer holds good.

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Accountancy and Audit

As shown earlier, a line of demarcation has to be drawn between accountancy and

auditing. The following points can be helpful in doing so :

1. Accountancy is mainly concerned with the preparation of summary and analysis of

the records prepared by the book-keeper. Auditing is the lamination of the completed

records.

2. The main object of accounting is to ascertain the trading results of a business during a

financial year while the object of audit is to certify as correct the financial statements

prepared by the accountant.

3. An accountant is an employee of the business while an auditor is □ independent

outsider.

4. As an employee of the business, he draws his monthly salary -egularly from the

business itself while an auditor is paid a remuneration agreed upon between him and

his client.

5. An accountant is not expected to have a knowledge of auditing but for an auditor, it is

very essential to possess a thorough knowledge of accountancy.

6. An auditor can be changed from year to year but an accountant is not, as he is usually

a permanent employee of the business.

7. An accountant does not submit his report on the financial statements prepared by him

while an auditor has to submit his report to his client.

Audit and Investigation

Auditing and investigation are not the same thing, but there is a lot of difference

between the two. The accounts of a firm may be investigated for some special purpose. It is a

sort of thorough enquiry into the financial position of a business to measure the profit-earning

capacity.

1. As already pointed out, investigation is done with some special purpose in view while

audit is carried out to find out whether the Balance Sheet of a concern is properly

drawn up and it exhibits a true and fair view of the state of affairs.

2. Audit is generally conducted at the end of a financial year and as such, it relates to the

accounts of one year only, while investigation covers several years, say 3, 5 or 7

years, to find out average earning capacity or to measure the financial position of a

concern.

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3. Investigation may be normally carried out on behalf of those who are outsiders who

either want to purchase the business, to become partners, to advance loans or to

purchase the shares of a firm. Audit is always conducted for proprietors only.

4. Audited accounts are further investigated for some special purpose in view while

investigated accounts are audited in the ordinary course.

5. As the purposes behind investigation are different from those of audit, one cannot take

the place of the other. As such, they have a separate function to perform.

6. Audit is legally compulsory, specially in the case of companies, but investigation is

voluntary and depends upon the necessity of some purpose in view.

QUALITIES OF AN AUDITOR

An auditor should be a Chartered Accountant. Without obtaining the certificate of a

Chartered Accountant, he cannot be appointed an auditor of a public company. So far as his

qualities are concerned, some of them are inherent in him while there are others which he has

to acquire. He must possess the necessary technique of doing his work and the qualities or

capacities. On the one hand, he should be an expert in his work while on the other hand, he

should be a man of character and noble behaviour. Ordinarily, an auditor must possess the

following qualifications (from 1 to 8) and qualities (from 9 to 20} :

(1) An auditor must be well-versed in the fundamental principles, theories and practices

of all the aspects of accounting. He must be familiar with the different systems of

maintaining accounts and their aspects. After all, accounting is a changing technique

and hence, he should be fully aware of the new changes and developments.

(2) He should not pass an entry or account as correct unless he becomes sure of its

correctness. Hence, the knowledge of the principles of accounting becomes very much

necessary for him.

(3) He must have a thorough knowledge of cost accounts so as to enable him to perform

cost audit.

(4) He should not only be familiar with the scope and nature of the accounts of a business

which he is auditing, but he should also know all the technical and minute details of

the working of such a business. He can inspect the works of his client if he thinks it

necessary before the commencement of his work.

(5) He should have a thorough knowledge of the Company and Mercantile Laws1 and

also of the Principles and Practices of Auditing.

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(6) He should also be familiar with the Principles of Economics and the Economic Laws.

It is essential because a business has to work within some specific social and

economic environments and its working is fully affected by their rapid change.

l e.g., Indian Partnership Act, Indian Contract Act, Factories Act, Income-tax Act, Sales

Tax Act,

(7) He should study the audit case laws which have been decided by irts in India and in

other countries. These decisions have their own lificance and go a long way in

defining the powers and duties of an auditor.

(8) He should have a good knowledge of industrial management, financial administration

and business organisation.

(9) He should be honest. He should always exercise reasonable skill and care.1 He should

not work under pressure and should keep himself ay from what he thinks to be untrue.

(10) He should be impartial and must not be influenced directly or directly by others in the

discharge of his responsibilities.

(11) He must be very cautious and vigilant. Sometimes he faces an awkward situation

when his duty to his client is opposed to his own rests. In such a position, he should

be bold enough to discharge his duties faithfully and honestly. It will pay him in the

long-run.

(12) He should have abilities to trace out the facts and figures. He should possess a

realistic attitude and an ability to pass accounts only • hen they reveal the true and fair

state of affairs.

(13) He should not disclose the secrets of his client. If he does so, the outsiders become

suspicious of his character and the entire business may be put to a loss.

(14) He should be so clever that he may be able to extract the necessary formation in full.

For this, he should be capable of preparing a proper questionnaire having intelligent

questions.

(15) He should not adopt an attitude of suspicion.2 It means that he must not be unduly

suspicious.

(16) He should always be prepared to hear arguments and must be reasonable.

(17) He should be methodical, hardworking and accurate.

(18) He should be well-behaved and should try to inculcate faith and confidence in the

minds of the staff of his client. He should be courteous throughout.

(19) He must have the necessary courage and ability to write out his report clearly,

correctly, concisely and forcefully.

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(20) He must possess some common sense. Nothing more can be put here than that "the

common sense is a thing which is uncommon in man."

"An auditor must be honest, i.e., he must not certify what he does not believe to be

true, and he must take reasonable care and skill before he believes what he certifies is

true."—Lord Justice Lindley (in re: London and General Bank, 1895).

"An auditor is bound to assume when he comes to do his duty that he is dealing with

fraudulent and dishonest people...if circumstances of suspicion arise... it is his duty to probe

them to the bottom." Lord Alverstone, C.J. (The London

Oil Storage Co Ltd. vs. Seear Hasluck & Co., 1904) "An auditor is not bound to be a

detective, or to approach his work with suspicion, or with the foregone conclusion that there

is something wrong. He is a watch-dog but not a blood-hound. He is justified in believing

tried servants of the company, and is entitled to rely upon their representation provided he

takes reasonable care."

—Lopes, L.I. (in re: Kingston Cotton Mills Co. Ltd., 1896)

MANAGEMENT AND AUDITOR

The information required by the management may be of three types as given below :

1. Financial Control

The management especially at the top requires information through regular statements

which should involve the following points:

(i) In the first instance, the working capital position of the company and the probable

changes in it throughout the period covered by the current production and financial

programme should be made known to the management. This information is vital to

determine the ability of the company to finance the plan and to understand the

traditional requirements of the working capital.

(ii) Immediately connected with the above information on working capital, the details of

the budgeted costs of manufacture should also be made known so as to find out the

materials and labour requirements.

(iii) Then, the burden of overheads, specially of fixed expenses, should be made known as

to be able to compute the level of turnover to be attained at the break-even point.

(iv) The relationship between profits and turnover must be known so as to determine the

likely effects of fluctuations in turnover on selling prices.

(v) To plan and finance the business expansion programme and development activities,

capital investment budgets are also required.

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2. Cost Finding

Standard and sometimes actual costs must be made known so as to determine prices

and Balance Sheet values.

(i) Details of records in regard to material, labour and overheads should be maintained to

provide the basis of price fixation.

(ii) The elements of costs should be grouped into product costs so as to find out profit or

loss for each product sold.

(iii) Product costs are significant for the pricing of stock and work-in-progress.

3. Cost Control

Cost finding relates to the collection and analysis of costs for some specific purposes,

e.g., determining the actual total expenditure of a particular department, whole cost control is

the check exercised on marketing of specific quantities of specific products made to a given

standard of quality. Cost control is sometimes apart from the normal cost of business.

It would be evident that the auditor must have a comprehensive knowledge of cost and

financial accountancy and of the use of budgetary control and standard costs. He must know

what is in each budget. He must be able to establish the relationship between production data

and financial data and as such, it becomes one of his important functions to ensure that

financial results agree with the quantitative statistics of production.

The auditor in order to function most effectively should be responsible to the top level

of the management. This is true that the internal auditor, though an independent person with

the company itself, is responsible to the directors while the external auditors are responsible

to the proprietors.

Objects of an Audit

The main object of audit is to verify the accounts and to report whether the Balance

Sheet and the Profit and Loss Account have been drawn properly according to the Companies

Act and whether they exhibit a true and fair view of the state of affairs of the concern. Such

verification of accounts and reporting to management are vital factors for promoting

efficiency and accuracy in the maintenance of accounts so that the owners of a business may

get accurate information about the financial condition of their business. The verification of

accounts is done to see if they are correct, complete and in conformity with the Law. For this,

an auditor has to discover errors and fraud. As such, the subsidiary objects of audit are:

(i) detection of errors and fraud, and

(ii) prevention of the recurrence of those errors and of fraud.

16

If the accounts of a firm are full of errors and fraud and the auditor is in a position to

discover such errors and fraud, he cannot certify them as correct. If he does so, it will be a

great mistake on his part.

ERRORS

At the very outset, it would be apt to remark that errors generally arise out of the

innocence or carelessness on the part of those responsible for the preparation of accounts,

while fraud involves some intention to gain out of manipulating records.

The following are the various kinds of errors:

Errors

(1) Errors of Omission (2) Errors of Commission (3) Compensating Errors (4) Errors of Principles

1. Errors of Omission

Errors of omission generally arise due to the mistake of a clerk. If a ransaction has

been omitted from being entered in the books of accounts, holly or partially, it is an example

of error of omission. There are items like purchases or sales which ought to have been

recorded in the books of counts but due to oversight or carelessness they have been wholly

omitted from being recorded.

Apart from these, there are cases where items remain partially recorded, e.g., (i) the

rent or interest may have been paid for 10 or 11 months and the remaining part of it which is

unpaid or outstanding has Jt been recorded in the journal. It is, of course, true that such a

mistake an be detected by careful audit but this is after all a case of clear omission. Secondly,

if an item has been recorded in the journal but has not been sted in the ledger, error of

omission may also arise. Really, this is an ample of omission in ledger-posting in which a

transaction has been recorded but not posted to the relevant accounts in the ledger.

The errors which arise due to non-recording of certain items will not affect the Trial

Balance and, as such, the omission can be detected by ireful scrutiny. But if one aspect of an

item, e.g., purchases or sales, has b een entered in the books, such an omission will affect the

Trial balance and, hence, will be easily detected. The errors which produce some effect on the

agreement of Trial Balance are easily detectable.

2. Errors of Commission

Errors of commission usually arise through negligence in the matter of recording

some business transactions in the books of accounts. They are the outcome of a sort of wrong

17

doing on the part of clerks. If an item is incorrectly recorded in the journal or posted in the

ledger, it is an error of commission.

The following are some examples of errors of commission:

(i) Incorrect Recording—Wholly or Partially. When a transaction though recorded in

the journal has been wrongly entered in the books of original entry, error of commission is

said to arise, e.g., a sale of Rs. 100 is entered in the sales book as Rs. 10. Such an error does

not affect the Trial Balance.

(ii) Incorrect Posting or Posting an Item to a Wrong Account. This is another example

of error of commission. It is possible that a transaction may be entered correctly in the

journal, but when posted in the ledger, a wrong amount may be entered, e.g., sale of Rs. 100

may be written as Rs. 10 to the debit of the customer's account, thus debiting Rs. 90 less than

the real figure. The effect of this erroneous posting in the Trial Balance would be that the

debit side would be short by Rs. 90 and it would show a difference.

Similarly, a wrong account may be debited instead of another when there is nothing

wrong on the credit side. When an amount of Rs. 100 is posted to the debit of Mohan's

account instead of Ram's account to whom goods are actually sold, error of commission may

creep up by posting an item to a wrong account. Such an error will not affect the agreement

of the Trial Balance.

(iii) Errors in Totalling and Balancing. Sometimes errors of commission arise in the

books through incorrect castings and calculations. Such cases are also the errors of

commission. Such errors will affect the Trial Balance. The result of such errors would be that

the error in the total on the debit side would lead to the error on debit side of the Trial

Balance and so on.

(iv) Errors in Carrying Forward Totals to Trial Balance. Errors of commission may

creep into the books when balances of different accounts are carried forward to the Trial

Balance. The balance of accounts may be carried forward less or more than the real figure or

double of it and sometimes also to the other side of the Trial Balance. For example, the

balance of Rs. 125 on the debit of an account may be carried forward to the debit column of

the Trial Balance as Rs. 115 or Rs. 135 or Rs. 250, and even Rs. 125 may be written to the

credit column of the Trial Balance, thus entering the correct figure against this account but in

the wrong column.

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Other Examples of Errors of Commission

(v) When an amount pertaining to the debit side is posted to the credit side of a ledger

account and another different amount of credit side posted to the debit side, error of

commission arises and such an error will affect the trial balance.

(vi) When an entry in a book of original entry has been made twice and so posted

twice, error of commission is said to arise. Some writers call h an error as an error of

duplication. In fact, it is also a case of error of :: mrnission. Such an error will not affect the

trial balance.

(vii) When an item is posted to only one side of a ledger account, it is -e of error of

commission. Such a mistake will affect the trial balance.

(viii) When a wrong figure is entered in a particular account, error of admission may

arise and it has its effect on the trial balance.

3 Compensating Errors

Compensating errors arise when an error is counter-balanced or compensated by any

other error or errors so that the adverse effect of one on debit or credit side is neutralised by

that of another on credit or debit le. For example, A's account which was to be debited for Rs.

200 was credited for Rs. 200 and similarly, B's account which was to be credited : Rs. 200

was debited for Rs. 200. If Rs. 120 is posted to the debit of the ages account in place of Rs.

100 and similarly to the credit of rent account 120 is posted in place of Rs. 100, it is an

example of compensating Such errors also creep up when an undercasting of an account is

counterbalanced by the overcasting of another account to the same extent n the same side.

Compensating errors will not affect the trial balance as such, will not be detected easily.

Hence, their detection requires a complete and exhaustive preparation on the part of an

auditor.

4. Errors of Principles

Errors of principle generally arise out of a disregard for the principles : accountancy.

Such errors are sometimes committed intentionally to Lsify and manipulate accounts with an

objective of showing more or less s than their actual figures. The following are some of the

examples of types of errors:

(i) Incorrect Allocation of Expenditure between Capital and Revenue. . When a

revenue expenditure is treated as capital expenditure and profits inflated thereby, it is a case

of error of principle. For example, if repairs to machinery are treated as an addition to it in the

Machinery Account, it aid be an error of this nature. The result would be an increase in the

19

cost of machinery without any charge on the Profit and Loss Account and, which, the

Balance Sheet would not exhibit a true and correct position be business.

(ii) Posting Revenue Items to the wrong class of Revenue Account. When rem of

wages is posted to general expenses account and similarly, an unt on salary account is posted

to Advertisement Account, such errors culminate in accounts. Such errors will not affect the

ultimate profit and nee, are said to be minor errors of principle. But after all, accounts of a :

cern are falsified and become incorrect,

(iii) Posting an Item of Revenue or Expenditure to a Personal Account. I rent paid to a

landlord is posted to the debit of his personal account, it an example of error of principle. The

result of such an error would be at profits would be inflated and the Balance Sheet would be

wrong,

(iv) Valuation of Assets against Fundamental Principles of Accountancy. en different

types of assets are not valued in accordance with the principles of accountancy, major errors

of principles arise and directly affect the profit and ultimately the Balance Sheet.

Thus, errors of principles are serious types of errors and they can be detected only if

the auditor makes a searching and exhaustive scrutiny. Nevertheless, errors of principles do

not affect the trial balance.

Other Examples of Errors of Principle

The following are some other examples of errors of principle:

(i) Provision for inadequate or excess depreciation;

(ii) Non-provision of depreciation;

(iii) Wrong provision for outstanding expenses and income accrued;

(iv) Wrong adjustment of prepaid expenses;

(v) Wrong provision for bad and doubtful debts; and

(vi) Undervaluation and overvaluation of stock.

How to Detect Errors?

Then, there is a serious question as to how the auditor should locate the error when he

is called upon to do so, although it is not always his duty to do so. It is true that the officials

of a business have failed to locate the error and they ask the auditor to detect it, it is naturally

his duty to do so. If an auditor does so, he works as an accountant and not as an auditor.

How he would proceed in the matter is a big question to decide. Much will depend

upon the circumstances of a particular case and on his own discretion. The auditor may pass

the small differences provided that he is himself satisfied that the books of accounts have

20

been thoroughly examined. But it is always to be remembered that there is a danger in

passing a difference in the agreement of a set of books of accounts.

The auditor should take note of the following devices to locate an error:

(i) If the books are maintained on the self-balancing system, errors can be located

with an exhaustive scrutiny of the books of accounts.

(ii) If the books are not maintained on the self-balancing system, the trial balance

should be thoroughly checked and the castings of ledger accounts should be tallied with those

given in the trial balance.

(iii) If necessary, books of original entry may be checked and postings into the ledger

verified.

(iv) The names of the accounts in the ledger should be compared with the names of

accounts recorded in the trial balance. There are possibilities where some balances have not

been carried forward to the trial balance.

(v) The lists of debtors and creditors should be totalled and should be properly

compared with the trial balance.

(vi) Errors can also be located if the various items given in the trial balance of the

current year are tallied with those given in the trial balance pertaining to the previous year.

(vii) The figures which appear to be doubtful and are struck off for some fraudulent

purpose should be carefully checked.

(viii) To check difference involving round figures, as 10,000, 1,000, casts and carry-

forwards should be examined and wrong totalling, if any, should be corrected. The difference

in rupees and paise should be traced through checking of postings and balancing of accounts.

(ix) If the difference is divisible by two, it may be due to wrong posting sting to the

wrong side of an account in particular, e.g., a difference 50 in the trial balance may be due to

the posting of Rs. 25 to the : :t side in place of the credit side of an account.

(x) Sometimes, errors culminate due to misplacement or transposition inures. Putting

45 for 54, 18 for 81, 27 for 72, etc., are some of such examples. If such a difference is

divisible by 9, it should be noted that the reason for this difference is misplacement of

figures.

(xi) After all, careful and intensive scrutiny is the only remedy for iting a particular

error. The task is, in fact, tedious and arduous.

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To sum up, the following table will reveal the error and its probable cause:

Error

Round sum, e.g.. Re. 1.00 Multiple of 9, e.g.,

Rs. 54

Odd amount, e.g., Rs. 7.89 (a) If there is an

excess of debits over credits in the Trial

Balance

Probable Cause

Error in additions

Misplaced or transposed

figures, e.g., Rs. 27 for 72.

(i) Item not posted in Purchases Journal;

debit side of Cash Book; Returns Inward

Book; Bills Receivable Book.

(ii) Balance omitted from creditors' journal.

(iii) Credit balance omitted from Impersonal

ledger.

(iv) Old balance in (ii) and/or (iii) not

brought forward at the beginning of the

period.

(v) An amount equal to half the difference

wrongly posted from any of the books in (i)

to the debit instead of the credit or a credit

balance equal to half the difference extracted

as a debit balance.

(i) Item not posted in Sales Journal; credit

side of Cash Book; Returns Outward Book;

Bills Payable Book.

(ii) Balance omitted from Debtors' Ledger.

(iii) Debit Balance omitted from Impersonal

Ledger.

(iv) Old balance in (ii) and/or (iii) not

brought forward at the beginning of the

period.

(v) An amount equal to half the difference

wrongly posted from any of the books in the

credit instead of the debit or a debit balance

equal to half the difference extracted as a

credit balance.

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FRAUD

Fraud is really a false representation or entry which is made always intentionally with some

mischievous objectives.

Fraud may be mainly of two types:

Fraud

Misappropriation of Misappropriation of accounts

Cash Goods

Misappropriation of Cash. Usually, Cash is misappropriated by:

(i) The theft of Cash receipts and Petty Cash.

(ii) The theft of Cheques and other negotiable instruments.

(iii) Payments made to fictitious creditors or workmen. Misappropriation or defalcation of

cash is a very easy affair. Anybody with a little skill on his part can misappropriate money,

especially in a big business-house where the contacts between the proprietor and the persons

handling cash are not so close as in the case of a small proprietary business. A transaction

relating to the receipt of cash may either go totally unrecorded or recorded at a figure less

than the actual one in the Cash Book and, thus, the total or a part of the cash may be pocketed

by the cashier. Similarly, it is possible to record false payment of money and to enter cash

payment at more than the actual figure. In this way, there may be concealment of money by

the cashier. Thus, in a big business, strict control should be exercised over the receipt and

payment of cash so that there may be a system of checking the work of one clerk

automatically by another. Technically, such a system is known in auditing as a system of

internal check which is dealt with later in detail.

The following are some of the examples of misappropriation of cash :

(a) Sales

(b) Purchases

(c) Receipt of Cash

(i) omitting to record sales and pocketing money received from

customers;

(ii) teeming and lading, i.e., concealing money received from first

customer and entering in his account the cash received from

second one;

In order to ensure that no customer account is kept

outstanding for a long period, this process is adopted for all the

subsequent collections till the fraud is discovered. Thus,

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(d) Payment

misappropriation of cash is concealed by a false entry relating to a

later transaction. Such a fraud can be prevented if customers are

advised to issue Crossed Cheques or 'A/c Payee Cheques' and are

kept well informed by issuing statements of account at regular

intervals.

(iii) making fictitious entries for discount, returns, bad debts, etc.,

in the customers' accounts;

(iv) omitting to enter cash received from sales;

(v) misappropriating money received from the sale of goods on

'sale or return' basis or per V.P.P by showing such goods as

returned in the books.

(vi) recording fictitious purchases and thus, misappropriating the

cash involved;

(vii) suppressing credit notes received from creditors for purchase

returns and discount;

(viii) concealing cash received on miscellaneous or extraordinary

account (e.g. from sale of some rejected stock or from a debtor

declared previously as bad debt, etc.);

(ix) misappropriating money-receipt on bills receivable account

discounted with a bank;

(x) omitting to record cash received by a cashier as a donation and

removing the counterfoil of the receipt from the receipt book;

(xi) misappropriating money shown as wages in the wage sheet by

entering dummy names of workers therein.

Misappropriation of Goods. Usually, it is seen that the proprietors of : business-

houses do not bother so much for the misappropriation of goods 9 for the defalcation of

money. The defalcation of goods is easy in those : business-houses which produce or deal

with goods which are less bulky and are of higher value.

Thus, goods can be misappropriated by :

(i) The actual theft of stock; and/or

(ii) Issuing fictitious credit notes to customers where there is collusion of the

employee with the customer.

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Fraud in respect of goods cannot easily be detected. When the auditor an detect the

misappropriation of cash by making a close scrutiny of cash k. salesman's reports,

counterfoils of receipt books, credit notes and :her vouchers, he has to depend, to a

considerable extent, on the system : internal check in operation with regard to sales and

purchases. Where this system is good and efficient, collusion between two or more persons a

ust have occu- rred for committing fraud of a serious nature which cannot : detected easily.

Only detailed checking by the auditor can bring fraud to light. He sh nuld check up the stock

records, purchases and sales very carefully.

Manipulation of Accounts. The falsification of accounts without corsponding

defalcation is not so common as the misappropriation of cash or goods. The accounts of a

business can be falsified by making false entries □ respect of fictitious sales or purchases not

necessarily resulting in the same type of misappropriation. It is true that whenever such a

class of fraud occurs, it involves usually very large amounts and it can be detected with a

great difficulty by the auditor because it is committed by high officials of a business, viz.,

Directors, Managers or other responsible persons.

There are normally two objects behind this type of fraud :

(a) Showing more profits than the actual ones

so as—

(i) to earn more commission on profits if they

get it on profit basis; or

(ii) to win the confidence of the shareholders

by claiming that higher profits are a result of

their efficiency; or

(ill) to fetch high price for their shares as

high profits will lead to the declaration of

more dividends; or

(iv) to enjoy better reputation to get credit in

the market by showing more sound financial

position than what it actually is; or

(v) to attract more persons to subscribe more

for the shares.

(b) Showing less profits than the actual ones

so as—

(i) to mislead Income-tax authorities and to

reduce or avoid the liability for Income-tax;

or

(ii) to deceive competitors by creating wrong

25

impressions in their minds about the success

of the business; or

(iii) to purchase shares in the market at a

lower price.

The following are some of the devices to falsify accounts :

(i) providing less or more or not providing for depreciation on various assets; or

(ii) overvaluation or undervaluation of assets and liabilities; or inflating or deflating

profits by entering non-existent items as sales, purchases or returns; or

(iii) changing capital expenditure to revenue account or vice- versa; or inflating profits by

omitting to record some items of expenditure or

(iv) showing less profits by entering fictitious expenditure; or

(v) utilizing secret reserves without making the fact known to the shareholders during

period when there is no profit or less profit; or

(vii) showing income of the next year to the current year's Profit and Loss Account or not

recording the accrued income in the Profit and Loss Account with the object of

manipulating the accounts thereby; or

(viii) window dressing, le., showing outwardly a more prosperous position than what it

actually is. It is a process by which the Balance Sheet is made to show a state of

affairs that is far better than the normal position of the business. Just to improve the

working capital position of the business; if an overdraft is extinguished before the

date of Balance Sheet out of the proceeds of a loan from a subsidiary company, it

would not be justifiable.

(ix) Inflating or suppressing purchases and expenses;

(x) Inflating or suppressing sales and other items of income;

(xi) Inflating or deflating the value of closing stock; and

(xii) Failing to adjust outstanding liabilities or prepaid expenses.

In short, the falsification of accounts may take any of the following forms :

(i) Inflation of the values of assets;

(ii) Omission or undervaluation of liabilities;

(ill) Inflation of profits to enhance commission payable to officials or to affect share

values; (iv) Window dressing.

26

Auditor's Duty

(In relation to the detection and prevention of errors and fraud)

The duty of an auditor is quite significant in relation to the detection and prevention

of errors and fraud. He knows fully well that he has to detect such acts of errors and fraud on

the one side and also to prevent them from occurring in future on the other. Really, it is

difficult for him to do so since fraud in usually committed by the officers who are presumed

to be honest, sincere and responsible.

Detection. It is true that the auditor should exercise considerable care and skill and

only then he can detect errors and fraud. He can be successful in his task if he carries routine

checking and vouching most carefully and checks thoroughly books of accounts, ledger

accounts and vouchers. Thus, his duty is mainly confined to making intelligent and careful

enquiry.

In doing so, if he is hot successful but feels that he has exercised a great degree of

skill, care and tact, his job is over. However, he will decide himself the degree and level of

the scrutiny. If to the best of his knowledge, care and skill, he certifies the accounts as

correct, he cannot be held responsible for an error or fraud which is still there in the accounts.

Prevention. So far as the prevention of errors and fraud is concerned, he cannot do

anything concrete directly. All that he can do is to advise his client and tell him the way to

prevent their future occurrence if he is asked for that. His job is simply to give advice but it is

the proprietor who is responsible for getting things done. It is certain that if his advice is

taken properly in the right spirit, chances of errors and fraud can be reduced to the minimum.

Then, the visits made by the auditor to check accounts serve also as a considerable

influence on those employees responsible for maintenance of accounts which are to be

audited. The persons responsible for the maintenance of accounts know well that the books

prepared by them would be subjected to a close scrutiny by the auditor and if some errors and

fraud are found therein, they will be held responsible for such acts of gross negligence and

bad name. Hence, under this fear, they always try to be on their guard. This is a sort of moral

influence exercised by the auditor which helps a lot in the prevention of further occurrence of

errors and fraud.

It would not be out of place here to quote an extract from the decision given by the

learned Judge in the case of Kingston Cotton Mills Company (1896) that "an auditor is a

27

watch-dog and not a blood-hound." The decision clearly makes an indication of the auditor's

duty in regard to the detection of errors and fraud.

There are two important points in the judgment :

Firstly, an auditor is a watch-dog which means that he is appointed to look after the

interests of those who happen to be the owners of a business. A watch-dog is kept and fed by

his owners and as such, he on his part looks after his owner's interests. Hence, the auditor

should leave no stone unturned in detecting errors and fraud so that he can protect the

interests of his client sincerely, honestly and tactfully.

Secondly, an auditor is not a blood-hound. It is no part of his duty to take those to task

who have been found guilty of committing errors and fraud. He should not be malicious

towards those whom he finds to be responsible for any act of negligence and manipulation or

misappropriation. He has to be sincere, honest and methodical in his approach without in any

way causing any harm to the persons whose work he has to certify. This is the real meaning

of the above-quoted statement.

In brief, the following is a brief sketch of the auditing standards :

1. An auditor should check the internal check system in force and examine its working

in practice.

2. He should ensure how far accountancy principles have been followed in recording

business transactions and it is to be seen whether the work of recording has been

made in pursuance with the policies of the management.

3. He has to see that the accounts have been drawn in conformity with the Companies

Act, and

4. Finally, he should check that the Balance Sheet exhibits a true and fair view of the

state of affairs.

However, his responsibility for not detecting errors and fraud will rest upon the

following factors :

1. He has fulfilled his duty with the prevailing standards of performance adopted by the

profession.

2. He has exercised reasonable care, skill and intelligence in his work.

3. He has not overlooked the materials which would have aroused his suspicion about

fraud and errors.

4. The loss has actually arisen on account of his negligence.

5. He has seen the substantial accuracy of the statements of accounts besides checking

the arithmetical accuracy.

28

The Council of the Institute of Chartered Accountants of India has expressed its

opinion in regard to the duties of an auditor that while conducting an audit, the auditor should

bear in mind the possibility of the existence of fraud or other irregularities in the accounts

under audit. The financial position may be mis-stated as a result of defalcations and other

irregularities. The auditor recognizes that any fraud, if sufficiently material, may affect his

position as to whether the accounts show a true and fair view and he takes this into account in

conducting an audit.

The duty of safeguarding the assets of the company is primarily that of the

management and the auditor is entitled to rely upon the safeguards and internal controls

instituted by the management, although he will, of course, take into account any deficiencies

he may note therein while drafting his audit programme. If an audit is to be conducted with

the object of discovering fraud, in the first place, it would take a considerable amount of time

and it would not be possible to complete the audit within the time limit prescribed by law for

the presentation of accounts to shareholders.

It is further stated that if after the auditor has completed his audit, a fraud is

discovered pertaining to that period, it does not necessarily mean that the auditor has been

negligent or that he has not performed his duties competently. The auditor does not guarantee

that once he has signed the report on the accounts, no fraud exists. If he has conducted his

audit by applying due care and skill in connection with the professional standards expected of

him and has exercised reasonable care and skill, the auditor would not be held responsible for

not having discovered that fraud.

LIMITATIONS OF AUDIT

Then, a word about the limitations of audit. The duties discussed heretofore make it

clear that an auditor has nothing more to do than merely checking, ticking, to talling and

vouching the books and accounts. The ultimate object of his work is to detect clerical errors

pertaining to the accounts. Hence, the scrutiny done by the auditor appears to be a sort of

routine work which he does with a reasonable care as he is bound to do it. This is simply his

professional liability.

Apart from these, an auditor has to depend upon books of accounts and other records

presented before him. He never thinks of intentions of those who have prepared them. If these

intentions are malafide and there are manipulation in the accounts, the auditor will not be in a

position to bring them to light. He has also to depend upon the opinion of experts as he is not

expert in all fields technical, legal or others.

29

Actually, it is rather difficult to find the accounts as complete and genuine

everywhere. For example, the details about stock-in-trade cannot be perfectly complete as it

is not possible to fix exactly the cost or market price of each item in the stock which may or

may not be marketable on a particular day. Practically, it is never found out. Similarly, it

cannot be said whether raw materials or other goods are of use to the business or not. For

electricity and coal, it is never established whether excessive expenditure ..as been incurred in

these items or the business can acquire them with less expenditure and can thus function

more economically.

These are the basic questions which are never answered by an auditor In his report. It

shows, therefore, that audit is historian's record within certain limitations. He has nothing to

do with finances, ethics and effective management. These are actually the fields which an

auditor must cover luring his work so as to enable the business to function more efficiently

and economically, but he does not. What is the use of audit, then?

This is also one of the limitations of the audit that the auditor is influenced by the

doings of those in management. The reason is quite simple. He is appointed by the

shareholders and directors who pay him his remuneration or fee. Hence, he cannot think

otherwise on any moment.

An auditor is said to be a watch-dog and he is appointed to protect the interests of

owners or shareholders. It is true that he should work as a financial police force so that he

may prevent anti-social activities and the isuse of powers. Unless financial controls are

properly exercised, an efficient management is rather an impossible task.

It will also not be out of place to mention here that the times are changing fast and the

business world is being shaped almost daily with new devices and procedures. The problems

are being complicated day-by-day as such, unless an auditor is familiar with the modern

changes, he cannot perform his functions with ability and prudence.

Hence, capable persons are needed in every country to perform the work of audit so

that the business may be properly directed and administered. This will depend upon the co-

operation, specially between the businessmen, the government and persons conducting audit.

ADVANTAGES OF AUDIT

It is no more controversial that accounting is a necessity while auditing is a luxury.

People now get their accounts audited by a qualified auditor so that they may be sure of the

smooth running of their business and validity of the investment that they have made therein.

30

The advantages of audit can be grouped into the following categories:

For Business itself

(i) The accounts of a business and its financial position can be examined by an

independent and qualified auditor.

(ii) Errors and fraud are located very easily at an early date and chances of their further

occurrence are reduced to the minimum.

(iii) The auditing of accounts makes the clerks who maintain them alert, careful and

vigilant, and moreso, they prepare accounts very carefully in future and keep them up-

to-date.

(iv) Money can easily be borrowed from banks and other money-lenders on the basis of

properly audited accounts.

(v) The business itself enjoys better reputation if its accounts are audited by an

independent auditor.

(vi) The auditor, if he audits a business regularly, can come into a close touch with the

working of that business and hence, can give concrete suggestions to improve it if he

is asked to do so.

(vii) Audit is useful in case business is managed by some agent or representative of its

owner.

For the Owners of a Business

(viii) If the business is owned by a sole trader, he can rely well on the audited accounts and

on his accounts clerks who are responsible for the maintenance of accounts.

(ix) If the business is organised as a partnership firm, its partners can utilize the audited

accounts to settle their disputes in regard to adjustment of capital and valuation of

goodwill at the time of admission, retirement and death of a partner.

(x) If the business is constituted as a joint-stock company, its shareholders who reside at

places distant from the head office of the company can rely on audited accounts and

can be sure of their investment being safe with the company.

(xi) If it is a trust, its trustees can easily make their position clear before others by getting

the accounts audited by an outside and impartial auditor.

For Others

(xli) The audited accounts of previous year are helpful in the settlement of claims by the

insurance company in case of fire.

31

(xiii) The banks or investors or other money-lenders can take decisions for granting loans to

business houses on the basis of their properly audited accounts.

(xiv) The purchaser of a business can easily calculate the amount of purchase consideration

on the basis of its audited accounts.

(xv) The taxation authorities can very well rely on the audited accounts for the purpose of

imposing Sales-tax, Income-tax, Wealth-tax, Expenditure-tax, etc.

(xvi) The audited accounts of a business can be produced in support of a legal case before

the Court. It forms a basis to determine action in bankruptcy and insolvency cases.

(xvii) In the case of employer-employee disputes, audited accounts are helpful in the

determination of profits and trends of profitability. Trade union disputes can be easily

settled on the basis of audited accounts of a concern.

CLASSIFICATION OF AUDIT

Audit may be classified and kept into two categories, mainly:

1. According to organizational structure of a business; and

2. From practical point of view.

According to Organizational Structure of a Business

It is rightly said that the method of maintaining accounts and their v.dit will be largely

dependent upon the organizational patterns of a t usiness-house. Different types of audit on

this basis may be as given in the table on page no. 26.

1. Statutory Audit

In case of many undertakings, audit is made compulsory under statute.. It is so

because these undertakings are established by statute. The undit of their accounts is termed as

statutory audit. The following are the samples of such an audit :

(i) Company Audit. The audit of the accounts of joint-stock companies India is

compulsory under the Companies Act. For the first time, the dian Companies Act, 1913 made

it legally compulsory for joint-stock mpanies in India to get their accounts audited by an

independent - fessional accountant, but now, the Companies Act, 1956 and subsequent

amendments have made tremendous changes in the rights, duties, powers, etc., of an auditor.

He should be a qualified auditor as laid down .r.der section 226 of the said Act.

32

33

(ii) Audit of Trusts. Trusts are usually created for the benefit of the weak and helpless

persons like widows, minors, etc., who are not in a position to have access to and understand

the accounts of such trusts. The trustees are made responsible to^ook after the property and to

maintain accounts. They work according to the terms and conditions of the Trust Deed,

collect the income from such property and distribute it among the beneficiaries. Examples of

large sums of money having been misappropriated by the trustees are not lacking in the

country. In a large number of cases, the trustees either do not maintain accounts at all or if

they are forced to do so, such accounts are very often misleading.

To avoid such a situation, specific provisions are sometimes made in the Trust Deed

for the appointment of auditors to check the accounts of trusts. In some of the states in India,

Public Trust Acts (e.g., the Bombay Public Trust Act, 1950, etc.) have been enacted which

provide for compulsory audit of the accounts of trusts by qualified auditors. Audit in these

cases has now assured the beneficiaries that they will no more be defrauded.

(iii) Audit of other Institutions. Then, besides joint-stock companies and trusts, there

are other corporate bodies, such as electricity and gas companies, banks and insurance

companies, and other corporate public bodies which have been formed under their respective

statutes. They have taken powers from the relevant Acts to appoint auditors and have recog-

nized the advantage of professional audit.

There is another set of public bodies in the name of public corporations, e.g., Reserve

Bank of India, Industrial Finance Corporation, etc., which work according to the various Acts

passed for the purpose. The institutions of this group also fully recognize the significance of a

professional audit which is compulsory in their case too. The powers, duties and liabilities of

auditors are also well-defined and fixed by the relevant statues.

Similarly, the audit of co-operative societies is conducted by the Co-operative

Department of the State Government or by Registrar of Co-operative Societies as the case

may be. Under section 17 of the Cooperative Societies Act, 1912, the responsibility of the

State Governments regarding the audit procedure of Co-operative Institutions have been

defined. The scope and nature of co-operative audit come under the purview of Statutory

Audit.

2. Private Audit

The institutions which are private in character also get their accounts audited by some

qualified auditors. Such an audit is not required by statute. Hence, it is known as private

audit. These bodies have their own arrangements for audit and run for their own interest so

34

that their accounts may be subject to a close scrutiny to be made by a professional

accountant. There may be three types of such institutions :

(i) Audit of the Accounts of Sole Trader. The appointment of an auditor in the case of

a proprietary concern rests absolutely on the proprietor. He is appointed under an agreement

and hence, his duties, rights and the nature of work will depend upon the terms given in the

agreement. Such an auditor must get clear and unambiguous instructions in writing by his

client as to what he has to do and how he has to proceed. This is necessary because the

auditor can be held responsible for any charge of negligence and by producing the agreement,

he can protect himself against such a charge.

(ii) Audit of the Accounts of Partnership Firms. A firm is a partnership run by several

partners. An audit of the accounts of such a firm is always in the interests of the partners,

although it is done by the auditor appointed by the partners under mutual agreement. As such,

in the case of a partnership firm, the auditor is not appointed under statute, but by agreement

between the partners. His rights, duties and liabilities are also defined by mutual agreement

and can be subjected to modification. On the contrary, the audit of joint-stock companies is

legally compulsory and the rights, duties, powers, etc., are also defined by statute and in their

case, the auditor should also possess the qualifications as laid down by the Companies Act.

These are the distinctions between the audit of a company and the audit of a partnership firm.

The partners of a firm recognise the advantages of a scientific audit which is of much help in

solving their mutual differences.

(iii) Audit of the Accounts of other Individuals and Institutions. Then, there are other

individuals, e.g., rent collectors, estate managers, etc., who have large income and huge

expenditure. They appoint accountants to prepare and maintain accounts. The audit of their

accounts can help these individuals to rely or otherwise on their clerks. Moreover, if their

accounts are properly audited by a qualified auditor, they are not liable to be harassed by the

taxation authorities.

Besides these individuals, there are institutions other than a company, a firm or sole

proprietorship, which are not meant for earning profits, e.g., clubs, hospitals, libraries,

colleges, schools, etc. Such institutions also require the services of an auditor whose scope of

work is defined by the appointment letter. They are increasingly realizing the significance of

a scientific audit and hence, auditors are regularly being appointed especially in big

institutions.

35

3. Government Audit

The Government maintains a separate department in the name of Accounts and Audit

Department which performs the audit of its different departments and offices. This

department is headed by the Comptroller and Auditor-General of India who is assisted by

different officials at various levels.

The duties and liabilities of such auditors are not defined by statute. They are not

public auditors and hence, cannot be appointed auditors for public concerns. They are meant

for Government departments and as such, they work according to the departmental rules and

instructions.

The following are the objectives of the Government Audit :

1. To ensure that the expenditure is incurred out of the fund which has been sanctioned

by the competent authority.

2. To verify that the expenditure of the Government department is sanctioned in

accordance with the rules and regulations of the department concerned.

3. To see that the expenditure already sanctioned has been incurred by an officer or

officers who are authorized to do so.

4. To ensure that the payments have been made to the right persons and they are duly

entered in the books on the basis of receipts received from them.

5. To see that the payments have been properly classified as capital and revenue.

6. To see that if the payment has been made to an individual against some account under

the rules and it is to be recoverable, it has been recorded in the account prescribed.

7. While vouching receipts, it is to be ensured that such receipts are against payments

which have already been made and are recoverable as such. They are also recorded in

the prescribed accounts.

8. To verify the existence and valuation of stores and the stock.

9. To ensure that a proper system of stock-taking has been adopted.

10. To check the system of granting allowances such as travelling allowance (T.A.), daily

allowance (D.A.), etc., and to ensure that they have been granted under rules framed

for the purpose.

11. To ensure that the entire expenditure has been incurred in accordance with the general

principles such as : (i) to exercise proper care to incur only so much as is necessary;

(ii) to sanction the expenditure without any personal gain or motive on the part of the

sanctioning authority; (iii) to utilize the public money in the public interest and not for

the benefit of a person or community.

36

GOVERNMENT AUDIT VS. COMMERCIAL AUDIT

The following table provides the main points of distinction between the Government audit

and the commercial audit :

Government Audit Commercial Audit

Usually, the Government runs the Accounts

and Audit Department which performs both

the functions, le., preparation of accounts and

their audit.1

The Government department is itself the

spending authority in the Government offices

and as such, the Department is responsible

for a part of audit work, though not actually

the audit. The Treasury Officer or the

Disbursing Officer on his behalf makes the

payment on Government accounts. He has no

place in the Accounts and Audit Department.

Bills for payment are submitted to him and

they are passed after preliminary scrutiny.

The audit of Government accounts is a sort of

continuous audit in the sense that mostly, the

transactions relate to the personal claims of

the Government Officers.

In case of commercial concerns, accounts are

prepared by the salaried accountants and their

audit is external and is conducted by an inde-

pendent auditor.

In commercial concerns, the Department

spending the money has no concern with the

audit of accounts.

The Cashier in commercial concerns has no

hand in the audit or preliminary scrutiny of

the bills that he pays.

In commercial concerns, the audit is normally

conducted after a fixed period, Le., a

financial year. It is not continuous in the

strict sense of the term.

Under the President of India's Ordinance dated March 1, 1976, the Comptroller and

Auditor-General of India has now been relieved of the responsibility of compilation of

accounts.

4. Internal Audit

The Institute of Internal Auditors has defined internal audit as given below :

"Internal Auditing is the independent appraisal activity within an organisation for the

review of the accounting, financial and other operations as a basis for protective and

constructive service to the management. It is a type of control which functions by measuring

and evaluating the effectiveness of other types of control. It deals primarily with accounting

and financial matters but it may also properly deal with matters of an operating nature."

37

By virtue of the organizational pattern, some business institutions appoint auditors

who are made responsible to have a constant and regular review of their accounts. Such a

cadre of auditors is of a permanent nature and helps a lot in the detection and prevention of

errors and fraud. It is true that the scope and objective of internal audit are likely to vary from

business to business depending upon the different nature of the organization. Thus, internal

audit is an integral part of internal control.

However, it is to be noted that the audit of accounts by internal auditors is not

compulsory and it is not essential under Statute. It is purely a matter of organizational

behaviour to appoint internal auditors for management to ensure smooth running of the

business.

Such auditors are known as internal auditors who, besides checking the accounts, are

required to report also as to how the system of accounting can be improved and the system of

the internal check be made economical and efficient. Such auditors cannot be appointed as

public auditors or external auditors and hence, are expected to know the minor details of

accounting pattern adopted in the business. They are not required to submit their reports in

the manner in which external auditors do.

In short, internal audit is the examination of books of accounts which is conducted by

the salaried officials of a business known as internal auditors throughout the year. The scope

of internal audit is a bit different. It is more closely related to managerial functions than to

accounting duties. When an outside auditor would ensure after scrutiny of accounts that such

records are correct and are being maintained in conformity with the relevant law, an internal

auditor, besides doing so, would see that the work of the business is going on smoothly,

efficiently and economically. Internal audit is, thus, an independent appraisal of activity

within an organization for reviewing the accounting, financial and other operations. It renders

a productive and constructive service to management.

Internal Audit Vs. Independent Audit

Internal Audit Independent Audit

1. Internal audit is conducted by the

employees of the business itself.

2. It serves primarily the needs of

management.

3. It is aimed at improving and complying

with the established policies and

Audit is performed by an independent

professional auditor. It is conducted to

safeguard interests of proprietors and

third parties directiy.

It is aimed at ensuring the reliability of

financial accounts and data.

38

procedures.

The work is done primarily in the light of

operating functions.

The main concern of an internal auditor is

with the prevention and detection of fraud.

An internal auditor is independent

accountant but is not independent of

management. He is appointed by the

management and as such, he reports to the

management. It provides a continuous

review of business activities.

The work is subdivided primarily in the

light of the financial statements prepared

by the business. The main concern of an

auditor is to ensure that the annual

accounts are correct and as such, he is

incidentally concerned with the detection

and prevention of fraud.

A auditor is independent of management

totally. He is appointed by the proprietors

and he reports to them.

The work of audit is done periodically,

Le., after some fixed interval, normally a

year

Characteristics of Internal Audit

1. The system of internal audit has got an independent status in the r_anization. The

system, therefore, maintains its independent position.

2. Internal audit is totally free from the managerial or executive actions. However, it

may help in formulating executive decisions without tually taking part in such

decisions.

3. It maintains its regular watch and constant review over the account-ng and financial

matters. Thus, it can make investigations into any phase

activities of the organization.

4. Internal audit is a system of audit by the internal auditor who is an -rr.ployee of the

organization. But he does not work under any sort of ~ anagerial pressure. However,

he must have a clear understanding of the .ties assigned to him.

From Practical Point of View

Under this head, we can keep all those forms in which audit is often "ducted

practically by the business houses.

I Continuous Audit

"A continuous audit is one where the auditor's staff is occupied ntinuously on the

accounts the whole year round, or where the auditor ends at intervals, fixed or otherwise,

during the currency of the financial ear, and performs an interim audit; such audits are

39

adopted where the rk involved is considerable, and have many points in their favour, hough

they are subject to certain disadvantages."Spicer and Pegler "A continuous audit is one where

the auditor or his staff is constantly : gaged in checking the accounts during the whole period

or where the :ditor or his staff attends at regular or irregular intervals during the period.

R.C. Williams

The following discussion reveals a clear distinction between internal - hit and

independent audit :

Thus, a continuous audit is an audit which involves the conducting of tdit of accounts

throughout the year at regular intervals, fixed or other-ise, say, one month or more months.

The accounts in such a case are - objected to audit as and when they are prepared. An auditor

in continuous audit pays visits at regular or irregular intervals all the year round and

examines the accounts. Such an audit is necessary only for big business houses and not for

small ones where accounts can be audited at the close of the financial year when they are

ready.

Continuous audit is applicable in case of the following business-houses:

(i) Where final accounts are prepared just after the close of the financial year, as in the

case of a bank.

(ii) Where the transactions are many in number and it is thought necessary to get them

audited at regular intervals.

(iii) Where the system of internal check in operation is not satisfactory.

(iv) Where the statements of accounts are prepared after every month or quarter to be

presented to the management.

(v) Where sales affected are very large.

Advantages

(1) As the auditor visits his clients after a month or so but at regular intervals, a detailed,

close and exhaustive checking can be possible.

(2) The detailed checking involved in continuous audit can discover errors and fraud

easily and quickly. If the accounts were checked after the year by the auditor, it was

easy to locate an error and more so, the clerks could get more opportunities to defraud

accounts in that case.

(3) Since the accounts are checked throughout the year, it becomes easily possible to

present the final audited accounts to the shareholders soon after the close of the

financial year. Thus, the work of the auditor becomes more efficient.

40

(4) The regular visits performed by the auditor make the clerks alert to maintain the

accounts up-to-date. The accounts thus maintained are also accurately prepared by

them.

(5) As the auditor pays surprise visits to the business in continuous audit, it has a

considerable moral check on them as these clerks are not aware when the auditor will

come.

(6) The auditor comes more and more in touch with the business affairs and its technical

details. Hence, he can advance valuable suggestions to his clients for improving the

working of the business and the system of maintaining accounts.

(7) In big business-houses where monthly statements are prepared and the management is

not smooth, continuous audit has proved to be very useful.

(8) In continuous audit, an auditor can perform his duties with ease. He can plan his work

well and proceed with confidence. Thus, he can be in a position to relieve himself of a

great undue burden which would otherwise have fallen upon him at the close of the

financial year.

Disadvantages

(1) Records and figures in the books of account which have already been checked by the

auditor may be altered after the audit is over. This is often done by a dishonest clerk

to defraud the accounts.

(2) The frequent visits made by the auditor may dislocate the work of his client and cause

inconvenience to him.

(3) For continuous audit, the auditor has to come at regular intervals to check the

accounts, and hence, the link between the past and present work cannot be

maintained. Consequently, the thread of work is very likely to be lost.

(4) The frequent visits of the auditor may establish some unhealthy relationship between

him and the clerks and there are chances of mitigating moral check upon them.

(5) It is a very expensive form of audit.

(6) Under it, the work of the auditor becomes mechanical and his frequent visits may also

cause boredom to him.

Precautions to Guard Against its Disadvantages

(1) The auditor should also issue clear instructions to the effect that the audited figures

should not be changed without bringing it to his notice. If some alteration is

necessary, it should be done by passing rectification entries in the journal.

41

(2) The auditor should try to check the accounts of similar nature in one and continuous

sitting as far as possible and note important totals and balances in his diary.

(3) The auditor should prepare an exhaustive programme to prevent any loopholes.

(4) The explanations of important questions which he finds unsatisfactory should be

noted in his note book.

(5) He should have a glance over the past work and alterations, if any, before he begins

his work.

(6) The fraud in personal accounts can easily be made by passing false or fictitious entries

in the impersonal accounts. Hence, the checking of impersonal accounts may be

postponed till the time of final audit. The auditor may confine his work for the present

to the vouching of cash transactions, subsidiary books, etc.

(7) The auditor should not try to make changes in the duties of his assistants as far as

possible. This reduces the chances of inconvenience and disturbance in the work.

2. Annual or Periodical or Final or Completed Audit

Annual or periodical audit is done at the close of the /financial or trading period when

final accounts are prepared. In such a case, the auditor visits his client only once a year and

checks the accounts in one visit till he is not in a position to cover the accounts pertaining to

the whole of the period.

Such a form of audit is very much convenient and useful for business-houses which

are small. For big ones, continuous audit is more useful because the work involved in them is

voluminous and hence final accounts cannot be prepared at the close of the financial year.

Besides, there is a lot of difference between the two. The main distinction between

continuous audit and final audit is that the work under audit in the former case does not cover

the full verification of assets and liabilities. This work is done only at the end of the year

when the Balance Sheet is prepared and the continuous audit is merged into the final audit.

Other items may, however, be verified from time to time during the course of the year.

This type of audit is free from the defects of continuous audit and carries other

advantages with it, though, of course, detailed checking is not possible in it. Hence, errors

and fraud cannot be detected easily, quickly and completely.

Briefly, the following are the advantages and disadvantages of this type of audit:

Advantages

(1) The work of audit does not present any inconvenience and dislocation in the work of

the concern as the auditor comes only once a year.

42

(2) Periodical audit is less expensive and more useful for a small business concern than

continuous audit.

(3) In periodical audit, the work of the auditor can be finished quickly and within a

reasonable time.

(4) The work does not become mechanical and the link in work can properly be

maintained.

(5) In periodical audit, undue collusion cannot be established between the auditor and the

clerks.

(6) Lastly, such an audit can easily be carried out with a simplified time-table for all the

staff.

Disadvantages

(1) In periodical audit, detailed checking of accounts is not possible.

(2) The chances of errors and fraud in accounts do exist.

(3) In periodical audit, there is usually delay in getting the auditor's report and, hence, it

brings some disturbance in the management of a concern as the Shareholders' Meeting

may be delayed.

(4) For big concerns, periodical audit is rarely practicable and it is not much popular for

them.

(5) Under this audit, the auditor has to rely on the management in most of the cases and

as such, there are chances of being misrepresented by the management. The auditor

cannot avoid the management totally.

3. Balance Sheet Audit

As is apparent from the name itself, in Balance Sheet audit, the auditor checks capital,

reserves, assets, liabilities, etc., given in the Balance Sheet. He checks only those documents

which are related to the items given in the Balance Sheet. Such an audit is not conducted to

check Profit and Loss Account and similar other transactions. The work of the auditor is

confined to the Balance Sheet alone. In India, no distinction is made between annual audit

and Balance Sheet audit.

The Balance Sheet audit is quite satisfactory for small or medium-sized business. But

for big concerns having mechanized book-keeping records, such an audit would be not only

unsatisfactory but in many cases totally impracticable. There would have been a large volume

of transactions involving exhaustive summaries made before the total eventually reaches the

final account.

43

It is to be noted that every transaction has an effect on the Balance Sheet and some of

them affect both the Profit and Loss Account and the Balance Sheet. For example, the

purchase of goods on credit will increase the liability to creditors, increase the stock and will

be shown in the ling Account as an increase in purchases and closing stock. Similarly,

purchase of plant will increase Plant and Machinery and reduce cash at ink, thus affecting

only the Balance Sheet. Hence, an auditor by comparing the items in the Balance Sheet with

those shown in the previous r can prove the accuracy of the Profit and Loss Account.

I Cash Audit

In cash audit, the auditor is concerned with the checking of cash transactions. He has

to audit entries pertaining to cash receipts and payments with the help of relevant vouchers.

Since his work is done under such restrictions and limitations, he submits his report

accordingly. He an mention the fact in his report.

5. Cost Audit

"By the term 'Cost Audit' is meant the detailed checking of the costing stem,

technique and accounts to verify their correctness and to ensure adherence to the objective of

cost accountancy." Smith and Day

"Cost Audit is the verification of the correctness of the cost accounts ad of the

adherence to the cost accounting plan." R.W. Dobson

From these definitions, it would be seen that cost audit is performed an some special

circumstances but the purpose behind such an audit is to verify the cost accounts so as to

ensure how far cost accounting plans have been adhered to. The Companies (Amendment)

Act, 1965 has made provisions to perform cost audit of certain categories of companies under

sections 209 and 233. A detailed description of cost audit has been made in a separate chapter

of this book.

6. Complete Audit

When an auditor is appointed to check each and every transaction, total, balance, book

of accounts with the help of the relevant vouchers, documents, correspondence, etc., it is said

to be complete audit. Under complete audit, nothing is to be left from checking by an auditor.

But complete audit is neither practicable nor feasible.

7. Partial Audit

In the case of complete audit, all the records and books of accounts are subjected to

audit by the auditor but when audit is conducted on some : f the records and books of a part

44

or whole of the period, it is called partial audit. Partial audit may relate to some part of the

work for some or whole : the trading period. Partial audit is not practicable again.

8 Detailed Audit

It is a bit different from complete audit. When in complete audit, all the books and

records are completely checked, detailed audit involves detailed and thorough scrutiny, but

not 'complete'. Detailed work is thorough, of course, but not complete in the strict sense of

the term. Hence, detailed audit is somewhat limited, but complete audit entails an exhaustive

scrutiny into the accounts. Detailed checking may be done through plying test-checking.

9. Interim Audit

An annual audit is one which is conducted at the close of the financial year and an

interim audit is that kind of audit which is conducted for a part of the accounting year with

some interim purpose. Such an interim purpose may be, for example, declaration of an

interim dividend by a joint-stock company. Interim audit involves a complete audit of the ac-

counts prepared and closed for a part of the year to the date of a set of interim accounts, e.g.,

quarterly or half-yearly accounts.

It is thus conducted between the two periodical audits.

Its Advantages

(i) With the interim audit, it becomes easy to complete the annual audit soon.

(ii) Errors and fraud can be more quickly detected.

(iii) Since the interim audit is performed during the course of a year it helps in exercising

moral check on the staff of the client.

(iv) This audit is helpful when the publication of interim figures becomes necessary.

Its Disadvantages

(i) There is an inherent danger of altering figures in the accounts already checked.

(ii) Interim audit involves additional work.

(iii) The audit staff becomes engaged in more work and strain as they have to prepare

notes after the end of the interim audit.

10. Management Audit

Some of the authors have synonymously used the terms, 'Management Audit' and

'Efficiency Audit'. However, it can be said that the management audit is an audit conducted to

examine all aspects of management in a business. Improvement in efficiency and maximum

utilization of resources of a business are the tools for its success. In this age of cut-throat

competition, every businessman wants to attain good success in his business career for which

he is, at all times, eager to know how he can be successful and for that, what changes should

45

be made. Thus, the management audit includes the examination of every activity of a

business, Le., plans, objectives, means of operation, utilization of physical resources,

organizational pattern, co-ordination of various activities at all levels and control of the entire

business. The management auditor has to evaluate the overall performance which includes

account books too and he has to submit a report stating whether the pre-determined targets

and objectives have been achieved or not. As an outsider, he looks to the affairs of the

business from an impartial, unbiased and objective point of view. The management audit is,

however, a voluntary form of audit and is related to the process of management.

Thus, management audit is an action over and above the statutory audit. The statutory

auditor of a company can easily undertake its management audit as he is well familiar with

the affairs of the company. He can, therefore, examine the effectiveness and efficiency of the

working of the company from the viewpoint of managerial performance.

The provision for social audit under the Manufacturing and other Companies (Auditor's

Report) Order, 1975 and now under the Manufacturing and other Companies (Auditor's

Report) Order, 1988 replacing the previous order of 1975 is a step in the direction of

management audit.1

The obvious advantages of this audit are given below :

(i) It helps the management to run the business more effectively and economically as this

type of audit can bring lacunae and defects in its working to light.

(ii) Decisions can be taken by the management quickly and effectively.

(iii) This type of audit is connected with every aspect of working of a business and hence,

it helps in improving the performance at all levels.

(iv) The management audit is directly concerned with the business which is the outcome

of improved efficiency affected and increased by introducing the management audit.

(v) The employees become more alert and active and their morale is toned up.

Its disadvantages are as under :

(i) It is a costly affair and is never suitable for small business concerns.

(ii) The management audit techniques as suggested by the management auditor are

applied and used with a view to increasing profitability of a business. If it does not

increase, such an audit becomes a sheer waste and nothing more.

(iii) The management auditor is expected to work at the 'Will' of the management. If he

does not, the management would like to get rid of him.

46

11. Propriety Audit and Performance Audit

While the propriety audit is confined to examine the validity of appropriations or is

concerned with verifying that there is no leakage of revenue and wastage of funds knowingly

or unknowingly in disregard to any legal requirement or financial or economic consideration,

the performance audit is a procedure for analyzing the profits and losses of economic

activities carried on by the business enterprise, examining the relationship between

production and sales and discovering the avenues for maximizing profits.

Under propriety audit, it is to be seen that the contracts entered into by the concern are

in its best interest and there is a proper check to ensure that the assets are safe. Thus, it is a

form of higher audit. Both the propriety and performance audits are the inter-related aspects

of management audit. The management of a company is expected to guarantee the propriety

and validity of all the transactions and the propriety auditor has to certify them. Similarly, the

performance auditor has to evaluate the performance of a concern. Thus, both the audits are

meant to cover examination of propriety aspects of transactions as well as the review of

operational aspects of a company. In a way, they are over and above the regular audit

conducted as per the requirements of the company legislation.

For details, refer to Chapter 14 on 'Management Audit'.

12. Operational Audit

The idea of operational audit is of recent origin and has become a matter of wide

concern with the expansion of industrial and economic activities. The operational audit is

desired to aim at improving the profitability of an industrial enterprise and also at achieving

the other organizational objectives, social and otherwise.

Usually, such an audit is conducted by internal auditors but when external auditors

carry it out, it is in the form of management consultancy services. The operational audit is in

a way over and above financial audit and has sole purpose of improving future business

operations carried out by the management.

13. Environmental Audit

The topic of 'environmental audit' is new and is in a very nebulous state. It covers a

wide range of services, methodologies, assessments, investigations, results, etc. and as such,

if encompasses a multidisciplinary approach. The Canadian Institute of Chartered

Accountants observes :

"The C. A. profession faces an unprecedented opportunity and challenge to respond to

significant emerging needs and expectations arising from concerns to protect the environment

47

for future generations. The profession has much to contribute in shaping future mechanisms

for environmental accountability more than it sometimes realizes; more than other may have

previously recognized."

The concept of industrialization has been universally accepted as an indicator of

development and consequently it is gradually becoming a part of industrial management to

monitor air, water, noise and biological environment and to design pollution control

equipment, to manage handling of hazardous wastes, etc. Companies can no longer afford to

bye-pass environmental laws and regulations. The pressure brought about by increasing

public opinion on the board of directors of companies has compelled them to manage the

business in accordance with eco-friendly requirements but also to mandatorily report to the

shareholders on the subject.

The Environment (Protection) Act, 1986 in India was enacted to stipulate control of

pollution at source. The Pollution Control Boards have laid down certain norms for handling

hazardous wastes, emissions from factories etc. before granting licences to factories.

Industries are required to conform to the standards prescribed. Besides this. The Factories

Act, 1948 provides for personnel monitoring against occupational hazards.

The environmental audit is aimed at maintaining proper standards for controlling

pollution, for handling hazardous wastes in factories and reporting to the shareholders and

proprietors of business in the matter. As is well remarked, it is essential to have 'green

auditing' lor the greening of the business'.

Distinction between Continuous Audit and Interim Audit

(1) In the case of continuous audit, the work of audit is carried on for the whole financial

year according to the convenience of the auditor, while in the interim audit, the audit

work is done only up to a certain date.

(2) In the case of continuous audit, verification of assets and liabilities :s done at the

close of the financial year, while in the case of interim audit, such a work is done at

the time of audit.

(3) The preparation of trial balance is not necessary at intervals when continuous audit is

done, but in the case of interim audit, the trial balance has to be prepared.

(4) The auditor reports at the close of the financial year in the case of continuous audit,

but in the case of interim audit, such a report is to be submitted by the auditor at the

time of audit.

(5) The continuous audit is expensive while interim audit is less expensive.

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(6) The continuous audit causes inconvenience to the staff of the client while interim

audit does not.

Distinction between Interim Audit and Internal Audit

(1) Interim audit is done at any time during the course of the financial year, while

internal audit is a part of the normal administrative routine.

(2) In the case of interim audit, the auditor is an outsider, but internal auditors are the

officials of the concern itself.

(3) Interim audit is meant to check the accounts when accounts are prepared for the part

of the financial year as it has some interim purpose. Internal audit is a constant review

of the accounts which is carried on throughout the year.

(4) In interim audit, the work of audit is on a certain date in a year, but internal audit,

being a system of the accounting procedure, goes on continuously throughout the life

time of a concern.

(5) In the case of interim audit, the auditor has to submit his report, but such a question

of reporting does not arise in the case of internal audit.

(6) Interim audit is always subjected to need ie., it is conducted whenever there is some

interim purpose to be fulfilled, while internal audit is a part of the organizational and

administrative procedure of a concern.

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PREPARATION BEFORE AND PROCEDURE OF AUDIT

(Audit Programme)

"Modern Techniques require a new approach to the practical aspect of the auditor's work."

—Taylor and Perry

PRINCIPLES VS. TECHNIQUES

Audit principles are the basic rules and involve all those procedures . hich are

completed during the course of the examination. Techniques are the devices which are

adopted in applying these principles. For example, ; archases of raw materials is always a

revenue item as a matter of rinciple. The receipt of vouchers such as order, invoice, etc., and

verifica-n of their existence is a process and to check their correctness and uthenticity

becomes a technique ultimately.

Techniques of Audit

It is established that techniques of audit are the devices or methods "hrough which an

auditor proceeds in his work to obtain evidential matter. Some of such techniques are given

below:

(i) Vouching. An auditor examines documentary evidences relating to :he recording of

transactions in support and thus, checks the authenticity of such records.

(ii) Confirming. It is a technique with an auditor to contact responsible tficials through

interview and to open communication with the outside parties for ensuring that the

transactions are authentic, valid and accurate.

(iii) Reconciling. The differences in figures are reconciled and causes for their existence

are brought to light.

(iv) Analysing. The device or process of segregating any accounting :acts or figures is

known as analysing.

(v) Testing. This technique is applied to examine a large number of : ansactions by

selecting actual representative data with accuracy as far as possible.

(vi) Physical Examination. To examine actual existence of an item, personal inspection by

an auditor becomes absolutely essential.

(vii) Scanning. This implies a critical study or appraisal of the charac-- risties of data.

(viii) Verification of Posting. To establish propriety and consistency of different entries, the

records in the books from one source to another can be verified.

(ix) Footing. To test accuracy of total, the columns of different accounting figures can be

added.

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(x) Extension Verification. It implies multiplication of two or more amounts to test the

accuracy of total.

PREPARATION BEFORE AUDIT

How to prepare and proceed with audit is another pertinent question to be examined.

How much time should be devoted by an auditor in auditing the accounts of a business

concern will depend entirely upon the circumstances of a particular case and the training,

experience and knowledge of the auditor. This much is certain that the auditor must prepare

well before he actually conducts audit. His preparation will be decided by the scope of work

assigned to him and the method in which he will proceed. To examine the issue, we may

proceed step by step.

1. Scope of Work to be Determined

The scope of work will depend upon the terms of agreement entered into between him

and his client, or upon the conditions laid by the appointment letter issued to him. It is true

that if the auditor is to examine the accounts of a joint-stock company, he has to proceed and

prepare in accordance with the provisions of the Companies Act and as such, in such a case,

the question of any agreement does not arise. But in other cases, it is the client who decides

the extent of the work which the auditor has to perform with regard to the checking of

accounts.

Before determining exactly the scope of his duties, the auditor should discuss the

nature, purpose, etc., of audit which he has to conduct. If certain limitations have been

placed on his duties, he should thoroughly know them and note them carefully in his Audit

Note Book. This is very essential.

2. Knowledge about Business

Next, the auditor should try to acquire full knowledge of business and its affairs. For

this, he should proceed with the scrutiny of some important documents and procedures:

(1) He should go through the rules and regulations which make the business in question

run, e.g., Memorandum of Association, Articles of Association, etc., in case of a joint-

stock company and partnership agreement in case of a partnership firm. The study of

such basic and guiding documents can make him familiar with the working of a

business and hence, the thorough knowledge and study of these rules is highly

imperative for the auditor.

(2) Further, he should examine the method of maintaining accounts. It should be

remembered that different types of business-houses, e.g., banks, insurance companies,

joint-stock companies, cinema-houses, gas companies, educational institutions, etc.,

51

use different systems of keeping books of accounts. Hence, the auditor should make

himself familiar with the nature of business so that he can satisfy himself with regard

to the accounting system being satisfactory or otherwise.

(3) Next, he should ask for a list of books of accounts maintained and also the names of

clerks who are assigned the role of keeping them from his client. Apart from this, he

should obtain the names of the responsible officials who control the various branches

of work.

(4) The auditor should examine the system of internal check in operation. The efficacy

or otherwise of this system will help him in determining the main lines on which he

should conduct the audit. If the system is defective, there are chances of errors and

fraud in the books of accounts. A sound system of internal check can rninimize such

chances.

(5) Technical details about the business : To make the work of audit more meaningful

and effective, the auditor should fully acquaint himself with the technical nature of the

transactions recorded. Since no two businesses are alike in nature, he should acquire

the necessary knowledge of the business affairs.

(6) Lastly, it is also advisable for the auditor to go through the Profit and Loss Account

and Balance Sheet of the previous year and look into the various objections, if any,

raised by the auditor in his previous year's report.

This should especially be done if an auditor is appointed to supersede another auditor.

If necessary, the retiring auditor may be contacted.

3. Instructions to the Client

After having acquired an up-to-date knowledge of the affairs of a concern, the auditor

should ask the client to direct his staff with regard to the following :

(i) The books of accounts should be totalled up and trial balance and final accounts

should be kept ready.

(ii) All the vouchers should be serially arranged and filed.

(iii) The schedules of debtors and creditors should be prepared.

(iv) A list of bad and doubtful debts should be prepared.

(v) Similarly, a schedule of outstanding and prepaid expenses and accrued income should

be kept ready.

(vi) Stock-sheet indicating the method of valuation of stock should be drawn up.

(vii) A schedule of investments indicating their cost price and market price should be

prepared.

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(viii) A certified list of goods returned by different branches, agents and other similar

institutions should be made available at the time of audit.

(ix) A statement containing details about the permanent capital expenditure should be kept

ready.

(x) Similarly, a list of deferred revenue expenditure should be prepared.

(xi) A list of those documents to which the auditor will have the access should be

prepared.

(xii) Names and addresses of Managers and Managing Director should be kept ready for

submission to the auditor.

4. Preparation by the Auditor

Next, in the series of various steps to be taken by the auditor before he actually

begins audit of the business of his client is the preparation which he makes for himself. The

following are some of the important aspects of his preparation :

(a) Distribution of Work

The auditor should distribute the work and assign duties among his subordinates

according to their qualifications, experience and training. They can be of two types—senior

and junior. It is very necessary that the senior clerks should be assigned such duties as relate

to difficult and technical work and the junior ones in his staff should be given simple type of

work.

But, after all, it is the auditor who has to certify the accounts as correct and, as such,

he is ultimately responsible for all the actions of his subordinates. Hence, the preparation of

an auditor at this stage is of special significance.

(b) Audit Programme

Technically speaking, a audit programme is the auditor's plan of action. It presents an

outline of procedures to be followed to support an opinion on the financial statements. The

primary basis of preparing an audit programme is the system of internal check or control and

since no two internal control systems can be exactly alike, an audit programme will also vary

among clients and business firms. An auditor, therefore, will have to keep in mind a basic

programme which he would modify to fit the special circumstances of each case.

Modifications to the basic plan of action are based on the weaknesses inherent in the system

of internal check or control prevailing in a particular business.

53

"An audit programme is a detailed plan of the audit work to be performed, specifying

the procedures to be followed in verification of each item in the financial statements and

giving the estimated time required."

An audit programme is a written scheme prepared by the auditor to distribute work to

be followed during audit. The preparation of such a programme involves mainly three things :

(i) How much work is to be done?

(ii) Who is going to do a particular portion of the work?

(iii) What is the duration of time by which the work is to be finished? Thus, the idea

implied in the preparation of an audit programme is to ensure to the auditor a

complete grip over his staff including his juniors and seniors, the procedures to be

followed and the portions of work actually to be performed by each of them and by

himself. The work involved in the preparation of audit programme is usually done by

a senior clerk in his

As has already been indicated earlier, the division of work connected with the audit of

the business of the client should be based on one principle, le., work to be distributed

according to the qualifications, experience and training of clerks, juniors and seniors. Audit

programme makes each of them certain about the specific task one has to perform, i.e,.

everyone knows what he has to do and by what date each item is to be completed. Usually,

such a programme is prepared well in advance, though, of course, sometimes it may be

allowed to grow as the work progresses. But the first practice is definitely more useful.

A specimen of an audit programme is given on page 28.

Advantages of Audit Programme

1. Audit programme is prepared to locate exactly the responsibility of every clerk in the

auditor's staff. Thus, each one of them gets work according to his capacity.

2. The auditor can know about the progress of the work done by his staff.

3. Since the programme takes into consideration all the details involved in the work to

be followed during audit, no portion of the work is left from checking.

4. It increases the efficiency of his staff as in that case, possibility of errors and

negligence is rninimized.

5. In case a clerk goes on leave, the portion of the work where he has left can easily be

located and assigned to another clerk.

6. In case charges of negligence are made against the auditor, an audit programme serves

as evidence or work carried out by the auditor.

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7. It provides a sort of guidance to ensure that the whole work of audit has been properly

distributed and nothing has been omitted.

8. The work of audit can be done smoothly with uniformity and the auditor can proceed

well with the same set programme in subsequent audits.

9. With the help of audit programme, the work of audit can be completed in time quite

methodically and efficiently.

10. The audit programme after completion of work becomes a sort of progress chart and

the auditor can easily find out that the work has been completed as per his plan and

with its help, he can confidently proceed to sign the final audit report.

Disadvantages of Audit Programme

The following are the disadvantages of audit programme :

1. A written audit programme leaves no scope for creativity on the part of the staff

carrying it out with the result that audit work more often became mechanical in

nature.

2. As the requirements of every company vary a different audit programme is needed for

different companies and a uniform audit programme may not suit all the companies.

3. Inefficient audit staff may try to hide their incompetence behind rigid/fixed audit

programme giving plea that no specific instructions were issued to them.

4. In a ever changing dynamic environment, constant amendments and updations are

required in audit programme every year to meet the changing needs of client

companies.

Hence, to guard against the disadvantages, it is usually suggested that an audit

programme should be divided into two parts, viz.,

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(i) Work common to all types of audit; and

(ii) Work relating to a particular audit.

This will, therefore, leave some scope for modification to be made in be audit

programme whenever necessary. It is well said that "an audit gramme to be serviceable must

be elastic." A flexible programme can : ovide an opportunity for clerks to exercise their

intelligence and initiative, he programme should be prepared and made up-to-date in

accordance ith the nature and character of a business.

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Other Precautions

1. The audit programme should be amended or revised in accordance with the internal

control system to be reviewed from time to time and from arm to firm.

2. It should also be revised by the auditor if a new system or a new of action has been

adopted by his client.

3. The junior assistants should be consulted while preparing the audit pgogramme. They

should be given adequate encouragement.

4. A rigid and stereotyped programme should be avoided.

5. While using the audit programme by juniors or audit assistants, they should feel that

they have actually some discretion in practice.

c) Audit Files

An auditor is often simultaneously occupied with a number of audits. Moreover, he is

mostly bound to his office in order to control and co-ornate the activities of his staff working

at different places. Hence, it is cessary for him to maintain a record of each audit for ready

reference. Such record is maintained in files, called audit files.

Thus, there may be two types of audit files : (i) permanent audit file, I (ii) current

audit file. The permanent audit file contains the following matters :

1. The rules which govern the company or the organization under audit h as

Memorandum and Articles of Association in case of a company and partnership deed

in case of a partnership firm.

2. Copies of minutes and extracts of agreements which are entered into between the

client and others for rendering/obtaining services.

3. A brief description of the business, its nature, address, area of peration, etc.

4. Particulars about the organization of the business along with a list of officials,

branches and departments under their charge.

5. Copy of instructions, if any, issued to the staff and of relevance to he auditor.

6. List of books and registers and names of persons dealing with them.

7. Copies of audited financial statements of previous years. The Current Audit File

contains the following matters :

1. Audit programme duly amended and modified in accordance with the system of

internal control in use.

2. Internal control questionnaires.

3. Flow chart covering the time budget.

4. All relevant notes properly filed and indexed.

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5. Bank and petty cash reconciliations.

6. Brief notes for discussion with the client before completion of the work of audit.

7. Weaknesses inherent in the system of internal control.

8. The draft final accounts and Balance Sheet and their completed copies.

Advantages

1. It assists in the preparation of audit plan which paves a way for subsequent audit

engagements.

2. It is a useful file for the use of auditor who depends on it for forming an opinion about

the matters to be included in his report.

3. It is a ready reference for an auditor and provides different materials to be used in the

field work in audit engagement.

4. It provides information to an auditor who is asked by the client to suggest

improvement in business operations and system of accounting.

5. It maximises efficiency in auditing procedures.

(d) Audit Note-Book

Audit note-book is maintained by audit clerk. He keeps there in a record of his

observations during the course of any audit work. He also notes down the important points

and enquiries which he has to refer to the officials of his client or to discuss with his senior or

the auditor himself. Thus, the use of this book has become important to keep an exhaustive

record of enquiries made, replies received thereto, correspondence, etc.

Contents of an Audit Note-Book

1. Technical details about a business;

2. Queries for which explanations and information have to be demanded, e.g., missing

vouchers and invoices;

3. Fraud and errors found in the books during the course of audit;

4. Details which are to be included in the audit report;

5. Notes regarding the system of maintaining accounts;

6. Information to be needed in future;

7. Names of officials who certify bad debts, depreciation, etc;

8. Record of all important correspondence;

9. Totals of important ledger accounts;

10. Progress of audit work;

11. Record of suggestions made by the audit staff.

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Advantages

1. The auditor is enabled to record important points which arise during the course of his

audit lest he might forget these points.

2. He can produce this book as a documentary evidence in a suit filed against him for

negligence or misfeasance.

3. A note-book makes the work of audit convenient as all the important details about

audit can be recorded in this book and, as such, any change in the staff of the auditor

does not disturb or dislocate the work of audit.

4. Such a book can help in making an assessment of the knowledge, efficiency and work

of audit clerks.

5. It makes the procedures of subsequent audit more easy.

6. It provides a key to evaluate the efficiency of the audit staff. Thus, the proper use of

this book can be of great value for subsequent audits of the concern or of other

businesses. Actually, this serves as a guide i the audit staff.

Disadvantages

1. It develops a fault finding attitude in the minds of the audit staff.

2. It places too much reliance on the staff of the client for its preparation.

3. If an audit note-book is prepared negligently, the auditor can use it s an evidence of

negligence in the courts of law.

4. Very often, it creates misunderstanding between the client's staff and the audit staff.

(e) Audit Evidence

Audit evidence has got a wide coverage and has direct impact on the mind of an

auditor so as to enable him to judge the truthfulness of prepositions brought before him for

scrutiny and analysis. It is through e\idences that the auditor can form an opinion about the

financial affairs.

Several evidences are to be collected for each assertion made in the financial

statement. Such assertions are varied and are of various types meaning thereby that their

nature differs under different circumstances.

Such evidences are not only documentary evidences but may be in the : irm of

personal enquiries, observations, verifications and inspections. There may be two important

considerations for planning the method of btaining audit evidences which are :

(1) Types of evidence to be made available to the auditors;

(2) Means of getting such evidences.

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It is to be noted that the nature of evidences depends entirely upon the circumstances

of individual cases. In the absence of well-knit internal mtrol system, the need for proper

evidences becomes more imperative.

Kinds or Types of Audit Evidences

1. Physical verification or inspection : Physical inspection or verification is the best

rather the most effective evidence through which physical inspection of cash, tangible

assets, petty cash etc. can be easily made and heir existence with the business can be

ensured.

2. Statement by independent third parties : Statement made by a competent third party is

one of the strongest types of audit evidence. Such parties may be debtors, creditors,

solicitors of the company. Obviously, the amount of debtors can be confirmed by

obtaining statements from debtors. Such statements may be written or oral.

3. Authoritative documents : The documentary evidence is usually more reliable than

oral representations. The various documentary evidences are purchase invoices,

copies of sales invoices, petty cash, vouchers, contract deeds, receipts, receipts given

by payees, debit and credit notes, minutes of meetings etc. These authoritative

documents are considered to be the main sources of evidences. Some documents

prepared from outside the organisation may be considered reliable evidences but those

prepared inside the organisation are not always reliable. However, the auditor should

be alert and should exercise reasonable care and skill before considering those

documents for the purpose of audit.

4. Statements by officers and employees of the company under examination : The

statements given by officers and employees may be formal or informal. The auditor

should not place full reliance or the statements given by the officers and employees of

the organisation under audit. The employees who prepare accounts may conceal some

material facts. That auditor in case of suspicion may call for explanation and

clarification from officers of the organisation.

5. Calculation performed by the Auditor: The calculation performed by the auditor

forms a part of the evidence and in order to verify arithmetical accuracy of the

calculation that appears in the accounts he may be required to recalculate it. These re-

calculated figures must be recorded and may act as evidence when occasions warrant.

6. Satisfactory Internal Control Procedures : It is an important duty of the auditor to see

that the internal control procedure is functioning satisfactorily or not. If not, such a

system cannot be considered as an evidence of reliability. How far this system will be

60

reliable will depend upon the skill of the auditor who can appraise or evaluate the

system for his work.

7. Subsequent actions by the company under examination and by others : The

subsequent action by the company under exarnination constitutes a type of evidence

in the sense that the statement of fact by the company as to the events subsequent to

balance sheet date may materially affect the financial statement and auditor's report.

This is because the actual audit work starts after the end of the financial year. Thus

the statement of fact by the high officials of the company acts as an evidence which

can be relied by the auditor with "little fear of going astray".

8. Subsidiary or Detailed Records with an significant indication of irregularity :

Subsidiary or detailed records may be considered another type of evidence through

which certain amount of reliability relating to the different figures may be obtained.

Records like stores ledger if maintained properly and having no indication of

irregularity may appear to be the supporting evidence to the auditor.

9. Inter-relationship with other data : Sometimes accounting data can be inter-related,

with other data. The result arising out of the reconciliation of two figures may be

taken as an evidence in support of the transactions.

It is for the auditor to collect evidences with special care and knowledge. It is for him

to make out the real significance of an accounting data and evolve ways and means to prove

that an evidence is vital so far as the audit procedure is concerned.

(f) Audit Working Papers

Audit working papers are those papers and documents which consists of details about

accounts which are under audit. The auditor notes down certain important facts and details

about accounts in these papers. The objects of an auditor's working papers are to control the

current year's audit and to provide a base for the audit of the following year. It also aims at

providing detailed information about the accounts and business of the client.

The use of these papers is quite important as it helps the auditor to nake a reference to

these papers whenever needed while going over the counts of his client. Such details may be

the following :

1. Schedules of debtors and creditors;

2. Certificates of officials in regard to such important matters as bad debts, valuation of

stock, unpaid expenses, accrued income, etc.;

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3. Certificates issued by the banks in regard to the bank balance of the client on certain

date, safe custody of documents, etc.;

4. Correspondence between the auditor and the debtors, creditors, etc. of the client.

5. Rough trial balance;

6. Important extracts from the minute books;

7. Particulars of investment;

8. Draft final accounts;

9. A copy of the auditor's book.

Purposes of Working Papers

1. These papers represent the volume of work which has been per-rmed by the auditor

and his staff and hence, it becomes quite easy to raft and prepare a detailed audit

report.

2. The various minute details and aspects of the audit report can be ell substantiated on

the basis of findings summarized in the report.

3. The working papers become an asset for the auditor on the occasions "hen he has to

defend himself against the charges of negligence etc., levelled against him.

4. The auditor can co-ordinate and organize the work of audit clerks which the help of

working papers.

5. The auditor's detailed advice to his client in regard to improving the stem of internal

check and efficiency of the accounting system can be available to the client.

6. The working papers act as a guide to the auditor in subsequent examinations.

Audit working papers should be complete and concise and contain all •-he relevant

information in regard to accounts and audit. They should be properly arranged and preserved

for future reference. The auditors use these tpers in drafting their final audit reports and

hence, they become valuable for future audits too.

Characteristics of Good Working Papers

1. They should be complete in all respects. They should clearly reflect full information

and should not include any superfluous material. Only -sential data should be

contained therein so that they may be of utmost itility.

2. They should be properly organized and arranged. The proper arrangement of these

papers will also make them easily understandable to "hose concerned.

3. The working papers must contain accurate information.

4. There must be clarity in thought and expression : The clarity of ideas contained in the

working papers makes them self-explanatory and easily understandable.

62

5. The relevant details should always be kept in the working papers.

6. The audit working paper files should be properly preserved and filed.

Ownership of Working Papers, etc.

The working papers are highly confidential papers and, therefore, must be kept in safe

custody. As for the ownership of these papers, there has arisen a lot of controversy whether

these papers belong to the client or to the auditor. The former claims that since the auditor is

his agent, he has no lien on these papers. On the contrary, the auditor establishes his claim on

them on the ground that they are his property as he has collected the information for the

purpose of discharging his audit duties.

Actually, these papers come to the rescue of the auditor at a time when a suit has been

filed against him by his client for negligence or any other charge. These papers serve as an

evidence with the auditor to defend himself. Therefore, auditor should be considered as the

rightful custodian of working paper.

In the cases of Sockockocktnsky vs. Bright Grahm and Co. (1938) in England and

Chantrey Martin & Co. vs. Martin (London, 1953), the question was whether the auditors

had a right to retain the working papers as if it were their own property even after the

payment of the audit fee. It was held that the working papers belonged to the auditor and not

to the client.

PROCEDURE OF AUDIT

How to proceed with audit is another important issue. No hard and fast method of

audit can be laid down but it can be said that the auditor with his prudence, experience and

tact will decide himself as to how he will proceed with the work during audit and what

method he will actually adopt. It is true that the success of his mission will absolutely depend

upon his own skill.

1. Adoption of Distinctive Ticks

The auditor should use distinctive ticks of various colours while auditing the books of

accounts of a business. But a successful use of ticks involves a lot of care to be taken by the

auditor. The following are some of the safeguards against improper use of such ticks:

(i) He should use different types of ticks for different purposes, e.g., vouchings, postings,

additions, carry-forwards, etc.

(ii) He should issue clear instructions to the members of his staff that the use of these

different ticks should not be made known to the clerks of his client.

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(iii) While using ticks the auditor should have the pencils and inks of different colours in

his control.

(iv) Vouching should be entrusted to two clerks like this :

(a) The senior clerk should check the voucher and call out the amount given in it, and

(b) The junior clerk should compare the amount and place a tick against the item in the

Cash Book.

Some Other Important Considerations

(i) As far as possible, the work connected with the checking of a book should be finished

in one sitting. If it is not possible, its important totals, balances, etc., should be noted

in the audit note-book.

(ii) In case of continuous audit, the work of audit should be done upto a particular date.

Pencil figures should not be accepted.

(iii) The audit clerk is not expected to balance books. If he does so, he works as an

accountant and not as an auditor. Generally, in small business concerns, where there is

no accountant, the auditor has to balance the books.

2. Routine Checking

Whatever may be the size, constitution, and nature of activities and transactions of a

business, there are certain records and books which are rnmon to all types of business

organizations. The checking of such rnmon records and books which is carried on by the

auditor as a matter routine is known as routine checking in auditing. Routine checking

r.volves normally four types of functions :

(i) Checking of casts, subcasts, carry-forwards and other calculations in the books of

original entry;

(ii) Checking of postings into the ledger;

(iii) Checking of casts and balances of various accounts in the ledger; and

(iv) Checking of transfer of balances from the ledger to the trial balance.

Thus, routine checking can verify the arithmetical accuracy of the ntries made in the

books of accounts. It can help in checking castings and istings and, as such, can ensure that

no alterations are made in the figures after they have been checked and ticked accordingly.

Advantages

(i) The books of original entry can be thoroughly checked and the errors and fraud can be

easily detected.

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(ii) Postings (i.e., matters taken from records made in the books of original entry to the

ledger) can be checked.

(iii) The checking of castings and postings done in routine checking is the very basis upon

which the final results of audit depend. Hence, it helps in the checking of final

accounts ultimately.

(iv) It reveals the errors and fraud of a simple nature and helps in the verification of the

arithmetical accuracy of the entries.

Disadvantages

(i) Routine checking is practically a mechanical process and hence, it can cause

monotony to those who are entrusted with this task.

(ii) Only minor cases of fraud can be detected by routine checking. Major items of fraud

cannot be brought to light.

(iii) It is difficult to trace out compensating errors and errors of principle.

(iv) Routine checking is not always considered important in the audit of a business where

self-balancing system is used.

3. Test Checking (or Selective Verification)

Just to reduce the time cost involved in the audit of a big manufacturing concern in

which there are large number of transactions, an auditor usually adopts the technique of test

checking.

Test checking is a substitute for detailed checking. Here, an auditor, through a process

of sampling, selects a few items and if they are found correct, he presumes that the remaining

entries would also be correct likewise. Thus, test checking is based on a simple theme that "If

a representative number of transactions, so selected at random by the auditor for test

checking, is found to be correct, the remaining ones would also be correct."

Thus, the whole system of test checking implies selecting and checking only a few

selected transactions so as to enable the auditor to form his final judgment as to the whole set

of transactions.

As stated above, in applying 'test check', the selection of transactions is made by the

auditor at random and no specific principles are followed in it. The choice for adoption of

testing methods is fully dependent on the discretion and judgment of the auditor who will

depend on the situation of individual cases. The use of test checking is, however, dependent

upon the system of internal check in operation. If this system is satisfactory, test checking can

be of immense help to the auditor. But it should be kept in mind that if the system is reliable

65

and test check is applied but mistakes are detected, a thorough checking of books would

provide an answer. Thus, given an efficient system of internal check in operation, test

checking can reduce the volume of work involved in audit.

Test checking should be applied and carried out intelligently and carefully, otherwise,

it may lead to dangerous consequences. But much will depend on the system of internal

check and the intelligence of the auditor.

Safeguards for the Application of Test Checking

(i) As far as possible, representative or sample transactions should be selected from

every book or ledger covering the whole of the period under audit.

(ii) The selection of transactions should be distributed in such a way that the work of

almost all the clerks of the client is checked.

(iii) The selection of items should be made at random.

(iv) The entries pertaining to the first and the last months of a year should be thoroughly

checked as fraudulent manipulations are usually made during these months.

(v) Cash Book and Pass Book should be thoroughly checked.

(vi) No consultation should be made with the staff of the client when a selection of

transactions for test checking is made by the auditor. This is absolutely his job and he

should do it with perfect secrecy.

It is to be noted that there are no universally accepted percentage tables or rules for

selecting audit sample which is applicable to each type of test. However, the use of test

checking or audit sampling provides results which are the same by pure coincidence as would

have been obtained by 100 per cent examination of the various transactions. However,

statistical sampling is always preferable in the conduct of an audit to arbitrary sampling.

Advantages

(i) Test checking saves time and energy.

(ii) If the selection of transactions is done intelligently, test checking is useful and

purposive.

(iii) It can help the auditor to arrive at a definite conclusion in regard to the true and fair

view of the state of affairs of the concern.

(iv) It helps in reducing the cost of audit.

Disadvantages

(i) All the errors and fraud may not be detected.

(ii) The staff of the client may become careless because they know that their work will

not be checked in detail.

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(iii) There may be difficulty in determining the sample size and if sample is not

representative it may lead to misleading results.

(iv) It is of no use if proper and effective systems of checks and controls are not being

adopted in business.

(v) It is unsuitable for small business-houses.

4. Audit in Depth

Audit in depth implies a detailed and step by step examination of transactions through

its processes of the activity from origin to conclusion. In audit in depth, a comprehensive

checking is involved and selected transactions are examined after tracing all the links from

beginning to the end.

The main objective for such a checking is to complete the audit of accounts in a

shorter interval and thus, he can maintain the time target in his work. One of the main

advantages of selective verifications is to enable an auditor to carry ou^ audit in depth of the

selected transactions. Such a procedure can be adopted by an auditor where there is an

effective system of internal check in the business.

As an example, if purchase of a costly machinery is to be checked and as such,

purchase is subjected to audit in depth, the following steps will be taken by an auditor:

• to see the minutes of Directors' Meeting to examine that the purchase of machine has

been authorised or not.

• to inspect the copy of purchase order sent for the purchase of the machinery.

• to check the invoice received from the seller.

• to check and inspect the machinery purchased.

• to verify the amount paid to the seller.

• to verify the expenses incurred for the installation of machinery.

• to examine the entries made in the Books of Accounts and Plant Register.

This shows that in audit in depth, the auditor reviews all the accounting and

operational aspects of transactions from the beginning to the end. Thus, he can take an overall

view of the transaction and evaluates the procedures through selected transactions.

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INTERNAL CONTROL AND INTERNAL CHECK

"Internal control has been defined as being "not only internal check and internal

audit but the whole system of controls, financial and otherwise established by the

management in order to carry on the business of the company in an orderly manner,

safeguard its assets and secure as far as possible the accuracy and reliability of its records."

INTERNAL CONTROL

"Internal control is best regarded as indicating the whole system of controls, financial

and otherwise, established by the management in the conduct of a business, including internal

check, internal audit and other forms of control." —W. W. Bigg

"Internal control comprises the plan of organization and all of the co-ordinate methods

and measures adopted within a business to safeguard its assets, check the accuracy and

reliability of its accounting data, promote operational efficiency, and encourage adherence to

prescribed managerial policies." —American Institute of CPAs (1948)

But, now, the definition has been revised and divided into two parts—Administrative

Controls and Accounting Controls as given below :

Administrative Control includes, but is not limited to, the plan of organization and the

procedures and records that are concerned with the decision processes leading to

management's authorization of transactions. Such authorization is a management function

directly associated with the responsibility for achieving the objectives of the organization and

is the starting point for establishing accounting control of transactions.

Accounting Control comprises the plan of organization and the procedures and

records that are concerned with the safeguarding of assets and the reliability of financial

records and consequently are designed to provide reasonable assurance that:

(a) Transactions are executed in accordance with management's general or specific

authorization.

(b) Transactions are recorded as necessary (1) to permit preparation of financial

statements in conformity with generally accepted accounting principles or any other

criteria applicable to such statements and (2) to maintain accountability for assets.

(c) Access to assets is permitted in accordance with management's authorization.

(d) The recorded accountability for assets is compared with the existing assets at

reasonable intervals and appropriate action is taken with respect to any difference.1

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From the above definitions, it would be evident that internal control is a broad term

with a wide coverage. It means a number of checks and controls exercised in a business to

ensure its efficient and economic working. This, internal control involves a sort of vigilance

and direction over important matters like budget and finance, purchases and sales and internal

administration by the management; for example, in case of proprietary concern, such a

control would be exercised by the proprietor while in the case of partnership firm and a joint

stock company, it would come from the acting partners and directors respectively. Thus, it

may be stated that a system of internal control provides a measure for the management to

obtain information, protection and control which are quite important for the successful

working of a business organization.

Every business enterprise is expected to have a properly developed system of internal

control which may include accounts control, standard of cost control, budgetary control,

periodic operating reports, statistical analysis, personnel training programme and an internal

audit staff. It may also include other activities such as time and motion studies and quality

controls through inspection. Various other forms of administrative checks and controls are

sometimes included in the internal control system. In short, it can be said that a system of

internal control includes all those measures adopted by a business enterprise to fulfil the

following objectives:

1. To avoid waste, inefficiency and fraud and to keep intact its resources;

2. To attain highest type of accuracy and reliability in the maintaining of the accounts

and operating data;

3. To encourage and measure how far the policy of the business is being implemented;

4. To evaluate the efficiency of performance in all aspects of business activity; and

5. To provide aid in management planning.

Characteristics of Good Internal Control

1. There should be a well-developed plan of organization with delegation of proper

responsibilities at various levels of operational hierarchy.

2. There should be a scientifically developed system of record procedures with a view to

maintain proper controls over capital and revenue organization.

3. A system of healthy practices and traditions is also necessary for the performance of

duties and activities of various departments of the organization.

AICPA, Statements on Auditing Standards, No. 1, 1973, sections 320-27 and 320-28

4. The personnel engaged in the business should be of high quality and character with a

thorough understanding of their responsibilities and a proper background of training

69

and ability. After all, controls are exercised by the personnel engaged in the business

and qualified people can better make use of such controls.

Divisions of Internal Control

Every business enterprise is expected to have well-knit organization of internal

control system. Much depends upon the nature of business and the environments in which it

works. The main divisions of an overall internal control system cover : (a) general financial

control; (b) cash control; (c) employees' remuneration; (d) trading transactions; (e) stock

maintenance; (f) fixed assets; and (g) investments. The particular aspects of each must be

considered by management when planning the allocation and distribution of work among its

employees. These divisions are briefly discussed below :

(a) General Financial Control. This control includes a proper efficient system of

accounting, adequate supervision, recording and duplicating system, good efficient staff and

maintenance of staff relationships. Under this system, an adequate system of flow of

information to the management should be developed through returns and statements

submitted by the supervising staff. Healthy staff relations should be maintained so as to

ensure more efficient and effective working. It is true that due to the lack of harmonious staff

relationships, staff may leave for better prospects elsewhere and thus, impair the working of

the system. Staff turnover is injurious from the viewpoint of general financial control and

hence, adequate stress should be laid on their proper maintenance.

(b) Cash Control. This system includes certain important aspects of control for

receipts, payments and balances held. A proper system of internal check must operate at all

stages. There may be specially deputed officials including the internal audit staff who should

be made responsible to exercise checks at regular and irregular intervals. Due safeguards

should be exercised to avoid misappropriation of cash.

There are other aspects of control of funds and payments. Specific instructions should

be given to all the staff in writing in this regard. As for payments, the system of payment by

cheques is the best at all times and at all levels of business. At this stage also there should be

proper allocation of duties.

(c) Employees' Remuneration. There have been many cases of defalcation and

misappropriation of cash payments to be made to the employees. The system must cover all

sections of employees' remuneration and maintenance of records for remuneration, their

preparation and their methods of payment should be brought under tight control. This further

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requires issue of specific instructions to the staff in writing engaged in the various processes

of work connected with the employees' remuneration.

(d) Trading Transactions. These transactions pertain to the purchases, sales, etc. In

regard to purchases, effective procedures should be laid down for acquisition, handling of

goods and for accounting technique adopted for such goods. Similarly, a good system of

procedures should be devised for authorization, recording, handling and accounting of goods

sold. The weaknesses, if any, might lead to a great loss to the business and hence, the entire

system of control should be kept strictly under regular review and constant check.

(e) Stock Maintenance. Stocks of raw materials, work-in-progress and finished goods

should be properly maintained and accounted for. The flow of goods from outside to the store

and again, from the store to the processing part and vice-versa should be made under an

efficient control and supervision. The tasks and responsibilities connected therewith should

be clearly defined and fully allocated. Regular stock-taking procedures are quite helpful as

means of independent checks and reconciliation of records.

(f) Fixed Assets. Capital expenditure on fixed assets should be kept under strict check

and supervision. The authority right from sanctioning of capital expenditure to its use should

be clearly defined so that any sort of misappropriation by officials of the organization can be

reduced to the minimum. There may be cases of collusion with the contractee and proper

safeguards should be exercised at all stages.

(g) Investments. The procedures of control in regard to investments cover such

measures as authorization, recording of all transactions including the maintenance of records

of investments held and safeguarding of documents of title. The whole system of control

requires that written instructions should be issued to enforce rigidly the procedure of internal

control.

Internal Control and Auditor

The introduction of a well-developed system of internal control is the responsibility of

the management. But it is a matter of concern for the auditor though he has no authority to

recommend and prescribe that certain rules and procedures should be adopted by the

business. He can simply guide and help if he is required to do so. What is expected from him

is that he must possess an expert's knowledge of such procedures. In the second standard of

field work set out by the AICPA, it is made clear that "there is to be a proper study and

evaluation of the existing internal control as a basis for reliance thereon and for the

determination of the resultant extent of the tests to which auditing procedures are to be

restricted."1 Thus, the aim behind the study of internal control by an auditor is to establish a

71

basis for reliance on the system of this control so as to enable him to assess the extent to

which he should apply tests during the course of audit.

This is much certain that if there is a good system of internal control, the work of an

auditor becomes quite easy. He can very conveniently rely on test checking. However, it

depends upon special circumstances of a particular case as to how far internal control would

be helpful in the audit

AICPA, Statement of Auditing Standards, No. 1, 1973, sections 320-321.

work. The following points would be helpful in screening the internal control system:

1. Study of accounting routine, its weaknesses and sources from which they would arise;

2. Financial powers vested in the various officials and the circumstances in which they

are to be used;

3. Study of limits of inspection over financial and other accounting duties;

4. Whether some mechanical appliances are used to prevent any defalcation of cash, etc.;

and

5. Whether any device of checks and balances is used to measure the success of

accounting methods of techniques.

The auditor can be in a position to perform audit efficiently provided that there is a

good and effective internal control system in use. However, it does not mean that he can take

shelter under the system and shirk to his duties. The entire responsibility is his and there is

nothing to protect him if he does his work carelessly and with negligence.

It is to be noted in this connection that the audit should impose the most rigorous

possible examination on the systems of internal control and should cover every aspect of the

administration from the purchasing procedure to the control of sales invoices and despatch of

goods. For this, the work of audit should be arranged in such a way that the system is checked

at the same time when the books and records are verified.

Under the provisions of the Manufacturing and Other Companies (Auditor's Report)

Order, 1988, it is now obligatory for a company auditor to ensure that there is an adequate

internal control procedure commensurate with the size of the company and the nature of its

business, for the purchase of stores, raw materials including components, plant and

machinery, equipments and other assets, and for the sale of goods.

Basic Principles of Internal Control

There are certain organizational devices which are considered important as basic

principles of internal control system. It is to be noted that :

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(1) Practically the physical handling of an asset should be separated from the accounting

work which should be done by a separate hand. The collusion between a person

handling an asset and another performing accounting work in relation thereto should

be avoided.

(2) The work should be so divided between persons that the work done by one is checked

by another.

Thus, the result expected from the work done and the check thereof can form a basis

for the reliability of records and reports maintained in the business. This practice is sound in

the sense that what one does can be compared well with the results obtained by another.

Internal Control Questionnaire (I.C.Q.)

The internal control questionnaire (I.C.Q.) is a series of questions which are prepared

by the auditor to test the adequacy or otherwise of the system of internal control adopted in

an organization. Such a questionnaire can be used by the auditor for all clients, small or big,

and it varies according to the requirements of each client.

I.C.Q. should contain sets of questions for different transactions in a business-house

and the answers to the questions contained in I.C.Q. will provide a clue for an auditor to

judge the adequacy or otherwise of the system. In other words, if the answers are positive, the

system of control would be deemed to be satisfactory. If otherwise, Le., the answers being

negative, the system would be presumed to be inadequate. However, much will depend upon

enquiries or further enquiries to arrive at a right decision about adequacy or otherwise of the

system.

It is evident that an auditor can use short-cut methods at his own risk, of course, such

as test checks or random sampling. It is his own discretion and nobody can question it. But

such an I.C.Q. with full observations should be kept by the auditor in his permanent file for

future reference.

The following points should be noted by an auditor while making use of internal

control questionnaire :

1. The I.C.Q. should be revised and reviewed every year so as to make it more effective

and up-to-date. This is very necessary because there may be questions which have

become out of date due to changes which have been brought about in the working of

the organization.

2. The efforts should be directed towards making the questionnaire complete in all

respects. There might be changes in the economic and commercial laws and also due

73

to legal requirements for which a revision of questions given in the I.C.Q. would be

necessary. Such changes should be made regularly.

3. The I.C.Q. also helps the auditor to advance some good and valid suggestions to the

client from time to time. It is certain that the answers to the questions in the I.C.Q.

would reveal some concrete weaknesses in the system and on their basis, suggestions

can be given to the client so as to enable him to improve the working of the

organization and make it more effective.

4. The I.C.Q. has got a close relationship with the audit programme. An auditor can

prepare a detailed audit programme if he finds that the internal control system is

defective and the working of the organization is faulty. He can also rely on the system

to a reasonable extent depending upon the positive or negative answers to the

questions given in the internal control questionnaire.

INTERNAL CHECK

In business-nouses, the work connected with the preparation and maintenance of

accounts is distributed amongst the various members of the staff in accordance with their

distinctive qualifications. One person enters transactions in the books, while others perform

tasks relating to posting, handling cash and entering cash transactions into the Cash Book.

Besides these, duties pertaining to writing up Purchases Book and its postings are not

entrusted to a single person. These are some of the examples which substantiate the argument

that different duties are assigned to different hands.

The reason is quite simple. If only one person is made responsible to finish up a

particular work from the beginning to the end, there is enough scope for errors and fraud

creeping into the books of accounts. The possibility of frauds can arise only when there is a

collusion between the clerks. Such situations will have to be avoided to ensure a clean and

efficient recording of business transactions.

Besides this, it is also kept in mind at the time of distributing the work that changes

should be made in the assignments and responsibilities as and when needed. By doing so the

work of one person is automatically checked by another and errors, fraud and irregularities

can easily be detected. The result is that the efficiency of the business increases in the long-

run.

This is a system of internal check which is based on the principle of division of

labour. It is certain that if the system of internal check is good and efficient, the possibility of

74

errors or fraud or irregularity will be minimized and the business can enjoy the benefit of

division of labour and of specialization also.

De Paula has rightly said that "an internal check means practically a continuous

internal audit carried on by the staff itself by means of which the work of each individual is

independently checked by other members of the staff." The system provides for an

independent and automatic scrutiny along with the work assignment. The method involves

mainly four things, viz. :

(i) That the work is properly divided in such a way that all the duties are assigned to

different clerks.

(ii) That the clerks get the work-load according to their capacities and qualifications.

(iii) That one person does not perform any single task from the beginning to the end.

(iv) That the work done by one clerk is checked independently and automatically by

another.

For example, if in a big business the number of labourers is large and six clerks are

needed to maintain records of their attendance, to prepare Wage Sheets and to make payment

of wages, Le., two clerks to perform the job connected with each of these three functions.

Thus, two persons are made responsible separately for doing the job connected with such of

the three functions in regard to wage payment.

There may be two ways of doing it :

(i) either one-third of the work connected with all the three portions of work relating to

wages may be performed by two persons; or

(ii) for every portion of this work, Le., maintenance of wage records, preparation of Wage

Sheets and the payment of wages, two persons may be made responsible.

It means that two clerks should maintain records, another set of two clerks should

prepare Wage Sheets and the remaining two clerks should arrange for the payment of wages.

Out of these two arrangements quoted above, the first one is defective as it provides

scope of collusion between two persons when they have to perform one-third portion of the

work from the beginning to the end. They can adopt malpractices and commit irregularities

by showing dummy names of workers in the Wage Sheets or by making extra payment to the

workers for the time which they have not devoted to the business or for work they have not

done.

But the second device is more reliable and efficient as in this case the whole of the

work is suitably and rationally divided and there is no possibility for fraud as the work

involved in each portion can be checked by the clerks. The whole arrangement is made in

75

such a way that the work and its checking are carried on independently. The division of work

on this basis is known as a system of internal check.

Hence, internal check is an arrangement of duties in a business done in such a way

that all the duties connected with the accounting work are properly allocated so that one

person may not be in a position to pursue single job from the beginning to the end and along

with this, the work of one person may be checked automatically and independently by

another.

Objects of Internal Check

(1) To allocate duties and responsibilities of every clerk in such a way that he may be

held responsible for a particular error or fraud;

(2) To minimize the possibilities of errors, fraud or irregularities;

(3) To detect errors or fraud easily if it is committed, as in an efficient system of internal

check there is provision for independent checking;

(4) To enhance the efficiency of clerks in a business as the assignment of duties is based

on the principle of division of labour;

(5) To distribute work in such a way that no business transaction is left from recording;

(6) To prepare final accounts with ease and efficiency as an efficient system of internal

check can make accounts more regular and reliable; and

(7) To exercise moral pressure over staff.

Internal Check and Internal Audit

There is a tot of difference between internal check and internal audit. In internal audit,

a batch of employees known as internal auditors is engaged to check the records of day-to-

day transactions while in internal check, the work and its checking go together.

Points of Distinction

(1) Internal check is an arrangement of duties allocated in such a way that the work of

one clerk is automatically checked by another while internal audit is an independent

review of operations and records undertaken by the staff specially appointed for the

purpose.

(2) In internal audit, a separate salaried staff of internal auditors is engaged to carry on

the independent appraisal of activities within a business. Their job is to audit the

financial records and operations from time to time. But in internal check, there is no

separate staff appointed especially for this purpose. Different clerks of a business are

76

allocated their assignments with which they proceed and carry on checking at the

same time.

(3) In internal audit the work of a clerk is checked by an internal auditor after the

former has finished the work while in the case of internal check, the work is so

distributed that the work of one clerk is automatically and independently checked by

another simultaneously.

(4) In internal audit, errors and fraud which have already been eornmitted can be

discovered but the system of internal check is so devised hat the possibilities of

errors and fraud or irregularities are reduced to the minimum.

(5) The work involved in internal audit is just like that of a watchman. The internal

auditor has to see how far the work of the business is being done Drrectly and

according to rules prescribed for the purpose. A system of internal heck is a process

in itself under which the work goes on uninterruptedly and becking, too, is more or

less automatic.

(6) Both internal audit and internal check are two important organs of a -stem of internal

control and as such, both are complementary and go together.

Virtually, the management adopts the system of internal audit to nsure that the

existing system of internal control is adequate and effective; mat the financial records reveal

the results of business operations and mnsactions correctly and all the units of the

organization follow the licies and practices framed and laid down by the management. Thus,

the stem of internal check is a device for doing work while internal audit is xpected to check

it in the light of policies and procedures laid down by the management.

Fundamental Principles of Internal Check

The following are some important rules of making the system of iternal check

efficient and successful, (a) General

(1) The work of the business should be allocated amongst various erks that their duties,

rights and responsibilities may be clearly and judiciously divided and there may not

be left any room for interference.

(2) The distribution of work should be so done that no single person - allowed to do a job

solely by himself from the beginning to the end.

(3) One person should be entrusted with the similar nature of work. It Is necessary for

efficiency and specialization.

77

(4) It is also necessary that no clerk should be engaged on particular b for long. Change in

duties would become essential but it will absolutely "pend upon the circumstances

prevailing before a business. Nevertheless, such a change in duties should be made

without making it known to those concerned.

(5) An efficient system of internal check must provide for an automatic : necking of the

work of an assistant by another.

(6) The division of work should not be expensive.

(7) No clerk of the business should be relied upon too much.

(8) For making the system of internal check efficient and successful, se of self-balancing

system should be invariably made.

(9) Labour-saving devices, as cash register, calculating machines, time recording clocks,

etc., should be made use of.

(10) There should be a proper system of filing vouchers, rrespondence, etc., in the

business.

(b) Those Relating to Specific Jobs

(11) A responsible official should be made responsible for receiving letters, etc. All

important letters, registered envelopes and money orders should be entered in a proper

register and then passed on to the clerks concerned.

(12) All the cash received should be sent daily to the bank.

(13) Persons dealing with cash, securities, cheques, etc., should be compelled to take

annual holidays in unbroken periods.

(14) Purchase, receipt and issue of goods should always be done under strict supervision

and control. No one should be permitted to take away any goods without proper

sanction.

(15) Jobs relating to bad debts, allowances, returns etc., should be performed under strict

control.

(16) It should be seen that some responsible person is assigned the task of dealing and

corresponding with the debtors and creditors of the business.

(17) Important work like payment of wages, valuation of stock, sales, etc., should be done

under strict supervision and control.

Advantages of Internal Check

(a) For the Business Itself

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(1) Internal check entails a proper and rational distribution of work between the members

of the staff of a business and hence, their duties can be determined precisely.

(2) It helps in the detection and discovery of errors and fraud.

(3) Besides, the possibilities of the commission of errors and fraud can be minimized.

(4) A good system of internal check increases the efficiency of work in a business as the

clerks do their jobs carefully and cautiously.

(5) The efficient work resulting from efficient operation of internal check enables the

staff to prepare the final accounts with ease and quickness.

(6) Since the whole system of internal check is based on the principles of division of

labour and specialization, a moral check is exercised on the clerks of business and this

leads towards more efficient and economic operation.

(b) For the Auditor

(7) If there is a good and efficient system of internal check, the auditor may rely upon it

and may not feel the necessity of making detailed checking of the accounts.

(8) The auditor may apply a few tests here and there very conveniently. He has to look to

the shortcomings and defects inherent in the system and then take a decision as to

what extent he can rely on it and apply tests.

(c) For the Owner

(9) If there is a good internal check system, the owner may rely upon the genuineness and

accuracy of the accounts.

(10) If his business is run with an efficient system of internal check, • becomes a more

efficient, economical and profit-yielding venture. The st of production thus reduced

can also be to his advantage.

Disadvantages of Internal Check

(1) The clerks of a business become quick and not so serious as they ught to have been.

(2) The possibility of some of the responsible and high officials being areless increases as

they feel a sort of over-confidence that the work is atomatically going on efficiently.

(3) Internal check may be quite expensive, especially for small usiness-houses.

(4) If the whole system is not properly organized, it may create chaos and disorder in the

working of a business.

(5) The work of the auditor cannot be free from irregularities if the system is itself

defective.

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To provide a safeguard against its disadvantages, it is essential that the system of

internal check should be adopted very cautiously and arefully. Nobody can gainsay the fact

that the system is of vital significance •r the efficient running of a business.

Internal Check and Auditor

To what extent should an auditor rely on the internal check system? This is a big

question which will depend upon the magnitude of a business. It is true that an efficient

system of internal check can make his work easy and convenient. He should first of all

examine the system of internal check, keeping in view the following points :

(1) He should call for a brief statement from his client in regard to the system of internal

check in operation.

(2) He should examine the system in the light of the size and nature of the business to

ensure how far the system can be good and efficient.

(3) Lastly, he should see how far the system has possibilities of errors and fraud and

whether the system is totally or partially unreliable.

Normally, these tests can help him in making a real assessment of the internal check

system and if it is not defective, the auditor can depend upon it. What is needed is that he

should examine the system carefully and work with prudence and caution. It is, of course,

true that a good system can be of much help to him.

But if, on the contrary, the system is defective and has some weaknesses to arouse his

suspicion, he should not presume that every thing is alright. He should carry on a detailed

checking of the books of accounts. The defects inherent in such a system can point to the

directions in which chances of errors and fraud exist. If the auditor does not care for these

shortcomings and fail to detect an irregularity, he will be held responsible. But, if the client

so likes, he may seek advice from the auditor to make improvements in the system. If the

client does not follow the advice and defects are found in the accounting system, the auditor

should mention this fact in his report.

Can a good internal check system reduce the liability of an auditof?

The answer is, quite obvious, "No, never." The existence of such an efficient system

of internal check can reduce to a great extent the work of the auditor but does not in the least

reduce his liability. But if the system is full of defects, his work becomes difficult. Whatever

the situation, the entire responsibility is his alone. He cannot be relieved of his liability on the

ground that since the system of internal check was good, he did not perform a particular

function. This is no argument. Thus, a good and efficient system of internal check is of much

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help to him but is in no way a device to relieve him of his liabilities and responsibilities. To

what extent should he depend upon the system will depend upon the circumstances of each

particular case and his own skill, experience and training.

Internal Check as regards Cash

INTERNAL CONTROL AND INTERNAL CHECK

Can a good internal check system reduce the liability of an auditof?

The answer is, quite obvious, "No, never." The existence of such an efficient system

of internal check can reduce to a great extent the work of the auditor but does not in the least

reduce his liability. But if the system is full of defects, his work becomes difficult. Whatever

the situation, the entire responsibility is his alone. He cannot be relieved of his liability on the

ground that since the system of internal check was good, he did not perform a particular

function. This is no argument. Thus, a good and efficient system of internal check is of much

help to him but is in no way a device to relieve him of his liabilities and responsibilities. To

what extent should he depend upon the system will depend upon the circumstances of each

particular case and his own skill, experience and training.

Internal Check as regards Cash

(1) There should be a separate clerk known as cashier to deal with the receipts of cash. As

soon as cash is received, it should be entered in a rough cash book or diary. He should

not be authorized to keep cash with him, to make expenditure out of it and to make

entries in the ledger and other books of prime entry.

(2) All remittances should be opened by the cashier in the presence of a responsible

officer who is not connected with the office of the cashier, and should be crossed

immediately by means of a rubber stamp as 'Not negotiable—A/c Payee only'.

(3) All receipts should be banked daily. It is also necessary that from time to time, bank

reconciliation statements should be prepared to reconcile bank and cash balances.

(4) The counterfoil portion of the paying-in-slip should be filled up by the clerk who

marks out the counterfoil receipts and the portion which is to be retained by the bank

should be filled in by the cashier.

(5) There should be a separate person to take money to the bank and he should not be

connected with the cash transactions.

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(6) The receipts which are issued for remittances received should be printed and

numbered serially. They should not be prepared by someone who is connected with

entering remittances in the rough cash book or diary.

(7) The debtors or institutions from whom cash is received should be advised to collect

proper receipts from the head office. They should also be directed to send payments

through crossed cheques.

(8) Spoiled receipts should be cancelled and must not be detached from the counterfoils

or totally removed from the receipt book. If some alteration is made in the receipt

already written, it should be properly initialled.

(9) While entering receipts in the cash book, it is a good practice to enter in it the relevant

receipt numbers. This makes checking in future quite convenient.

(10) The unused receipt books should be kept in safe custody under lock and key.

(11) A proper system of affecting and recording cash sales should be in operation under

proper control and supervision.

(b) Cash Sales

In big business-houses where daily transactions of cash sales are larger in number,

there are many chances of fraud and irregularities. Unless there is a good system of internal

check, the auditor finds a great difficulty in detecting errors and fraud. There may be three

types of sales:

1. Sales at Counter,

2. Sales by Travelling Agents, and

3. Postal Sales.

1. Sales at Counter

Generally, big businesses employ a set of assistants to deal with daily cash sales, and

tools like cash register, etc., are also usefully employed. The following procedure may be of

great use in regard to cash sales :

(i) The salesman is in charge of making sales. A specific number or word may be allotted

to every salesman.

(ii) Every salesman is given a separate book containing blank copies of cash memo. Such

books are of different colours for different departments.

(iii) The salesman sells goods to a customer and prepares three copies of the cash memo.

(iv) These copies are checked by another official sitting nearby, and are, then, signed by

the salesman.

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(v) Two copies of the cash memo are handed over to the customer to whom the goods

have been sold. He is instructed to pay cash to the cashier.

(vi) The customer goes to the cashier and hands over the two copies of the cash memo.

The cashier after having received the price of goods, hands over the goods and a copy

of the cash memo duly stamped as 'cash paid'.

(vii) Sometimes, goods are handed over to the customer by the gatekeeper after showing

his copy of the cash memo. But in such a case, four copies of the cash memo are

prepared and the fourth copy is retained by the gate-keeper.

This is the daily routine. At the end of the day, the salesman, the cashier and the gate-

keeper (if four copies of the cash memo are prepared) prepare summaries and send them to

the General Manager or the officer-in-charge. The salesman's summary reveals the quantity

and value of the goods sold and that of the cashier shows the cash collections and the gate-

keeper's summary reveals the goods delivered during the day. If these summaries tally, the

accounts are certified as correct. The cash received is sent to the bank, and the statements to

the Accounts Department. In case of any discrepancy, it shows some fraud being committed

by someone of those responsible for making cash sales.

Such a system of internal check can reduce the chances of errors and .raud in regard

to cash sales.

2. Sales by Travelling Agents

There is practice in big business-houses to engage travelling agents to push sales and

to collect debts. These travellers collect debts from old customers and accept advances from

the new ones. A good system of control over these agents may be like this :

(i) The agents should be authorized to issue rough receipts to the customers for cash

received and they should be instructed to acquire receipts from the head office.

(ii) The customers should also be told that if they do not get properly authorized receipts

from the head office, they should make correspondence to the head office direct.

(iii) These agents should be instructed to remit the entire cash to the head office. They

should not be allowed to deduct their commission or any other expenditure out of it.

They should charge for these expenses directly from the head office.

(iv) The head office should send, as a matter of routine, statements to old debtors and

customers so as to appraise them of their debts and balances.

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(v) The agents or salesman should invariably send statements showing the names of

defaulters and make correspondence with the head office in this regard.

(vi) These agents should also be transferred to other places or areas. This is necessary for

increasing their efficiency and avoiding fraud.

3. Postal Sales

(i) A separate register should be maintained for recording sales made by post or V.P.P.

(ii) The goods returned should also be entered in this register.

(iii) Receipts of cash on this account should be entered in the V.P.P. Register.

(iv) A responsible officer should be deputed to check carefully the V.P.P. Register and the

goods for which cash has not been received should be especially audited.

(v) In this connection, Cash Book and orders received should also be checked. Orders

received should be properly filed.

(c) Payments

(1) A good system of internal check is one in which a separate person has charge of

making payments. He should have no connection with the receipt of cash.

(2) Petty cash payments should be made by the petty cashier.

(3) All payments should be made by cheque, with the exception of those dealt with

through petty cash. As far as possible, cheques should be made payable to order and

crossed before they are sent out.

(4) Proper regulations should be in force for checking invoices and other relevant

correspondence before cheques are prepared. Such vouchers should be stamped 'paid'

before the cheques are signed.

(5) The bill for which payment is to be made should not be used for sanction but a

separate paper, sanction should be attached to the bill and on this paper, sanction

should be taken from the proper authority.

(6) All cheques and bills should be scrutinized and signed by the proper authority.

(7) Strict regulations should be in force to sanction payments of a special nature. Such a

work should be entrusted to directors or high officers. It is also a good practice if

cheques involving heavy amounts are signed by more than one responsible person.

(8) Confirmation of accounts with the creditors should be made through direct

correspondence.

(9) Bank Reconciliation Statements should be prepared to reconcile bank and cash

balances from time to time.

(10) Petty cash payment should be kept under proper control.

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(11) A proper system should be in operation for the payment of wages, (d) Petty Expenses

(1) The petty cash book should be kept on the imprest system. The necessary amount,

which should be as low as possible, should be handed over to the petty cashier every

month.

(2) Petty cash expenses should be entered on the basis of proper vouchers. The items for

which vouchers cannot be had should be supported by statements signed by some

responsible officer.

(3) All vouchers should be serially filed.

(4) The cashier should check the petty cash at frequent intervals.

(5) The petty cashier is charged with making petty cash payments and maintaining

records thereof. Hence, he should not be allowed to lend money or incur any other

type of expenditure.

Internal Check as regards Wages

In businesses where the number ov workers is large, the work connected with the

maintenance of wage records and payment of wages is of much importance. There are many

possibilities of misappropriation of cash under this item. Unless there is an efficient system of

internal check in operation as regards wages, the auditor cannot satisfactorily check entries

connected with wages. The auditor should at the first instance satisfy himself with the

arrangement for the preparation of Wage Sheets. If there are some shortcomings, he must

disown his liability. The following may be the chances of errors or fraud :

(1) The time records may be incorrect and incomplete and as a result, workers get wages

for the period for which they have not worked.

(2) Similarly, the piece-wage records may be incomplete and incorrect and workers may

get wages for the work which they have not done.

(3) Chances of clerical errors in the preparation of Wage- Sheets.

(4) Inclusion of fictitious names of 'dummy' or 'ghost' workers in the Wage Sheets.

The whole system of internal check may be kept as given :

Internal Check as regards Wages

(1) Maintenance of Wage Records

(2) Preparation of Wage Sheets

(3) Payment of Wages

Time Records

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Piece-work Records

Overtime Records

Pass-out Records

Time Recording Clock

Use of Tokens

Attendance Cards

1. Maintenance of Wage Records

(a) Time Records. Wages may be paid to the workers according to the time spent by

them. It is necessary that correct records should be maintained with regard to the time

devoted by them in the factory.

Some general rules may be as follows:

(i) A separate wage department should be set-up under a responsible officer.

(ii) For each worker, a Record Card should be used and on this card, details about him

should be shown.

(iii) Rates of wages and alterations, if any, should all be in writing and duly authorized.

(iv) For recording time, different devices may be used.

Time Recording Clock. When a worker enters the gate of a factory, he puts his card in

the slot of the clock. The date and time of his entry are recorded on this card. Similarly, he

gets the time and date recorded on the card when he leaves the factory. Thus, the card

provides a correct and clear record of the time spent by a worker in the factory.

Use of Tokens. This is not a much popular device for maintaining time records. Under

this system, a token, duly numbered is issued to each worker who keeps it hanging on the

board meant for the purpose when he enters the factory and the time-keeper records his

attendance in the attendance register.

Attendance Cards. In some business houses, attendance cards are used. When a

worker enters the works, he drops his card in the box meant for the purpose and the gate-

keeper records his attendance in the Attendance Register. This can also be done without using

Attendance Cards.

Similarly, the time of entering or leaving the works is also recorded usually by the

foreman of the department in which a worker works. These two records, i.e., the one

maintained by the gate-keeper and the other kept by the foreman, are then compared. Thus,

errors and fraud can be avoided but all this should be done under proper supervision and

control.

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(b) Piece-work Records. When wages are paid according to the actual work

performed by a worker, there should be a good system to maintain records. A card known as

Job Card or piece-worker's card is given to each such worker. The amount of work done by a

worker is recorded on this card which is signed by the worker, foreman of the department

and, where possible, by the stock-keeper to whom the-goods produced are to be delivered.

Sometimes, in place of the foreman, the viewer has to sign the card.

In certain organizations a separate register is kept to maintain the records along with

the use of Job Cards.

(c) Overtime Records. No worker should be allowed to work overtime unless he is

properly authorized to do so by some responsible officer. An overtime slip is issued to each

worker on which details about his name, address, duty, etc. are given. When he works

overtime, it should be recorded on the overtime slip. It should be noted that overtime records

should be separately maintained and passed by the foreman and also by the works manager.

(d) Pass-out Records. Sometimes, a worker goes out of the factory on his personal

work during working hours. He should not be allowed to go out without the permission of the

foreman or of the works manager. Two copies of pass-out slips may be prepared—one for the

gate-keeper and the other for the foreman and the second one should be sent to the wages

department for record. The nature of work should clearly be mentioned in the slip.

2. Preparation of Wage Sheets

How to prepare Wage Sheets is another important work connected with wages. As

quoted already, information regarding attendance, etc., can be had from the Attendance

Register, Job Cards or Piece-worker's Cards, Piece-work Register, Overtime Slip, Pass-out

slips, etc., and on their basis, Wage Sheets can be prepared.

The work entailed in the preparation of Wage Sheets should normally be divided into

four portions to be done by clerks in the wage office or department, e.g.,

(1) Two Clerks to examine the time and piece-wage records, overtime records, statements

received from the foreman, etc., so that irregularities if any, may be removed.

(2) Third Clerk to fill in the names and addresses of workers, rates of wages, attendance,

gross amount of wages, etc.

(3) Fourth Clerk to check the work done already and to calculate the net amount of wages

after making the deductions pertaining to rent, tax. insurance, etc.

(4) Fifth Clerk to check the whole work thoroughly.

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(5) All these clerks should perform their jobs and sign the sheets which should be

certified as correct and signed by some responsible officer, such as Director,

Manager, etc.

(6) Such Wage Sheets can be prepared for both types of wages, time as well as piece-

wages.

The gross wage consists of the basic pay, piece-work or other bonus and overtime. It

is to be noted in particular :

(1) The basic wage should be checked for a number of employees several times each year

by verifying the number of hours actually worked and calculating them on the basic

rate.

(2) Overtime payments should be carefully attended to. Such payments should be

authorized by the head of the department and be duly supported by relevant overtime

slips.

(3) The wage sheets are generally prepared as individual pay rolls but if there are group

pay rolls in which earnings depend on the group productive performance, such sheets

should be signed by the foremen or the charge head of the department.

3. Payment of Wages

The Wage Sheets should then be passed over to the Cashier who has not been

associated with their preparation. The Cashier should withdraw the necessary sum as shown

by the Wage Sheets under the column 'Net Wages'. After the amount has been withdrawn, the

following procedure may be adopted to avoid a fraud or irregularity in payment:

(1) The clerks who were associated with the preparation of Wage Sheets should not take

part in the payment of wages to avoid collusion between two or more persons.

(2) The use of envelopes [le., pay packets) indicating the names of workers and amounts

contained therein can be a suitable device for making payments.

(3) All workers who are to receive wages should be present at the time of payment.

(4) The foreman of each department should be present at the time of payment to prevent

any sort of impersonation for workers who are absent.

(5) Proper precaution should be taken to make payments to workers who become absent

at this time. In such cases, payment may be made on the basis of a letter of authority

brought by a worker who is present.

(6) Generally, it is not possible to obtain the signature of each worker on the Wage

Sheets. Hence, the payment should be attested by those present, e.g., the foreman, the

works manager and the cashier.

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(7) The payment of wages to casual labour present problems. A separate list of such

workers should be prepared and the payment should be made in the presence of a

responsible officer. To avoid fraud, the officer employing casual labour should not be

connected with the payment of wages.

A separate department for credit purchases is usually maintained in Ibusiness-houses.

This efficiency of such a department depends upon its policy of purchasing best goods at the

cheapest price. The Purchases Department should function separately and its work should be

sub-divided between small departments, each of which should be headed by a responsible

officer. To facilitate its operation, the whole work connected with purchases may be divided

into five heads :

1. Assessment of Requirements,

2. Enquiry,

3. Placing Orders,

4. Receipt of Goods, and

5. Recording and Making Payments.

1. Assessment of Requirements

This is the first important job to assess requirements of goods. Requisition Books

should be issued to the various departments of a concern. The head of the department which

is in need of goods should fill in a requisition slip duly signed and then send it to the

Purchase Department. The details about the quantity, quality, the price (if it can be quoted)

and the time by which goods must be supplied, should be entered in the requisition slip. On

receipt of similar requisition slips from the various departments, the Purchase Department

can know exactiy the volume of requirements of different goods to be purchased.

2. Enquiry

Then, the Purchase Department makes an enquiry about the terms and conditions of

purchases from different suppliers. For this, tenders or quotations are invited from them. The

lowest tender should be accepted, and accordingly, a decision be taken by an officer or by a

sub-committee of the Purchase Department if the amount of purchase is heavy and involves a

huge expenditure.

3. Placing Orders

The Purchase Department places orders which should be recorded in the Purchases

Order Book. Three copies of such orders should be prepared—one each for the supplier, the

Store and the Purchase Department itself. A responsible officer should sign the order. After

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putting the number of the order on the requisition slip concerned and vice-versa, such

requisition slip should then be filed in the Purchase Department.

4. Receipt of Goods

On receipt of goods, the gate-keeper should enter the particulars of all goods received

in the Goods Inward Book after having checked them properly. The goods then should be

sent to the Store where they should be carefully preserved. The Stores Department should

prepare a 'Goods Received Note' and send a copy thereof to the Purchase Department, the

Accounts Department and the Production Control Department.

The goods received note should be prepared with the following details :

1. The date when the goods were received.

2. The name of the supplier.

3. The advice note number.

4. The description and code number of goods.

5. The quantity advised.

6. The quantity received.

Besides, if a part of the goods has been rejected, the goods received note should

contain the following additional information :

7. The quantity rejected.

8. The rejection note number.

9. The quantity accepted into store.

10. Signatures of employees concerned with having entered items on it.

5. Recording and Making Payments

Lastly, the Purchase Department should scrutinize the requisition slip, the order, the

goods received note and the invoice. Invoices are usually checked by a separate person

known as the Invoice Clerk. The number of the order should be entered on the invoice and so

an. All these documents should be marked as checked and signed, if necessary. The invoice

should then be handed over to the Accounts Department where steps will be taken to make

payments. It is to be seen that the invoices when checked have been properly stamped.

The Accounts Department should enter the invoice in the Purchases Book. If the

goods are defective partially or wholly, the invoice should not be passed in such cases. It is,

however, for the Purchase Department to make correspondence with the suppliers about the

return of such goods which are defective.

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The aim of an efficient system of internal check is to prevent the following errors and

fraud in connection with purchases:

(1) Fictitious purchases may be recorded in Purchases Book so that payments withdrawn

from the business may be misappropriated.

(2) The same invoice may be recorded twice so that double payment made may be

misappropriated.

(3) Goods purchased may not be entered in that period so as to inflate profits.

(4) Goods not received in one period may be entered as purchases so as to show profits

less than the actual.

Internal Check as regards Purchases Returns

(1) There should be a proper system of control in regard to purchases returns so that full

credit may be ensured for all goods returned.

(2) A statement should be prepared by the Stores Department for all goods returned.

(3) The Purchase Department should check such goods and prepare an advice note which

should be sent to the Accounts Department.

(4) The Accounts Department should further examine the advice note with original

invoice and enter it in the Purchases Returns Book.

(5) All goods returned should be entered in the Goods Outward Book.

(6) A credit note should be obtained from the supplier, i.e., the creditor for each return of

goods which should then be attached to the invoice if it is not yet paid.

It should be remembered that, if the system of internal check is not good, a credit note

so received may be suppressed and the corresponding cash payment misappropriated.

Internal Check as regards Sales

The whole system of credit sales should be kept under proper control and supervision.

There should be a separate Sales Department for the purpose. The Sales Department should

have charge of receiving orders, supplying goods to customers, preparing invoices and

maintaining accounts of goods supplied. The Sales Department should function as a

composite of some sub-departments. The procedure of its working may be like this :

(1) All orders received should be entered in the Orders Received Book and properly

numbered. The original order or its copy should then be sent to the Despatch

Department.

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(2) The Despatch Department should take steps to pack the goods as per the order. It

should prepare a statement showing the goods packed.

(3) The statement so prepared by the Despatch Department should be sent to the

Counting House where the list of goods should be checked and rates, etc. entered in it.

The invoice will then be prepared in triplicate by means of carbon papers.

(4) Two copies may be sent to the customers who will then return one of them after

signing it in token of having received the goods. Thus, it will serve the purpose of

delivery note. The third copy will be retained for further reference.

(5) The Accounts Department should prepare documents like Railway Receipt, Bill of

Lading, etc.

(6) All goods supplied on order should be entered in the Goods Outward Book which

should be checked at frequent intervals with the Orders Received Book.

(7) The Invoice Book should also be compared with the Goods Outward Book and the

Orders Received Book.

(8) The Sales Book should be written up with the help of the copies of invoices.

The following type of fraud may be committed in connection with sales :

(1) Sales may be omitted from recording in the Sales Book.

(2) Inflation of sales in the Sales Book in any of the following ways :

(a) Recording fictitious sales;

(b) Treating goods as sales sent on approval or by V.P.P., but not yet accepted or sent on

consignment but not yet sold by the consignee;

(c) Treating sales of fixed assets as sales of goods;

(d) Entering sales of the next year as sales of the current year; and

(e) Treating sales of consignment inward as own sales.

Internal Check as regards Sales Returns

(1) All goods returned by customers should be recorded in the Goods Inward Book.

(2) The statement of goods so returned when received should be sent to the Despatch

Department which should check it and, then send it to the Accounts Department.

(3) A credit note should then be prepared and signed by a responsible official before it is

sent to the customer.

(4) The Sales Returns Book should be written up with the help of the copies of credit

notes issued. The number and date of credit notes should also be entered in this book.

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The aim of such a system is to prevent an improper credit being passed in the books

for fictitious returns and to avoid fraud involved in misappropriating equivalent cash.

Internal Check as regards Stores

The Stores Department has charge of preserving and issuing stores to the different

departments. If the stores are not kept under proper control and a proper system of internal

check is not adopted, chances of fraud arise. Besides this, the maintenance of stores and

purchasing functions should be separated. The chances of fraud and misappropriation would

he more if both these functions are performed by the same person.

1. Receipt of Stores

On receiving stores, the Stores Department will prepare a 'Goods Received Note' in

triplicate—one for the Purchases Department, second for the Accountant and third for the

Stores Department itself. All details about stores should be noted on the note. The stores

should be properly checked after their receipt.

2. Preservation of Stores

The stores should be properly preserved before they are issued. The following points

may be noted :

(i) A separate place should be earmarked for each type of stores.

(ii) A system of proper numbering should be adopted for all stores and places where they

are to be kept.

(iii) The use of bin cards should be made for preserving stores. Such bin cards should

contain details about stores and have three columns for receipt, issue and balance of

stores. Such bin cards may be kept hanging on the places where stores are preserved.

(iv) The stores should frequently be counted and checked by a responsible official who

should also compare the bin cards with the stores ledger.

(v) Stock-taking should be conducted at the end of a year or at regular or irregular

intervals during the year, if necessary.

(vi) Difference, if any, between the actual stock and the balance of stock as shown by the

books should be adjusted or written-off after getting the sanction of the appropriate

authority.

3. Issue of Stores

For issue of stores, an organized procedure may be like this :

(i) The issue of stores should be made only against the requisition slip received from a

department whose head should sign it.

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(ii) After issue, the requisition slip should be sent to the accountant who will make entries

for the issue.

(iii) The requisition slips used by the departments should be of different colours.

(iv) Only a responsible clerk should have charge of issue of stores so that in case of fraud,

he may be held liable.

(v) The Stores Officer should be seated near the gate so that all issues can be made under

his supervision and control.

(vi) A system of permits should be in operation for those who go out of the Stores

Department. The permits should be entered in the Gate Book.

(vii) Whenever stores are returned by some department, a Stores Returned Note should be

prepared and the return should be recorded in the Gate Book.

(viii) Stores returned should be entered in the bin cards.

4. Recording

A separate accountant should maintain records of stores. If the stores are of a small

variety, ledgers may be maintained. But if there is a large variety of stores used in the

business, stores record cards may be used.

The stores record cards may be of different size and colour. The details in the stores

record cards may be written-up with the help of goods received notes, requisition slips, goods

returned notes, etc.

The bin cards should be checked and compared from time to time with stores record

cards.

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VOUCHING

Meaning of Vouching

It is an important part of an auditor's duty to certify as correct the transactions

recorded in the books of accounts. The accountant of a business is responsible for passing

entries in the books of prime entry. The question arises how and on what basis such entries

have been passed. The auditor's primary duty is to check these entries and only then certify

the accounts as correct and free from any error or fraud.

We all know that the accountant does not enter any transaction in the books of

original entry for which he has not got a proper documentary evidence. If he does, it is an

irregularity in the strict sense of the term and such a step of the accountant would be an

example of fraud leading to some manipulation of accounts or misappropriation of cash or

goods. Hence, there should be no entry in the books without a voucher and no voucher

without its entry. Every voucher must also, therefore, be recorded in the books.

Thus, when an auditor verifies the authority and authenticity of transactions as

recorded in the books of accounts and submits his report accordingly to the effect that the

accounts are correct, complete and free from errors or fraud, he has to see that the entries

passed in the books of prime entry are properly made, are supported by proper documentary

evidence and are also in order. This is known as vouching.

A Few Definition of Vouching

1. "By vouching is meant the verification of the authority and authenticity of

transactions as recorded in the books of accounts." —R. B. Bose

2. 'Vouching does not mean merely the inspection of receipts with the cash book, but

includes the examination of receipts with the transactions of a business, together with

documentary and other evidence of sufficient validity to satisfy an auditor that such

transactions are in order, have been properly authorized and are correctly recorded in the

books." —De Paula

3. "It is often thought that vouching consists of the mere examination of the vouchers or

documentary evidence with the book entries. This, however, is quite wrong, for vouching

comprises such an examination of the ledger entries as will satisfy the auditor, not only that

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the entry is supported by documentary evidence but it has been properly made upon the

books of accounts." —Joseph Lancaster

Thus, it is evident that vouching consists of checking the entries in the financial books

with the help of available documentary evidences, e.g., vouchers, receipts, invoices, minutes,

contracts, statements, correspondence, etc. For each entry, it is to be ascertained that it is

properly authorized and no transaction has been omitted from recording in the books of

accounts.

Routine Checking and Vouching

Routine checking has already been discussed earlier. It includes checking of casts,

postings, carry-forwards, extensions and other calculations in the books of original entry. The

auditor uses distinct ticks in routine checking and tries to establish genuineness of records,

e.g., that the casts are correct, postings are correctly made and no alterations have been made.

Broadly speaking, vouching includes routine checking and it is a part of it. Both are

important in their own way. Vouching is the checking of entries while routine checking is the

checking of castings and postings. Hence, there is nothing to distinguish one from the other.

However, in routine checking, arithmetical accuracy of the entries is to be verified and in

vouching, entries are to be checked with the help of documentary evidence.

Objects of Vouching

In vouching, an auditor verifies the authority and authenticity of transactions as

recorded in the financial books so that he can satisfy himself that :

(i) all transactions connected with the business have been recorded in the books of

accounts and nothing pertaining to the business has been left as unrecorded;

(ii) no transaction which is not connected with the business has been recorded. Le., no

extra item having no concern with the business has been entered in the books; and

(iii) all entries for transactions which are authorised, are genuine and supported by

documentary evidences which are available in the business.

Importance of Vouching

The definition of vouching discloses that it is a sort of preliminary work which forms

an important part of audit work. Since accounts of a business begin with the passing of

entries, hence it becomes a basis for further scrutiny to be made at a later stage. Its

importance, therefore, can hardly be over-emphasized. The purpose of checking entries by

reference to appropriate documentary evidence is to ensure that the transactions relating to a

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particular period have been recorded and there is no voucher left unrecorded in the financial

books. The auditor, after satisfying himself with regard to the authority, authenticity of

transactions, can only then say categorically that the books of accounts are correct and the

Balance Sheet and Profit and Loss Account exhibit the true and correct state of the financial

affairs of business.

It is certainly true that vouching is done with care and caution by the auditor, he can

proceed well further in this work. Thus, vouching becomes an indispensable preliminary to

carry on further scrutiny with ease and to tisfy him that the financial books reveal the true

position of the business, lis is why vouching is said to be the backbone of auditing. Actually,

it is he essence of auditing.

In practice, vouching may be a lengthy process in many big organiza-lons. For this, an

auditor may apply test checking depending upon the .stem of internal check in existence in

the organization.

Vouchers

As quoted earlier, vouchers are the documentary or other evidences n support of

transactions entered in the books of accounts. They may e of two types :

(1) Primary. A written evidence in original is said to be the primary lucher, e.g., invoice

for a purchase.

(2) Collateral When the original voucher is not available, copies thereof are produced in

support or subsidiary evidence is made available so as to remove suspicions and to

satisfy the auditor. Such a voucher is usually .-oiown as a Collateral Voucher.

The following are some of the examples of vouchers :

(1) Cash Receipts—Carbon copies of receipts, contracts, minutes, correspondence, etc.

(2) Cash Payments—invoice, Bill, Demand Notes, Wage Sheets, Salary Register,

contracts, correspondence, etc.

(3) Purchases—Invoice, Goods Inward Book, copies of orders received, correspondence,

etc.

(4) Sales—Copies of Invoices, Orders Received, Goods Outward Book, correspondence,

etc.

With these examples, it can be held that correspondence, contracts, documents,

receipts, invoices, bills, minute books maintained for recording resolutions of Directors or

Shareholders and any other similar documentary evidences are vouchers which are quoted

wherever necessary, in the pages that follow.

While examining vouchers, the following points should be noted by the auditor :

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1. General

(1) All the vouchers should be consecutively numbered and filed serially and in order of

entries in the books. If it is not done, the auditor will have to waste a lot of time in

finding out a particular voucher.

(2) The vouchers which have been inspected by the auditor should be cancelled by a

stamp so that they may not be produced again. The auditor may also use special type

of tick marks right across the face of the vouchers, if no stamp is available.

(3) It should be seen by the auditor that vouchers which are in the personal name of one

of the Partners, Directors, Manager, Secretary or any other official of a business may

or may not relate to the business itself. If such voucher is related to purchase, the

Goods Inward Book should be examined to ensure that goods have actually been

received in the business. The client should be especially instructed not to adopt this

practice in the business.

(4) If a voucher requires some special scrutiny, the auditor should proceed cautiously and

use special ticks for its checking.

(5) As far as possible, the work relating to a particular period or a set of books should be

completed in one sitting or as a continuous process.

(6) The auditor should see that every voucher is certified as correct by a responsible

official who should put down his signature on it.

(7) For missing vouchers and receipts the auditor should satisfy himself with regard to the

reasons of their being lost and demand for their duplicate copies. He has to be much

careful in this matter.

(8) The auditor should not usually take the help of any member of the staff of the client

while vouching the entries and checking the vouchers.

(9) While examining vouchers, the auditor should see that they are properly entered in the

proper financial books. Sometimes, proper allocation of items is not made between

capital and revenue. This should invariably be done to maintain correct record and

ensure faultless final accounts.

(10) Test-checking should be resorted to only in special circumstances when the auditor is

satisfied with the internal check system in operation, otherwise detailed checking

should be done. After all, absolute responsibility is his.

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2. Particulars (t.e., relating to the voucher itselfi

(1) The auditor should carefully examine the date, the amount and the name of his client

on the voucher so as to ensure that no voucher which is not related to the business has

been entered in the books.

(2) He should see that the voucher is related to the business itself either for goods

purchased or for expenses.

(3) It should further be seen that the voucher relates to the period, under audit.

(4) A voucher should be acceptable only when it is on the printed form of the payee.

(5) The amount of the voucher should be written both in words and figures.

(6) If the voucher is a receipt for cash payment over Rs. 500, it must bear a revenue

stamp of one rupee.

(7) Every voucher should be signed by some responsible officer on behalf of the payee.

(8) The contents of a voucher should be examined with reference to the particulars of the

relevant entry so as to ensure that they tally as regards the date, the amount, etc.

(9) It has to be remembered that if some alteration is made in the voucher, it is properly

initialled by the invoice clerk.

Thus, it will be seen that while comparing vouchers with the entries made in the

books of account, the auditor should be able to verify the following :

1. The authority of the voucher;

2. The authenticity of a transaction;

3. The proper classification of the account; and

4. The accuracy of the amount and correctness of the details connected with an entry.

Vouching of Cash Book

Cash Book is a very important financial book for a business concern. Mostly, errors

and fraud arise in connection with receipts and payments f cash by making its

misappropriation, wherever possible. That is why the auditor has to be on his guard in

checking items of cash and he should ensure that no receipt or payment of cash is unrecorded

in the Cash Book and no fictitious payment has been entered in it.

In vouching Cash Book, the checking of cash receipts is more difficult than cash

payments; for cash receipts, the business under audit has itself to issue receipts and it gets

nothing in return from other institutions as in case of cash payment. The business issues

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receipts for cash receipts and on the basis of their carbon copies or counterfoils, entries are

passed in the Cash Book. Hence, on the one hand, the auditor has to examine vouchers in

support of entries and on the other, he has to see that the receipt of cash has not been

misappropriated or misused. For this, he has to proceed with care and caution.

Vouching of Cash Receipt Transactions

The following points should be noted in vouching cash receipt transactions :

(1) Internal Check. The auditor has to satisfy himself that there is a good system of

internal check in operation. This has to be thoroughly enquired into. He should fully

understand the rules and regulations in vogue for granting receipts, making records thereof,

dealing with the bank, etc. As quoted earlier, the auditor can resort to test checking only if he

has satisfied himself that there is an efficient system of internal check. He may, in such a

case, check a few items at random and if he finds that they are all in order and free from

irregularities, he has reasons to assume that the remaining ones will be correct.

(2) Comparison of the Rough Cash Book with the Cash Book. Usually, cash receipts

are first entered in the Rough Cash Book or the Diary before they are entered in the Cash

Book. He should examine the Rough Cash Book or the Diary and compare it with Cash

Book. If he does not do so, he might be held liable in case a fraud is detected.

(3) Control over use of Receipt Book. Another point to be noted by the auditor in this

connections is to see whether Receipt Books are kept under proper control. He should keep in

mind the following points :

(i) All receipts are on printed forms.

(ii) Counterfoil receipts are used for cash receipts or a system of issuing carbon copies of

receipts is in use. The system has to be examined.

(iii) All receipts and Receipt Books should be separately and consecutively numbered.

(iv) The particulars, as regards date, amount, name, etc., on the receipt should be

compared with those given in the Cash Book.

(v) If there are certain entries in the Cash Book for which receipts have not been issued,

they should be carefully checked.

(vi) Along with cash receipts, the rules for granting cash discount should be examined.

Usually, in such a case, the rules should be uniform for all customers.

(vii) The receipts have to be signed by a responsible officer.

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(viii) The unused Receipt Books should be kept in safe custody with some responsible

person or officer.

(ix) If there is a system under which a receipt accompanies the receipt of cash, such a

receipt (usually known as a delivery note) should be properly signed before its return

to the customer. (4) The method of depositing daily receipts into the bank should be

examined. The use of Pay-in-Slip Book should invariably be made for this purpose.

Cash Sales. The auditor should examine the effectiveness of the system of internal

check in operation in regard to cash sales. Wherever loopholes exist in such a system, he

should note them down and check the cash sales in their light very carefully and cautiously.

He should thoroughly check the carbon duplicates of cash memos with the summaries

of cash sales. Further, he should compare well the abstracts of the salesman with the cash

analysis of the receiving cashier and then, should check up the Cash Book. He can scrutinize

the General Cash Book with the summaries prepared by the cashier.

Sometimes, in small businesses, cash memos are issued for credit sales to ensure

prompt payment. Thus, the auditor will find so many cash memos for which no cash is

received in the business and hence, no entry in the abstract prepared by the cashier. This is

rather odd, le., issuing cash memos for which no cash is received. Such a practice has to be

discouraged by the auditor.

[Vouchers—Carbon Duplicates of Cash Memos, Salesman's Abstracts, Cashier's

Summaries.)

Receipts from Debtors. The cash received from debtors can be vouched with reference

to the counterfoils of the receipts issued to them. Thus, the counterfoil is the only proper

documentary evidence available for the purpose. But this is not a reliable voucher as frauds

are usually committed.

(i) by inserting less amount in the counterfoil than what is actually received from a

debtor; or

(ii) by recording less amount on the debit side of the Cash Book; or

(iii) by issuing a receipt from the unused books if these are not properly kept in custody;

(iv) by the process of 'teeming and lading' or 'lapping'. 'Lapping' is done through

concealment of a shortage by delaying the recording of receipt of cash while 'teeming

and lading' is the process of misappropriating cash received from a debtor without

entering it in his account. When cash is received from another debtor, it is posted to

the account of the former.

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There is a fraudulent practice on the part of cashier to misappropriate or misuse cash

through the process of teeming and lading, le., not entering cash in the Cash Book received

from a debtor and entering it only when a similar amount is received from another debtor and

so on. Such practices are common and the auditor can check them with reference to the

Rough Cash Book and counterfoils of the Pay-in-Slips. If a fraud is committed like this, less

amount would have been deposited in the bank.

The auditor should pay special attention to discount allowed to ustomers and bad

debts written-off. He should enquire into the method and rate of granting discounts. Discount

rates should not exceed the usual ercentage. Similarly, for bad debts written-off, he should

enquire as to ho is made responsible to write-off debts as bad. Cash received can be

misappropriated by writing-off the whole or a part of the debit balance as bad.

The auditor, with the permission of his client, can establish contacts directly with the

debtors by sending from time to time the statements or verification slips' and asking them to

send their confirmation directly to him.

[Vouchers—Counterfoils, Correspondence, etc.)

Bills Receivable. All details about bills receivable can be available in the Bills

Receivable Book. The receipts for bills receivable can be in two ways :

(1) Receipts from Bills Discounted. The bills receivable which have been discounted and

have not matured at the date of the Balance Sheet, the cash so received should be properly

entered in the Cash Book. The amount deducted for discount on such bills should be

separately debited in the Discount Account.

Contingent liability in respect of such bills should be shown on the Balance Sheet.

(2) Receipt from Bills Matured. The cash receipt for the bills receivable in respect of

which the amount has been received on the dates of maturity should be checked by

comparing the Bills Receivable Book with the Cash Book and the Pass Book.

Special enquiry should be made about bills which have matured but the amount in respect

thereof has not been received. Such bills might have been dishonoured or retired. It is

possible that such bills might have been paid but their proceeds might have been

misappropriated by the cashier.

(Vouchers—Bills Receivable Book, Cash Book, Pass Book.)

Income from Interest and Dividend. If interest is received on account of fixed deposits

in the bank, such income should be vouched with the Bank Pass Book. The Pass Book should

be a genuine one. If such an interest is receivable from a loan granted to a borrower, the

necessary agreement between the borrower and the business should be referred to for the rate

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of interest, date of payment, etc. If the interest comes from securities, then vouching of such

income should be made from a schedule obtained from some responsible official. For all such

cash receipts, counterfoils of receipts may be checked. Usually, the interest from debentures

and government securities is received half-yearly. The interest warrant is received from the

company that has issued the debentures and is deposited with the bank. The interest is

received along with the tax deduction certificates.

For receipt of dividend, three vouchers, viz., counterfoils, dividend warrants and

letters received along with the cheques, should be seen. If the bank is authorized to collect

this income, the Pass Book should be referred to. The auditor should ensure that all such

income whether received or accrued has been accounted for in the books and shown in the

Balance Sheet.

(Vouchers—(i) For Interest—Pass Book, Agreement, Schedule, Counterfoils, (ii) For

Dividend—Counterfoils, Dividend Warrants, Pass Book.)

Sale of Investments. Investments are usually sold through brokers. Hence, the broker's

sold note should be examined to vouch the amount received from the sale of investments. The

broker's sold note contains details about the actual amount received on this account and the

commission paid to the broker. If the sale has been affected through the bank, the bank advice

should be examined.

If the investments have been sold cum-dividend, it should be seen that dividend has

subsequently been received and the sale proceeds thereof have been apportioned between

capital and revenue. If they are sold ex-dividend, the entry for it has to be properly checked

by the auditor.

[Vouchers—Broker's Sold Note, Bank Advice.)

Receipts from Hire Purchase. The hire purchase agreement should be examined in

detail so as to ascertain the duration of the agreement, the amount of instalments and the total

number of instalments payable by the close of the period the accounts of which are under

audit. The auditor has to keep in mind that the instalment includes interest also. He should

note that the whole amount of an instalment in not credited to Sales Account and it has been

properly apportioned between sales and interest.

(Vouchers—Hire Purchase Agreement, Counterfoils of Receipts.)

Rent Received. If the rent-rolls are maintained, the same should be examined and

compared with the Cash Book. The lease deeds and agreements should be examined to

ascertain the amount of rent, the due date and the provision regarding repairs.

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The counterfoils of rent receipts issued to tenants should be checked. It agents are

appointed to collect rent, the accounts or statements submitted by them should be carefully

checked.

The auditor should be particularly careful about the outstanding rent. It is possible that

the rent has been received but has been shown as outstanding and the necessary amount has

been misappropriated. If need be, the auditor may ask the tenants to confirm the outstanding

rent.

(Vouchers—Lease Deeds and Agreements, Rent-rolls, Accounts Received from

Agents, Counterfoils, Correspondence.)

Commission Received. For commission received, the agreements between the client

and the parties from whom it is receivable should be examined first so that the terms of

commission, its rate, etc., may be examined. Counterfoils of receipts should be compared

with the particulars entered in the Cash Book. If commission is received in respect of goods

received on consignment, the amount of commission should be vouched with reference to the

copy of the account sale sent to the consignor. If necessary, the auditor should make

calculations himself.

Proceeds from Sale of Fixed Assets. Whenever fixed assets, such as land, building,

machinery, furniture, etc, are sold, correspondence is made with the parties who are willing to

purchase them. Usually, fixed assets are sold through a broker or an auctioneer.

If it is made through a broker, the broker's sold note should be seen otherwise the

auctioneer's note should be examined. If a Sale Deed has been executed, it may also be

examined by the auditor. It has to be remembered that any profit so earned should be credited

to the Capital Reserve Account and not to the General Profit and Loss Account. Due regard

should be made for expenses payable in respect of such assets.

The auditor should see that the sale has been duly sanctioned.

(Vouchers—Auctioneer's Note or Broker's Sold Note, Sale Deed, Correspondence.)

Insurance Claim Money. Insurance claim money received from an insurance company

against a claim should be checked by making a reference to the correspondence between the

company and the client and the amount rendered by the insurance company to the client.

(Vouchers—Accounts, Correspondence.)

Subscriptions. The income received on account of subscriptions can be vouched with

the help of the register of subscriptions and the counterfoils of the receipts.

(Vouchers—Register of Subscriptions, Counterfoils.)

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Vouching of Cash Payments

The vouchers related to cash payments should be properly authorized, serially

numbered and filed in order. It is usually asserted that in vouching payments, an auditor does

not merely seek proof that money has been paid away. It means that it is not merely the duty

of an auditor to see that the payment has been made but he should satisfy himself that the

payment :

(a) has been actually made for the business itself;

(b) relates to the period under audit;

(c) has been made to the right person;

(d) is properly sanctioned;

(e) is properly recorded;

(f) is supported by a proper voucher; and

(g) the particulars given in the voucher tally with those of the cash book.

The payment has been made, but to whom and for what purpose, these are some of the

big questions to be correctly answered. Thus, the vouching of cash payments means to ensure

that payment is correct, genuine and properly authorized.

It is true that if an effective system of internal check is in operation, chances of errors

and fraud are minimized.

Cash Purchases. The auditor should see that goods paid for have actually been

received. He should examine the entries in the Cash Book with the help of Cash Memos or

receipted invoices issued by suppliers and also the Goods Inward Book or Stock Ledger.

Thus, for cash purchases, he has especially to examine the genuineness of purchase, receipt

of goods and also the relevant vouchers. It is to be seen that only net amount (Le., purchases

minus trade discount) has to be carried to the books of accounts.

(Vouchers—Cash Memos, Goods Inward Book.)

Payment to Creditors. Payment to creditors may be vouched with the receipts issued

by the creditors. Money due to them can be compared with the accounts of the creditors, and

for goods received, the invoices can be referred to. He should especially scrutinize the

method of comparing the statements of accounts with their actual accounts. Before passing an

entry as correct, he should refer to minutes, contracts and other documentary evidence in

support of it.

[Vouchers—Receipts, Statement of Accounts, Minutes, Contracts.)

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Wages. The vouching of wage payment is one of the most important duties of the

auditor. He should first of all assess the operation of an efficient and effective system of

internal check. If the system is good, possibilities of errors or fraud are minimized. He has to

satisfy himself in regard to this system so far as it relates to the maintaining of wage records,

preparation of wage sheets and payment of wages.

The auditor should look for the following points while examining the system of

internal check in force:

(1) Likely avenues for fraud, e.g., casual labour or the inclusion of 'dummy' names in the

Wage Sheet.

(2) Occurrence of clerical errors.

(3) Adequacy of both time and piece-work records. He should note the following points:

(1) The system of internal check has to be thoroughly investigated.

(2) The totals and calculations involved in the Wages Sheet should be checked.

(3) He should check a few items, Le., deductions in the form of rent, fire insurance,

provident fund, etc., and the method of deducting them should be scrutinized.

(4) It should be seen that the amount of the cheque drawn for payment of wages tallies

with the net amount as shown in the Wage Sheets.

(5) Names of workers given in the Wage Sheets should be well-compared with those

given in the wage records, e.g., Job Cards, Foremen's Register, etc., to ensure that no

dummy names have been included in the Wage Sheets.

(6) The auditor should see that the Wage Sheets have been properly initialled by those

responsible for their preparation.

(7) He should carefully check the payments made to the casual labour. It is advisable to

prepare separate wage sheet for casual workers to be certified by the foreman or the

departmental head. The auditor should ensure that casual workers are paid correctly.

Thus, as regards wages, the auditor has to see that :

(i) the wages as recorded in the Cash Book have actually been paid;

(ii) such an amount of wages was actually due to be paid by the business; and

(iii) such a payment was duly authorized.

(Vouchers—Wage Records, Job Cards, Wage Sheets, etc.)

Salary. The auditor should check the Salary Book and then compare it with the entries

in the Cash Book. He should examine the Salary Accounts of each individual employee

month by month if separate cheques are issued to employees but if one cheque is drawn for

the whole amount of salary, the totals of Cash Book and of Salary Book may be examined.

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The counterfoils of cheques drawn can help him in verifying the different payments made to

employees.

The auditor should see that the Salary Book is duly signed by a possible officer and

that the increases in salaries are properly authorized. The variations in salary in certain cases

may be due to annual increments falling due, some special increments or rewards being

granted. They should be carefully checked. He should also examine any alterations in the

amounts due to deductions on account of fines, fund, rent, insurance, loans or advances, etc.

Besides examining the Salary Book, the auditor should refer to the appointment

letters, agreements and minutes. This will, however, depend upon the rules of a business as to

who will sanction rewards or impose fines. The entire procedure has to be thoroughly

examined by the auditor.

[Vouchers—Salary Book, Appointment Letters, Agreements, Minutes, Counterfoils of

Cheques.)

Remuneration to an Auditor. Whatever may be the remuneration payable to an auditor

for the audit work performed by him is not so important as the treatment which such a

remuneration should have in the Revenue Account of a company or a firm. There is a lot of

controversy whether the remuneration given to an auditor should be charged to the Profit and

Loss Account pertaining to the year under audit or to the Profit and Loss Account for the year

during which such an audit is being conducted. In the former case, it is argued that such a

remuneration as payable after the close of the Financial Accounts should be shown as an

outstanding liability in the accounts of the year under audit as it is payable for the work

connected with that year.

It is further argued that since the audit work is to be performed by the auditor in the

next financial year, the remuneration payable should be debited to the Profit and Loss

Account of the next year and not to the current year. Both the arguments have some basis. It

is, however, justifiable to debit the Profit and Loss Account of the year under review if the

audit work has commenced before the closing of the books and the auditor's remuneration can

be brought as an outstanding liability. But if the audit work begins after the books have been

closed, such a remuneration should be debited to the Profit and Loss Account of the

subsequent year during which the accounts are audited. In no case, double the amount should

be debited.

Bills Payable. The bills honoured and returned by the payees should be examined

together with the Bills Payable Book. If the payments are made through the bank, the Pass

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Book should be checked and a reference may also be made to the statement received from the

bank.

(Vouchers—Receipts, Bills Payable Returned, Bills Payable Book, Pass Book.)

Purchase of Land and Building. If the asset is purchased through an auctioneer, the

auctioneer's accounts should be checked. In other cases, the receipt obtained from the vendor

can be a good evidence to vouch the purchase. Two things have to be specially noted:

(1) If the purchase of freehold land or building is made, the Title Deed should be

examined.

(2) If the property purchased is leasehold, in which case the purchaser's right over the

property is for some fixed period, the lease should be examined.

If the property is purchased through a broker, the broker's note should be examined.

The agreement for purchase is the proper document of any evidence in support. If the

building is erected under contract, the actual contract should be checked together with the

architect's certificate on the basis of which the payments are made.

The expenses incurred, e.g., auctioneer's commission, brokerage, registration fee,

architect's fee, etc., can be vouched with the help of the receipts obtained and it should be

seen that they are capitalized.

(Vouchers—Title Deed Lease, Auctioneer's Note, Broker's Note, Receipts, Contract,

Architect's Certificate.)

Purchase of Plant and Machinery. A reference to the invoice and the receipt obtained

from the supplier can be of much help to the auditor in vouching purchase of plant and

machinery to see that the price has been paid. The auditor can well proceed on the lines as

suggested in case of land and building. It should be noted that the expenses incurred in

erecting and fixing up the plant have been capitalized.

Purchase of Investments. Payments for the purchase of investments should be

vouched with reference to the Broker's Bought Note. The actual investments can also be

examined. If they are purchased through the bank, the Pass Book may be examined. In case

of cum-dividend purchase, it should be seen that the expenditure has been properly

apportioned between capital and revenue.

If it is a case of new issue, letters of allotment, share certificates, etc., may be

examined. It is needless to say that the purchase of investments should be properly

authorized. If the investments consist of inscribed stocks, the certificate from the bank should

be obtained.

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(Vouchers—Broker's Bought Note, Pass Book, Letters of Allotment, Share

Certificates, etc.)

Patents and Copyrights. The agreement of purchase may be examined for the patent

and copyright and the receipt in token of having paid the amount should also be examined.

Any expenses incurred in connection with the purchase should be capitalized. If the purchase

is affected through an agent, his commission should also be capitalized. However, the

renewal fee is not a capital expenditure and must be treated as a revenue expenditure.

(Vouchers—Agreement, Receipts, Agent's Account.)

Payment under Hire Purchase Agreement. The vouching of the payment made for

hire purchase should be done by examining the agreement and the receipt so received can be

a good evidence for it. The instalment paid includes interest also and, therefore, the auditor

should see that such an interest is charged as a revenue expenditure.

Such payments should be vouched with the periodical statements received from the

hire trader and other relevant vouchers.

(Vouchers—Agreement, Receipt, etc.)

Travelling Expenses. It should be noted that travelling expenses are paid for the travel

in connection with the business. The vouchers should contain details as the name and

designation of the person, particulars of journey, amount of fare, amount of boarding and

lodging expenses and :her expenses. Where the amount is payable as fixed, there is no

difficulty in checking it, but in other cases, he has to check a lot of calculations made. The

travellfng expenses should be passed by a responsible officer as ing in order. The receipts

obtained from those receiving payments should e scrutinized.

{Vouchers—Bills, Receipts, etc.)

Advertising. If the amounts spent on advertising are substantial, the auditor should see

that adequate controls have been kept on this expen-i.iure. It is essential to know the amount

which has been budgeted for advertising for each product, the amount actually spent, the

amount to which the company is committed and the balance on the budget which has not

been allocated. There may be some common or general advertising rxpenses such as prestige

advertising where the name of the firm is p ublished without reference to any particular

product.

In case of heavy or abnormal advertising expenditure where the question of carrying

forward a part of expenditure from one accounting period to the another is involved, the

auditor should be guided by the policy of the firm in this regard. Such an expenditure is

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known as deferred revenue expenditure and a part of it charged against the current period -

hould be budgeted as a revenue expense.

Usually, it is preferable to see that the financial records run parallel to the statistical

records and with the aid of such records, the budgeted and actual expenditure pertaining to a

period can be comparable.

Interest on Loan. From whatever source, either a bank or any other, if loan is

obtained, interest thereon has to be paid. The terms of loan should be studied and it should be

seen that the rate of interest does not differ from the one given in the loan agreement. If

interest is payable on debentures, the debentures interest book should be referred to. If the

interest is payable through the bank, the Pass Book and Interest Register should be examined.

[Vouchers—Loan Agreement, Debenture Interest Book, Pass Book.) Dividends. The payment

of dividends can be examined with the help of dividend warrants returned. If the payment is

made through the bank, Dividend Warrants and Pass Book may be compared. The amount of

unclaimed dividend should tally with the balance given in the Pass Book on this account.

(Vouchers—Dividend Warrants, Pass Book, etc.)

Directors' Fees. To vouch payment of Directors' Fees, the Directors' Minute Book,

the Attendance Register and the receipts obtained from directors for this payment should be

examined. The auditor should also study the Articles of Association and see the provisions in

regard to the payment of Directors' Fees. The resolution of shareholders should also be seen

to ensure that correct payment has been made.

(Vouchers—Minute Book, Attendance Register, Articles of Association, Resolution

of Shareholders.)

Remuneration to Directors. The amount of remuneration payable to Directors of

Public Companies is controlled by the provisions contained in section 309, subject to the

overall limit and explanation contained in section 198 of the Companies Act. Under the

Companies (Amendment) Act, 1965 even a Director who is neither in the whole time

employment of the company nor a managing director can be paid remuneration either by way

of monthly salary or by way of commission on profit. If payment is to be made as a

commission, it can be done with the sanction of the company by a special resolution and also

with the approval of the Central Government if a monthly, quarterly or annual payment is

envisaged.

The amount of remuneration is, however, limited to 1 to 3 per cent depending on

whether or not the company has a Managing Director or a whole time director.

The auditor should see that legal provisions have been duly complied with.

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[Vouchers—Special Resolution, Approval Note of Central Government, Minute

Book, etc.)

Deposits. Sundry deposits such as telephone deposits, gas and electricity deposits and

travel warrant deposits should be vouched with the help of relevant receipts. It is usual that

these amounts remain in the books uncharged for a number of years. A schedule of the

composition of such deposits should be kept. However, the cases of deposits should be

reviewed to ensure that the circumstances under which they were originally made have

charged. Further, direct confirmation can be obtained from the persons holding these

deposits.

As for the deposit of duty, it is made when exact amount of duty payable cannot be

agreed and the purchaser wants to obtain possession of the goods. This is applicable to certain

kinds of machinery and equipment and similar other imported goods. It is to be seen that the

invoices for duty have been clearly marked 'Duty Deposits' and debited to a debtor account

for duty deposit and not written-off to revenue. The auditor should examine the details of the

amount on deposit and pay special attention to items which have been outstanding for a long

time.

Commission. The conditions relating to the payment of commission should be

examined with reference to the agreements between the clients and the agents. Usually, the

commission is paid on the amount of net sales after deducting discounts, allowances, etc.,

from the gross sales. The statement of accounts submitted by the agents or representatives

should also be seen.

[Vouchers—Agreements, Statement of Accounts.)

Payment of Taxes. To vouch the payment of taxes, the auditor should made reference

to the copy of the assessment order, assessment form, notice of demand and the receipted

challan. The advance payment of Income-tax under section 207 should be verified with the

Notice of Demand and the relevant receipted challan.

The interest allowed on advance payments of Income-tax under section 214 should be

included as income and penal interest charged for non-payment of these should be debited to

the Interest Account as given in sections 215, 216 and 217.

Payment of Sales-tax can be vouched by reference to the return submitted by the

dealer and Treasury or Bank Receipt. Such returns are submitted every month or quarter. At

the final assessment for the year, if le amount of tax falls short, he is asked to deposit the

difference and if it - in excess, he is allowed a refund.

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(Vouchers—1. Income-tax—Assessment Order Form, Notice of Demand rid

Receipted Challan. 2. Sales-tax— Return submitted by the dealer and, reasury or Bank

Receipt.)

Bank Charges. To vouch bank charges such as commission, interest n overdraft and

loan, etc., the Bank Pass Book should be examined. If r.ecessary, the auditor should check the

calculation of interest.

(Vouchers—Bank Pass Book.)

Insurance. For payment made on account of insurance premiums, the rceipts from the

insurance company and the policy itself may be ex-mined. In case of renewal, the renewal

receipt for the premium should be referred to. The auditor should call for a schedule of all the

policies if their imber is large and check them accordingly. (Vouchers—Insurance Policy,

Receipts.)

Petty Cash. To vouch petty cash payments, the auditor should examine the Petty Cash

Book which is dealt with in detail in the pages that follow. However, he can check petty cash

payments by reference to the Requisition Slips and Petty Cashier's Receipts.

(Vouchers—Requisition Slip, Petty Cashier's Receipts.)

Postage. The auditor should compare the Postage Book with the Cash 3ook and Petty

Cash Book and count the stamps in hand. He should see "hat postage includes only the postal

expenses connected with the business and not with any private account.

Petty Cash Book. First of all, the auditor should check the system of mternal check in

regard to the petty cash transactions. Since there are no proper vouchers, chances of

misappropriation of cash exist, the petty cash : s usually maintained on the imprest system. If

he finds that the system rf internal check is sound, he should adopt the following course of

action.

(1) He should check the payment entered in the Cash Book which has been made to the

Petty Cashier for petty expenses.

(2) He should examine the totals and balances etc., of the Petty Cash Book.

(3) If vouchers for a few months are available, they should be examined. He should insist

upon having vouchers for every expenditure above Rs. 2 or so.

(4) For expenses for which vouchers are not available, he should call for a summary from

the Petty Cashier which should be duly signed by a responsible officer.

(5) He should see that the Petty Cash Book is periodically checked and initialled by some

responsible person to ensure that the petty cash payments are bona fide.

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(6) He should verify the closing balance of the petty cash on the Balance Sheet date. The

auditor should count the amount of petty cash in hand if he is unable to attend on the

date of Balance Sheet and also to arrange for the petty cash balance to be paid into the

Bank, it will be necessary for him to carry its vouching to the day of his visit and

count the petty cash as at that date.

In the case of London Oil Storage Co. Ltd. vs. Seear Hasluck & Co. (1904), it was

held that the auditor had committed a breach of duty in not vouching the existence of the

petty cash balance which was shown in the books to be £ 796 but was in fact only about £ 30.

(7) No IOUs should be included in the petty cash balance.

Purchases Book. It is the first and foremost duty of an auditor to satisfy himself with

the internal check system in operation in regard to purchases. He should specially

made investigations into the procedure of placing orders, receiving goods, examining

invoices and maintaining records in regard thereto. If the system of internal check in

operation is efficient and effective, he can conveniently proceed with the vouching of

Purchases Book.

(1) He should keep in mind the following points while checking invoices :

(i) The invoice is in the name of his client.

(ii) The date given in the invoice relate to the period under audit.

(iii) The invoice relates to the business in which the concern deals.

(iv) The invoice is initialled by some responsible person who has checked it.

(v) The invoice is entered in the name of supplier in the Purchases Book.

(vi) The trade discount has been deducted from the amount of the invoice and then, only

net amount has been entered.

(2) Often business-houses maintain Goods Inward Book recording receipt of goods

purchased and received in the premises. Such records should be checked with the

invoices. This will avoid the inclusion of fictitious invoices or the duplicates as

'original' ones.

(3) Sometimes, invoices are suppressed to manipulate accounts and purchases are shown

at less figures than the actual ones. The auditor should, therefore, compare the Goods

Inward Book and the Stock Sheets with the Purchases Book, specially for goods

received during the last two or three weeks of a financial year and during a few weeks

of the beginning of the next financial year.

(4) It should be seen that no invoice has been entered twice in the books.

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(5) It has to be examined that capital purchases have not been written as revenue

purchases in the financial book.

(6) He should examine costs and balances of the Purchases Book, and posting to the

respective ledger accounts should also be checked.

(7) If for a purchase, proper voucher is not available, he should ask for a duplicate. If it is

not supplied, he may mention the fact in his report.

(8) If the invoice contains several pages, its total should be checked with reference to the

totals given on separate pages.

Purchases Returns Book. The auditor should examine the system of internal check in

operation. Having satisfied himself with the system, he should vouch the Purchases Returns

Book and proceed in the following manners :

(1) He should compare the credit notes with the Purchases Returns ok and also the Goods

Outward Book. He should ensure that the Credit Htes have not been suppressed.

Usually, such frauds are committed for g jods returned at the close or in the beginning

of the financial year. Hence, he accounts relating to these periods should especially be

examined.

(2) The auditor should also check castings and postings of the Pur-hases Returns Book

and their postings to the Ledger Accounts.

Sales Book. As usual, the auditor should examine the system of :.iernal check in

regard to the credit sales. This includes the procedure ginning from receiving orders to the

delivery of goods and making ayments therefor. The following points may be noted:

(1) He should compare the name, the date, the amounts, etc., given on he copy of the

invoice with those given in the Sales Book.

(2) If some distinction is made in granting trade discount to two Afferent customers, the

reason thereof should be enquired into.

(3) The Sales Book should be vouched with the help of the Orders ceived Book and the

Goods Outward Book to ensure that no sales have een omitted from recording.

(4) If goods are supplied on 'approve or return' basis, it should be seen that such goods are

not to be treated as sales till the letters of acceptance have been received.

(5) The auditor should especially examine the sales relating to the eriods in the beginning

or at the close of the financial year to ensure that no manipulation has been made in

accounts. He may check such sales with the Goods Outward Book.

(6) It should be seen that capital sales have not been treated as revenue sales.

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(7) He should check the castings and postings of the Sales Book and also examine the

postings to the Ledger Accounts.

To see that the sales transactions are bona fide, the auditor has to be very careful.

Sales Returns Book. The auditor should examine the system of internal check in

operation. The goods returned by customers on account of their being defective or inferior in

quality are recorded in the Goods Inward Book on their receipt. The following points should

be kept in mind while vouching sales returns :

(1) He should check the entries in the Sales Returns Book with the help of the copies of

notes maintained and the Goods Inward Book.

(2) He should especially check a few entries made in the beginning or at the close of the

financial year. This may involve some sort of manipulation of accounts.

(3) He should check the castings of the Sales Returns Book and their postings in the

Ledger Accounts.

Bills Receivable Book. Entries for bills receivable are passed in the Bills Receivable

Book. There may be five such categories :

(1) Bills matured for which payments have been received. The receipt of money on this

account may be checked by reference to the Cash Book. If payments are received

through the bank, the Bank Pass Book should be examined.

(2) For bills discounted, the Cash Book and the Pass Book entries should be checked.

(3) There may be bills-in-hand which are not matured. If such bills are with the client,

personal verification should be done by the auditor. If they are deposited with the

bank, a certificate to that effect should be obtained from the bank.

(4) For bills dishonoured, it should be seen that the proper entries have been passed in the

financial books.

(5) For bills discounted and dishonoured, the auditor should verify such bills returned by

the bank and see that the bank's advice has been attached to the voucher. It is to be

ensured that the amount of such bills along with the commission, if charged by the

bank, has been debited to the party and credited to the bank account.

He should check the castings of the Bills Receivable Book and their postings to the

Ledger Accounts. The liability for bills discounted should be properly shown in the liability

side of the Balance Sheet.

Bills Payable Book. Bills accepted and entered in the Bills Payable Book may be of

two types :

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(1) Bills for which payment has been made by the client on maturity. The evidence of the

payment will be found in the returned bills. Cash Book should be checked for such

bills and if the payment is made through the bank, Pass Book should be examined.

(2) Bills which have not yet matured. The counterfoils or copies of such bills will be the

documents in the support for such bills. The Bills Payable Book should be examined

and if necessary, the statement of accounts submitted by creditors should be referred

to.

The castings of Bills Payable Book should be checked and their postings into the

Ledger Account should be examined.

Journal Proper. The entries which cannot be passed through any other book of

original entry, are passed through the Journal Proper. The auditor should see that all such

entries recorded in the Journal are duly supported by vouchers and relevant documents are

correct. He should remember that there is a lot of scope for the manipulation of accounts in

the Journal.

(1) Opening Entries. The opening entries may be checked by reference to the various

relevant items on the previous Balance Sheet. If the business has been purchased from

the vendor and then the opening entries have been passed, agreement between the

client and the vendor, Articles of Association (if it is a company) and Directors'

Minutes should be examined to ensure that correct records are maintained and there is

no manipulation in the accounts.

(2) Closing Entries. Such entries are those which are passed for closing and transferring

balances from the nominal accounts to the Profit and Loss Account. It should be seen

that balances have been correctly arrived at and carried to proper accounts.

(3) Adjusting Entries. Adjusting entries include such items as provision for bad and

doubtful debts, outstanding and prepaid expenses, accrued and unearned income,

depreciation and reserves, allocations between capital and revenue, etc.

The auditor should check all the available evidences in order to ensure that such

entries are accurately and correctly made. He should explore the chances for

committing fraud through the Journal and check them thoroughly.

Provision for bad debts should be based on the procedures followed in the past and its

adequacy should be verified. Bad debts should be written-off only under proper

authority. For outstanding and prepaid expenses and also for accrued and unearned

income, the auditor should obtain schedules from the client and ensure that items have

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been correctly arrived at. Thus, he should not pass any entry until he is satisfied with

regard to its validity and correctness.

To vouch entries for provision for depreciation, he should obtain information with

regard to the nature of assets, their estimated effective life and also the bases upon

which provision for depreciation has been made. Director's Minutes should also be

seen for the authority.

(4) Issue, Allotment and Forfeiture of Shares. Entries relating to issue, allotment and

forfeiture of shares are also passed through the Journal. For such entries, the auditor

should study the Prospectus, Articles of Association, Director's Minutes Book,

Applications, Copies of Allotment Letters, Correspondence, etc. These items are dealt

with in detail in the chapter on Company Audit'.

(5) Consignment Transactions. Consignment transactions are usually entered in the

Journal but if the volume of such transactions is large, it would be advisable to

maintain a separate book called 'Consignment Outward Journal'. The vouching of

consignment transactions should be done with the copies of the proforma invoices,

correspondence, account sales received and contracts with the consignees. If the price

quoted is higher than the cost, the necessary adjustment should be made before

finding out the actual profit or loss. The goods unsold should be separately shown in

the Balance Sheet as 'Stock of Goods on Consignment'.

If goods are received on consignment from other parties, entries therefor will also be passed

through the Journal. Such entries should be vouched with the help of the copies of account

sales submitted to the consignor. The sales of such goods should not be included in the

ordinary sales but should be dealt with separately.

Purchases (Creditors) Ledger. The Purchases Ledger contains accounts relating to creditors.

The following points may be noted :

(1) The opening balance of different accounts may be checked with the Audited Balance

Sheet of the previous year.

(2) All supporting books, viz., Purchases Book, Goods Outward Book, Cash Book,

Allowance Book, Discount Register, Bills Payable Book, etc., should be thoroughly

investigated.

(3) If the self-balancing system is in use, the auditor should call for a schedule of

creditors from the client and total of the schedule should be tallied with the Creditors'

Ledger Adjustment Account in the Ledger Account.

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(4) The auditor should examine all the Creditors' Statements and with their help, the

Purchases Ledger balance should be checked.

(5) It should be seen that the balances of the Purchases Ledger whether debit or credit are

shown on the proper side of the Balance Sheet.

(6) If provision for reserve for discount on creditors is made, it should be ensured that it

is not excessive.

Sales (Debtors) Ledger. The Sales Ledger contains accounts relating to debtors.

The auditor has to place considerable reliance upon the system of internal check as regards

the Sales Ledger. He should note the following points :

(1) He should ensure that the work of each Ledger Clerk is independently checked.

(2) He should see that entries in the ledger are made by some other person who is not the

Ledger Clerk.

(3) He should verify that ledger is balanced frequently and the extraction of the balances

independently checked.

(4) It is to be examined that the collection of accounts and the writing-off of bad debts is

properly supervised by a responsible official.

The following steps should be taken to vouch the Sales Ledger:

(1) The opening balance should be checked with balance given in the previous year's

Balance Sheet.

(2) Books like Bills Receivable Book, Cash Book, Sales Returns Book or Goods Outward

Book, Journal or other subsidiary books should be checked to vouch the accounts in

the Sales Ledger.

(3) The auditor should call for a schedule of Debtors' Accounts and check it carefully.

(4) If the books are maintained on the self-balancing system, the total of the balance in

the schedule of debtors should tally with the total of the balance shown in the Debtor's

Ledger Adjustment Accounts.

(5) It should be ensured that the debit or credit balance of the Sales Ledger should be

shown on the proper side of Balance Sheet.

(6) He should call for a list of bad, doubtful and good debts and verify them thoroughly.

Total Account. A total or control account is an account which is debited in total with all the

amounts on the debit of the individual accounts and credited in total with all the

amounts on the credit of individual accounts in the ledger. The balance of this account

would be equal to the difference between the sum of the debit and credit balances

appearing in that ledger.

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Thus, in the preparation of a total account, a reference is made to the various books of

original entry and the Cash Book. Such separate accounts are prepared for Sales Ledger and

Purchases Ledger. This account, therefore, provides a check on the balances of the Purchases

and Sales Ledger.

Total accounts are maintained in the general or impersonal ledger. Monthly totals of

the Purchases Book or Sales Book or Returns Inward or Outward Book are posted in the total

accounts. Total monthly receipts from customers and payments to the suppliers are posted in

these accounts. Any entry which affects debtors or creditors is also posted to the control or

total accounts and simultaneously, it is posted with the individual account either in the bought

ledger or sales ledger. In the control accounts, mthly summaries are posted. Thus, the balance

in the total account must be equal to the total of the summary of the respective ledgers. This

s, however, true that under the self-balancing system, the chances of rrors are always reduced

to the minimum.

Mechanized Accounting

In mechanized accounting machines are used to facilitate the handling : numerous

transactions and provide mechanism to apply controls and necks. Thus, there can be some

inconveniences in the checking work and rocedures. Mechanized system of accounting can

best be applied with 1 vantage, if the auditor is consulted before it is introduced.

Under the traditional system of accounting, everything relating to the .aintenance of

account is done by hand and one transaction has to pass r.rough many books from journal to

ledger and so on. This involves a lot : waste of time and unnecessary burden of expenditure.

Today, the wide expansion of industries in different directions has rought about a

significant change for demand of an accounting system that the cost can be lessened and

work performed with least possible ands in minimum possible time. In these days of

modernization, it has ecome absolutely essential to recognize the accounting procedures so

that the entire process of work may be simplified. 'Short-cut Methods' are being Inolved and

adopted to speed up the work and tendencies for the adoption if such methods are increasing

day-by-day. As a result, mechanised System of accounting has been evolved and machines

have been put to-ervice for the preparation of account.

Advantages

The following are the main advantages of mechanised accounting system :

1. Since under the mechanised accounting system machines are used o record

transactions and to prepare accounts, the speed of work can be enhanced.

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2. Machines can prove to be better servants that human beings and as such chances of

errors are reduced to the minimum.

3. Machines always do better and, therefore, the work done by machines is always more

legible and neat than that done by hand.

4. The work under the mechanised system can be done with minimum amount of man-

power and with little cost. There are, therefore, more chances of affecting greater

economy.

5. Under mechanised system of accounting, as many as required copies of records can

be made available for action at the Board or any other level without incurring any

extra cost.

6. This system minimizes Overtime Payments which can be avoided under the system,

as the balances of accounts are struck whenever an entry is made.

7. The mechanised accounting, thus, facilitates the preparation of Interim Accounts

whenever there is need for doing so. Besides this, Collection of Accounts becomes

very quick as the Statement of Accounts are made available to customers without any

delay.

8. As the machines always perform better, the expenditure on audit, internal audit and

internal check can be minimized.

9. This system facilitates compilations of Statistical Records and, therefore, it becomes

very convenient for the management to make analyses and take quick decisions

thereafter.

Disadvantages

1. Under the mechanised system of accounting, loose Cards or Sheets are used and there

are possibilities of their being lost very easily.

2. If original records are lost or destroyed, the errors can be located with a lot of

difficulty.

3. Under this system, there is no narration to an entry and hence, it takes a lot of time to

understand a transaction.

4. Such accounts are not easily understandable to an auditor.

5. The initial stage of recording transactions is very risky and, therefore, it involves a lot

of time and energy on the part of an auditor to certify the results shown by the

financial accounts.

6. Loose Cards and Sheets maintained under this system are not acceptable normally by

the Courts.

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Auditor in Relation to Mechanized Accounting

An auditor has to perform his duties quite carefully as there is no change in the

procedure of auditing even if mechanized system of accounting is adopted. He has to see

whether there are errors at the initial stage of recording transactions and only authorized

transactions have been entered into the books. He has to be quite cautious to ensure whether

there has been some collusion between the clerks and there are cases of manipulation or

misappropriation in the records as a result thereof. A close scrutiny of the system of internal

check would be very much necessary on his part. The ultimate responsibility, however, rests

on his shoulders.

At the very outset, he should call for a certificate from some responsible officer to the

effect that the machines used in the business are operating in proper order. The mistake of

miscoding is very common under the system and the auditor should guard against it. In the

absence of narration he should try to understand each and" every item quite thoroughly. He

should see that an efficient system of internal check is the only answer in case of ioss or

substitution of any sheet or card.

VOUCHING OF IMPERSONAL LEDGER

It is an important part of the auditor's duty to vouch the Impersonal Ledger which

contains accounts from which Trading and Profit and Loss Account and the Balance Sheet

are prepared. The Impersonal Ledger has two kinds of accounts, viz.. Nominal Accounts and

Real Accounts. Nominal Accounts relate to the Trading and Profit and Loss Account and

Real Accounts record assets. It is clear, therefore, that if the accounts in the General Ledger

are incorrect, they will affect the Profit and Loss Account and the Balance Sheet. The auditor

can conveniently check these accounts in detail as their number is not very large even in big

business concerns.

Earlier, transactions relating to purchases, purchases returns, sales and sales returns,

salary, wages, etc., which appear in the trading account have already been dealt with. The

remaining transactions which appear in the Impersonal Ledger but relate to Profit and Loss

Account will now be dealt with. The Impersonal Ledger will be vouched as follows :

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1. The auditor should check the postings of cash transactions to the Impersonal Ledger.

The Journal should be carefully vouched and it should be ensured that each entry is

supported by sufficient evidence. Their postings to the Impersonal Ledger should also

be checked.

2. He should carefully check the totals of the various other books of original entry and

the postings thereof to the Impersonal Ledger.

3. Direct entries are sometimes passed from one account to another in the Impersonal

Ledger. In such cases, the auditor should vouch the direct transfers in the manner in

which he examines those items which pass through the Journal.

4. He should check very carefully the adjustments which are usually done at the end of

the year when the final accounts are prepared. Such adjustments relate to outstanding

assets and liabilities, depreciation, etc. As these adjustments pass through the Journal,

their postings to the Impersonal Ledger should be checked. Special attention should

be paid to these adjustments as they ultimately affect the position shown by the final

accounts.

Outstanding Assets and Liabilities

If correct profit or loss of a business concern for a certain period is to :e found out, it

is very much desirable that (1) all income and expenditure which relate to that period should

be brought into the Profit and Loss Account, and (2) no income and expenditure which do not

pertain to that period should be brought to the Profit and Loss Account. To record these,

adjusting entries are passed so as to arrive at a correct Profit and Loss Account and to prepare

a proper Balance Sheet. As a matter of practice, an outstanding Memorandum Book is

maintained in some business concerns for this purpose. This book can help the auditor to

know exactly as to what the outstandings are for which adjusting entries have been passed

during the year. The book is useful for the auditor for comparing the outstandings of two

periods. Such balances are to be shown as debit or credit balances in the Impersonal Ledger

and ultimately shown as assets and liabilities in the Balance Sheet.

Outstanding Assets

There may be an expenditure already incurred for which the corresponding benefit

could not be made available for the business during the period or some portion of this

pertains to the period subsequent to the date of Balance Sheet. Besides this, there may be

some items accruing or due which may not have been recorded in the books. The examples of

such items are—Prepaid Expenses, Accrued Income and Deferred Revenue Expenditure.

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1. Prepaid Expenses. Prepaid expenses are the expenses which actually pertain to the

next financial year but have been paid this year, i.e., in advance. If the whole of the amount is

charged to the Profit and Loss Account of the current year, it will be unduly burdened and the

profit or loss thus arrived at will not be correct. Hence that part of the expenditure which

relates to the next financial year will have to be shown separately and should be deducted

from the total expenditure. Their examples are insurance premium, rent, rates, telephone

charges, subscription, etc.

The auditor should examine the nominal accounts, the demand notes, receipts, etc.,

and ensure that proper adjustments have been made in the books at the date of Balance Sheet.

He should also satisfy himself that a correct calculation has been made for the part of the

expenditure which is unexpired on that date.

2. Accrued Income. There might be certain items of income which ought to have been

received at the date of Balance Sheet but have not actually been received, e.g., rent might not

have been received for a part of the current year; interest, "dividend, commission might have

been receivable but not received before that date of Balance Sheet, etc. To arrive at the

current profit or loss, such items of income must be accounted for in the Profit and Loss

Account.

The auditor should go through the records very carefully and see that accrued income

which actually relates to the current year has been brought into account. He should check the

adjusting entries passed for this purpose at the date of Balance Sheet and also scrutinize that

they appear as correct figures on the asset side of the Balance Sheet.

3. Deferred Revenue Expenditure. Deferred Revenue Expenditure is a non-recurring

item of expenditure which is incurred with a view to have financial benefit to many

accounting years. The entire amount, as such, should not be charged to the Profit and Loss

Account of the year in which it is incurred. The expenditure will have to be carried forward

and spread over a number of years, otherwise it will bring an undue and extra burden on the

Profit and Loss Account of the current year.

Outstanding Liabilities

Like the outstanding assets, outstanding liabilities should also be included in the

Profit and Loss Account. If it is not done, the final accounts will not reveal the correct

position of profit or loss and also of financial affairs of the business concern. To verify such

items of outstanding liabilities is a bit difficult for the auditor but it is his important duty and

he is likely to be held liable if he does not do so. He should realise that if the actual liabilities

are not brought into account, the profits shown by the Profit and Loss Account will be more

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than the actual profits and in that case, the dividends will be paid out of capital. However, it

will not be easy for the auditor to ensure whether some of the expenses might have been

suppressed or concealed. As such, it will be better on his part to obtain a certificate from a

responsible official that there are no expenses which relate to the current year but have been

omitted from being recorded in the Books of Accounts. The examples of such liabilities are

unearned income, unpaid expenses, purchases made at the close of the year, liabilities for

rent, and taxes, electricity charges, wages and salaries, freight and carriage, travellers' and

agents' commission, etc.

1. Unearned Income. Unearned income is that income which has been actually

received during the current year but it does not relate to this year. It will be earned in the next

year, e.g., rent or interest received in advance. For example, a concern receives Rs. 750 for

rent in a particular year but actually, Rs. 600 relates to the current year. In such a case, Rs.

150 should be treated as rent received in advance as it is an item of unearned income.

The auditor should examine such items very carefully and see that a part of such income

which pertains to the next financial year has been treated as unearned income and shown

separately in the liability side of the Balance Sheet.

2. Unpaid or Outstanding Expenses. The expenses which have been incurred during

the year but their payments are wholly or partly outstanding are known as unpaid expenses.

In such cases, the total amount of such expenditure whether unpaid in part or in toto should

be charged to the Profit and Loss Account and included also as a liability in the Balance

Sheet.

The auditor should examine nominal accounts, demand notes, receipts, invoices and

other relevant vouchers and note the period covered by such payment. He should ascertain

with their help that the expenses unpaid have been debited to the Profit and Loss account of

the current year and shown separately in the liability side of the Balance Sheet.

3. Purchases made at the Close of the Year. Purchases made at the close of the year

have been received and entered in the Stock Book but no entry has been passed in the

Purchase Book as the relevant invoice has not been received.

The auditor should call for a schedule of such purchases and see that their total is

debited to the Purchases Account and credited to Outstanding Liabilities Account. The Goods

Inward Book should be compared with the Purchase Book for the few days of the closing

month of the year. He should also compare the creditors' statement with their accounts in the

Bought Ledger.

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Liability for Rent, Rates and Taxes, Electricity Charges

To calculate correct profits or losses of the current year, provision should be made for

all liabilities for rent, rates and taxes. If it is not done, the Profit and Loss Account will not

reveal correct position. This is a liability for expenses payable which have become due for

payment during current year.

The auditor's duty is to inspect the relevant accounts in the ledger, demand notes,

receipts, etc., and find out what period is covered. The accounts should be adjusted for the

amount, which has become due but not yet paid.

1. Wages and Salaries. There is a usual practice in business concerns that the

accounts are closed on the 1st day of the month, and wages or salaries are paid on first of the

following month. Since no payment has been made, wages and salaries will not be debited to

the Profit and Loss Account of the year. The profits thus revealed by the Profit and Loss

Account will not be shown as correct figures. It is proper, therefore, that such outstanding

salaries and wages should be brought in the books for the purpose of arriving at the correct or

actual profits. An entry should be passed to debit the Wages and Salaries Account and credit

Outstanding Liabilities Account.

The auditor should see that the Profit and Loss Account has been debited with the

amount of 12 months' wages and salaries every year.

2. Other Liabilities. The auditor should examine other liabilities relating to freight

and carriage, travellers' and agents' commission as he has done in the case of unpaid expenses

discussed above. For checking liability for freight and carriage, he should scrutinize the

Statement of Accounts rendered by the clearing and forwarding agents and ensure that they

are correct.

To vouch the travellers' and agents' commission, he should examine Commission

Accounts received from travellers and agents. He should ensure that provision has been made

in the books of accounts for a part of such commission unpaid at the date of the Balance

Sheet. He should ensure what amount is due to travellers and agents at the date of Balance

Sheet after deducting the advance. Only that part of it should be shown as outstanding

liability. If the advance is more than the amount of commission due, it should be shown as

loan to the travelling agents on the asset side. For Such a loan, it will be advisable to make a

reserve for doubtful debts as some of the travelling agents do not clear their accounts and

give up their jobs.

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3. Apportionment of Expenditure between Capital and Revenue. When a business

concern incurs some expenditure, it may be of capital or revenue in nature. It is, therefore,

quite important to make an apportionment between capital and revenue so as to arrive at

correct figures of profit or loss. As a matter of rule, all revenue expenditures should be

charged to the Profit and Loss Account and all capital expenditures should be shown in the

Balance Sheet.

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VERIFICATION OF ASSETS AND LIABILITIES

"The verification of assets implies an enquiry into the value, ownership and title;

existence and possession; the presence of any charge on the assets." —Spicer and Pegler

"The verification of assets is a process by which the auditor substantiates the

accuracy of the right-hand side of the Balance Sheet, and must be considered as having three

distinct objects : (a) the verification of existence of assets, (b) the valuation of assets, (c) the

authority of their acquisition.'' —Lancaster

The auditor of a business is required to report in concrete terms that the Balance Sheet

exhibits a true and fair view of the state of its affairs. In other words, he has to examine and

ascertain the correctness of the money value of assets and liabilities appearing in the Balance

Sheet. This is known as verification of assets and liabilities. Thus, verification means to

prove the truth about and the correctness and authenticity of assets and liabilities. In the

London Oil Storage Co. Ltd. vs. SeearHasluck & Co. (1904), it was held that it is the duty of

an auditor to verify the existence of the assets stated in the Balance Sheet and that he will be

liable for any damage suffered by the client if he fails to do so.

Very often, vouching and verification are considered to be one and the same thing. It

is not so. A clear line of demarcation can be drawn between the two. Vouching is to examine

the correctness and authenticity of the transactions recorded in the books of prime entry while

verification is to confirm the value of assets and liabilities as shown in the Balance Sheet. As

such, in verification it is not merely the duty of the auditor to see that assets have been

acquired but he has to certify that such assets (i) exist with the business, (ii) are the property

of the client, and (iii) are valued at proper figures on a particular date, viz., the date of the

Balance Sheet.

It may be possible that after having acquired an asset, some persons employed in the

business might have either sold or mortgaged it as a security for loan with some other firms.

Hence, the auditor has to see that the assets existed with the client on the date of the Balance

Sheet. If he does not proceed in an effective way while verifying the assets and liabilities, he

will be held liable for negligence. In the decision of McKesson & Robins case (1939), it was

held that the auditor must physically inspect some of the assets. He should, therefore,

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examine the documents of title, e.g., shares, debentures, securities, negotiable instruments,

etc., to ensure that the assets existed on the closing day of the financial year.

Thus, the auditor has to perform four types of functions in verifying the assets :

(1) To see that they are clearly stated in the Balance Sheet.

(2) To ensure that they are in existence on the day of the Balance Sheet.

(3) To verify that they are the Property of the business and as such, they are free from any

charge or mortgage.

(4) To satisfy himself that they are properly valued.

On an analysis, it can be held that in verification it becomes the primary duty of the

auditor to satisfy himself in regard to the existence, ownership and value of the assets. So,

also for liabilities, he has to check the nature and extent of their amount due on the day of the

Balance Sheet.

Assets like cash, bills receivable, investments, etc., should be inspected by the auditor

by examining them personally on the day of Balance Sheet. If personal inspection is not

possible, he should try to reach thereafter as soon as possible. If he visits the business some

time after the close of business on the day of the Balance Sheet, he should check the

transactions thoroughly which have been made during this day and the date of his visit.

It is also equally necessary that the assets which are of easily negotiable in character

or easily exchangeable should be verified by him very cautiously, e.g., in verifying securities,

he should try to check them in one sitting, if possible, and if it is not possible, he should note

down their number, date, etc. in his note book. At least, he should have the securities in his

possession till they are completely verified by him. If some of them are pledged or sent to

some bank, etc., for inspection, a certificate to that should be obtained from the institution

concerned.

Valuation

At the very outset, it would be apt to remark that the valuation of assets is an

important part of their verification. Hence, it should be studied as a part of verification and

not separately. It would be a great mistake to take it otherwise. It is rather true that the correct

profits cannot be calculated unless the assets are properly valued. Only then, the Balance

Sheet will reveal the true and fair position of the financial affairs of a business. The valuation

as such involves to ensure the correct valuation of the assets while in verification, the auditor

has to verify the authority and existence of the property also besides its valuation.

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Thus, valuation means to test the exact value of an assets on the basis of its utility. It

is actually the ascertainment or measurement of the money value at which an asset has been

shown in the books of accounts or in the financial statement. Normally, valuation is done

after deducting the depreciation for the value of an asset. If proper depreciation on assets is

not provided for, the result would be very serious. If the amount of depreciation charged to

the Profit and Loss Account is more than the actual, the profits will be reduced and

consequently, the shareholders of a joint-stock company would get less dividend. On the

contrary, if it is shown at a less figure than the actual, the profit would be inflated and the

shareholders would receive more dividend, a part of which would, thus, be paid out of

capital. As a result of this, the capital would be exhausted by and by, and the company would

be insolvent. These are, in short, the repercussions that will follow the incorrect valuation of

assets of a business.

The following are some of the interpretations of the value used in the valuation of assets :

(1) Cost Price. It is a price paid for the acquisition of an asset. As a matter of practice, the

expenses incurred in the purchase of an asset and its installation are included in its

Cost Price.

(2) Replacement Value. It is a price at which a particular asset can be replaced. In such a

value, the expenses, e.g., commission, Freight, etc., are also included.

(3) Market Value. If an asset has a market for it, a value which it will bring when sold in

the market, is termed as Market Value.

(4) Book Value. It is a value at which an asset appears in the books of Accounts. It is

usually the cost less depreciation written-off so far.

(5) Realizable Value. A value which will be realized in the market and received from the

sale of an asset is known as its Realizable Value. Usually, expenses such as

commission, brokerage, etc., are deducted from it. The realizable value is normally

used in the valuation of existing assets.

(6) Break-up Value and Scrap Value. A value which may be obtained from the asset if it

is sold as scrap and unserviceable is Break-up value.

(7) Going-concern Value or Value of the Business as a Going Concern. This is also

known as Conventional or Token or Historical Value. It is equivalent to the cost less a

reasonable amount of depreciation written off.

How far the valuation of a particular asset is correctly made is a question which will

depend upon its nature, size and use. However, the following points have to be considered in

the valuation of assets :

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(i) The Original Cost;

(ii) The probable working life, le., the lifetime for which an asset will remain in proper

working order;

(iii) Its Wear and Tear;

(iv) Its Break-up Value; and

(v) The chances of its being Obsolete.

Classification of Assets

Assets are generally classified under five main categories :

(1) Fixed Assets,

(2) Floating or Current or Circulating Assets,

(3) Wasting Assets,

(4) Intangible Assets,

(5) Fictitious Assets.

(1) Fixed Assets. Fixed Assets are acquired for permanent use and continuous service

rendered by them for a pretty long time. They are neither meant for resale in the ordinary

course of business nor consumed totally or partially in the business. Thus, such assets are

more or less of permanent character and are used for the purpose of earning profits. The

utility of these assets remains so long as they are in working order. Land, building, plant,

machinery, furniture, etc., are some of the examples of fixed assets.

Out of the fixed assets, land is peculiar in the sense that it is not subjected to depletion

in value by its use. Hence, its valuation is usually done at cost price. The remaining assets

depreciate on account of their constant use and as such, are of depreciable nature, they are,

therefore, valued at what is popularly known as a 'Going-concern Value', or 'Historical or

Token Value' as explained earlier. The reason for it is that fixed assets are acquired for the

running of a business and put to their repeated uses. They are valued at cost less a reasonable

depreciation written-off and any fluctuation in their prices is not cared for.

Thus, market price of realizable value of these assets is not considered for their

valuation as they are not meant for resale in the market. The utility of such assets is not in the

least affected by their market value being low or high. Service of experts are sought to

recommend the estimated amount of depreciation in each case.

(2) Floating or Current or Circulating Assets. The assets which cannot be put to

constant uses are floating or current or circulating assets. Floating assets are meant for resale

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or are processed or produced for the purpose of sale and converting them into cash. Closing

stock, semimanufactured goods, book debts, bills receivable, cash, etc., are some of the

examples of floating assets.

Book debts, bills receivable, etc., are normally valued at book value and in case of

book debts, a provision is made for bad and doubtful debts. Raw materials and semi-

manufactured goods are valued at cost. The closing stock of goods is valued at the date of the

Balance Sheet at a cost price or market price whichever is lower. This principle is to be

followed in most of the cases.

The valuation of floating assets should be done at the cost price or the market price,

whichever is less. Why? This is an important issue to be considered. This clearly means that

anticipated profits must not be accounted for while expected losses must always be taken note

of. This is essential. The profits which have not yet been earned cannot be called and treated

as actual profit in the strict sense of the term and even if they are treated as such for the

present, it will be a great shock to the business in case there is loss instead of profit as

anticipated. Similarly, if dividend is also distributed out of such anticipated profits to the

shareholders of a company, it will not be a sound policy in the interests of the business itself

and in the future, if it is a loss, money so distributed will not be taken back from the

shareholders. On the contrary, if expected loss is taken into account at present and even if a

loss occurs at a later stage, the business will not be affected adversely and if there is no loss,

it is quite good for the business. This is the reason as to why the guiding principle, le., cost

price or market price, whichever is less, is followed for the valuation of floating assets.

(3) Wasting Assets. There does not appear any necessity to provide depreciation on

Wasting Assets like mines, quarries, etc., in terms of the decision of the case of Lee us.

Nauchatel Asphalte Co. Ltd. (1889). But as a matter of principle, the theory propounded in

the case does not hold good. Wasting Assets exhaust by working and hence the process

involves depletion of the capital employed. Hence, a charge should necessarily be made to

maintain the capital employed so as to exhibit a true and fair value of the assets for the

purpose of cost accounting. Wasting Assets are of Fixed nature and are depleted gradually or

exhausted in the process of earning income, such as mines, quarries, oil-wells, etc. But there

is difference between Fixed Assets and Wasting Assets. The decrease in the value of Fixed

Assets is due to their use, Le., wear and tear or obsolescence, while in the case of Wasting

Assets, the decrease in value is a result of the operation of extracting a part of it or gradual

exhaustion.

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As a general rule the value of the Wasting Assets should be reduced each year to the

extent of the estimated amount by which as a result of exhaustion, such assets have

diminished in value. However, it is difficult to ascertain how much of the mine is exhausted

and how much mineral remains more. Hence, Wasting Assets are shown in the Balance Sheet

at their original value and provision is made for depreciation or depletion on the basis of their

estimated exhaustion.

(4) Intangible Assets. Intangible assets do not have their form and hence, they are

visible in their concrete form. However, they are equally well serviceable and valuable for a

business concern like any other assets. They are actually fixed assets without any concrete

form. Goodwill, patents, copyrights, trademarks, etc., are some of the examples of such

assets. Intangible assets are more or less treated as Fixed Assets for the purpose of valuation.

(5) Fictitious Assets. Fictitious Assets are different by their nature itself. Such assets are not

physically visible, though, of course, money is spent in their case or are unrealizable assets.

The examples of such assets are preliminary expenses in a new company, special advertising

expenses, development expenses, debenture discount and issue expenses, discount on issue

on shares, share issue expenses, etc. These items are really items of expenditure not

represented by actual values and have no exchange value.

Hence, fictitious assets are of peculiar nature and are represented by the revenue

expenditure that has been temporarily capitalized with the ultimate object of spreading the

amount over several future years. Practically, these assets appear in the Balance Sheet as the

amount of expenditure or loss represented, less any amount written-off from year to year to

the Profit and Loss Account.

Position of an Auditor as regards the Valuation of Assets

"He is not a valuer and cannot be expected to act as such. All that he can do is to

verify the original cost price and to ascertain as far as possible that the current values are fair

and reasonable and are in accordance with the accepted commercial principles." —Lancaster

"An auditor is not liable, if in the absence of suspicious circumstances, he relies on trusted

officials of the company."

In re: Kingston Cotton Mills Ltd. (1896)

It is, thus, evident that an auditor has to be very careful and cautious in examining the

valuation of assets. He should remember that the accuracy of the Profit and Loss Account and

Balance Sheet depends upon the accuracy of the valuation of assets. But he is not a valuer or

a technical expert who can estimate the value of assets which are different in their nature and

character. As such, he has no alternative but to rely upon the valuation made by directors,

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partners, technical experts, surveyors, etc. He has to satisfy himself that the valuation of

assets has been correctly made according to some accepted principles. He should ensure that

such valuation appears to him to be fair and reasonable. If some fairly ordinary methods of

valuation are adopted, the auditor can examine himself the utility of such methods and report

on them.

But does it mean that he is absolved from his liability if assets are incorrectly valued

by the officials of the business and also if he entirely depends upon their reports? Is he in a

position to submit his report that the Balance Sheet exhibits a true and fair state of the

financial affairs of a business? The answer is obviously 'no'. He must use his best judgment as

regards each item and take reasonable possible steps to verify that the valuation of assets has

been made correctly. He should specially note the following two things :

(i) How far the principles of accounting have been adopted in the valuation of assets.

(ii) Whatever steps are taken in the valuation of assets are based on the established

practices already in vogue in the business and are the procedures already accepted in

previous years.

If on these two bases, he is satisfied with the methods of valuation of the assets, he is

free from his responsibility and liability. If he is not satisfied in this respect, he must qualify

his report to the shareholders accordingly.

In every business, it is a usual practice to engage technical experts who possess the

technical knowledge of different types of assets. They submit their certificates indicating

therein the estimates on the basis of which depreciation has been provided for. The auditor

should rely on their reports and assessment and make up his mind as to how far the valuation

is fair and correct. If there is the slightest suspicion in his mind as regards the valuation of

assets, he should make enquiries from the responsible officers of the business. This is the

only remedy before him for certifying valuation of assets.

Verification of Different Types of Assets

As has already been stated, the auditor has to keep four considerations in his mind in

verifying the different types of assets. They are :

(i) That an asset is clearly stated in the Balance Sheet.

(ii) That it was in existence with the business as an asset of the business on a particular

day, viz., the date of the Balance Sheet.

(iii) That it is free from any charge or mortgage.

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(iv) That it is correctly valued and its value is correctly disclosed in the Balance Sheet. It

is to be seen that the depreciation provided is adequate and the basis on which it is

provided is consistent with one applied in the previous years.

In the pages that follow, an effort has been made to verify different Kinds of assets on the

basis of these four considerations.

Goodwill

This is an intangible asset and, as such, has value so long as it is attached with the

business. Its value, therefore, depends upon the earning capacity of the business and it

fluctuates according to this capacity. In other words, it increases with the rise in profits

leading to an increased value of the reputation of the business and falls with fall of profits.

There are normally four situations in which Goodwill is calculated or assessed and

shown in the books of the business. They are :

(i) It is valued at the time of purchase when it is paid for. In such a case, Goodwill is

equivalent to the difference between the purchase price and the net assets (le., assets -

liabilities) acquired.

(ii) The company has written-up the values of its assets on a revaluation of the whole of

its assets and a Goodwill Account has been raised in its books.

(iii) There is another occasion when the Goodwill acquired by the company and written-

off as such has been later brought back to write-off the debit balance in the Profit and

Loss Account or a capital loss which the company has subsequently incurred.

(iv) In case of partnership firms, the amount of Goodwill is calculated and assessed

usually at the time of admission and retirement or death of a partner.

The auditor in all the above cases should check the accounts and compare the

Goodwill Account with the Balance Sheet to ensure that Goodwill is clearly stated in the

Balance Sheet and no other asset is mixed with it.

In case of purchase of the business, the auditor should verify it with the help of the

contract made with the vendors. In the case of revaluation of assets which has raised

Goodwill Account in the books of the company, it will be necessary for the auditor to make a

reference on the basis on which the assets of the company have been revalued. In the case of

Goodwill which has been later brought back to write-off the debit balance in the Profit and

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Loss Account or a capital loss, the auditor will be required to investigate the period over

which the Goodwill originally acquired by the company was written-off. He will also

ascertain the amount of Goodwill. He should refer to the resolution of the Board of Directors

in this respect for reintroducing Goodwill as an asset. To utilize this amount for some specific

purpose, approval by the shareholders will be necessary. For Goodwill in the partnership

firm, the Partnership Deed should be referred to. He may verify the changes made in the

Goodwill Account from time to time on the basis of provisions made in the Partnership Deed

in this regard. He is not expected to press upon the Directors or the Partners to write-off a

particular portion of the Goodwill Account, but he can satisfy himself by making a reference

to the Articles of Association and Directors' resolution in the case of company and to the

resolutions of partners, if the business is a partnership firm.

Since Goodwill is an intangible asset having no physical existence, the question of

some mortgage or charge on it does not arise at all.

Goodwill is valued at cost as, like fixed assets, it is not subjected to depreciation or

depletion in value. Hence, it is shown at cost less the amount written-off. Legally, it is not

binding on a company or a firm to write-off goodwill, but, however, it is advisable from the

sound financial point of view to write it off gradually within a reasonable period out of the

current profits or reserves. The auditor should very carefully look to the reasonableness of

appreciation in its value, if any.

Freehold Land

First of all, the auditor should see that in freehold land, no other asset, leasehold or

freehold is shown alongwith this as its part. This is highly objectionable. He should compare

the relevant Ledger Accounts with the Balance Sheet to ensure that freehold land is

separately and distinctly shown in the Balance Sheet.

The freehold land or property is absolutely the property of the client. Hence, he

should examine the Title Deeds relating to the freehold land and see that the asset is in the

name of the client and is in his free and fair possession and the Tide Deeds are genuine. He

should verify the sale, if a part of it has been sold out during the course of the year and it is

purchased during the year under audit he should examine correspondence and Broker's Note

or Auctioneer's Account.

The land is not subjected to depreciation, but there may be some fluctuations in its

value according to the changed circumstances. The auditor should see that no notice of such

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an appreciation or fall is taken into account while valuing the asset. But if such a fluctuation

is accounted for, the auditor should see that such an adjustment in value has been disclosed in

the Balance Sheet. Usually, land appears at cost in the Balance Sheet.

Freehold Building

The auditor should examine the genuineness of the records made in the accounts to

ensure that freehold land and buildings are shown in the separate accounts. It is to be

remembered that building is to be treated separately from land as in the case of the former,

depreciation has to be provided for building while there is no depreciation of land.

He should examine the Title Deeds relating to the property. If it is purchased,

correspondence and Broker's Note has to be examined. If the purchase is affected through

auction the Auctioneer's Account should be checked. But if the building has been constructed

by the client, he should examine the certificates received from the Builder, the Contractor, the

Architect and other necessary papers and documents.

If the building has been mortgaged, and its Title Deeds are with the mortgagee, the

auditor should obtain a certificate from the mortgagee, and verify the asset with its help. If

the Title Deeds are with the Solicitor or the Banker for the safe custody, it should be seen that

they are for safe custody and not deposited as a security for a loan.

Freehold building should be valued at cost less depreciation. Fluctuations in the

market value are not to be considered in its valuation. But if something otherwise has been

done, it should be clearly disclosed in the Balance Sheet.

Leasehold Property

When an asset is acquired by the business for a duration on lease, the property is said

to be leasehold. It should be seen by the auditor that separate accounts are maintained both

for freehold and leasehold properties.

To scrutinize the existence of the property on the day of the Balance sheet, he should

examine the Lease Deed to find out its value and duration, It should be seen that the lease has

been registered with the Registrar and he conditions of the lease as regards payment of lease

rent, maintenance : tire insurance, etc., have been duly complied with. It is to be noted that f

the conditions are not fulfilled, the lease is likely to be forfeited.,

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The leasehold property cannot be mortgaged but can be sublet. If so, the agreement

with the tenant should be examined.

There is no depreciation in the case of freehold land but the leasehold property which

includes land also is subjected to depreciation and hence, provision for depreciation has to be

made. The annual charge for depreciation will be arrived at by dividing the total cost by the

term of the lease. The amount written-off should be such as would be sufficient to provide for

dilapidation at the end of the term.

Plant and Machinery

Usually, the money spent in the acquisition of plant and machinery is shown in one

account i.e., Plant and Machinery Account. The auditor should check the Balance Sheet with

the help of Ledger Accounts and ensure that the asset is clearly stated. The asset is to be

verified and entries relating thereto have to be vouched by reference to the original invoices,

correspondence, etc.

The auditor should examine the Plant Register in which particulars about the cost,

records about sales, provision for depreciation, etc., are available. It is advisable for the

auditor to ask for a schedule of various plants in which details about cost, depreciation, etc.,

should be clearly given. He can now verify the asset by comparing the schedule with the

Plant Register. If a part of the asset has been purchased during the year, the purchase should

be vouched by reference to the invoice to the relevant vouchers. If a part of the asset is sold

out, it should be seen that the necessary entries have been passed at proper places. Profit or

loss arising out of the sales has been duly recorded. If plant and machinery is kept abroad, a

certificate to that effect should be obtained from the local auditor. He should verify the

existence of the asset by his personal inspection.

To see the mortgage or charge on the asset, the auditor should look to the details

given in the Plant Register.

Plant and Machinery is to be valued at its going-concern value. It should be shown in

the Balance Sheet at cost less depreciation after making necessary adjustments relating to

additions or substitutions made by the concern during the course of the year. Every

depreciation is deducted from the cost and repairs and renewals are charged to Revenue

Account. This is the usual practice, but if revaluation method is adopted for its valuation, the

auditor should examine the Valuation Sheets.

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Furniture, Fixtures and Fittings

Furniture, fixtures and fittings are shown usually as one asset and verified as such by

the auditor. But in practice, there is a distinction. Furniture is a movable asset and can easily

be removed from one place to another, e.g., chair, table, etc. Fixture is an asset tightly fixed

to the ground. For example, in science classes in a college, furniture is usually kept as fixed

to the ground. It cannot be removed from place to place. Fittings are fitted on the walls and

their examples are electric fittings and fans which are fitted and fixed on the walls of a

building.

The assets like furniture, etc., are verified as it is done in the case of plant and

machinery. Normally, Furniture Stock Register is maintained in the business. It is to be seen

that on the date of Balance Sheet, the register so maintained has been properly balanced and

the balance is shown clearly in the Balance Sheet. If furniture is acquired on lease (though it

is not usually the case), the conditions mentioned in the Lease Deed should be examined.

The auditor should see that the asset is properly valued. Furniture includes chairs,

tables, alrnirahs, etc., and is movable from one place to another, while fittings are those fitted

on the walls, as electric wires, etc. Fixtures are those assets which are fixed on the ground or

walls and are not movable. It should be seen in each case that proper depreciation has been

provided for and the assets are shown at net figures in the Balance Sheet. The amount of

depreciation will depend upon the nature of the use of a particular asset. It is to be noted that

the depreciation should be so provided every year that the entire asset may be written-off by

the expiry of its life-time.

Patents

The auditor should first of all examine the patents and verify them with the help of the

certificates under which patent rights have been granted. The patents should be clearly stated

in the Balance Sheet under separate head.

The auditor should ensure that the patents are registered in the name of the client.

Patents may have been either secured as a result of experiments carried out by the business

itself or may have been purchased. Patent rights are acquired in two ways :

(1) By Purchase. If they are purchased, the fees paid for purchasing or taking out such

rights should be treated as capital expenditure and as such, debited to the Patents Account,

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while renewal fees, being of revenue nature, should be debited to the Profit and Loss

Account.

(2) By Development and Research. If the patents are created by the client by doing

some research, it should be seen that the money so spent on research is of capital nature and,

hence, should be debited to the Patents Account.

Thus, for purchases, the Assignment of Purchase or Patent Agent's Accounts should

be examined. If it is the first year, the auditor should check the cost and the duration for

which such rights are to last from the relevant accounts. If the number of patents is large, he

can call for a schedule thereof from the client, and should examine the registered number,

dates of acquisition, description and the unexpired period from this schedule. The renewal

fees should be vouched with the aid of receipts available with the client. It should be noted

that if a patent is not renewed, it will lapse. A patent right lasts for 16 years unless the term is

extended.

The question of having any charge or mortgage on patents does not arise as the asset

itself is used and maintained as a right by the business which acquires or develops it.

The patents should be written-off in a period of 16 years after which the right lapses

unless the term is extended. There may be three causes of depreciation, viz., (i) lapse of time,

(ii) obsolescence, (iii) the patented article going out of fashion.

The asset as such should be valued on the date of the Balance Sheet. If by revaluation

the present value becomes higher than the cost price, it should not be taken into account. If

the cost value of patents is to be written-off during some fixed period, it should be seen that it

is done so. It should be noted that the money spent in the acquisition of the asset is of capital

nature while the renewal fee paid each year should be debited to the Profit and Loss Account.

Copyrights

This is the exclusive right to produce or reproduce a book or an article or, in the case

of a lecture, to deliver the work or any part thereof in public. The author of the work is

regarded as the first owner of the copyright and the duration of the copyright is the lifetime of

the author and fifty years after his death. The auditor should proceed with their verification

more or less in the same manner as he has done in case of patents.

In verifying copyrights, the agreement between the Author and the Publisher is of

immense value and it should be examined by the auditor. If there are many copyrights with a

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business, the auditor should call for a schedule thereof from the client and verify them from

this schedule.

Copyrights suffer depreciation from the effluxion of time and thus, lose their value

with the passage of time. Hence, in this case, the revaluation method of charging depreciation

is considered to be most appropriate. The auditor may rely on the certificates of experts who

are responsible for the revaluation of the asset.

Trademarks

Trademarks like patent rights are also registered in the name of the client. The

Companies Act, 1956 provides that Goodwill, Patents, Trademarks and Designs should be

separately and distinctly shown in the Balance Sheet of a company. The auditor should see

that it is so done.

Most of the remarks relating to patents apply to this type of asset. The Assignment

Deed should be examined and it should be seen that the renewal fee is paid each year at the

right time. If the number of Trademarks is very large, a schedule duly signed by some

responsible officer should be called for.

The revaluation method is the most suitable method of valuation of Trademarks. It

should be seen that it is properly valued and shown in the Balance Sheet.

Endowment Policies

There is a practise usually followed by business firms to undertake Endowment

Policies for the purpose of redeeming some liability which falls due at a later date or of

replacing an asset later on. The example is that of Sinking Fund Policies which are taken up

to redeem debentures. It is the duty of the auditor to inspect the policies physically. He should

further ensure that the premiums due have been paid in time and the policies have not lapsed.

Patterns, Designs and Drawings

Some business-houses maintain patterns of goods produced by them and make

advertisement with their help and get orders. Generally, patterns are prepared on a miniature

scale for the products of a business while drawings and pictures are prepared on the paper.

Designs are used for clothes and similar other things. Drawings are actually the pictures

prepared by experts and artists on the model papers to depict the size and nature of the

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products of a business. The auditor has to see the respective accounts to ensure that such

assets are clearly and separately shown in the Balance Sheet.

The auditor should call for a duly authorized schedule of all such assets. If the cost

incurred in their preparation is very high, it is usually capitalized. But if it is quite nominal, it

is written-off by charging to the Profit and Loss Account.

There is no question of having any charge on the assets of this nature.

The assets of this nature cannot last long as they are used for the purpose of

advertisement. Hence, the revaluation method is the appropriate method for their valuation.

The auditor should see that this is shown in the Balance Sheet at proper cost.

Motor Vehicles

Motor Vehicles Account is to be separately maintained. The auditor should compare it

with the Balance Sheet in which it should be clearly stated under separate head.

If the number of motor vehicles is very large, a separate register, as Plant Register in

case of plant, is maintained. The auditor may call for a schedule of motor vehicles and

compare it with the register so kept. He should check the Registration Books and Licences

and ascertain if all the vehicles are registered in the name of the client. He should further see

that actual purchases or additions during the year are capitalized. He should check the

Premium Receipts to ensure that the vehicles are fully insured against accidents and similar

other risks. The fees paid for renewal, etc., should be properly entered and the entries should

be vouched.

Motor Vehicles are to be adequately depreciated. The auditor should see that they are

shown in the Balance Sheet at cost less depreciation.

Livestock

Besides comparing the necessary ledger accounts with the records in the Balance

Sheet, the auditor should check the asset with the help of a certified inventory of all the

animals like horses, bullocks, cows, etc., which he should obtain from the client. Usually, a

separate register is maintained to record the asset in which the purchase price, life, etc., are

distinctly written about all the animals. He should check this register with the inventory.

As for valuation, he should see that they are annually revalued and any loss on

account of death or sale of an animal is written-off.

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Assets acquired on Hire-Purchase or Installment Agreement

Assets acquired on hire-purchase or installment agreement should be properly

recorded. Each year the instalment has to be paid and so much of the money paid in this

connection is to be recorded in the books of accounts. If the asset has been written-off at its

full value in the Balance Sheet, it is necessary to show the unpaid instalments on the liability

side.

The necessary agreement should be examined and it should be seen that the

expenditure has been distinctly allocated as capital and revenue. The interest paid on the

unpaid balance should be charged to the Profit and Loss Account.

The provision for depreciation should be made on the basis of the full cash price and

the asset should be shown in the Balance Sheet after deducting the amount of depreciation.

Stores and Spare Parts

The asset known as stores and spare parts consists of materials which are meant for

consumption in the business and not for resale. Lubricants, grease, dyes, fuel, etc., are

examples of stores, while spare pails of the machinery are preserved to maintain it in proper

order. The asset as such should be clearly shown in the Balance Sheet.

The auditor should obtain an inventory of stores and spare parts duly certified by a

responsible officer. He should count the stock himself and thus, verify their existence by

personal inspection, if possible. It is to be remembered that the stores consumed are debited

to the Manufacturing Account and spare parts used are debited to the Machinery Account.

The asset is to be shown at cost price in the Balance Sheet. It is not a depreciable asset

by use and provision for depreciation is not necessary. However, the loss on account of

breakage or waste or being worn out should be duly written-off. The asset should be revalued

annually.

Loose Tools

The auditor should obtain a list of loose tools which should be duly authorized by

some responsible officer. Such assets consist of small tools, moulds, etc., which have short

useful life and are also priced low. Hence, all such tools are shown in one account and not

separately. The auditor should check the certified list of loose tools.

Revaluation of loose tools is the most appropriate method of valuation. The difference

between the cost price and the current price should be treated as depreciation or loss to be

charged to the Profit and Loss Account. If the loose tools are prepared in the business itself,

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the cost thereof should be verified from the Cost Sheet certified by the Chief Engineer of

Works. In such a case, the valuation should not be made at a price more than the cost so

incurred.

Investments

Investments include Government Securities, Shares, Debentures, etc. When the

number of investments is very large, the auditor should insist upon asking for a schedule of

investments held by the client. Such a schedule should include all details about investments,

e.g., name of the Securities, date of purchase, nominal value, cost price, market price at the

date of Balance Sheet, etc. The schedule so obtained should be examined by reference to the

relevant ledger accounts and it should be seen that the asset has been shown distinctly and

properly in the Balance Sheet according to the Schedule VI, Part I of the Companies Act. The

auditor should, in particular, examine the following :

(i) The authority of purchase of investments (if purchased during the year).

(ii) The prices of investments be checked by reference to Allotment Letters or Stock

Brokers' Bought Notes.

(iii) The Stock Exchange quotations be examined to verify the price paid along with the

payees' receipt.

(iv) It should be ensured that all investments are in the name of the client.

(v) The Memorandum and Articles of Association of the company be examined for the

authority of the company to purchase.

(vi) It is to be seen that the purchase or sale of investments possess adequate approval of

the Board of Directors.

(vii) Section 372 of the Companies Act provides that a company, whether by itself or

together with its subsidiaries shall not be entitled to acquire by way of subscription,

purchase or otherwise the shares of any other body corporate except to the extent and

except in accordance with the restrictions and conditions specified in this section.

This is to be verified.

The auditor should verify the existence of investments by his personal inspection at

the same time. If there is a very large number of investments, he should take special care as

he would not be in a position to verify all of them in one sitting. Those checked should be

kept by him in a safe custody under lock and key which should be in his possession till the

entire lot is checked. He should compare the Schedule and Securities with the Register of

Investments maintained by the client. If the Securities have been entrusted to the bank for

safe custody, he should obtain a certificate from the bank giving details about all such

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Securities so kept. It is to be ensured that the Securities are free from any charge. Thus, in all

the situations, the auditor should personally inspect all the Securities wherever or by

whomsoever they may be held. In the case of Ciry Equitable Fire Insurance Company Ltd.

(1924) it was held that the auditor should try to inspect all Securities himself. If the Securities

have been purchased during the year, he should examine the Transfer Deed when no

certificate has been issued till the date of verification. He may also inspect the Bought Note

received from the broker. Similarly, if Securities are held by any Trustee on behalf of the

company, the Trust Deed should be inspected. If some of the Securities have been sold during

the course of the year after the date of the Balance Sheet but before the date of audit, the

auditor should vouch the sale proceeds either in the Cash Book or in the Bank Pass Book.

As has been already stated, it is very essential to ensure that the investments are

registered in the name of the client and they are free from any charge. He should rely on the

relevant vouchers and certificates to do so.

Having verified the Securities through devices mentioned above, the auditor should

proceed further to find out that the investments are properly valued. Really speaking,

investments are not subjected to the depreciation except investment in shares of mines and

plantations, but it has to be seen as to the purpose for which investments are held. In case of

trust companies, the object of having investment is to earn interest and dividend so that the

same may be distributed among the shareholders. Hence, investments are to be treated as

fixed assets. In such cases, investments are valued at cost and even permanent fall in their

value is not taken into account. Much will depend, however, on the provisions of the Articles

of Association and the Memorandum of Association of trust companies.

If investments are held by finance companies (i.e., ordinary financial institutions),

where they are treated as current assets to be sold wherever it is thought necessary that they

are vouched at "cost price or market price, whichever is less." In case of Securities purchased

by underwriters, the cost price thereof will be the face value less the underwriting

commission.

Interest Accrued on Investments. The auditor should obtain a schedule showing the

accrued interest on different types of investments and examine it. If there is a part of interest

which is not likely to be realised, proper provision should be made therefor. Such an interest

should be shown in the Balance Sheet separately. The auditor should check costs,

calculations, etc.

Stock-in-Trade [Inventory). The verification of the stock of goods in hand at the close

of the period requires a lot of care and caution on the part of the auditor. Similarly also, the

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value of the stock should be correctly arrived at, otherwise the Profit and Loss Account will

be incorrect and show misleading results. In every business, stock is taken at the close and if

the Stock Accounts are maintained properly and there is an effective system of internal check

in operation, the possibility of fraud and errors is minimized.

The following points should be kept in mind while verifying the stock-in-trade :

(1) The method of stock-taking should be examined so that possibilities of fraud and

errors may be found out. It should also be seen whether proper control is exercised

over the receipt and the issue of goods in stock.

(2) The auditor should obtain a list of instructions issued in connection with the stock-

taking.

(3) A few items should be checked in the rough stock sheets.

(4) The totals and balances of Stock Sheets should be thoroughly checked.

(5) The value of different items of stock should be examined with the help of Valuation

Sheets, Invoices, etc.

(6) The principles and bases followed in the valuation of stock should be examined to

ensure that they are those followed in previous years. To verify the work-in-progress

and the closing stock, the accounts relating to costs should be checked.

(7) It should be seen that the valuation of stock is done on the basis of 'cost price or

market price, whichever is less' as stock is a floating asset and is meant for resale. The

actual loss has been provided for and the stock is properly valued.

(8) The Goods Inward Register should be examined and it should be seen that the goods

received on the closing day or earlier have been included in the stock.

(9) Similarly, the goods sold on or prior to the closing day, have not been included in the

stock.

(10) It should also be ensured that the goods not related to the business have not been

recorded in the stock.

(11) The percentage of gross profit to sale of the current year should be compared with that

of the previous years. If there is some difference, that matter should be enquired into.

Method of Stock-taking. The usual procedure followed is that a clerk of the business

goes to the godown and calls out the number and other particulars of items of each class of

goods and another clerk enters these particulars on sheets of papers, popularly known as

Stock Sheets. Thus, the entire quantity of goods in stock and all the details connected with the

stock are written on the Stock Sheets. When it is done, another independent batch of two

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clerks checks the records to ensure that there is no mistake. Then, a responsible officer fills in

the rates of goods at which they are to be valued.

After the rates are written in the relevant column of the Stock Sheets, another clerk is

made responsible for calculating the value of each class of goods and his work is then

checked by another clerk. It is necessary that each of the persons who has taken part in the

preparation of the Stock Sheet should sign at proper places so that if there is some

discrepancy in their work, they may be held responsible.

The Stock Sheets should then be signed by the General Manager or the Partner.

A Few Precautions

(1) There may be some goods which may be legally in the ownership of the client but not

actually in his possession. For example, goods might have been purchased but not yet

delivered while the invoices have been entered in the financial books. As a rule, such

goods must be included in the Stock Sheets.

(2) Similarly, goods which are with the Branches or Agents or have been sent on

'approval or return' basis for which approval has not been received should be entered

in the Stock Sheets.

(3) Goods received but not entered in the financial books should not be included in the

goods shown in the Stock Sheets.

(4) Goods sold but not delivered to the buyer on or prior to the last day should not be

recorded in the Stock Sheets and similarly, the goods which are in the stock of the

client as an agent should also not be included in the closing stock.

(5) If proper precautions are not observed, errors may creep up and hence, the whole

work of stock-taking should be supervised by some responsible officials.

It is an important duty of the auditor while verifying the stock-in-trade to obtain the

following certificates :

(i) So far as we know, the particulars, the value and the quantity of stock entered in the

Stock Sheets on 31st December, 1998 are correct.

(ii) The goods included in the stock are the property of the business.

(iii) The stock of goods does neither include goods not entered in the business records nor

the goods sold but not yet delivered.

(iv) The goods which are neither saleable nor suitable for use, are either written-off or

provision has been made for such losses.

(v) The basis of valuation of stock is the same as in the previous years.

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Characteristics of a Good System of Stock-taking

The following are the main characteristics of a suitable system of stock-taking :

1. Stock-taking should take place at the close of business on the last day of the

accounting period.

2. The work of calling out the quantities and description of the goods and the making of

the entries on the Stock Sheets should be performed by senior clerks.

3. Such entries should be thoroughly checked.

4. A responsible officer should enter the price on the Stock Sheets.

5. The work of extensions and calculations should be done by separate clerks and of

checking by other clerks.

6. Additions should be done by another clerk and their checking should be

independently done.

7. The task involved as above should be initiated by those who do it so as to fix the

responsibility for the same.

Valuation of Stock : Some Basic Principles

There are not two opinions on the issue that stock should be correctly valued. If the

stock is over-valued or shown at a figure more than its actual value, the profits will be

inflated and shown at some artificial or misleading figures which can be misused by the

Managers or Partners for earning or receiving more commission. If it is under-valued, the

price of shares of a company will fall in the market or secret reserves will be created. The

auditor should see that it is not done as the practice is always detrimental to the interests of

the business itself.

v/ Stock is a floating asset and is meant for resale. Hence, it should be valued "at cost

price or market price, whichever is less." Even if the rise in price is of a permanent nature, the

stock should not be valued at a higher price than the cost price. The idea underlying this

principle is that anticipated losses should always be provided for.

What are the cost price and market price, then? There are several opinions on this

issue.

Cost Price

The term 'cost price' is interpreted in the following ways :

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(1) Unit Cost. If different lots of goods have been purchased, the stock in hand can be

easily identified and the invoices or the Cash Memos can help in finding out the cost price.

The cost price of unsold stock will be the cost price at which such a lot is acquired. This is

the 'Unit Cost' method of finding out the cost price. It is easy to know the cost price if goods

have been kept separately.

(2) Average Cost Method. If goods have been purchased and acquired at different

intervals of time, it is very difficult to identify them in case they are mixed up together. In

such a situation, goods in stock are valued at the average cost price of various consignments

taken together.

(3) First In, First Out [FIFO) Method. According to this method, the stock is valued

at the rate at which the most recent purchases were made. It is assumed that the goods issued

out of the store or sold are those which entered it first, le., the goods are issued in the order in

which they were purchased. The goods which entered first are issued first and the most recent

purchases remain in stock at the rate of the latest consignment so purchased.

(4) Last In, First Out [UFO) Method. Under this method, the whole of the stock is

valued at the rate at which the earliest purchases were made. It is assumed that the latest

purchases are sold first and the unsold stock consists of the earliest purchases and is priced

accordingly. This method is not much in use for the purpose of valuation.

(5) Adjusted Selling Price Method. Under this method, an estimated cost is found out

by pricing the unsold stock at the prevailing selling price less a normal margin of profits and

the estimated selling expenses included overhead charges.

(6) Standard Cost Method. Under this method, the stock is valued at some

predetermined cost per unit which is known as the standard cost.

Market Price

There are two different ways of expressing market price :

(1) Replacement Cost. This is virtually the cost of replacing the stock at the date of

the Balance Sheet. Thus, it includes the expenses also in the market price at which such

goods can be acquired.

(2) Net Realizable Value. This denotes the price at which the goods can be sold in the

market. Thus, the estimated selling expenses are deducted out of the selling price.

Methods of Valuation

The valuation of stock is ordinary made on the basis of cost price or market price,

whichever is lower in the two different ways given below :

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(1) Individual Method or Pick and Choose Method. According to this method, the cost

or market price, whichever is less, of each individual item of stock is taken into

consideration.

(2) Global Method. Under this method, the aggregate cost of all the items of stock is

taken separately and so also, the aggregate market price is calculated. Then, the lower of the

two valuations becomes the basis for he valuation of stock.

Example

Units of Cost Market Lower of Cost or

Stock Price Price Market Price

Rs. Rs. Rs.

1 200 300 200

2 500 400 400

3 300 350 300

4 600 550 550

5 300 350 300

6 350 400 350

2,250 2,350 2,100

According to the individual method, stock will be valued at Rs. 2,100 while according

to the global method, it will be valued at Rs. 2,250.

The goods in stock may be placed into three categories, Le., raw materials, semi-

manufactured goods and finished goods.

(1) Ram Materials. Raw materials are not meant for resale but are for use in the

manufacture of goods. Hence, they are valued at the cost price which may also include a

reasonable amount of expenses incurred in connection therewith. Thus, the market price is

not taken into consideration in the valuation of raw materials. But if there is some abnormal

fall in the value of raw materials on the day of the Balance Sheet, then, their valuation should

be made at under cost.

(2) Semi-Manufactured Goods. There may be some semi-manufactured goods in stock

on the last day of the financial year. They are the goods in the process of manufacture. Such

goods are valued at cost price including the cost of raw materials used and the proportionate

amount of wages, establishment charges, etc.

(3) (a) Manufactured or Finished Goods. Usually, the stock of finished goods is

valued at the cost price or market price, whichever is lower but in practice, it is not done so.

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Often, it is valued at cost, at under cost, at market price or at below market price. This all

depends upon the circumstances. However, if it is not possible to calculate cost or to find out

the market price of various items of stock, one of the bases just quoted is taken for granted in

valuation just to avoid inconveniences and complicated calculations.

If the goods have been sold under forward contracts but not delivered at the date of

the Balance Sheet, they are valued at contract rates for the purpose of the Balance Sheet.

(b) Goods on Consignment. The stock of goods with the consignee is valued at cost

price plus the proportionate expenses including freight, rent, etc., or market price, whichever

is lower. If it is not convenient to find out the market price, which is usually the case, it is

valued at cost price on account of its being a convenient basis of valuation.

(c) Goods on Approval or Return Basis. The goods which have been sent on 'approval

or return' basis should never be valued at more than the cost price.

(d) Stock of Special Trades. There are some special goods or trades such as wine, rice,

leather, etc., whose value tends to rise with the passage of time. Hence, they are valued at

above cost, a rule which is usually not followed in the valuation of floating assets. In the

value of the stock of special trades, the expenses of maintaining such stocks in safety and

interest on them at a reasonable rate are added to the cost. In no case, the valuation should be

made at a price which is higher than the price at which such goods are available in the

market.

(e) Goods of Plantation Products. The stock of plantation products, such as rubber,

tea, sugarcane, coffee, etc., should be valued at the net amount to be subsequently realized,

i.e., the expected selling price less reasonable selling expenses.

Work-in-Progress

According to the Companies (Amendment) Act, 1960, work-in-progress should be

separately shown in the Balance Sheet. The auditor should examine all accounts pertaining to

the work-in-progress :

He should keep in mind the following points while verifying the work-in-progress :

(1) If Cost Accounts are properly maintained in the business, he should check the

Statement of Raw Materials used and wages. If overhead expenses have been included in the

valuation, he should see that they are not excessive.

(2) The basis of valuation and cost of work-in-progress for the current year should be

compared with that of the previous year and the difference, if any, should be carefully

enquired into.

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(3) If Cost Accounts are not maintained, detailed statement should be prepared to

know the progress of work completed.

(4) The progress of work should be checked according to the time devoted and work

being done.

(5) It should be seen that creditors' balances are duly provided for. The auditor should

obtain the certified Stock Sheets from the client

and check them. Such sheets should contain details about the work-in-progress, work

completed, work certified and uncertified, etc., and he should check them thoroughly and

carefully.

The work-in-progress is normally valued at cost price. The cost includes the actual

cost of materials put into manufacturing process plus some of the labour and other

manufacturing expenses. In the calculation of cost price, a reasonable proportion of the profit

earned and received to date is also included specially in case of contracts which extend for a

considerable period. De Paula talks of the use of standard cost for the valuation of work-in-

progress. The standard cost is also known as 'estimated cost' under which the valuation of

stock is made on the basis of a pre-determined cost or budgeted cost per unit. However, the

standard cost or budgeted cost is not a static cost but it is sometimes reviewed periodically

and is subject to change which depends upon time and motion studies and also on

performance appraisal.

Some other writers are of the opinion that the work-in-progress should be valued at

cost price or replacement value, whichever is lower.

Valuation of Stock and Auditor's Duty

In the case of Kingston Cotton Mills (1896), it was held that it is not he duty of the

auditor to take the stock, and that he is not guilty of ^ligence if he accepts the certificate of a

responsible official in the osence of suspicious circumstances.

Broadly speaking, there are three points raised in the decision :

(1) The auditor is not a valuer;

(2) It is not his duty to take stock; and

(3) If he has some suspicion in his mind as regards the valuation of stock, he should

rely on the certificate of a responsible official.

It was also said that the auditor is not an insurer and all that he is quired to do is to

exercise reasonable care and skill. But what amount : skill and care will be reasonable will

depend upon the auditor and the rcumstances of a particular case.

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Nevertheless, it should be remembered that the decision in the above ase was given

more than seventy years ago. Since then, many remarkable hanges have taken place. As such,

it will not be advisable to proceed ntirely in accordance with this decision.

A few years back, another decision was given, in re: The Westminster Road

Construction & Engineering Co. Ltd. (1932). This, too, is an important ecision in which it

was held that the auditor is liable for not detecting er-valuation of assets or omission of

liabilities from the Balance Sheet, : such could be detected by the application of reasonable

skill and care. The acceptance of certificate without question in such a case is amounting 3

negligence.

Three things are as follows :

(1) To value stock is not the duty of the auditor.

(2) He can rely on reports and statements duly certified by some responsible officials in

case of suspicious circumstances.

(3) He should exercise reasonable care and skill.

The foregoing views are acceptable to all without exception. It is also generally

accepted that it is not a part of the auditor's duty to verify stock through his personal

inspection. Still, after the decision which was given hi the case of Mckesson & Robins, some

auditors do verify the stock ersonally at the close of the financial year. Whatever the case,

new developments have taken place in the field of business organization and business

management which must be kept in mind by the auditor.

But one thing is noteworthy. If an auditor is not able to detect fraud because of his

quality and the method of audit procedure which is below "he practice normally recognized,

he would be held guilty. Such a decision was given in re: Thomas Gerrad & Sons Ltd.

(1968) case. Thus, an auditor annot leave everything on company's management. When he

gives his report, he is expected to examine all the accounting data. It is evident that :he

auditor is now required to go more in details than what was expected :rom him in the

judgment given in the Kingston Cotton Mills case. He annot rely on the commercial honesty

of the management and he should g< i into the depth more than what was expected from him

earlier. It shows hat now the standards of auditing are changing.

It is to be noted that the auditor should satisfy himself that the stock lists have been

duly examined by the technical and commercial managers. It is also to be seen that adequate

provision has been made for obsolescence. It becomes, therefore, clear that while he has to

satisfy himself of the physical and financial accuracy of the stocks, he is not expected to have

the technical knowledge to judge the exact length of obsolescence that he has set in. For this,

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he can discuss with the technical staff available and satisfy himself accordingly. Actually, he

should verify that the charge for obsolescence has been correctly made on the Profit and Loss

Account of the year. The charge for obsolescence must correlate with that of the previous

year and if budgeted, it should be compared with that budgeted.

The Companies Act requires an auditor to report that the Balance Sheet of a company

exhibits a true and fair view of the state of affairs for which he has to examine all the assets

thoroughly. Hence, he should not be satisfied simply by certifying the stock but should apply

tests in checking the Stock Sheets. The volume of tests, however, will depend upon the size

of a business, particular circumstances of a case and system of maintaining accounts. If there

is a properly maintained costing system and accounts of stores and stock are also kept and if

the auditor thinks them to be effective, he can rely on the quantity balances at the date of the

Balance Sheet.

Debtors

According to the Companies Act, the book debts of a company should be shown as

under :

(a) Debts considered good in respect of which the company is full}, secured;

(b) Debts considered good for which the company holds no security other than the

debtor's personal security; and

(c) Debts considered doubtful or bad.

In order to form an opinion whether the debts are good, doubtful or bad, the following

points should be borne in mind :

1. The Age of Debts. This is the main consideration to establish whether a debt is

good, doubtful or bad. The age of the debts must be viewed in relation to the terms of credit

allowed by the company. The settlement of accounts regularly within a reasonable time after

the expiry of the credit period and cash discounts being taken regularly are some of the signs

to denote that the debts are good and not doubtful.

2. Regular Payments. If payments are made regularly, the accounts may be good. But

if payments are erratic and balances are increasing, the accounts should be considered as

doubtful.

3. Heavy Dishonoured Bills. Dishonoured bills are always considered to be a sign of

weakness and similarly returned cheques and renewed bills should be viewed with suspicion

that such debts are doubtful.

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4. Noting on the Accounts. Notes on the accounts such as 'In Solicitor's Hands', 'In

Liquidation', 'Address Unknown', etc. clearly indicate that the accounts are doubtful. There

should be sufficient provision in the accounts to guard against such doubtful debts.

5. A Comparison of Bad Debts, Budgeted and Actual In many busi-sses, a simple

comparison of actual bad debts with budgeted bad debts ides a basis for considering debts

bad, doubtful or good. Such a mparison can be made for a number of years and the opinion be

formed accordingly.

The auditor should see that the debtors have been shown properly. He aid examine the

Ledger Accounts and should obtain a certified schedule ill debts. He should compare the

schedule with the Ledger Accounts.

He should examine the schedule of debtors with the help of some -ponsible officials

and should see that proper provision has been made - doubtful debts, discounts etc. Debts

written-off as bad should be :ched by reference to necessary vouchers for which the auditor

should mine and Directors' Minute Book. He should contact debtors through ~espondence to

verify the money received from the debtors.

It is a good practice to get the balances confirmed by the parties erned. This will

provide a sufficient basis for an opinion regarding the satiability of the book debts. Such a

sort of confirmation of balances has ed to be the sound evidence. However, the auditor may

not send the ers of confirmation to all the parties but can be satisfied by testing only few

cases.

If loans are granted in cash under security, he should examine the urities. He should

check the accounts relating to the receipts of erests in the ledger. If loans are granted to the

officers of the business, should see that they are given under rules and regulations prevailing

this connection in the business.

Bills Receivable

To verify bills receivable given in the Balance Sheet, the auditor should all for a

certified schedule of bills in hand. The totals of the schedule hould be checked by reference

to the accounts in the General Ledger. He ould examine each bill to see that it is properly

drawn, signed by the oeptor and is also properly stamped.

If audit is conducted some time after the last day of the financial year, e auditor

should check the transactions pertaining to bills during the rriod.

(1) Bills subsequently met should be verified by vouching the cash eceived and entered in

the Cash Book.

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(2) Bills discounted should be examined by way of entries in the Cash Book and Bills

Receivable Book. The auditor should see that a note for the contingent liability in

respect of bills discounted appears on the Balance sheet.

(3) If bills have been deposited with a bank either for safe custody or :r security of a

loan, they should be verified on the basis of a certificate btained from the bank

concerned which may be regarded as good evidence )f their existence.

(4) If the bills have been retired before the date of the Balance Sheet, the proceeds thereof

should be checked by reference to the Cash Book.

Payments in Advance

The amount paid in advance, such as insurance, telephone rent, rates, etc., should be

verified by the auditor by reference to the schedule which he should obtain from the client.

Such a schedule should contain all details regarding payments made in advance. He should

examine the receipts and demand notes for the latest payments and compare the schedule

with the Ledger Accounts.

According to the Companies Act, payments in advance should be separately shown in

the Balance Sheet.

Cash in Hand

The auditor may proceed in one of the following three ways while verifying the cash in hand

(1) He should visit the business premises at the close of the financial year and actually

count the cash in hand and compare it with the balance as shown in the Cash Book. It is to be

remembered that all the balances of cash should be counted by him simultaneously so as to

avoid any fraudulent manipulation, e.g., the shortage in one account may be made up from

the balance in another account. He should count cash, stamps. IOUs in hand. He should see

that IOUs are genuine. To avoid a fraud, he should take all vouchers and books in his

possession till the entire cash balance is duly verified.

(2) If it is not possible for him to pay a visit and count the cash in hand himself, he

should pay a visit on a subsequent day after the day of close of the year and verify the cash by

checking exhaustively the balances of cash, receipts and payments in between the date of the

Balance Sheet and the day of his visit.

(3) Then, there is another method. The auditor should ask his clier. to deposit the

whole of the cash in hand on the closing day into the bank By doing so, the entire cash will

be counted and the auditor will easily verify it. But the difficulty is that IOUs cannot be

deposited in the bank He can pay a surprise visit if he so likes.

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It is to be noted that in cases where physical counting of cash is n< possible, the

auditor should get a certificate signed by the Branch Manage: or the person in-charge to the

effect that he himself has counted the cash balance including notes and coins or he has

physically verified the counting of such a balance.

As a matter of safety it is prudent to advise that large cash balanc should not be held

by the business. If such balances show a tendency- I increase, the auditor should make careful

enquiries to verify their existence and to know the reasons for holding such a heavy balance

of cash with thfl business.

The auditor should also verify revenue stamps or postage stamps the closing day of

the financial year as they are a part of the cash balance to be shown in the Balance Sheet.

The documents such as stock of unsold canteen tickets, lun coupons, etc., should also

be physically counted by the auditor as they ai readily to be converted into cash.

lash at Bank

First of all, the auditor should compare the balances as shown in the s Book with the

balance of cash as shown in the bank column of the ash Book. If there is some difference, he

should prepare a Bank Reconciliation Statement.

It is possible that fictitious Pass Book may be presented to the auditor ithout bringing

the fact to his knowledge. In such a suspicious situation, should obtain a certificate directly

from the bank. In case of some ifficultly, he can check the accounts himself in the bank

ledger.

He should obtain separate certificates for Fixed Deposit Account, urrent Account,

Savings Bank Account, etc. from the bank. This is the :.lv valid way of verifying the balance

in the different accounts.

Verification of Liabilities

Verification of liabilities is equally important as the verification of -ssets. If liabilities

are not properly verified and valued, the Balance Sheet ill not reveal a true and fair view of

the state of affairs of a business neern. Hence, it should be seen that the liabilities are true and

duly authorized.

It is necessary, therefore, for the auditor to examine that :

(1) all the liabilities have been clearly stated in the liability side of the Balance Sheet;

(2) all these liabilities relate to the business itself;

(3) they are all correct and authorised; and

(4) they are shown in the Balance Sheet at their actual figures.

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It is to be realized that the liabilities are not valued like the assets. It of special

significance to show them at their proper figures.

The auditor should verify all the liabilities that they are correct. He should obtain a

certificate from some responsible officials of the business the effect that all the liabilities for

purchases or for expenses have been recorded in the books of accounts and all doubtful debts

have either been rovided for or have been shown by way of footnote in the Balance Sheet.

In the case of the Westminster Road Construction & Engineering Co. Ltd. 932), it

was held that the auditor is liable for omission of liabilities from le Balance Sheet, if such

could be detected by the application of atonable care and skill. The acceptance of certificate

without question in iich a case is amounting to negligence.

Normally, the auditor should keep in mind the following important points while

verifying the liabilities :

(a) Liabilities for Trade Creditors

(1) He should vouch the Purchases Book and Purchases Returns Book Ith the help of

invoices, credit notes, etc., and check the postings into the ledger.

(2) He should obtain a schedule of creditors from the client and check with reference

to the balance of Ledger Accounts and Statement of counts received from the creditors.

(3) He should inspect the Goods Inward Book to ensure that the goods purchased have

actually been received.

(4) He should check the outstanding bills payable in the Bills Payable Book at the

date of the Balance Sheet.

(5) He should check the purchase invoices pertaining to a few weeks at the close of

the financial period.

(6) The correctness of liabilities depends upon the correctness of purchases. Hence, he

should compare the percentage of gross profits to purchases with that of the previous year to

verify the correctness of purchase.

(b) Liabilities in respect of Loans

(1) The auditor should verify the existence of loans, if any. He should examine the

correspondence, contracts, Directors' Minute Book, if the business is a company.

(2) It should be seen that the interest due on loans has been either paid to date or

recorded as unpaid in the Books of Accounts.

(c) Liabilities of Expenses

(1) The auditor should see that all the outstanding expenses have beer, provided for.

He should check receipts and other vouchers to ensure tha: the provision has been duly made.

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(2) He should check the entries, sales and demand note pertaining t a few weeks of the

next financial year and ensure that they do not relate to the period under audit.

(3) The expenses shown as unpaid during the current year should b compared with

those of the last year and difference, if any, should be enquired into.

(4) He should obtain a certificate for outstanding expenses duly signe by some

responsible official.

Capital

Capital is not the liability of a company but still the auditor is require to verify it so

that he can report of the genuineness and correctness of the Balance Sheet. The duties of the

auditor can be the following :

(a) If it is the First Year of the Existence of a Company :

(1) He should examine the Memorandum of Association and t; Articles of Association.

(2) He should check the Cash Book, Pass Book and Directors' Minute Book to find out

the number of shares, the various classes of shares, the amount received thereon and

the amount due from the shareholders.

(3) If some shares have been allotted to vendors, he should exami: the contract between

the vendors and the company.

(b) If it is not the First Year of a Company :

(4) The share capital would be the same as in the previous year utile-there is some

alteration or addition by fresh issue or otherwise. He shou! see the relevant Sections

(Sees. 94-95) of the Companies Act.

(5) Similarly, for reduction of share capital, he should see t: provisions of the Act

(Sections 100-105).1

l Details are given in Chapter on 'Company Audit'.

(c) To Verify Capital in a Partnership Firm :

(1) The auditor should see the Partnership Deed; and

(2) He should also check the Cash Book and the Pass Book.

Reserves and Funds

It would not be out of place here to state that the auditor should examine the Profit

and Loss Appropriation Account to verify reserves and unds. The volume and the propriety

of reserves and funds created would, however, depend upon the circumstances of a business,

and nature and discretion of those who direct and manage it. It is to be remembered that such

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reserves and funds are appropriations out of profits and are determined under the decisions of

Directors of a company.

Creditors

The auditor should obtain a schedule of creditors from the client, and heck the

Purchases Ledger with its help. If necessary, he may check the purchases Ledger with entries

in the Purchases Book and also examine invoices, credit notes, Goods Inward Book, Goods

Outward Book, Bills ayable Book and Cash Book.

He should ensure that goods purchased during the year have been entered in the books

of accounts. He may call for the Statements of .ccounts from the creditors and compare these

with the schedule which he has received.

Debentures1

The auditor should note the following points while verifying debentures :

(1) By examining the Memorandum of Association and the Articles of association, he

should acquire the knowledge of powers of the company. The Debentures should not

be issued beyond these powers to borrow money.

(2) He should examine the Debenture Trust Deed and, with its help, he Debentures

Account in the Ledger.

(3) If necessary, he can obtain a certificate from the Debentureholders.

(4) He should also see the arrangement made for the redemption of iebentures. If a

Debenture Redemption Fund has been created for the purpose, he should examine the

Article of Association.

(5) If Debentures have been issued at a discount or at a premium, he -hould check the

entries made in the books of accounts.

(6) He should also see the details as given in the Register of Mortgages and Charges.

Bills Payable

A schedule of bills payable should be obtained and its totals should e compared with

the Bills Payable Book and Bills Payable Account. The :11s paid should be vouched with the

entries passed in the Cash Book. He should specially see that bills paid during the date of the

Balance Sheet nd the date of his audit have been duly written in the books.

This has been discussed in Chapter on 'Company Audit'.

Amount Received in Advance

Sometimes, some money is received in advance for work not completed by the

closing day. Hence, it is shown on the liability side of the Balance Sheet.

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To verify it, the auditor should obtain a certified schedule thereof. It should be

ensured that such an amount received in advance is not omitted from recording in the Balance

Sheet.

Forfeited Shares1

The Auditor should examine the Articles of Association of the Company, Directors'

Minute Book and the relevant accounts kept in the financial books.

Employees' Deposits

Normally, in commercial and industrial ventures, the employees who deal with cash

or stores are required to deposit cash security as a safeguard against some possible

misappropriation or pilferage. Sometimes, the employees in place of paying cash endorse

trustee Securities in favour of the employers. It should be remembered in this connection that

(1) Such a security in cash or in Securities should be deposited separately in the bank.

(2) It should be shown distinctly on the liabilities side of the Balance Sheet.

(3) He should verify the amount of deposits by reference to the certified schedule

received from the client.

Reserves for Bad and Doubtful Debts

The verification should be done as follows :

(1) The auditor should obtain a certificate from some responsible officers of the business

and then check the amount received from bad and doubtful debts.

(2) The schedules of debtors should be compared with the balances of ledger accounts to

ascertain the possible amount of bad and doubtfi: debts.

(3) The adequacy of such a reserve has specially to be checked. He should examine the

nature, the circumstances of a particular business and the necessary rules in practice in

this connection.

Taxation Liability

Taxation is an important liability these days and, hence, full provision should be made

in the accounts in this regard. The auditor should see tha the provision made therefor is

sufficient to meet the estimated liability Usually, auditors are required to advise on the

adequacy of the liability an in such a case, they work as tax consultant. If this is the case,

there is n difficulty in making the assessments.

Loans and Advances

The loans and advances may be for short and long periods. They ma be of three types

l Details are given in Chapter on 'Company Audit'.

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(1) Unsecured Loans and Advances. The duty of an auditor would be :

(i) to examine the correspondence and relevant documents, if any:

(ii) to study the conditions for interest payable, repayment of loan, refund by instalments,

etc.;

(iii) to ensure that the loans are taken for use in the business; and

(iv) to get confirmation from the lenders concerned certifying the balances of principal

and interest outstanding at the date of the Balance Sheet.

(2) Secured Loans and Advances. To verify the secured loans and ivances, two important

things should be noted :

(i) Actual amount which has been advanced, and

(ii) Security for the loan.

So far as the actual amount of loan or advance is concerned, if such an amount has

been granted during the period under audit, it should be examined that this amount has been

properly authorized and sanctioned v Directors in case of a company and by Partners in case

of a partnership rm. The auditor should examine the applications received and check the

receipts which have been given in token of having received the loans. For return of a part of

the loan and interest thereon, it should be verified that the payment has been received from

the borrower himself. The securities for loans can be of the following types :

(i) Investments, le., stock and shares;

(ii) Mortgage on Property;

(iii) Insurance Policies;

(iv) Guarantees by Third Parties; and

(v) Security of Goods.

(i) Investments. Ordinarily, bearer Securities are said to be the best form of securities.

The auditor should examine them and their valuation should be checked. Registered

Securities can be deposited with the lender for loans. It would be in the interest of the lender

if securities are transferred in his name.

(ii) Mortgage on Property. Mortgage on property can be used by depositing the Deed

with the lender. The auditor in such cases should inspect the Title Deeds. If mortgage has

been exercised through conveyance in the name of the lender, the Mortgage Deed should be

inspected. If there is a second charge of mortgage on the property, a mention thereof should

be made in the Mortgage Deed. The auditor should also examine the certificate of the valuer

for its valuation.

161

(iii) Insurance Policies. The auditor should inspect the insurance policies. It should

be ensured that the interests of the lender have been duly recognized by the insurance

company. It should be seen that loans are granted within the amount of surrender value of the

policy and the auditor should examine the certificate issued by the insurance company in this

connection.

(iv) Guarantee by Third Parties. The value of security depends upon the status of the

guarantor. The auditor should ascertain whether his position continues to be as such

throughout the term for which the loan is granted. Such a guarantee must be conveyed in

writing and there should be nothing in it which might go against the interests of the lender.

The following points should specially be noted :

(i) to examine the Mortgage Deed to know the nature of the mortgage or the charge

whether fixed or floating;

(ii) to see that the right of selling a property mortgaged has exercised with the due

approval of the mortgagee;

(iii) if it is sold, to ensure that there is nothing beyond the conditions laid down; and

(iv) to examine the Register of Mortgages and Charges if the borrower is a company.

(v) Security of Goods. The loan may be advanced against the security of goods. Such

goods may be kept in the godown with a godown-keeper. The auditor should examine

the godown-keeper's receipt. If the goods are at docks or in a bonded warehouse, the

dock warrant or the warehouse receipt should be examined. In the absence of the dock

warrant or the warehouse receipt (if not issued), he should examine the delivery note

issued in favour of the client. He should ensure that the warehouse rent has been paid

by the borrower. If not, the amount has to be added to the loan.

The auditor should examine the Railway Receipt of the bills of Lading along with the

Letter of Hypothecation, Invoices and Insurance Policy as the case may be, which have been

endorsed in the name of the client.

The value of the security may vary according to the market conditions For this, he

should examine the market quotations. To verify the quantity of goods, the Inspector's Report

should be inspected. He should see the.: the goods are not of perishable nature.

(3) Loans to Employees. Applications for loans are received by employers from their

employees. Such applications are granted on some specific terms and conditions and they are

considered to be as an agreement in the absence of a separate loan agreement. Such

agreements contain terms and conditions for repayment of loans and the interes payable

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thereon. Normally, such loans to employees are granted again si the provident fund accounts

as securities.

Auditor's Duty

(1) The auditor should examine the terms and conditions of the loan given in the loan

agreements.

(2) He should see the conditions in respect of repayment of loans an the interest payable.

Such an interest may be payable at a low rate or the: may be no interest at all.

(3) He should ensure that instalments of loans are being deducted out of the employee's

salary regularly in all the cases.

(4) He should arrange to get the confirmation from the employee-regard to their

indebtedness at the end of each year.

(5) He should see that proper steps are taken by the organization recovery of loans is

doubtful in some cases.

Bank Overdraft

The verification of bank overdraft will be on the same lines as that loans and

advances. The difference is that it is the financial assisted obtained from a bank. The auditor

should examine the Bank Pass Bo and call for a Statement of Mortgaged Assets. It is to be

remembered that the assets so mortgaged should be clearly stated as such in the Balance

Sheet.

The auditor should take the following steps to verify the overdraft:

(1) He should examine the Memorandum and Articles of Association of the company or

the Partnership Deed in the case of partnership firm and ensure that the overdraft

facility has been made use of with the powers given in these documents.

(2) He should see the authority for contracting the overdraft and it should be ascertained

from Board's resolution or resolution of the partners.

(3) The agreement for overdraft with the bank should also be inspected. It is to be seen

whether the overdraft is a clean one or it is against hypothecation or pledged assets of

the company.

(4) He should see the Register of charges to ascertain the assets given as security against

the overdraft. Such a charge ought to have been registered by the company with the

Registrar of Companies.

(5) He should verify the rate of interest and other terms of interest payment from the

agreement.

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(6) The amount of overdraft should be verified from the books of accounts and compared

with the Pass Book.

(7) If the overdraft is against the hypothecation of assets like stock, a certificate from the

bank should be obtained in this regard.

(8) It should be seen that the value of security on the date of Balance Sheet was neither

lower nor higher than what was agreed with the bank. If there is some change which

is possible in a hypothecation or pledge of stocks, the amount of the overdraft should

be adjusted accordingly.

(9) Lastly, he should see that the overdraft is properly shown under secured loans', and

the nature of security for overdraft has been properly disclosed in the Balance Sheet.

Unexpired Discount

Discount is an income from a bank which discounts bills receivable of its customers.

If the date of maturity of the bills discounted falls next year, the discount received therefor is

not to be treated as the income of the current year. Hence, such a part of discount not related

to the current year is transferred to a separate account as rebate on bills discounted. The

auditor should examine carefully this account and also check the bills discounted.

Outstanding Expenses

The auditor should obtain a certificate from a responsible officer to the effect that all

the outstanding expenses have been included in the current year's accounts. The amount paid

on various accounts should be verified from the entries in the Cash Book. It should be

ensured that the outstanding expenses include that part which is unpaid at the date of the

Balance Sheet. The following points should be noted :

(1) He should carefully note that all expenses, e.g., rent, rate, interest, wages, salary, audit

fee, legal expenses, etc., have been accounted for in the books.

(2) He should check entries in the books passed on the basis of invoices and demand

notes for some weeks after the close of the financial year to ensure that they are not

related to the year under audit.

(3) He should compare all the paid and unpaid expenses of the current year with those of

the previous year to see that there is not much difference.

(4) It should be ensured that all outstanding wages and salaries have subsequently been

paid.

Contingent Liabilities

Contingent liabilities are those liabilities which may or may not arise in the future for

payment. The auditor's duty is to see that all known and unknown liabilities have been

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brought into the accounts at the date of the Balance Sheet and have been shown in the

Balance Sheet separately as such :

(1) Liabilities on Bills Receivable Discounted and not Matured. If the bills

receivable are discounted with a bank and the money so received from it is made use of, the

entire money will be refunded to the bank if the acceptor does not make payment on the date

of its maturity. This is why such a contingent liability is distinctly shown in the Balance

Sheet by way of a note at the foot.

(2) Liability for Calls on Partly Paid Shares. The amount called on shares held and

paid should be verified from the Cash Book and the liability for the amount uncalled should

be ascertained.

(3) Liability under a Guarantee. The auditor should ascertain the liability for a

guarantee given by the client for a loan or overdraft to his friend, or partner. In case of non-

payment of such loan, the possible liability should be ascertained.

(4) Liability for Cases against the Company not Acknowledged as Debts. It is a

liability in a disputed case where damages may have to be paid. A contingent liability should

be ascertained and a note should be made at the foot of the Balance Sheet.

(5) Liability for Penalties under Forward Contracts. If losses are to arise in case of

purchases or sales made under forward contracts, a proper provision should be made for such

losses. This is an example of contingent liabilities.

(6) Liability in respect of Arrears of Dividend on Cumulative Prefereru Shares. The

auditor should examine the Articles of Association which should contain rules in this regard

and due provision should be made for such a liability.

Auditor's Duty. The auditor should very carefully check the various contingent

liabilities named above. There may be some such liabilities for which no provision has been

made in the books but merely a note has beer, made at the foot of the Balance Sheet, e.g.,

bills receivable which have been discounted and which have not matured at the date of the

Balance Sheet arrears of fixed accumulated dividends, etc. For liabilities in respect of which

provision has to be made on the Balance Sheet, e.g., liability which may arise in connection

with a suit, etc., the auditor should examine such cases and ascertain the amount to be

specifically reserved for the purpose The auditor should examine the Directors' Minute Book,

correspondence made with the legal advisers and the information obtained from the tficials of

the business. He has to ensure that proper provision has been :iade for all such liabilities and

if he is not satisfied, he should mention he fact in his report. It is to be remembered that the

165

requirements of the Companies Act regarding the contingent liability should be complied

with in the Balance Sheet on the liabilities side.

Contingent Assets

Some of the examples of contingent assets may be the following:

(i) option to apply for shares in another company on favourable terms;

(ii) refund of octroi paid for goods sent out later on;

(iii) claim for money from a previous endorser of a bill receivable discounted but might be

dishonored;

(iv) uncalled Share Capital;

(v) legal action for infringement of a copyright, etc.

Usually, contingent assets are not shown at the foot of the Balance Sheet on the assets

side and the Companies Act does not require the contingent assets to be disclosed as such.

166

APPOINTMENT, REMUNERATION, RIGHTS AND DUTIES OF AN AUDITOR

QUALIFICATION OF A COMPANY AUDITOR

The auditor of a company must possess the qualifications prescribed . section 226(1)

and (2) of Companies Act, 1956. The object of section 226 - to ensure that :

• An auditor possesses adequate educational qualifications for the profession of

accounting

• He is independent of all influences, controls and personal interest in the company.

The prescribed qualifications under section 226 are as under :

(i) Chartered accountant in practice : A person who is a chartered countant within

the meaning of Chartered Accountants Act, 1949 and Ids a certificate of practice.

(ii) Partnership firm of chartered accountants in practice : A partnership Inn where

all the partners practicing in India are chartered accountants holding certificate of practice,

may also be appointed as an auditor of a mpany. In such a case, the appointment of an auditor

may be made in name of the firm and any partner may act in its name.

Disqualifications

According to Section 226(3), the following persons are debarred from Lng appointed

as auditors of a company :

(a) a body corporate;

(b) an officer or employee of the company;

(c) a person who is a partner, or who is in the employment of an officer r employee of the

company;

(d) a person who is indebted to the company for an amount exceeding one thousand

rupees, or who has given any guarantee or provided any security in connection with

the indebtedness of any third person to the company for an amount exceeding one

thousand rupees;

(e) a person holding any security of the company after a period of one year from the date

of commencement of the Companies (Amendment) Act.

(f) Under section 226(4), a person who has been disqualified for appointment as an

auditor of a company on above-mentioned grounds, shall also not be eligible for

167

appointment with any other body corporate which may be that company's subsidiary

or that company's holding company or that company's fellow subsidiary.

The provisions of section 8 of the Chartered Accountants Act, 1949 may be noted in

this regard as it provides additional grounds for disqualification of a company auditor.

Automatic vacation on becoming disqualified: Where an auditor incurs any of the

above disqualifications after his appointment, he will deemed to have vacated his office. [Sec.

226(5)]

APPOINTMENT OF COMPANY AUDITORS

Every company, even a private company, must appoint an auditor or auditors to audit

its Annual Accounts. There are following three authorities to appoint auditors:

(1) Appointment by Directors. The first auditors of a newly floated company are

appointed by the Board of Directors within one month of the registration of the company, and

the auditors so appointed shall hold office till the conclusion of the First Annual General

Meeting.

Casual Vacancy : The Directors are also empowered to fill any casual vacancy in the

office of an auditor except one which is caused by prior resignation. The auditor so appointed

shall hold office until the conclusion of the next Annual General Meeting. But if the vacancy

is caused by the resignation of an auditor it shall only be filled by the company in General

Meeting.

(2) Appointment in General Meeting, (i) If the Board of Directors fails tc appoint the

auditor, the company shall appoint the first auditor in General Meeting.

(ii) Every company shall, at each General Meeting, appoint an auditor or auditors to

hold office from the conclusion of that meeting until the conclusion of the next Annual

General Meeting.

(iii) The company shall, within seven days of the appointment, givi intimation thereof

to every auditor so appointed.

(iv) An auditor so appointed shall, within thirty days of the receipt fron the company

of the intimation of his appointment, inform the Registrar in writing that he has accepted or

refused to accept the appointment.

(3) Appointment by Central Government: (i) If a company, at an annul general

meeting, fails to appoint or re-appoint an auditor(s), the Centra. Government may appoint a

person to fill the vacancy. [Sec. 224 i

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(ii) The said company has to give notice of the above fact to th Government. If

company fails to give such notice, the company and even officer of the company who is in

default shall be punishable with fine which may extend upto five thousand rupees.

(iii) The appointment by the Central Government is made from tbj panel of names

suggested by the applicant company.

(iv) In case of Government Companies, the Controller and Auditc: General of India

appoints (or reappoints) the auditor.

Appointment by Special Resolution

(Sec. 224A)

In the case of a company, in which not less than 25% of the subscribed share capital

is singly or jointly held by :

(a) a public financial institution or a Government company, or the Central

Government, or any State Government; or

(b) any financial or other institution established by any Provincial or State Act, in

which a State Government holds not less than 51% of the subscribed share capital; or

(c) a nationalized bank, or an insurance company carrying on general insurance

business, the appointment or reappointment (at each annual general meeting) of an

auditors(s) shall be made by a special resolution.

The auditor so appointed should also be informed and he should also communicate his

acceptance/non-acceptance to the Registrar.

Where any company referred to section 224A omits or fails to pass at its annual

general meeting any special resolution appointing an auditor or auditors, it shall be deemed

that no auditor or auditors had been appointed by the company at its annual general meeting

and thereupon the Central Government will get the right [under section 224(3)] to make an

appointment.

Compulsory Re-appointment. Section 224(2) provides that subject to the provisions

of sub-section (IB) of section 224A at any Annual General Meeting (a) retiring auditor, by

whatsoever authority (Board of Directors, General Meeting or Central Government)

appointed, shall be re-appointed, unless :

(i) he is not qualified for re-appointment;

(ii) he has given a notice in writing of his unwillingness to be re-appointed;

(iii) a resolution has been passed at that meeting appointing somebody instead of him

or providing expressly that he shall not be re-appointed; or

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(iv) where notice has been given of an intended resolution to appoint some person or

persons in the place of a retiring auditor, and by reason of death, incapacity or

disqualification of that person or of all those persons, as the case may be, the resolution

cannot be proceeded with.

Appointment in the case of Government Companies (Section 619). The auditor of a

Government Company shall be appointed or re-appointed by "he Central Government on the

advice of the Comptroller and Auditor-General of India.

CEILING ON NUMBER OF AUDITS [Sec. 224(1-B)]

Section 224(1-B) prescribes a ceiling on the number of companies of vhich a person

or a firm could be the auditors. Summarised contents of this section are given below :

(i) In the case of any person who holds appointment as auditor of a number of

companies and no such company has a paid-up capital of Rs. 25 lakh or more—20 such

companies.

(ii) In any other case—20 companies (excluding private companies but subject to the

condition that the number of companies with paid-up share capital of Rs. 25 lakh or more

shall not exceed ten. Note : (i) In case of a firm of auditors 'specified number' will be 20

companies per partner, who is not in full time employment elsewhere.

(ii) In computing the specified number, the following audits shall be excluded :

— Audit of private companies.

— Audit of branches of Indian and foreign companies.

— Audit of guarantee companies not having share capital.

— Audit of statutory corporations.

— Investigations.

— Audit of foreign comapnies.

— Special audit.

(iii) Before such appointment, a certificate in writing is required to be obtained by the

company from the auditor regarding compliance of such 'ceiling on number of audit'. [section

224(8)]

Remuneration of an Auditor

Remuneration shall be determined as under :

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(a) in the case of an auditor appointed by the Board of Directors or the Central

Government, his remuneration is to be fixed by the Board or Central Government as the case

may be,

(aa) in the case of an auditor appointed [under section 619] by Comptroller and

Auditor-General of India, the remuneration shall be fixed by the company in General Meeting

or in such manner as the company in General Meeting may determine,

(b) in the other cases, the remuneration of the auditor shall be fixed by the Company

in General Meeting or in such a manner as the company in General Meeting may determine.

For the purposes of this sub-section, any sums paid by the company in respect of the

auditor's expenses shall be deemed to be included in the expression 'remuneration'. However,

for legal or technical advice sought by him in connection with his duties as an auditor, he can

claim the expenditure from the company.

The auditor, besides remuneration for audit work, may also be paid extra

remuneration for services rendered in any other capacity, i.e., advisor in taxation matters,

company law matters, etc. But such payment shall be disclosed in the Profit and Doss A/c in

the manner provided in Part II of Schedule VI to the Act.

REMOVAL OF AUDITOR [Sec. 224(7)]

(1) First Auditorfs) : When the first auditors of a limited company are appointed by

the Directors prior to the First Annual General Meeting, such auditors may be removed by the

members in General Meeting. The General Meeting may, in their place, appoint any other

person whose nomination notice has been given by any member not less than fourteen days

before the date of the meeting.

(2) In any other case : In any other case, an auditor may be removed m office before

the expiry of his term, only by the company in General eting after obtaining the previous

approval of the Central Government.

(3) Section 225 of the Companies Act, 1956, makes special provisions this respect,

which, it appears, have been provided to ensure justice and IT play. The procedure so laid

down is as follows:

(i) Special notice shall be required for a resolution at an annual general eting

appointing as auditor a person other than a retiring auditor, or

-oviding expressly that a retiring auditor shall not be re-appointed.

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(ii) On receipt of notice of such a resolution, the Company shall rthwith send a copy

thereof to the retiring auditor.

(iii) Where notice is given of such a resolution and the retiring auditor ikes with

respect thereto representations in writing to the company (not : eeding a reasonable length)

and requests their notification to members the Company, the company shall, unless the

representations are received it too late for it to do so :

(a) in any notice of the resolution given to members of the company, state the fact of

the representations having been made; and

(b) send a copy of the representations to every member of the company to whom

notice of the meeting is sent, and if a copy of the representations is not sent as aforesaid

because they were received too late or because of the company's default the auditor may

(without prejudice to his right to be heard orally) require that the representations shall be read

out at the meeting:

Provided that copies of the representations need not be sent out and e representations

need not be read out at the meeting if, on the plication either of the company or of any other

person who claims to be grieved, the Company Law Board is satisfied that the rights

conferred by bis sub-section are being abused to secure needless publicity for tamatory

matter; and the Company Law Board may order the company's sts on such an application to

be paid in whole or in part by the auditor, {withstanding that he is not a party to the

application.

(4) Sub-sections (2) and (3) shall apply to a resolution to remove the rst auditors or

any of them under sub-section (5) of section 224 or to the moval of any auditor or auditors

under sub-section (7) of that section, as hey apply in relation to a resolution that a retiring

auditor shall not be -e-appointed.

Status of an Auditor

(1) Agent of the Shareholders. An auditor is appointed by the .areholders and the

Directors in case of the first auditor (or by the Central overnment in certain cases). He has the

status of an agent but the lestion arises as to whether he is the agent of shareholders or of

Directors.

The answer is obvious. He, for the purpose of audit, is expected to safeguard the

interests of the shareholders and hence, he is the agent of the shareholders. In the course of

the judgement delivered by Lord Iranworth in the case of Spackman vs. Evans, it was said :

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'The auditors may be agents of the shareholders so far as relates to the audit of the

accounts. For the purpose of the audit, the auditors will bind the members." in the case of

Nicols Case re : Royal British Bank, it was held:

"These were auditors of the company appointed by the shareholders. These auditors

were within the scope of their duty, at least as much as the agent of the shareholders as the

directors were, and the false and fraudulent representations were discoverable by them."

Thus, it appears that an auditor is an agent of the shareholders so far as the audit of

accounts is concerned.

(2) An Officer of the Company. In another sense, an auditor enjoys the status of an

officer of the company like manager, accountant, secretary, etc. Actually, he is not an officer

but (under sections 477, 478, 539, 543. 545, 621, 625 and 633), he is considered as an officer.

Section 477—Power of the Court in winding up to common persons suspected of having

property of the company.

Section 478—Power of the Court to order public examination < promoters, directors, etc.,

guilty of fraud, etc.

Section 539—Penalty for the falsification of books.

Section 543—Power of the Court to assess damages against delinquen: officers.

Section 545—Prosecution of delinquent officers and members.

Section 621—Cognizance of offences under the Act.

Section 625—Payment of compensation in cases of frivolous < vexatious prosecution.

Section 633—Power of the Court to grant relief in certain cases, le.. i: proceedings for

negligence, default, breach of duty, misfeasance, etc.

In two well-known English cases, viz., Kingston Cotton Mills Co. Lie (1896) and

London and General Bank (1895), it was decided that the auditors are the officers of the

company.

(3) A Servant of the Company. The auditor is not an employee of th company in the

sense in which the term is commonly understood. Neithe: he is an employee of the directors,

because his principal duty is to examine the accounts prepared under them. But for certain

purposes, as described above, the auditor is an officer of the company.

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RIGHTS/POWERS OF AN AUDITOR

A company auditor has the following rights : [Section 227( 1

(1) Rights of Access to Books of Accounts. Every auditor of a compa; shall have a

right of access at all times to the books and accounts and vouchers of the company whether

kept at the head office of the company or elsewhere.

Thus, the auditor may consult all the books, vouchers and documerr -whenever he so

likes. This is his statutory right. He may pay a surprise visit without informing the Directors

in advance but in practice, the auditor? inform the Directors before they pay their visits.

(2) Rights to Obtain Information and Explanations. He has a right obtain from the

Directors and Officers of the company any information and :planations as he thinks necessary

for the performance of his duties as n auditor.

This is another important power in the hands of the auditor. He will, wever, decide as

to which information or explanations he thinks t-cessary to obtain. If the Directors or Officers

of the company refuse to - apply some information on the ground that in their opinion it is not

tressary to furnish it, he has a right to mention the fact in his report.

(3) Right to correct any Wrong Statement. The auditor is required to ake a report to

the members of the company on the accounts examined him and on every Balance Sheet and

Profit and Loss Account and on ery other document declared by this Act to be part of or

annexed to the balance Sheet or Profit and Loss Account which are laid before the jmpany in

General Meeting during his tenure of office. The Directors have duty to prepare them and

present them to the auditor. The auditor cannot -quire but advise the Directors to amend their

system of maintaining counts if it is faulty. If his suggestions are not carried out, he has a

right i refer the matter to the members. If the method of accounting is iadequate, he must state

the fact in his report that proper books of counts have not been kept by the company.

(4) Right to visit Branches [Section 228). If a company has a branch : lice, the

accounts of the office shall be audited by the company's auditor opointed under section 224

or by a person qualified for appointment as auditor of the company under section 226. Where

the Branch Accounts are not audited by a duly qualified auditor, the auditor has a right of

access at all times to the books, accounts and vouchers of the company and thus, may visit

the branch, if he deems it necessary.

(5) Right to Sign Audit Report (Section 229). The person appointed as auditor of the

company, or where a firm is so appointed, only a partner in he firm practising in India, may

174

sign the auditor's report, or sign or uthenticate any other document of the company required

by law to be signed or authenticated by the auditor.

(6) Right to receive Notice and other Communications relating to General Meeting

and attend them (Section 231). An auditor of a company has a right to receive notices and

other communications relating to General Meeting in the same way as a member of the

company. He is also entitled to attend any General Meeting and to be heard at any General

Meeting which he attends or any part of the business which concerns him as an auditor.

According to the power of the auditor, he may make any statement or explanation

with regard to the accounts as he may desire. He need not, however, answer any questions.

Ordinarily, it is not necessary for the auditor to attend every General Meeting, but it

will be good for him to attend meetings in the following circumstances:

(a) When his report contains important qualifications directly affecting the management,

so that his remarks may not be misunderstood or misinterpreted.

(b) When he has received a notice from the company that someone else is going to be

proposed for appointment as auditor of the company at the Annual General Meeting.

(c) When he has been specially asked by the management to be present.

(7) Right of being Indemnified (Section 633). An auditor (being an officer of a

company), has a right to be indemnified out of the assets of the company against any

liability incurred by him defending himself agains; any civil and criminal proceedings

by the company if it is proved that the auditor has acted honestly or the judgment

delivered is in his favour.

(8) Right to have Legal and Technical Advice. He has a right to seek the opinion of the

experts and, thus, take legal and technical advice. This is necessary to give his opinion

in his report. (Re. London and General Bank Case, 1895).

(9) He has a right to receive his remuneration provided he has completed the work

which he undertook to do.

Right of lien : An auditor has no right to exercise lien on the books, he works as an

auditor.

DUTIES OF AN AUDITOR

Section 227 imposes the following duties on an auditor of a company

1. Duty to enquire : [Section 227(1A)]. An auditor is required to enquir into the

following matters :

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(a) Whether loans and advances made by a company on the basis security have been

properly secured.

(b) Whether the terms on which they have been made are not agains the interests of

the company or its members;

(c) Whether transactions of the company which are represented mere by book entries

are not against the interests of the company;

(d) Where the company is not an investment company within th meaning of section

372 or a banking company, whether so much of the assets of the company, as consists of

shares, debentures and other securities have been sold at a price less than at which they were

purchase by the company;

(e) Whether loans and advances made by the company have bee: shown as deposits;

(f) Whether personal expenses have been charged to revenue accoun:

(g) Where it is stated in the books and papers of the company that an shares have been

allotted for cash, whether cash has actually been receivec in respect of such allotment, and if

no cash has actually been so received whether the position as stated in the account books and

the Balance Shee-is correct, regular and not misleading.

2. Duty to Submit Report [Section 227{2)(3)]. The auditor shall report to the

shareholders on the accounts examined by him. The report sc submitted shall state the

following:

(a) Whether, in his opinion, the Profit and Loss Account referred to his report exhibits

a true and fair view of the profit or loss.

(b) Whether, in his opinion, the Balance Sheet referred to in his repi i is properly

drawn up so as to exhibit a true and fair view of the state o:' affairs of the business according

to the best of the information and explanations given to hfm as shown by the books of

accounts.

(c) Whether he has obtained all the information and explanations which to the best of

his knowledge and belief were necessary for the purpose of his audit.

(d) Whether, in his opinion, proper books of accounts as required by law have been

kept by the company so far as appears from his examination of those books, and proper

returns adequate for the purpose of his audit have been received from branches not visited by

him.

(e) Whether the report on the accounts of any branch office audited under section 228

by a person other than the company's auditor has been forwarded to him as required by

Section 228(3) and how he had dealt with the same in preparing the auditor's report.

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(f) Whether the company's Balance Sheet and Profit and Loss Account dealt with by

the report are in agreement with the books of accounts and returns.

(g) Whether, in his opinion the profit and loss account and balance sheet complied

with the accounting standards referred to in sub-section (3C) of section 211.

(h) Whether any director is disqualified from being appointed as director under

section 274(l)(g).

(i) Whether cess payable under section 441A has been paid, if not the details of

amount of cess not so paid.

It should state in thick type or in italics the observations or commetns of the auditors

which have any adverse effect on the functioning of the company;

3. Duty to make statement on additional matters specified by the Central

Government : [Section 227(4A)] : The Central Government has a power to direct by general

or specifie order, that in case of specified companies, the auditor's report shall also include a

statement on such matters as specified therein.

4. Duty to Sign Report [Section 229] : It is the duty of an auditor to sign the report

prepared by him. Only a partner in the firm practising in India may sign the Auditor's Report

or authenticate any other document.

5. Duty to certify the Statement contained in Prospectus [Section 56(1)]. The

Prospectus issued by an existing company shall contain a report from the auditor of the

company regarding :

(i) profits and losse;

(ff) assets and liabilites of the company and its subsidiaries; and (iii) rates of

dividends paid by the company for each of the five financial

years preceding the issue of the Prospectus. It is auditor's duty to submit his report.

(6) Duty to certify the contents of Statutory Report [Section 165(4)]. The auditor of

the company has to certify the statutory report as correct to the extent it relates to :

(i) Shares allotted by the company;

(ii) Cash received in respect of such shares; and

(iii) Receipts and payments of the comapny.

7. Duty to report under voluntary winding-up : When a company goes into its

voluntary winding-up and a declaration of solvency is made by its Directors [under Section

488(1)], such a declaration is to be accompanied by the report of the auditors of the company

[under section 488(2)]. It is the duty of the auditor to make such report.

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8. Duty to help Investigation [Sec. 240]: When an inspector is appointed [under

Section 235 or 237] to investigate the affairs of the company, it is the duty of the auditor to

give all assistance to inspector in connection with the investigation.

Other Duties Based on Case Laws

(1) An auditor should correspond in writing with the previous auditor. He should see

that for his appointment, the Articles of Association have been complied with or not. —

B.N.Mohan vs. K.C.J. Satyawadi (1955)

(2) It is the duty of an auditor that he should not adopt foul means over the

shareholders to get himself appointed as an auditor and maintain his office at two places to

defraud others.

—B.G. Daferiavs. S.S. Kasvekar (1955)

(3) The auditor should inform the shareholders about the violation of the provisions of

the Sections of the Companies Act.

—Institute of the Chartered Accountants of India vs. K.R. Khanna (1960)

(4) It is the duty of an auditor to bring to bear on the work, he has to perform that

skill, care and caution which is a reasonable, competent, careful and cautious auditor should

use.

—Re: Kingston Cotton Mills Co. Ltd. (1896) and London & General Bank (1895)

(5) While auditing the accounts of a company, it becomes the duty of an auditor to

scrutinize debentures in detail and examine properly the rules in the Debenture Trust Deed.

—Davar & Sons vs. M.S. Krishnaswamy (1952)

(6) It is the duty of an auditor that he should verify investments himself while

certifying such investments. —Government vs. G.M. Oka (1952)

(7) An auditor should check properly the stock and the accounts.

—Henry Squire [Cash Chemist) vs. Ball Baker Co. (1911)

JOINT AUDITORS

Sometimes, a company or any other institution may appoint more than one person to

work as auditors where the business is large, such as, in banking or insurance companies or in

concerns where the regulations so require. In such cases, such an auditor is jointly liable and

responsible for the entire audit. But where the work of auditors is divided by mutual

178

agreement, it may be desirable for each auditor to avoid responsibility for the work he has not

performed by stating specifically in this report the extent of work carried out by him.

As per the statement issued by the Institute of Chartered Accountants of India (Dec.

1978), it is made clear that ".in the absence of any agreement between the auditors, each

auditor is entitled to adopt his own criteria regarding the selection of items, the extent of test

checks, the extent of auditing and his own criteria regarding the materiality of items

involved."

As for the report of joint auditors, "no problem arises if the joint auditors are able to

arrive at an agreed report. But where the joint auditors are in disagreement with regard to the

report, each one of them would be i stifled in expressing his own opinion through a separate

report. Even vhere more than two joint auditors are appointed, there is no question of he

majority or minority with regard to the joint audit report. Each auditor s entitled to express

his own separate report and, in fact, it is his duty to do so."

Branch Auditors [Section 228)

The provision in regard to the audit of accounts of branches of a impany are as given

below :

Where a company has a branch office, the accounts of the office, shall audited by the

company's auditor appointed under section 224 or by a erson qualified under section 226, or

where the branch office is situated : a country outside India, either by the company's auditor

or a person qualified as aforesaid or by an accountant duly qualified to act as an auditor : the

accounts of the Branch Office in accordance with the laws of that Juntry. [Section 228(1)]

Where the accounts of any branch office are audited by a person other ban company's

auditor, the Company's auditor :

(a) shall be entitled is visit the branch office, if he deems it necessary do so for the

performance of his duties as auditor, and

(b) shall have a right of access at all times to the books and accounts : d vouchers of

the company maintained at the branch office :

Provided that in the case of a banking company having a branch office utside India, it

shall be sufficient if the auditor is allowed access to such pies of, and extracts from, the books

and the accounts of the branch as lave been transmitted to the principal office of the company

in India.

[Section 228(2)]

Appointment. The auditor for a branch may be appointed by the mpany in its general

meeting, or by Board of Directors in consultation th the statutory auditor. If the branch is

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situated outside India, a person ho is duly qualified to act as an auditor of the accounts of the

branch in c ordance with the laws of that country can also be appointed as auditor f the

branch. Consultation of statutory auditor is also desired. [Section 228(3)(a)]

Rights and Duties. The person so appointed as the branch auditor shall ive the same

powers and duties in respect of audit of the accounts of the 3ranch Office as the company's

auditor has in respect of the same. [Section 228(3) (b)]

Report. The Branch auditor shall prepare a report on the accounts of le Branch Office

examined by him and forward the same to the Company's iditor who shall in preparing the

Auditor's Report deal with the same in Such manner as he considers necessary. [Section

228(3)(c)]

Remuneration. The Branch Auditor shall receive such remuneration nd shall hold his

appointment subject to such terms and conditions as may be fixed either by the company in

General Meeting or by the Board of I : rectors if so authorised by the company in General

Meeting. [Section 228<3)(d)]

Central Government and Exemption to Branch Audit

The Central Government may make rules providing for the exemption of any Branch

Office to the extent specified in the rules, viz., 'Companies (Branch Audit Exemption) Rules,

1961'.

Special Audit of Companies (Section 233A)

The Central Government is empowered to direct special audit in certain cases. The

provisions are as under:

(1) Appointment. Where the Central Government is of the opinion :

(a) that the affairs of any company are not being managed in accordance with sound

business principles or prudent commercial practices; or

(b) that any company is being managed in a manner likely to cause serious injury or

damage to the interests of the trade, industry or business to which it pertains; or

(c) that the financial position of any company is such as to endanger its solvency;

the Central Government may at any time by order direct that a specia audit of the company's

accounts for such a period as may be specified in the order, shall be conducted and may by

the same or different order appoint a Chartered Accountant as defined in clause (b) of sub-

section (1 of section 2 of the Chartered Accountants Act, 1949 (38 of 1949) (whether or not

180

such Chartered Accountant is a chartered accountant in practk within the meaning of that

Act) or the company's auditor himself to conduc such special audit.

(2) The chartered accountant or the company's auditor appointed undo sub-section (1)

to conduct a special audit as aforesaid is hereafter in this section referred to as the special

auditor.

(3) Powers and Duties. The special auditor will have the same powers and duties in

relation to the special audit as an auditor of a company has under section 227.

Provided that the special auditor shall, instead of making his report I the members of

the company, make the same to the Central Governmer.

(4) The report of the special auditor shall, as far as may be, include al the matters

required to be included in an auditor's report under seer 227 and, if the Central Government

so directs shall also include statement on any other matter which may be referred to him by tl

Government.

(5) The Central Government may by order direct any person specific in the order or

furnish to the special auditor within such time as may specified therein such information or

additional information as may required by the special auditor in connection with the special

audit; an on failure to comply with such order, such person will be punishable wit fine which

may extend to five thousand rupees.

(6) On receipt of the report of the Special Auditor, the Centr Government may take

such action on the report as it considers necessa: in accordance with provisions on this Act or

any other law for the rim being in force.

Provided that if the Central Government does not like any action on the report within

four months from the date of its receipt, that Government shall send to the company either a

copy of, or relevant extract from the report with its comments thereon and require the

company either to circulate that copy or those extracts to the members or to have such copy

or extracts read before the company at its next general meeting.

(7) The expenses of, and incidental to, any special audit under this section, including

the remuneration of the special auditor shall be determined by the Central Government

(which determination shall be final) and paid by the company and in default of such payment

shall be recoverable from the company as an arrear of Land Revenue.

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COMPANY AUDIT

(Audit of Share Capital, Share Transfer and Managerial Remuneration)

In the preceding chapters an effort has been made to explain the basic principles of

Audit which have been universally recognized for conducting audit of institutions of different

nature and character. Limited companies have their own constitution and. as such, work

under a different set of rules which are not applicable to the sole proprietary concerns and

partnership firms. There are special rules and legal provisions to conduct audit of companies

like banking, insurance, etc., a study of which is of dire necessity and importance for an

auditor.

Company Law

The Companies Act, 1956 has brought about various changes for the direction and

administration of limited companies. The Act has subsequently been amended and

remarkable procedures have been laid down. A company auditor is expected to be familiar

with all these provisions.

The Company Law has distinctly defined the rights, powers and duties of an auditor

who cannot be relieved of his legal responsi- bilities. It is needless to state that the company

form of organization is rather the most important form in the business world today.

Secondly, a company has its separate legal entity. Its owners, viz.. shareholders are

distributed over long distances and hence, they cannot know of their investments beings safe

or otherwise unless the Directors duly inform them through their reports. This is why the

audit of accounts of a limited company is made compulsory by law.

An auditor has to study the Company Law so as to familiarize himself with his rights

and duties. There are provisions in the law in regard to issue of Share Capital, preparation of

Memorandum of Association and Articles of Association, appointment of Director, and

Managing Directors issue of Prospectus and other important matters which an auditor has to

study for the successful conduct of a company's audit.

Class of Companies under Companies Act, 1956

Private Company Public Company

jas per section 3(f)(iii)]__[as per section 3 (l)(iv)l

Private Company" means a company which has a minimum paid-up capital of one

lakh rupees or such higher paid-up capital as may be prescribed and by Its articles :

(a) restricts the right to transfer its shares, if any;

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(b) limits the number of its members to fifty not including :

(i) persons who are in the employment of the company, and

(ii) persons who, having been formerly in the employment of the company, were

members of the company while in that employment and have continued to be members after

the employment ceased and

(c) prohibits any invitation to the public to subscribe for any shares in, or debentures

of the company;

(d) prohibits any invitation or acceptance of deposits from persons other than its

members, directors or their relatives.

Provided that where two or more persons hold one or more shares in a company

jointly, that shall, for the purposes of this definition, be treated as a single member.

Every private company existing on the commencement of the Companies

(Amendment) Act, 2000 with a paid-up capital of less than one lakh rupees, shall within a

period of two years from such commencement, enhance its paid-up capital to one lakh rupees.

"Public Company" means a company which :

(a) is not a private company;

(b) has a minimum paid-up capital of five lakh rupees or such higher paid-up capital

as may be prescribed

(c) is a private company which is a subsidiary of a company which is not a private

company.

Every public company existing on the commencement of the Companies

(Amendment) Act, 2000, with a paid-up capital of less than five lakh rupees, shall, within a

period of two years from such commencement, enhance its paid-up capital to five lakh

rupees. A public company may be a listed public company which means—a public company

which has any of its securities listed in any recognised stock exchange.

[Inserted by Companies (Amendment) Act, 2000, Section 2(23-A)[. An unlisted

company is one whose securities are not listed in any recognised stock exchange.

Preparation by the Auditor before Audit

The auditor should go through the following preliminaries before he begins his actual work :

1. To see that his appointment is in order;

2. Inspection of documents, books and registers;

3. Inspection of contracts;

4. Study of previous year's Balance Sheet and Auditor's Report;

5. Obtaining a schedule of books and persons handling them;

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6. Study of internal check system; and

7. Certificate of incorporation and commencement of business.

1. To see that his Appointment is in Order

(a) If he is appointed as the first (newly appointed) auditor of the company by the

Board of Directors, he should ask for a copy of the resolution by the Directors authorizing his

appointment.

(b) If he is appointed in place of a retiring auditor, he should enquire from the retiring

auditor whether due notice was served and the provisions of section 225 were complied with

or not. It would be a breach of professional etiquette if he does not enquire from him in

writing about the circumstances which led to his removal.

(c) If he is appointed by the shareholders at the Annual General Meeting, he should

obtain a copy of the resolution. He should inform the Registrar within 30 days of the receipt

of the appointment letter in writing that he has accepted or refused to accept the appointment.

He should ensure that proper notice or nomination was given, otherwise his appointment will

be invalid.

The auditor should correspond in writing with the previous auditor, informing the

latter of the fact of his appointment. —B.N. Mohan vs. K.C. Satyawadi

(a) If he is appointed to fill a casual vacancy caused by the death of the previous

auditor, he should obtain a copy of the resolution passed by the Directors so as to ensure that

his appointment is valid.

(e) Under section 224(6) of the Companies Act, a General Meeting of the

shareholders should be called to appoint a new auditor in place of the auditor who has

resigned. Thus, the vacancy caused by the resignation has to be filled by the company in a

General Meeting and not by the Board of Directors. The auditor should see that his

appointment is regular under such circumstances. He should, however, enquire from the

auditor who has resigned, about the circumstances in which he has resigned and then decide

whether he should accept the appointment or not.

2. Inspection of Documents, Books and Registers

Documents

1. Memorandum. (1) Under the provisions of Section 13 of the Companies Act, the

Memorandum of every company shall state :

(a) the name of the company with 'Limited' as the last word of the name in the case of

a public limited company and with 'Private Limited' as the last words of the name in the case

of a private limited company;

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(b) the State in which the registered office of the company is to be situated;

(c) In the case of a company in existence immediately before commencement of the

Companies (Amendment) Act, 1965, the objects of the company;

(d) in the case of a company formed after such commencement :

(i) the main objects of the company to be pursued by the company on its incorporation

and objects incidental or ancillary to the attainment of the main objects.

(ii) other objects of the company not included in Sub-section (i); and

(e) in the case of companies (other than trading corporations), with objects not

confined to one State, the State to whose territories the objects extend.

(2) The Memorandum of a company limited by shares or by guarantee also state that

the liability of its members is limited.

(3) The Memorandum of a company limited by guarantee shall also e that each

member undertakes to contribute to the assets of the mpany in the event of its being wound

up while he is a member or within year after he ceases to be a member, for payment of the

debts and oilities of the company, or of such debts and liabilities of the company - may have

been contracted before he ceases to be a member, as the case lay be, and of the costs, charges

and expenses of winding up, and for hutment of the rights of the contributories among

themselves, such >unt as may be required, not exceeding a specified amount.

(4) In the case of a company having a share capital :

(a) unless the company is an unlimited company, the Memoran- dum ill also state

amount of share capital with which the company is to be Jstered and the division thereof into

shares of a fixed amount;

(b) no subscriber of the Memorandum shall take less than one share;

and

(c) each subscriber of the Memorandum shall write against his name number of shares

he takes.

Alteration of Memorandum

17.(1) A company may, by special resolution, alter the provisions of its morandum so as to

change the place of its registered office from one ate to another, or with respect to the objects

of the company so far as ay be required to enable it :

(a) to carry on its business more economically or more effi- ciently;

(b) to attain its main purpose by new or improved means;

(c) to enlarge or change the local area of its operations;

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(d) to carry on some business which under existing circumstances may iveniently or

advantageously be combined with the business of the mpany;

(e) to restrict or abandon any of the objects specified in the morandum;

(f) to sell or dispose of the whole, or any part, of the under- takings, :of any of the

undertakings, of the company; or

(g) to amalgamate with any other company or body of persons.

(2) The alteration of the provisions of memorandum relating to the lge of the place of

its registered office from one state to another shall take effect unless it is confirmed by the

Company Law Board on alteration, the Company Law Board must be

(a) that sufficient notice has been given to every holder of the ventures of the

company, and to every other person or class of persons the affected the alteration, and

substituted by the Companies (Amendment) Act, 1996 Uu.e.f. 1-3-97).

(b) that with respect to every creditor who, in the opinion of the Company Law Board,

is entitled to object to the alteration, and who signifies his objection in the manner directed by

the Company Law Board, either his consent to the alteration has been obtained or his debt or

claim has been discharged or has determined, or has been secured to the satisfaction of the

Company Law Board.

It is provided that the Company Law Board may, in the case of any person or class of

persons, for special reasons, dispense with the notice required by clause (a).

(4) The Company Law Board shall cause notice of the petition for confirmation of the

alteration to be served on the Registrar who shall also be given a reasonable opportunity to

appear before the Company Law Board and state his objections and suggestions, if any, with

respect to the confirmation of the alteration.

(5) The Company Law Board may make an order confirming the alteration on such

terms and conditions, if any, as it thinks fit, and may make such order as to costs as it thinks

proper.

(6) The Company Law Board shall, in exercising its powers under this section have

regard to the rights and interests of the members of the company and every class of them, as

well as to the rights and interests of the creditors of the company and of every class of them.

(7) The Company Law Board, if it thinks fit, adjourn the proceeding-in order that an

arrangement may be made to the satisfaction of the Company Law Board for the purchase of

the interests of dissentient members, and may give such directions and make such orders as it

thinks fit for facilitating or carrying into effect, any such arrangement.

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Provided that no part of the capital of the company may be expendo: in any such

purchase.

Alteration to be Registered. Under Section 18(1), a company shall file with the

Registrar (a) a special resolution passed by a company in relatio: to clause (a) to (g) sub-

section (1) of section 17 within one month from the date of such resolution, or (b) a certified

copy of the order of the Compar Law Board made under sub-section (5) of that section,

confirming th-alteration, within three months from the date of order, together with a printed

copy of the memorandum as altered and the Registrar sha! register the same and certify the

registration under his hand within or. month from the date of filing of such documents.

Under section 18(3), where the alteration involves a transfer of th registered office

from one state to another, a certified copy of the order sha be filed by the company with the

Registrar of each of the States and th Registrar of each such State shall register the same and

shall certify unci his hand the registration thereof and the Registrar of the State from whit

such office is transferred shall send to the Registrar of the other State a documents filed in his

office. The Company Law Board may extend the tin for filing the document.

Auditor's Duty. The auditor should proceed in the following way ii examining the

Memorandum of Association :

(1) He should very carefully examine the 'Object Clause' of the Memorandum to

ensure that the company is carrying on the work as specified.

(2) He should check the 'Capital Clause' and see that the issue of share capital is

within the 'Authorized Capital'.

(3) If the Authorized Capital has been increased according to law, it should be

verified and traced out.

(4) If the Memorandum has been altered, it should be seen that such an alteration has

been made within the provisions of sections 17 and 18 »f the Companies Act.

2. Articles of Association. Under section 26, there may in the case of a public

company limited by shares, and there shall in the case of an unlimited company or a company

limited by guarantee or a private ompany limited by shares, be registered with the

memorandum, articles of association signed by the subscribers of the memorandum,

prescribing regulations for the company. The Articles of Association of a company united by

shares may adopt all or any of the regulations of Table A in Schedule I.

The Articles of Association contain regulations to control the internal administration

of the company, viz., regulation for day-to-day work, relationship between its members, their

rights and responsibilities, etc. Since the Articles of Association are framed by the company

187

for its use, hey may be altered by a special resolution as and when necessary, subject o the

provisions of the Companies Act and to the conditions contained in Its Memorandum.

According to section 30, the Articles shall be printed and divided into paragraphs

numbered consecutively and signed by each subscriber of the Memorandum of Association

(who shall add his address, description and < cupation, if any) in the presence of at least one

witness who shall attest "he signature and shall likewise add his address, description and

occupation, if any.

Section 31(1) provides their subject to the provisions of this Act and to he conditions

contained in its memorandum, a company may, by special resolution, alter its articles.

It is provided that no alteration made in the articles under this sub-section which has

the effect of converting a public company into a private company, shall have effect unless

such alteration has been approved by the Central Government.

A printed copy of the Articles should be filed by the company within month of the

date of receipt of the order of approval [31(2A)].

Thus, the Memorandum of the company, its articles, if any, and the agreement, if any,

which the company proposes to enter into with any dividable for appointment as its managing

or whole-time director or manager, shall be presented to the Registrar of the State in which

the registered office of the company is situated as provided by section 33. Under section 36,

Memorandum and Articles shall, when registered, bind the company and the members thereof

to the same extent as if they respectively a ad been signed by the company and by each

member and contained covenants on its and his part to observe all the provisions of the

Memorandum and of the Articles. All money payable by any member to the company under

the Memorandum or Articles shall be a debt due from him to the company.

Auditor's Duty. The auditor should examine the Articles of Association of the

company for the following matters :

(i) Issue of Share Capital.

(ii) Calls on shares.

(iii) Calls in advance.

(iv) Calls in arrear.

(v) Forfeiture and re-issue of shares.

(vi) Transmission of shares.

(vii) Payment of commission on shares.

(viii) Rights of various classes of shareholders.

(ix) Appointment, remuneration, rights and Director or Manager.

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(x) Appointment, remuneration, qualification duties of Directors.

(xi) Alteration of Share Capital.

(xii) Dividends and Reserves.

(xiii) Borrowing powers of the Company and Directors, etc.

(xiv) Appointment, rights and duties of an auditor.

(xv) Accounts and Audit of the Company.

(xvi) Underwriting of Shares.

(xvii) Meetings and their procedure.

(xviii) How to inform Shareholders.

(xix) Voting Powers of the Shareholders.

(xx) Payment of interest out of capital.

(xxi) How far Table A has been followed in framing the Articles of Association?

The auditor should go through the Articles very carefully and so specially that the

regulations contained are in accordance with the law. He should further see that for alteration

of the Articles, section 31 has beer, followed. It is to be noted that if a company has not

adopted its own Articles Table A of the Companies Act will be applicable.

In the case of Leeds Estate Building and Investment Society Ltd. \ -Shepherd (1887),

it was held that an auditor has no defence with him tc say that he could not see the Articles of

Association when he knew of thei: existence.

3. Prospectus. Matters to be stated and reports to be set out ii Prospectus are given in

section 56 of the Companies Act. A Prospectus is issued with the objective of inviting public

to purchase the shares of the company. Ordinarily, all matters dealt with above in the Articles

o: Association are found in the Prospectus.

Under section 56(1), every prospectus issued (a) by or on behalf ol company, or (b)

by or on behalf of any person who is or has been engage; or interested in the formation of a

company, shall state the matter-specified in Part I of Schedule II and set out the reports

specified in Part II of that schedule, and the said parts I and II shall have effect subject to the

provisions contained in Part III of that Schedule.

Under section 56(3), no one shall issue any form of application for shares in or

debentures of a company, unless the form is accompanied by a memorandum containing such

salient features of a prospectus as may be prescribed which complies with the requirements of

this section.

Provided that a copy of the prospectus shall on a request being made by any person

before the closing of the subscription list be furnished to him.

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Provided further that this sub-section shall not apply if it is shown that the form of

application was issued either :

(a) in connection with a bona fide invitation to a person to enter into an underwriting

agreement with respect to the shares or debentures, or

(b) in relation to shares or debentures which were not offered to the public.

If any person acts in contravention of the provisions of this sub-section, he shall be

punishable with fine which may extend to fifty thousand rupees.1

Under section 56(4), a director or other person responsible for the prospectus shall not

incur any liability by reason of any non-compliance with, or contravention of, any of the

requirements of this section, if :

(a) as regards any matter not disclosed, he proves that he had no knowledge thereof;

or

(b) he proves that the non-compliance or contravention arose from an honest mistake

of fact on his part; or

(c) the non-compliance or contravention was in respect of matters vhich in the opinion

of the court dealing with the case were immaterial or was otherwise such as ought in the

opinion of that court, having regard to all the circumstances of the case, reasonably to be

excused.

It is further provided that no director or other person shall incur any lability in respect

of the failure to include in a prospectus statement with respect to the matters specified in

clause 18 of Schedule II, unless it is proved that he had knowledge of the matters not

disclosed.

Auditor's Duty. The auditor should examine the Prospectus for the llowing matters:

(i) Amount of capital to be issued, classification of shares and rights of shareholders

attached therewith,

(ii) Amount payable on allotment and calls,

(iii) Amount of minimum subscription,

(iv) Particulars of any contact entered into with the vendors for the purchase of business,

(v) Amount payable for underwriting commission on shares or debentures,

(vi) Amount of preliminary expenses paid or payable.

(vii) Qualifications, remuneration, etc. of Directors,

(viii) Appointment, remuneration, etc. of Managers, (ix) Particulars of any material

contracts entered into within two years of the date of issue of the Prospectus.

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Books and Registers

Under section 209 every company shall keep at its registered office proper Books of

Account with respect to :

(a) all sums of money received and expended by the company and the matters in respect

of which the receipt and expenditure take place;

(b) all sales and purchases of goods by the company;

(c) the assets and liabilities of the company; and

(d) in the case of a company pertaining to any class of companies engaged in production,

processing, manufacturing or mining activities, such particulars relating to utilization

of material or labour or to other items of cost as may be prescribed if such class of

companies is required by the Central Government to include such particulars in the

Books of Accounts.

It is provided that all or any of the Books of Accounts may be kept at such other place

in India as the Board of Directors may decide. When the Board of Directors so decides the

company shall, within seven days of the decision, file with the Registrar a notice in writing

giving the full address of that other place.

Where a company has a Branch Office, whether in or outside India, the company shall

be deemed to have complied with the provisions given above, if proper Books of Account

relating to the transactions affected at the Branch Office are kept at that office and proper

summarized returns, made up to dates at intervals of not more that three months, are sent by

the Branch Office to the company at the registered office or the other place referred to earlier.

For the purposes of sub-sections (1) and (2), proper books of account shall not be deemed to

be kept with respect to the matters specified therein.

(a) if there are not kept such books as are necessary to give a true and fair view of the

state of affairs of the company or branch office, as the case may be, and to explain its

transactions; and

(b) if such books are not kept on accrual basis and according to the double entry system

of accounting.

The Books of Account and other books and papers shall be open to inspection by any

Director during business hours.

The Books of Account of every company relating to a period of not less than eight

years immediately preceding the current year shall be preserved in good order. In the case of

191

a company incorporated less than eight years before the current year, the Books of Account

for the entire period preceding the current year shall be preserved.

The Managing Director or Manager is made responsible for maintaining and

preserving the Books of Account. The Board of Directors of the company, if there is no

Managing Director or Manager, will be responsible for maintaining the books. In default any

one responsible will be punishable with imprisonment for a term which may extend to six

months or with fine which may extend to tan thousand rupees, or with both.

1. Register of Members. Every company will keep in one or more books a Register of

its Members and enter therein the following particulars (under section 150):

(a) the name and address, and the occupations, if any, of each member;

(b) the shares held by each member, the amount paid thereon, etc.;

(c) the date at which each person was entered in the register as a member; and

(d) the date at which any person ceased to be a member. Provided that where the

company has converted any of its shares into stock and has given notice of the

conversion to the Registrar, the register shall show the amount of stock held by each

of the members converted instead of the shares so converted which were previously

held by him.

If default is made in complying with these provisions, the company and every officer

of the company who is in default shall be punishable with fine which may extend to five

hundred rupees for every day during which the default continues.

2. Register of Charges. Under section 143 every company is required to keep at its

registered office a Register of Charges and enter therein all charges on the undertaking or on

any property of the company giving in each case :

(i) a short description of property charged,

(ii) the amount of the charge, and

(iii) except in the case of securities to bearer, the names of the persons entitled to the

charges.

If any officer of the company knowingly omits, or wilfully authorizes or permits the

omission of any entry required to be made, he shall be punishable with fine which may

extend to five thousand rupees.

3. Minute Books. According to section 193, every company shall cause minutes of all

proceedings of every general meeting and of all proceedings of every meeting of its Board of

Directors or of every Committee of the Board, to be kept by making within thirty days of the

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conclusion of every such meeting concerned, entries thereof in Minute Books with their

pages consecutively numbered. Minute Books are statutory books, and are of three types :

(i) Shareholders' Minute Books to record the proceedings of Shareholders' Meetings.

(ii) Directors' Minute Books to record the proceedings of the Meetings of the Board of

Directors.

(iii) Committees' Minute Books to record the proceedings of the meetings of the

committees appointed by the Board of Directors.

As was held in the case of Hearts of Oak Insurance Co. Ltd. vs. Flower, 1935, the

Minute Books should be in the form of a bound book and not loose sheets that can be

removed or substituted. The Minutes recorded in the Minute Books have to be certified by the

Chairman of the meetings concerned.

In no case the minutes of proceedings of a meeting shall be attached to any other book

by pasting or otherwise.

The Chairman shall exercise an absolute discretion in regard to the inclusion or non-

inclusion of any matter in the minutes on the grounds specified.

If default is made in complying with the provisions of this Section, every officer of

the company who is in default shall be punishable with fine which may extend to five

hundred rupees.

The auditor must inspect the Shareholders' Minute Book to examine the following

matters :

(i) Issue of Shares at a discount;

(ii) Issue of Redeemable Preference Shares;

(iii) Issue of further shares to persons other than the existing equity shareholders;

(iv) Alteration of Share Capital;

(v) Adoption of Annual Accounts;

(vi) Declaration of Dividends;

(vii) Appointment and Remuneration of Auditors;

(viii) Appointment and Remuneration of Directors;

(ix) Increasing the powers of the Board of Directors;

(x) Increasing the remuneration of Directors, with the sanction of the Central

Government;

(xi) Investments in Shares and Debentures of other companies;

(xii) Reduction of Shares Capital;

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(xiii) Payment of interest out of capital;

(xiv) Authorizing remuneration to an ordinary Director on the basis of a percentage of the

net profits;

(xv) Appointing a Director, his relative or associate to an office of profit under the

company;

(xvi) Granting any loans, etc., to a company under the same management; etc.

The Directors' Minute Book will be examined by the auditor to obtair. confirmation of the

following :

(i) Issue of capital and allotment of shares;

(ii) Calls made by the company;

(iii) Forfeiture of shares;

(iv) Approval of contracts;

(v) Adoption of Annual Accounts;

(vi) Appointment, remuneration, rights and duties, etc. of Managers Auditors, etc.;

(vii) Sanction of borrowing powers;

(viii) Exercising of borrowing powers;

(ix) Declaration of interim dividend and recommendation for fina. dividend;

(x) Purchase of Fixed Assets;

(xi) Transfer to General Reserve and other Reserves;

(xii) Alteration of Articles;

(xiii) Payment of travelling expenses to officials and Directors of the company;

(xlv) Redemption of Debentures; etc.

4. Register of Directors, etc. Under section 303(l)(a) of the Companies Act, every

company is required to keep at its registered office a register of its Directors, Managing

Director, Manager and Secretary containing with respect to each of them, the following

particulars, that is to say :

(a) in the case of an individual, his present name and surname in full; any former name or

surname in full; his father's name and surname in full or where the individual is a married

woman, the husband's name and surname in full, his usual residential address, his nationality;

and if that nationality is not the nationality of origin, his nationality of origin; his business

occupation, if any; if he holds the office of director, managing director, manager or secretary

in any other body corporate, the particulars of each such office held by him; and except in the

case of a private company which is not a subsidiary of a public company, the date of his birth.

194

Similar particulars are also required to be kept in the case of body corporate under clause (b)

and in the case of a firm under clause (c); if any director or directors have been nominated by

a body corporate, similar details are required to be kept under clause (c) and if nominated by

a firm under clause (d).

The company under section 303(2) shall send to the Registrar a return in duplicate in

the prescribed form within a period of thirty days from the appointment of the first directors

of the company and the notification of a change is to be sent within thirty days from the

happening thereof.

If default is made in complying with the provisions of this Section, the company and

every officer of the company who is in default shall be punishable which may extend to five

hundred rupees for every day during which the default continues.

5. Register of Directors' Shareholdings, etc. Under section 307, a separate register

has to be maintained by every company to record the number, description and amount of any

shares or debentures of the company or any other body corporate being the company's

subsidiary or aolding company, or a subsidiary of the company's holding company, \ hich are

held by him or in trust for him or of which he has any right to become the holder whether on

payment or not.

6. Register of Contracts, Companies and Firms in which Directors are nterested.

According to section 301, every company is required to keep one more registers in which

separate particulars of all contracts or arrangements, e.g., dates of contract or arrangement,

names of the parties, principal terms and conditions and the date of the meeting of the Board

of Directors on which the contract is considered, will be entered.

Auditor has to see whether the register is kept as per requirements of he Act and is in

order.

7. Index of Members. Under section 151, every company having more han fifty

members shall, unless the Register of Members is in such a form - in itself to constitute an

index, keep an index (which may be in the form : card index) of the names of the members of

the company and shall within fourteen days after the date on which any alteration is made in

the Register of Members, make the necessary alteration in the index.

The index will contain a sufficient indication to enable the entries relating to each

member in the register to be readily found and shall be kept at the same place at which the

Register of Members shall be kept.

In default, the company and every officer who is in default, shall be punishable with

fine which may extend to five hundred rupees.

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8. Register and Index of Debentureholders. Under section 152, every company shall

keep in one or more books a Register of the holders of its Debentures and enter therein the

particulars relating to the names, addresses, occupations, etc. about the Debentureholders.

Every company having more than fifty debentureholders shall, unless the register of

debentureholders is in such a form as in itself to constitute an index, keep an index (which

may be in the form of a card index) of the names of the debentureholders of the company and

shall within fourteen days after the date on which any alteration is made in the register of

debentureholders make the necessary alteration in the index.

In default, the company and every officer of the company shall be punishable with

fine which may extend to five hundred rupees.

9. Register of all Investments made by the Company in Shares. Under section

372(6), every company shall keep a Register of Investments made by it in shares of any other

body or bodies corporate showing names of such corporate bodies in which investment has

been made, date of investment, date on which body corporate came in the same group and the

names of all bodies corporate in the same group as investing company.

10. Register of Loans. According to section 370(1 c) of the Companies Act, every

lending company shall keep a register in respect of loan made, guarantee given, the date on

which the loan has been made and the date on which guarantee has been given or security has

been provided in connection with a loan made by any other person to, or to any other person

by, any body corporate or firm together with the name of the person, body corporate or firm.

If default is made in complying with the provisions, the company and every officer of the

company who is in default, shall be punishable with fine which may extend to five hundred

rupees and also with a further fine which may extend to fifty rupees for every day after the

first during which the default continues.

11. Register of Public Deposit. Under section 58(A) every company shall maintain a

separate register in which all public deposits are to be recorded.

12. Register of Investments. According to section 49 of the Companies Act, it is

provided that "all investments of a company shall be made and held in its own name." If the

company's nominee or director becomes or. its behalf a director in another company and is

required to hold qualification shares, they may be held jointly in the name of the company

and such person. A separate register shall be maintained by the company for such investment.

13. Foreign Register of Members and Debenture holders. Under section^ 157 and

158, if it is authorized by the Articles of Association, a company may keep a register of

members and debenture holders in the state or country outside India where they are resident.

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Such a register is kept in that state or country as a branch register. It is known as Foreign

Register.

3. Inspection of Contracts

Next, the auditor should examine the contracts which have been entered into between

a company and other parties, e.g.,

(i) Contracts with the vendors of any property.

(ii) Contracts with the brokers and underwriters.

(iii) Contracts with the promoters for the preliminary expenses, etc. Usually, brief

particulars about such contracts are given in the

Prospectus of a Company. The auditor should see that the Statement of Particulars is

correct and transactions relating to such contracts have been properly recorded in the Books

of Accounts.

4. Study of Previous Year's Balance Sheet and Auditor's Report

When the auditor is appointed in place of retiring auditor, he should examine the

Balance Sheet of the last year and also the report of the auditor appointed last year to be

familiar with any relevant matter raised by the previous auditor. He should ensure that the

objections or qualifications raised in the previous audit report have been duly met by the

company.

Besides this, he may also examine the Directors' Report to the members containing

the recommendations of the Directors in respect of the appropriation of profits made last

year. This is very important.

5. Obtaining a Schedule of Books and Persons Handling them

The auditor should, then, get a list of the persons employed to maintain accounts of

the company and also of books maintained by them. This will help him in the successful

conduct of the audit whenever he needs some information and explanations and difficulties

can, thus, be met easily.

6. Study of Internal Check System

This is another significant part of an auditor's duty to obtain a detailed statement from

the Directors of the Company about the system of the internal check in operation. This will

enable him to note down the shortcomings of the accounting system and the procedure

followed by the company.

7. Certificate of Incorporation and Commencement of Business

A public limited company is not allowed to commence business unless a certificate

entitling the company to commence business is granted. A private company is entitled to

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commence business and exercise borrowing powers immediately after incorporation. The

auditor should examine the certificate and see that the company has commenced business

after it is granted.

SHARE CAPITAL

Under section 86, the Share Capital of a company limited by shares formed after the

commencement of the Companies Act or issued after such commencement is of two types,

Le., Equity Share Capital and Preference Share Capital.

The audit of Share Capital is necessary on incorporation and afterwards as well as

whenever the Directors decide to increase the subscribed Share Capital. To verify capital

newly issued, the auditor should have the following points in view:

(1) The "guidelines for disclosure and investor protection" issued by Securities and

Exchange Board of India (SEBI) must be complied with. These guidelines will apply to all

issues to be made after the promulgation of the Ordinance No. 9 of 1992 by which the Capital

Issues (Control) Act, 1947 has been repealed. All those holding the consents of the Controller

of Capital Issues (CCI) issued prior to the promulgation of the Ordinance may proceed with

the issues on the terms and conditions laid down therein provided, however, that these

guidelines are also followed where they are not inconsistent with the terms and conditions of

the CCI consent. If the company intends to retain 15 per cent over-subscription, the same is

permissible only if it has been noted as such by the CCI. In such cases, all conditions

including pricing of CCI consent will apply. (Clarification 1. dated 17-6-1992)

(2) It should be seen that Prospectus or a Statement in lieu of Prospectus has been

filed with the Registrar. This is necessary in case of the first allotment of shares. It is to be

noted that :

(a) a Prospectus will include in it all the details as required under the Act;

(b) a Prospectus should be duly signed and dated by the Directors of the company as

required by the Act; and

(c) no Prospectus will be issued more than ninety days after the date on which a copy

thereof is delivered for registration.

(3) No allotment shall be made of any Share Capital of a company offered to the

public for subscription unless the amount stated in the Prospectus as the minimum amount

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has been subscribed. The provisions of sections 69 and 70 have to be complied with in this

connection.

Restrictions on Allotment of Shares

(1) No allotment shall be made of any Share Capital of a company unless any sum

payable on application for the amount so stated has been paid to and received by the company

whether in cash or by a cheque or other instrument which has been paid.

Minimum Subscription. The minimum amount which in the opinion of the Directors or of

the signatories of the Memorandum, must be raised by the issue of shares in the Minimum

Subscription. The following items decide the total amount of the minimum subscription :

(a) Purchase price of property to be paid in whole or in part out of the proceeds of the

issue.

(b) Preliminary expenses and underwriting commission payable by the company.

(c) Repayment of any sums borrowed by the company for the above purposes.

(d) Working Capital.

(e) Any other expenditure, stating the nature and purpose thereof and the estimated

amount in each case.

The Prospectus issued by the company should contain full information about the

minimum subscription.

(2) The company has received the sum payable on application in respect of shares to be

allotted.

(3) The amount payable on application on each share must not be less than five per cent

of the nominal value of the share.

All sums so received from the applicants for shares must be deposited in a Scheduled

Bank until the certificate to commence business is obtained under section 149 or they are

returned in accordance with provisions of section 69(5).

In the event of any contravention of the provisions of these rules, every Promoter,

Director or other person who is knowingly responsible for such contravention shall be

punishable with fine which may extend to fifty thousand rupees.

If aforesaid conditions have not been complied with within 120 days after the first

issue of the Prospectus, all moneys received on this account must be repaid, without interest,

within 130 days after the fssue of the Prospectus, and if not, the Directors shall be jointly and

severally liable to repay the same with interest at six per cent per annum from the expiry of

the one hundred and thirtieth day.

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(4) Under section 75, a company is required to file with the Registrar within thirty

days a return of allotment stating the number and nominal amount of the shares comprised in

the allotment, the names, addresses out occupations of the allottees, and the amount, if any,

paid or due and payable on each share. Such particulars are to be given for :

(a) Shares issued for cash,

(b) Shares issued for consideration other than cash,

(c) Bonus Shares allotted.

In the case of bonus shares, a return stating the number and nominal amount of such

shares comprised in the allotment, full particulars of the allottees and a copy of the resolution

authorising the issue of such shares is to be filed. As for issue of shares at a discount, a copy

of the relevant resolution with a copy of the order of the court and the maximum rate of

discount exceeds ten per cent, a copy of the order of the Central Government have to be filed.

(5) Every company should within three months after the allotment of any of the shares

have ready for delivery the certificates of all shares, debentures, etc.

(6) Entries should be passed into the Register of Members immediately after the

allotment.

If default is made in complying with this section, every officer of the company who is

in default shall be punishable with fine which may extend to five thousand rupees for every

day during which the default continues.

Audit of Share Capital

The auditor should examine the following books and documents for the purpose of

auditing Share Capital newly issued :

(i) Memorandum of Association,

(ii) Articles of Association,

(iii) Prospectus,

(iv) Directors' Minute Book,

(v) Application for Shares,

(vi) Application and Allotment Book,

(vii) Copies of Letters of Allotment,

(viii) Copies of Letters of Regret,

(ix) Letters of Calls,

(x) Calls Book,

(xi) Share Register,

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(xii) Cash Book,

(xiii) Pass Book.

For the purpose of audit, the Share Capital of a company may be put under two heads:

I. Shares issued for cash.

II. Shares issued for consideration other than cash.

I. Shares Issued for Cash

The entire procedure may be divided into three stages:

1. Receipts of applications along with the application money, Le., Application Stage.

2. Allotment of shares, issuing letters of allotment and receipt of the allotment money,

Le., Allotment Stage.

3. Calls made and money due thereon received, Le., Call Stage.

1. Application Stage

The auditor should proceed in the following manner :

(i) He should check original applications, and entries in the Application and Allotment

Book should be vouched with these applications.

(ii) Then he should compare the entries in the Application and Allotment Book with those

in the Cash Book.

(iii) He should ensure that the application moneys were deposited into a Scheduled Bank

until the certificate to commence business is obtained or they are returned in

accordance with the provisions of section 69(5).

(iv) Entries of the amount passed in the Cash Book returned to the unsuccessful applicants

should be vouched with the copies of letters of regret and compared with those in the

Application and Allotment Book.

(v) The totals of the Application and Allotment Book should be checked and it should be

seen that the Journal Entry debiting the Share Application Account and crediting

Share Capital Account has been passed.

2. Allotment Stage

(i) The auditor should examine the Directors' Minute Book to verify approvals for

allotment.

(ii) He should compare the entries in the Application and Allotment Book with the copies

of letters of regret.

(iii) For receipt of moneys on allotment, he should check the Cash Book and compare it

with the Application and Allotment Book.

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(iv) Postings of the receipts on application and allotment into the Share Register should

be checked.

(v) It should be confirmed that the totals are correct and allotment has been duly recorded

in the Journal.

3. Call Stage

(i) The auditor should examine the Directors' Minute Book for making calls.

(ii) Entries in the Calls Book should be checked with the help of the copies of letters of

calls.

(iii) Postings from the Calls Book and the Cash Book into the Share Register should be

checked.

(iv) He should compare the Application and Allotment Book with the schedule of calls in

arrears and confirm that the amount is correct.

(v) Calls in advance should be verified.

(vi) The totals of the Calls Book should be checked and the entries passed in this

connection shall be vouched.

Other General Duties

(i) The auditor should confirm that the nominal value of shares allotted does not exceed

the authorized and issued capital and conditions mentioned in the Prospectus have

been duly complied with.

(ii) The total of the balances of Shareholders' Account should be tallied with balances of

Share Capital Account.

(iii) If the issue is underwritten, the contract with the underwriters should be examined and

it should be confirmed whether the terms laid down in the contract have been

complied with.

(iv) Payment of commission, brokerage, etc. should be vouched by reference to the

relevant documentary evidence.

The above-cited procedure can be well applied to the checking of accounts of a

company in the first year of existence. In subsequent years, however, an auditor can apply

test checking unless there is further issue of shares in these years.

II. Shares Issued for Consideration other than Cash

Shares for consideration other than cash are issued to those persons or institutions

from which either property has been acquired or which have rendered some services to the

company. Such cases may be as follows:

1. Issue of Shares to a Vendor,

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2. Issue of Shares to Underwriters of Shares, and

3. Issue of Shares to Promoters.

1. Issue of Shares to a Vendor

The auditor should proceed in the following manner :

(i) Contract He should examine the contract entered into by the company with the

vendors so as to know the exact amount of the purchase consideration. This is the basic

document to be consulted by the auditor.

(ii) Prospectus. He should examine the Prospectus to enquire the mode of payment of

the purchase consideration.

(iii) Directors' Minute Book. The Directors' Minute Book should be referred to

confirm the allotment of shares to the vendor.

(iv) Vendor's Authority in the name of Nominees. If shares have been allotted to the

Nominees of the vendor, he should examine the authority of the vendor given to them in their

favour.

2. Issue of Shares to Underwriters of Shares

(i) Contract. If the shares are issued to the underwriters as a remuneration for

underwriting shares or debentures, the contract with the underwriters should be inspected.

This is necessary to have a knowledge of the terms and conditions given in the contract.

(ii) Directors' Minute Book. Next, he should examine the resolution of the Directors

by reference to the minutes of the Board of Directors. It is to be seen whether the allotment of

shares to the underwriters is in order.

(iii) Articles of Association. He may also confirm from the Articles of Association the

amount of the underwriting commission and the procedure to be followed for its payment.

(iv) Prospectus. The Prospectus of the company has to be seen to verify whether the

right for the payment of commission has been mentioned in it or not.

3. Issue of Shares to Promoters

(i) Contract. For this, again, the auditor should examine the contract with the promoters.

(ii) Directors' Minute Book. Then, the Minutes of the Board of Directors should be

inspected to verify the allotment of shares.

Besides taking the steps as given above in individual cases, the auditor should also

note that :

(i) The copies of contracts as required by section 75(l)(b) of the Companies Act have

been filed with the Registrar of Joint Stock Companies within thirty days of the date of

allotment along with a return stating the number and nominal amount of shares so allotted,

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the extent to which they are to be treated as paid up, and the consideration for which they

have been allotted.

(ii) He should vouch the entries passed into the Journal to ensure that the issue of

shares for consideration other than cash has been properly recorded.

(iii) It is also to be seen that such shares have been separately shown in the liabilities

side of the Balance Sheet.

Purchase of its own Shares by a Company

Under Section 77(1), no company limited by shares, and no company limited by

guarantee and having a share capital, shall have power to buy its own shares, unless the

consequent reduction of capital is effected and sanctioned in pursuance of sections 100 to 104

or of section 402.

Under Sections, 77A, 77AA and 77B of the Companies (Amendment Act, 1999 and

guidelines of SEBI (Securities and Exchange Board of India) a company may purchase its

own shares or other specified securities (hereinafter referred to as "buy-back").

77A. Power of Company to Purchase its own Securities

(1) Notwithstanding anything contained in this Act, but subject to the provisions of

sub-section (2) of this section and section 77B, a company may purchase its own shares or

other specified securities (hereinafter referred to as "buy-back") out of

(1) its free reserves; or

(ii) the securities premium account; or

(iii) the proceeds of any shares or other specified securities; Provided that no buy-back of

any kind of shares or other specified securities shall be made out of the proceeds of an

earlier issue of the same kind of shares or same kind of other specified securities.

(2) No company shall purchase its own shares or other specified securities under sub-

section (1) unless :

(a) the buy-back is authorised by its articles;

(b) a special resolution has been passed in general meeting of the company authorising

the buy-back;

(c) the buy-back is or less than twenty-five per cent, of the total paid-up capital and free

reserves of the company;

Provided that the buy-back of equity shares in any financial year shall not exceed

twenty-five per cent of its total paid-up equity capital in that financial year;

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(d) the ratio of the debt owed by the company is not more than twice the capital and its

free reserves after such buy-back;

Provided that the Central Government may prescribe a higher ratio of the debt than

that specified under this clause for a class or classes of companies.

Explanation : For the purposes of this clause, the expression "debt" includes all amounts of

unsecured and secured debts;

(e) all the shares or other specified securities for buy-back are fully paid-up;

(f) the buy-back of the shares or other specified securities listed on any recognised stock

exchange is in accordance with the regulations made by the Securities and Exchange

Board of India in this behalf;

(g) the buy-back in respect of shares or other specified securities other than those

specified in clause (f) is in accordance with the guidelines as may be prescribed.

(3) The notice of the meeting at which special resolution is proposed to be passed shall be

accompanied by an explanatory statement stating :

(a) a full and complete disclosure of all material facts;

(b) the necessity for the buy-back;

(c) the class of security intended to be purchased under the buy-back;

(d) the amount to be invested under the buy-back; and

(e) the time limit for completion of buy-back.

(4) Every buy-back shall be completed within twelve months from the date of passing the

special resolution under clause (b) to sub-section (2).

(5) The buy-back under sub-section (1) may be :

(a) from the existing security-holders on a proportionate basis; or

(b) from the open market; or

(c) from odd lots, that is to say, where the lot of securities of a public company, whose

shares are listed on a recognised stock exchange, is smaller than such marketable lot,

as may be specified by the stock exchange; or

(d) by purchasing the securities issued to employees of the company pursuant to a scheme

of stock option or sweat equity.

(6) Where a company has passed a special resolution under clause (b) of subsection (2) to

but-back its own shares or other securities under this section, it shall, before making

such buy-back, file with the Registrar and the Securities and Exchange Board of India

a declaration of solvency in the form as may be prescribed and verified by an affidavit

to the effect that the Board has made a full inquiry into the affairs of the company as a

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result of which they have formed an opinion that it is capable of meeting its liabilities

and will not be rendered insolvent within a period of one year of the date of

declaration adopted by the Board, and signed by at least two directors of the company,

one of whom shall be the managing director, if any;

Provided that no declaration of solvency shall be filed with the Securities and

Exchange Board of India by a company whose shares are not listed on any recognised

stock exchange.

(7) Where a company buys-back its own securities, it shall extinguish and physically

destroy the securities so bought-back within seven days of the last date of completion

of buy-back.

(8) Where a company completes a buy-back of its shares or other specified securities

under this section, it shall not make further issue of the same kind of shares [including

allotment of further shares under clause (a) of sub-section (1) of section 81] or other

specified securities within a period of twenty-four months except by way of bonus

issue or in the discharge of subsisting obligations such as conversion of warrants,

stock option schemes, sweat equity or conversion of preference shares or debentures

into equity shares.

(9) Where a company buys-back its securities under this section, it shall maintain a

register of the securities so bought, the consideration paid for the securities bought-

back, the date of cancellation of securities, the date of extinguishing and physically

destroying of securities and such other particulars as may be prescribed.

(10) A company shall, after the completion of the buy-back under this section, file with the

Registrar and the Securities and Exchange Board of India, a return containing such

particulars relating to the buy-back within thirty days of such completion, as may be

prescribed;

Provided that no return shall be filed with the Securities and Exchange Board of India by a

company whose shares are not listed on any recognised stock exchange.

(11) If a company makes default in complying with the provisions c this section or any

rules made thereunder, or any regulations made under clause (f) of sub-section (2),

the company or any officer of the company who is in default shall be punishable with

imprisonment for a term which may extend to two years, or with find which may

extend to fifty thousand rupees, r with both.

Explanation : For the purposes of this section,

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(a) "specified securities" includes employees' stock option or other securities as may be

notified by the Central Government from time to time.

(b) "free reserves" shall have the meaning assigned to it in clause (b) )f Explanation to

section 372A.

77AA. Transfer of certain sums to Capital Redemption Reserve Account

Where a company purchases its own shares out of free reserves, then a sum equal to

the nominal value of the share so purchased shall be transferred to the capital redemption

reserve account referred to in clause d) of the proviso to sub-section (1) of section 80 and

details of such transfer shall be disclosed in the balance sheet.

77B. Prohibition for Buy-back in certain Circumstances

(1) No company shall directly or indirectly purchase its own shares or :ther specified

securities :

(a) through any subsidiary company including its own subsidiary .ompanies; or

(b) through any investment company or group of investment companies; or

(c) if a default, by the company, in repayment of deposit or interest payable thereon,

redemption of debentures, or preference shares or payment of dividend to any

shareholder or repayment of any term loan or interest payable thereon to any

financial institution or bank, is subsisting.

(2) No company shall directly or indirectly purchase its own shares OT other specified

securities in case such company has not complied with provisions of sections 159, 207 and

211.

Issue of Shares at a Premium

Section 78 of the Companies Act prescribes that :

(1) When a company issues securities at a premium, whether for cash or otherwise, a sum

equal to the aggregate amount or value of the premiums on those securities collected shall be

transferred to an account to be called The Securities Premium Account' and the provisions of

this Act relating to the reduction of the Capital of a Company shall except as provided in this

section, apply as if the securities premium account were paid-up securities capital of the

Company.

(2) The Securities Premium Account may be applied by the company :

(a) In paying up unissued shares of the company to be issued to members of the

company as fully paid bonus shares;

(b) In writing-off the preliminary expenses of the company;

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(c) In writing-off the expenses of or the commission paid or discount allowed on any

issue of securities or debentures of the company; or

(d) In providing for the premium payable on the redemption of any redeemable

preference securities or debentures of the company.

(3) Where a company has issued any security at a premium before the commencement

of the Act, these provisions will apply as if the securities had been issued after the

commencement of the Act.

Provided that any part of the premium which has been so applied that it does not at

the commencement of this Act form an identifiable part < : the company's reserves within this

meaning of schedule VI, shall be disregarded in determining the sum to be included in the

securities premium account.

Auditor's Duty

(i) The auditor should examine the Prospectus, the Articles and the Minutes of the

Directors to see whether the issue of shares at a premium is duly authorized or not. He should

confirm the rate of premium.

(ii) The receipt of the premium should be vouched with the entries in the Cash Book

and the supporting documents.

(iii) He should see that the provisions of section 78 have been complie with.

(iv) The auditor should not have any objection so far as the utilizatir of the amount of

premium is concerned. However, he should see that th sum available has been utilized in the

manner as laid down by the Articles

Issue of Shares at a Discount

Under section 79, a company may issue at a discount shares in th company of a class already

issued in accordance with the conditions as given below :

(i) Such an issue must be authorized by a resolution passed by the company in

General Meeting and sanctioned by the Company La Board.

(ii) The resolution must specify the maximum rate of discount which the shares are to

be issued.

(iii) Not less than one year must have elapsed at the date of issue sine the date on

which the company was entitled to comment business.

(iv) The shares must be issued within two months after the date i which the issue was

sanctioned by the Company Law Board within such extended time as the Company Law

Board may allow

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Provided that no such resolution shall be sanctioned by the Compai. Law Board if the

maximum rate of discount specified in the resoluti exceeds ten per cent, unless that Board is

of the opinion that a high percentage of discount may be allowed in the special circumstances

of th case.

Where a company has passed a resolution authorising the issue shares at a discount, it

may apply to the Company Law Board for an ord sanctioning the issue, and on any such

application, the Company La Board if, having regard to all the circumstances of the case, it

thinks pro so to do, may make an order sanctioning the issue on such terms an conditions as it

thinks fit.

Every Prospectus relating to the issue of shares must conta particulars of the discount

allowed on the issue of the shares or so mu as has not been written-off at the date of the

Prospectus.

If default is made in complying with the above provisions, the company id every

officer of the company who is in default will be punishable with e which may extend to five

hundred rupees.

Auditor's Duty

(i) The auditor should see that the provisions of section 79 given above ive been

complied with.

(ii) The amount of discount, not written-off or adjusted to date, should shown in the

Balance Sheet under the head 'Miscellaneous Expenditure'.

As a matter of principle, the amount of discount should be written-off er a short

period of years, though, of course, there is no statutory binding write it off.

79A1. Issue of Sweat Equity Shares

(1) Notwithstanding anything contained in section 79, a company may ue sweat

equity shares of a class of shares already issued if the following nditions are fulfilled, namely

(a) the issue of sweat equity shares is authorised by a special resolution ssed by the

company in the general meeting;

(b) the resolution specifies the number of shares, current market price, nsideration, if

any, and the class or classes of directors or employees to hom such equity shares are to be

issued;

(c) not less than one year has, at the date of the issue elapsed since he date on which

the company was entitled to commence business;

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(d) the sweat equity shares of a company whose equity shares are listed n a recognised

stock exchange are issued in accordance with the emulations made by the Securities and

Exchange Board of India in this ehalf;

Provided that in the case of a company whose equity shares are not sted on any

recognized stock exchange, the sweat equity shares are issued in accordance with the

guidelines as may be prescribed.

Explanation I: For the purposes of this sub-section, the expression "a : company"

means the company incorporated, formed and registered under this Act and includes its

subsidiary company incorporated in a country utside India.

Explanation II : For the purposes of this Act, the expression "sweat equity shares"

means equity shares issued by the company to employees r directors at a discount or for

consideration other than cash for providing Know-how or making available rights in the

nature of intellectual property rights or value additions, by whatever name called.

(2) All the limitations, restrictions and provisions relating to equity shares shall be

applicable to such sweat equity shares issued under sub-section (1)."

Calls in Arrears

The calls in arrears are the sums of call money due from shareholders. Such calls due

from others are required to be shown separately in the 3alance Sheet. Often, there is a

provision in the Articles of Association of a company to charge interest on calls in arrears.

Auditors' Duty

(i) The auditor should obtain a schedule of all calls in arrears, the amount of calls due

should be verified by reference to the Share Register.

(ii) He should ensure that calls in arrears are properly shown in the Balance Sheet. It

is deducted from the amount of the called-up capital and shown in the liabilities side.

Calls in Advance

Under Section 92, a company, if permitted by the Articles of Association, may accept

from members either the whole or a part of the amount remaining unpaid on any shares held

by him, as calls in advance. The amount so received should not be treated as part of the

capital for purposes of any voting rights.

Under section 93 of the Companies Act, a company may, if so authorized by the

Articles, pay dividends in proportion to the amount paid up on each share where a large

amount is paid up on some shares than on others. However, it is prescribed in Clause 88(2) of

Table A that no amount paid or credited as paid on a share in advance of calls shall be treated

for the purpose of paying dividends.1

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The shareholders who have paid the calls in advance will be entitled to receive

interest at the rate specified in the Articles. In Table A of Schedule I of the Companies Act

(Clause 18), it is provided that the Board of Directors can pay on the advance money such

interest not exceeding 6 per cent per annum as may be agreed upon between the Board and

the members paying the sum in advance. Such an interest can be paid out of capital if profits

are not available for such a payment.

Auditor's Duty

1. The auditor should see that calls in advance have not been treated as part of the

capital. Calls in advance should be shown separately in the Balance Sheet.

2. He should vouch the calls in advance with counterfoils of the Receipt Book and

entries in the Cash Book.

3. He should see that interest on calls in advance if its payment is permitted by the

Articles has been paid. He should study the Articles.

4. He should compare the Share Register and the Cash Book.

Issue and Redemption of Preference Shares

If the Articles of a Company limited by shares permit, it may issue preference shares

which are liable to be redeemed at the option of the company before, or on an appointed date.

Section 80 of the Companies Ac prescribes the following conditions :

(1) No such shares will be redeemed unless they are fully paid.

(2) No such shares shall be redeemed except out of profits otherwise of the company

which would otherwise be available for dividend or out of the proceeds of a fresh

issue of shares for the purposes of the redemption

l In the absence of a provision in the Articles of Association authorizing payment of

dividend u proportion to the amount paid up on each share, dividend will have to be paid only

in proportion to the nominal value of the shares. —Oak Bank Oil Co. vs. Cram (1882), App.

Cas t;

(3) The premium, if any, payable on redemption shall be provided for, her out of the

'Securities Premium Account' or out of profits of the ~ipany before shares are

redeemed.

(4) If the shares are redeemed out of profits otherwise than out of the eeds of a fresh

issue, there shall, out of profits which would otherwise been available for dividend, be

transferred to a reserve fund to be Bed Capital Redemption Reserve Account a sum

equal to the nominal milt of the shares redeemed; and the provisions of the Act

relating to E reduction of the share capital of a company shall, except as provided k

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his section, apply as if the capital redemption reserve account were paid share capital

of the company.

(5) The redemption of preference shares will not be taken as reducing he amount of the

Authorized Share Capital.

(6) Subject to the provisions of this section, the redemption of "deference shares there

under may be affected on such terms and in such inner as may be provided by the

Articles of the company.

(7) Where in pursuance of this Section, a company has redeemed or is out to redeem any

preference shares, it shall have power to issue shares up : the nominal amount of

shares redeemed or to be redeemed as if those shares ad never been issued; and

accordingly, the share capital of the company, shall : t, for the purpose of calculating

the fees payable under section 611, be deemed be increased by the issue of shares in

pursuance of this Sub-section.

Provided that, where new shares are issued before the redemption of :e old shares, the

new shares shall not, so far as relates to stamp duty, c deemed to have been issued in

pursuance of this Sub-section unless .e old shares are redeemed within one month after the

issue of new shares.

(8) The Capital Redemption Reserve Account is a part of the share apital in the same way

as 'Share Premium Account' and hence, it cannot e forfeited or applied except for

paying up unissued share capital of the :mpany which can be issued to its members as

fully paid bonus shares.

Notwithstanding anything contained in this Act, no company limited by -.ares shall,

after the commencement of the Companies (Amendment) Act, ?96, issue any preference

share which is irredeemable or is redeemable after :e expiry of a period of twenty years from

the date of its issue.

If a company fails to comply with the provisions of this Section, the Dmpany. and

every officer of the company who is in default, shall be unishable with fine which may

extend to ten thousand rupees.

Auditor's Duty

(i) For Issue :

(1) The auditor should, first of all, examine the Articles of Association "the company to

ensure such an issue is authorized by the Articles.

(2) The issue should be vouched and he should check the necessary ■cords made in the

books of accounts in this connection.

212

(3) Unless the shares are redeemed, the terms of redemption, if any, ust be stated in the

Balance Sheet along with the earliest date of •demption or conversion.

(ii) For Redemption :

(1) The auditor should see that the provisions of section 80 given above ave been

complied with.

(2) If the shares are redeemed out of a fresh issue, he should examine the Articles and the

Minutes of Directors.

(3) He should vouch the entries passed to give effect to redemption and ensure that they

are correct.

Redemption of Irredeemable Preference Shares, etc.

Under the Companies (Amendment) Act, 1988 a new section 80A has been inserted

which provides as under :

(1) Notwithstanding anything contained in the terms of issue of any preference shares,

every preference share issued before the commencement of the Companies (Amendment)

Act, 1988

(a) which is irredeemable, shall be redeemed by the company withir. a period not

exceeding five years from such commencement; or

(b) which is not redeemable before the expiry of ten years from the date of issue

thereon in accordance with the terms of its issue and which had not been redeemed before

such commencement, shall be redeemed by the company on the date on which such share is

due for redemption or within a period not exceeding ten years front such commencement,

whichever is earlier:

Provided that where a company is not in a position to redeem any sue: share within

the period aforesaid and to pay the dividend, if any, due thereon (such shares being

hereinafter referred to as unredeemed preference shares), it may, with the consent of the

Company Law Board on a petition made by it in this behalf and notwithstanding anything

contained in this Act, issue further redeemable preference shares equal to the amounts due

(including the dividend due thereon), in respect of the unredeemed preference shares, and on

the issue of such further redeemable preference shares, the unredeemable shares shall be

deemed to have been redeemed.

(2) Nothing contained in section 106 or any scheme referred to In sections 391 to 395,

or in any scheme made under section 396, shall be deemed to confer power on any class of

shareholders by resolution or on any court or the Central Government to vary or modify the

provisions of this section.

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(3) If any default is made in complying with the provisions of this section :

(a) the company making such default shall be punishable with fin which may extend

to ten thousand rupees for every day during which such default continues; and

(b) every officer of the company who is in default shall be punishab: with

imprisonment for a term which may extend to three years and shall also be liable to fine.

Forfeiture of Shares

If some of the shareholders of a company do not pay the amount du on calls and if the

Articles of Association so authorize, it can forfeit the amount received by the company under

the regulations laid down by the Articles or the Regulations 29 to 35 of Table A. Usually, the

Articles o:" Association of a company lay down the procedure to be followed and the

rights and liabilities of the members whose shares have been forfeited.

Procedure. The Articles lay down the procedure under which a company is required

to give to defaulting shareholders a notice asking them o pay the amount due on a certain call

and in the event of non-payment, he shares will be forfeited. If they do not, the amount

received from them Is forfeited and is, thus, transferred to the Forfeited Shares Account. If

shares to be forfeited have been issued at a premium, the amount of premium in respect

thereof is not transferred to the Forfeited Shares Account.

The Forfeited Shares Account should be separately shown in the Balance Sheet until

the shares have been reissued. If the forfeited shares re reissued, the total amount (the amount

received before the forfeiture tnd on the reissue) received should not be less than the nominal

value of the shares otherwise it will amount to a reduction of capital. The final balance (Le.,

the amount more than the nominal value of the shares received) to the credit of the Forfeited

Shares Account should be transferred to the Capital Reserve Account as it is a Capital Profit.

In Madhwa Ram Chandra Kamath vs. Canara Banking Corporation 1941), it was held that

the Articles of a company only authorised it to expel a member. That was held to be not

sufficient to enable the company to deprive the expelled member of his shares.

Forfeited shares become the property of the company. To this extent orfeiture

involves a reduction of the company's capital. The shares can, iowever, be issued even at a

discount, but that is not the same thing as in allotment. This was observed in re: Calcutta

Stock Exchange Association 1957). Upon reissue, the capital becomes intact.

In Kaushiram vs. Kishore Chandra (1915) it was held, 'The right to forfeit shares

must be pursued with the greatest exactness; it must be exercised by the proper parties, that

is, by Directors properly appointed, and by the requisite number of them and in the proper

manner and for the proper cause. The right must be exercised bona fide for the purposes for

214

which it is conferred. The power of expulsion is a trust, the execution of which will be

narrowly scanned by the Courts. In Vishwanath Prasad Jallan vs. Holyland CinetoneLtd.

(1939) it was held that where certain subscribers had undertaken to purchase a certain number

of shares but there was no term in the Articles of Association by which they were to pay the

amount on a particular date, nor was any date fixed by the Board of Directors, their shares

were not liable to forfeiture. Similarly, in Panna Lais vs. Jagjit D. & A. Industries (1952) it

was held that where a call for payment is made on the transferee of shares before his name is

registered as a member, the call would be invalid and consequently, the forfeiture of shares

for non-payment of the call money would also be invalid.

Auditor's Duty

(i) Forfeiture :

(1) The auditor should study Articles of the company to ascertain that the Board of

Directors has been authorized to forfeit the shares. If the Articles of Association do

not have any such provisions, Regulations 29 to 35 of Table A of the Companies Act,

1956 would be applicable.

(2) He should verify the amount of calls or instalments outstanding in respect of shares

forfeited.

(3) He should refer to the Minutes of the Board of Directors to ensure that the procedure

prescribed by the Articles has been followed.

(4) Then, he should check the entries passed in the books of accounts and confirm that the

premium, if any, received on issue of shares, has not been transferred to the Forfeited

Shares Account.

(5) After forfeiture, a shareholder ceases to be a member of the company in respect of

shares forfeited. The auditor should see that the necessary entries have been made in

the Register of Members as required.

(ii) Reissue :

(1) He should ascertain that the Board of Directors has the necessary authority under the

Articles to reissue the forfeited shares.

(2) He should study the resolution of the Board of Directors under which the forfeited

shares have been reallotted.

(3) He should vouch the entries made on reallotment in the Cash Book.

(4) He should inspect the copy of the return on allotment filed with the Registrar of Joint

Stock Companies.

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(5) He should see that the balance remaining in the Forfeited Shares Account has been

transferred to the Capital Reserve Account.

Bonus Shares

Usually, the following reasons are given for the issue of Bonus Shares:

(1) When the company has sufficient reserves which it does not need in future, it issues

Bonus Shares.

(2) When there is a big gap between the paid-up capital and the capital actually employed

in the business on account of huge reserves, it is thought proper to issue Bonus Shares

and, thus, to fill up the gap.

(3) Payment of dividend at a high rate is possible if there are excessive divisible profits

with the company. This attracts the competitors in the business. Thus, Bonus Shares

are issued to reduce the rate of dividend and to regularize it from year to year.

(4) A high rate of dividend paid to the shareholders is usually resented by the employees

and customers. Hence, Bonus Shares are issued and the rate of dividend is kept down.

It is thus seen that the issue of Bonus Shares is a good method of capitalizing large

profits or reserves. The following points have to be noted:

(1) The issue of Bonus Shares increases the volume of the Share Capital of a company. It

should be seen that the profits are enough so as to enable the company to pay the

same rate of dividend.

(2) There should be a sufficient number of unissued shares for allotment as Bonus Shares.

Only then, Bonus Shares can be issued.

(3) If there is no unissued Share Capital, a resolution altering the Memorandum and

Articles of Association should be passed so as to enable the company to increase the

authorized capital of the company.

(4) For making payment of dividend otherwise than in cash, Articles will have to be

altered to enable the company to do so.

Bonus shares are issued to all the existing shareholders in their shareholding proportion.

Revised Guidelines, 2000

In keeping with current pace of liberalisation and reforms in the primary market, the

SEBI has decided to modify the extant guidelines for shares.

The SBBI believes that the Board of Directors of companies wishing to make bonus

shares will take into due consideration the relevant financial factors while deciding on bonus

shares and observe the following guidelines:

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1. These guidelines are applicable to existing listed companies who shall forward a

certificate duly signed by the issuer and duly countersigned by its statutory auditor or

by a company secretary in practice to the effect that the terms and conditions for issue

of bonus shares, as laid down in these guidelines, have been complied with.

2. Issue of bonus shares after any public/rights issue is subject to the condition that no

bonus issue will be made which will dilute the value of rights of the holders of

debentures, convertible fully or partly.

In other words, no company shall, pending conversion of FCDs/PCDs issue any

shares by way of bonus unless similar benefit is extended to the holders of such FCDs/PCDs

through reservation of shares in proportion to such convertible part of FCDs or PCDs.

3. The bonus issue is made out of free reserves built out of the genuine profits or share

premium collected in cash only.

4. Reserves created by revaluation of fixed assets are not capitalised.

5. The declaration of bonus issue in lieu of dividend is not made.

6. The bonus issue is not made unless the partly-paid shares, if any existing, are made

fully paid up.

7. The company :

(i) has not defaulted in payment of interest or principal in respect of fixed deposits and

interest on existing debentures or principal on redemption thereof, and

(ii) has sufficient reason to believe that it has not defaulted in respect of the payment of

statutory dues of the employees such as contribution to provident fund, gratuity,

bonus, etc.

8. A company which announces its bonus issue after the approval of the Board of

Directors must implement the proposals within a period of 6 months from the date of

such approval and shall not have the option of changing the decision.

9. There should be a provision in the articles of association of the company for

capitalisation of reserves etc. and if not, the company shall pass a resolution of its

general body meeting making provisions in the articles of association for

capitalization.

10. Consequent to the issue of bonus shares of the subscribed and paid-up capital exceed

the authorised share capital, a resolution shall be passed by the company at its general

body meeting for increasing the authorised capital.

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Share Transfer Audit

It is no part of an auditor's duty to check the share transactions in detail but he is

usually asked to undertake the audit of share transfer for which he is paid an extra

remuneration.

Its objects are :

(i) to prevent clerical errors, and

(ii) to prevent the improper issue of Duplicate Share Certificates or certified transfers

(whether fraudulently or otherwise).

Under section 108, it is provided that a company shall not register a transfer of shares

in (or debentures of) the company unless a proper instrument of transfer duly stamped and

executed by or on behalf of the transferor and by or on behalf of the transferee and specifying

the name, address and occupation, if any, of the transferee, has been delivered to the

company along with the certificate relating to the shares or if no such certificate is in

existence, along with the letter of allotment of shares (or debentures).

Provided that where, on an application in writing made to the company by the

transferee and bearing the stamp required for an instrument of transfer, it is proved to the

satisfaction of the Board of Directors that the instrument of transfer signed by or on behalf of

the transferor and by or on behalf of the transferee has been lost, the company any register the

transfer on such terms as to indemnity as the Board may think fit :

Provided further that nothing in this section shall prejudice any power of the

company to register as shareholder or deben- tureholder any person to whom the right to any

shares in, or debentures of, the company has been transmitted by operation of law.

(1 ) A) Every instrument of transfer of shares shall be in such form as may be prescribed,

and

(a) every such form shall, before it is signed by or on behalf of the transferor and

before any entry is made therein, be presented to the prescribed authority being a person

already in the service of the Government, who shall stamp or otherwise endorse thereon the

date on which it is so presented, and

(b) every instrument of transfer in the prescribed form with the date of such

presentation stamped or otherwise endorsed thereon shall, after it is executed by or on behalf

of the transferor and the transferee and completed in all other respects, be delivered to the

company,

(i) in the case of shares dealt in or quoted on a recognised stock exchange, at any time

before the date on which the register of members is closed, in accordance with law, for the

218

first time after the date of the presentation of the prescribed form to the prescribed authority

under clause (a) or within ^twelvemonths from the date of such presentation, whichever is

later:

(ii) in any other case, within two months from the date of such presentation.

1 Substituted by the Companies (Second Amendment) Act, 1966, w.e.f. 1.4.1966.

2 Substituted for 'two' by the Companies (Amendment) Act, 1988.

(B) Notwithstanding anything contained in sub-section (1A), an instrument of transfer of

shares, executed before the commencement of section 13 of the Companies (Amendment)

Act, 1965 (31 of 1965), or executed after such commencement in a form other than the

prescribed form, shall be accepted by a company,

(a) in the case of shares dealt in or quoted on a recognized stock exchange, at any time

not later the expiry of six months from such commencement or the date on which the register

of members is closed in accordance with law, for the first time after such commencement,

whichever is later;

(b) in any other case, at any time not later than the expiry of six months from such

commencement.

(C) Nothing contained in sub-sections (1A) and (IB) shall apply to :

(A) any share :

(i) which is held by a company in any other body corporate in the name of a director

or nominee in pursuance of sub-section (2), or as the case may be, sub-section (3) of section

49, or

(ii) which is held by a corporation, owned or controlled by the Central Government or

a State Government, in any other body corporate in the name of a director or nominee, or

(iii) in respect of which a declaration has been made to the Public Trustee under

section 153B,

if:

(1) the company or corporation, as the case may be, stamps or otherwise endorses, on

the form of transfer in respect of such share, the date on which it decides that such share shall

not be held in the name of the said director or nominee or, as the case may be, in the case of

any share in respect of which any such declaration has been made to the Public Trustee, the

Public Trustee stamps or otherwise endorses, on the form of transfer in respect of such share

under his seal, the date on which the form is presented to him, and

(2) the instrument of transfer in such form, duly completed in all respects, is delivered

to the :

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(a) body corporate in whose share such company or corporation has made investment

in the name of its director or nominee, or

(b) company in which such share is held in trust, within two months of the date so

stamped or otherwise endorsed: or

(B) any share deposited by any person with :

(i) the State Bank of India, or

(ii) any scheduled bank, or

(iii) any banking company (other than a scheduled bank) or financial institution

approved by the Central Government by notification in the Official Gazette (and any such

approval may be accorded so as to be retrospective to any date not earlier than the 1st day of

April, 1966), or

(iv) the Central Government or a State Government or any corporation owned or

controlled by the Central Government or a State Government,

by way of security for the repayment of any loan or advance to, or for the performance of any

obligation undertaken by such person, if:

(1) the bank, institution, Government or corporation, as the case may be, stamps or

otherwise endorses on the form of transfer of such share :

(a) the date on which such share is returned by it to the depositor, or

(b) in the case of failure on the part of the depositor to repay the loan or advance or to

perform the obligation, the date on which such share is released for sale by such bank, institu-

tion, Government or corporation, as the case may be, or

(c) where the bank, institution, Government or corporation, as the case may be,

intends to get such share registered in its own name, the date on which the instrument of

transfer relating to such share is executed by it; and

(2) the instrument of transfer in such form, duly completed in all respects, is delivered

to the company within two months from the date so stamped or endorsed.

Explanation. Where any in investment by a company or a corporation in the name of

its director or norninee referred to in clause (A) (i) or clause (A) (ii), or any declaration

referred to in clause (A) (iii), or any deposit referred to in clause (B), of this sub-section is

made after the expiry of the period or date mentioned in clause (a) of sub-section (IB) or after

the expiry of the period mentioned in clause (b) of that sub-section, as the case maybe, the

form of transfer, in respect of the share which is the subject of such investment, declaration or

deposit, means the prescribed form; or (C) any share which is held in any company by the

Central Government or a State Government in the name of its nominee, except that every

220

instrument of transfer which is executed on or after the 1st day of October, 1966, in respect of

any such share shall be in the prescribed form. *(1D) Notwithstanding anything in sub-

section (1A) or sub-section (IB) 2[or sub-section (1C)], where in the opinion of the Central

Government it is necessary so to do to avoid hardship in any case, that Government may on

an application made to it in that behalf, extend the periods mentioned in those sub-sections by

such further time as it may deem fit (whether such application is made before or after the

expiry of the periods aforesaid); and the number of extensions granted hereunder and the

period of each such extension shall be shown in the annual report laid before the House of

Parliament under section 638.

1 Inserted by the Companies (Amendment) Act, 1965, w.e.f. 1.4.1966.

2 Inserted by the Companies (Second Amendment) Act, 1966, w.e.f. 1.4.1966.

(2) In the case of a company having no share capital sub-section (1) shall apply as if

the references therein to shares were references instead to the interest of the member in the

company.

(3) Nothing contained in this section shall apply to transfer of a security effected by

the transferor and the transferee both of whom are entered as beneficial owners in the records

of a depository.

Section 109 lays down that a transfer of the share or other interest in a company of a

deceased member thereof made by his legal representative shall, although the legal

representative is not himself a member, be as valid as if the had been a member at the time of

the execution of the instrument of transfer.

Sections 109A and 109B the Companies (Amendment) Act, 1999 (w.e.f. 31-10-

1998) provide: 109A. Nomination of Shares

(1) Every holder of shares in, or holder of debentures of, a company may, at any time,

nominate, in the prescribed manner, a person to whom his shares in, or debentures of,

the company shall vest in the event of his death.

(2) Where the shares in, or debentures of, a company are held by more than one person

jointly, the joint holders may together nominate, in the prescribed manner, a person to

whom all the rights in the shares or debentures of the company shall vest in the event

of death of all the joint holders.

(3) Notwithstanding anything contained in any other law at the time being in force or in

any disposition, whether testamentary or otherwise, in respect of such shares in, or

debentures of, the company, where a nomination made in the prescribed manner

purports to confer on any person the right to vest the shares in, or debentures of, the

221

company, the nominee shall, on the death of the shareholder or holder of debentures

of, the company or as the case may be, on the death of the joint holders become

entitled to all the rights in the shares or debentures of the company or, as the case may

be, all the joint holders, in relation to such shares in, or debentures of the company to

the exclusion of all other persons, unless the nomination is varied or cancelled in the

prescribed manner.

(4) Where the nominee is a minor, it shall be lawful for the holder of shares or holder of

debentures, to make the nomination to appoint in the prescribed manner any person to

become entitled to shares in or debentures of, the company, in the event of his death,

during the minority.

109B. Transmission of Shares

(1) Any person who becomes a nominee by virtue of the provisions of section 109A,

upon the production of such evidence as may be required by the Board and subject as

hereinafter provided, elect, either :

(a) to be registered himself as holder of the share or debenture as the case may be; or

Inserted by the Depositories Act, 1996, w.e.f., 20.9.1996.

(b) to make such transfer of the share or debenture, as the case may be, as the

deceased shareholder or debentureholder, as the case may be, could have made.

(2) If the person being a nominee, so becoming entitled, elects to be registered as

holder of the share or debenture, himself as the case may be, he shall deliver or send to the

company a notice in writing signed by him stating that he so elects and such notice shall be

accompanied with the death certificate of the deceased shareholder or debentureholder, as the

case may be.

(3) All the limitations, restrictions and provisions of this Act relating to the right to

transfer and the registration of transfers of shares or debentures shall be applicable to any

such notice or transfer as aforesaid as if the death of the member had not occurred and the

notice or transfer were a transfer signed by that shareholder or debentureholder, as the case

may be.

(4) A person, being a nominee, becoming entitled to a share or debenture by reason of

the death of the holder shall be entitled to the same dividends and other advantages to which

he would be entitled if he were the registered holder of the share or debenture except that he

shall not, before being registered a member in respect of his share or debenture, be entitled in

respect of it to exercise any right conferred by membership in relation to meetings of the

company;

222

Provided that the Board may, at any time, give notice requiring any such person to

elect either to be registered himself or to transfer the share or debenture, and if the notice is

not complied with within ninety days, the Board may thereafter withhold payment of all

dividends, bonuses or other moneys payable in respect of the share or debenture, until the

requirements of the notice have been complied with.

Section 110 provides that an application for the registration of a transfer may be made

either by the transferor or by the transferee and where such an application relates to partly

paid-up shares, the transfer shall not be registered, unless the company gives notice of the

application to the transferee and the transferee makes no objection to the transfer within two

weeks from the receipt of the notice.

Notice to the transferee shall be deemed to have been duly given if it is despatched by

pre-paid registered post to the transferee at the address given in the instrument of transfer,

and shall be deemed to have been duly delivered at the time at which it would have been

delivered in the ordinary course of post.

Auditor's Duty

Besides confirming that the provisions of sections 108, 109, 110, 111 and 1121 have

been duly complied with and the procedure as laid down above has been followed, the auditor

should take the following steps which are considered necessary for the audit of share transfer

(1) He should examine the Articles of Association as to the procedure to be followed

in case of transfer of shares.

l Section 111 deals with power to refuse rgistration and appeal against refusal.

Section 112 deals with Certification of transfers (see Companies Act, for details).

(2) It should be seen that due notices have been given to all the transferors and if the

application for registration has been made by the transferor in the case of partly paid shares,

the provisions of section 110 given above have been complied with.

(3) He should check the transfer forms and confirm specially that the provisions of

section 108 given above have been complied with.

(4) Next, he should examine and verify the signatures of the transferors from their

specimen signatures on the original application forms or previous transfer deeds.

(5) It should be seen that none of the transferees is disqualified for holding shares in

the company.

(6) He should vouch the entries in the Share Transfer Journal on the basis of transfer

forms.

223

(7) He should inspect the Minutes Book of the Board of Directors to ascertafn that the

transfer is duly approved by the Board.

(8) He should check the transfer and postings made from the Share Transfer Journal

into the Share Register and the Register of Members.

(9) He should cancel the old Share Certificates by a distinctive mark and specially

verify the particulars entered on the counterfoils of certificates issued to the transferees.

(10) He should confirm that a duplicate certificate issued in place of the one lost or

destroyed has been issued with the consent of the Board of Directors. The fact has to be

entered in the duplicate certificate that it is so issued.

(11) It should be seen that share certificates have been issued on printed forms and

unused stock of share certificates is being kept under safe-custody.

(12) If shares have been issued in the absence of Share Certificates, he should

examine the Letters of Indemnity.

(13) If shares mortgaged with some other institutions have been transferred, it is to be

ensured that due notices were given to the mortgagees.

(14) In the case of transmissions registered on the death or insolvency of shareholders,

the auditor should see :

(i) that the provisions of the Articles have been duly followed, (ii) that for

transmissions on death to any executor, the following documents have to be examined:

(a) Succession Certificate granted by the Court.

(b) Certificate issued by the Controller of Estate Duty to ensure that Estate Duty has

been paid.

(c) Request from the executor that the shares be entered in his name.

(d) Order of the Court of Insolvency.

(e) The resolution of the Board of Directors in their Minutes Book approving the

transmission.

(15) He should see that the transfer fee is duly received and credited the Profit and Loss

Account. He should also compare it with the number transfers lodged.

(16) He should confirm that if the registration of the transfers has been refused, due notices

are given to the transferor and the transferee within a period of two months as

required under section 111 of the Companies Act.

(17) Lastly, he should confirm that in case of shares held by Directors, Managing Agents,

Secretaries and Treasurers, the relevant entries in respect thereof have been duly

passed.

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Blank Transfer

Under a blank transfer, the transferor hands over to the transferee the Share Certificate

with a transfer form completely blank except for the signature of the transferor. Its advantage

is that the transferee shall be at liberty to sell the shares again to a subsequent buyer without

disclosing his own identity and without paying for the transfer stamp.

Evils Associated with a Blank Transfer

1. Concealment of the identity of the real owner.

2. Evasion of Tax.

3. Window-dressing of the Balance Sheet.

4. Creation of fictitious transactions in the books to manipulate accounts.

The provisions of section 108 (as amended by the Companies Act, 1965) apply for

curbing down the above evils.

Every instrument of transfer of shares must be in the prescribed form and before it is

signed by the transferor and before any entry is made in it, be presented to the prescribed

authority who shall stamp or otherwise endorse thereon the date on which it is so presented. It

should then be executed by the transferor and the transferee and completed in all other

respects and should be presented to the company for registration. Presentation to the company

should be made (i) in the case of shares dealt on a recognized stock exchange before the

closing of the Register of Members, in accordance with the provisions of the Act or within

two months whichever is later, and (ii) in any other case within twelve months from the date

of presentation to the prescribed authority. [Section 108(1A)]

An instrument of transfer not in conformity with the above provisions (in sub-section

1A) shall not be accepted by the company. Also, it shall not be accepted by the company if

presented after six months from the date of commencement of the Amendment Act, 1965 (le.,

15th October, 1965) or the date on which the Register of Members is closed, in accordance

with law, for the first time after such commencement, whichever is later; in any other case, at

any time not later than the expiry of six months from such commencement. [Section 108(1B)]

The Government has reserved the right to extend the period in order to avoid any hardships in

any case. These provisions do not apply to shares deposited by way of security with any

approved Banking Company or Financial Institution. [Section 108(1C) & (ID)]

The basic principles have recenuy been restated by the Gujarat High Court in Pranlal

Jayanand Thakur vs. Vasudev Ramchandra Shelat (1973) as given below :

1. An instrument of transfer which carries no entry except the signature of the transferor

is a valid instrument.

225

2. A person to whom such an instrument is delivered along with share scrip gets an

implied authority to complete the instrument.

3. The transferee acquires good title to the shares if he has received the documents in

good faith and for consideration.

The facts of the case were that the transferee had received the shares under a Gift Deed from

a lady who signed blank transfer forms which, however, could not be registered before

her death.

The other heirs having claimed the shares the Court held that the transferee had not

acquired a goods title to shares as he had received them ithout consideration.

Thus, the transferee gets good title if the transfer is registered during the lifetime of

the transferor. But if the transferor dies before registration, the other heirs can question the

validity of the gift.

The Supreme Court has overruled the decision in Vasudev Ramchandra Shelatvs.

Pranlal Jayanand Thakur (1974) and has held that on these facts a complete equitable and

legal ownership is transferred to the transferee and he is entitled to have the transfer

registered in the company's registers.

Alteration of Share Capital v*-"^

According to sections 94 and 95, a company, if so authorized by the Articles, may

alter its Share Capital by passing an ordinary resolution, without confirmation from the

Court, in any of the ways given below :

(1) Increasing its Share Capital by such amount as it thinks expedient by issuing new

shares;

(2) Consolidating and dividing all or any of its Share Capital into shares of larger

amounts than its existing shares;

(3) Converting all or any of its fully paid-up shares into stock, and reconverting that stock

into fully paid-up shares of any denomination;

(4) Sub-dividing its shares, or any of them, into shares of smaller amount than is fixed by

the Memorandum, so however, that in the sub-division the proportion between the

amount paid and the amount, if any, unpaid on each reduced share shall be the same

as it was in the case of the share from which the reduced share is derived;

(5) Cancelling shares which, of the date of the passing of the resolution in that behalf,

have not been taken or agreed to be taken by any person, and diminish the amount of

its share capital by the amount of the shares so cancelled.

226

The company is required to give notice of the alteration of its Share Capital to the

Registrar within thirty days of doing so.

In default, the company and every officer of the company shall be punishable with

fine which may extend to five hundred rupees for every day during which the default

continues.

Under section 97, if a company, whether its shares have or have not been converted

into stock, has increased its Share Capital beyond the authorized capital, and where a

company, not being a company limited by shares has increased the number of its members

beyond the registered

member, it shall file with the Registrar a notice of the increase of the capital or of members

within thirty days after the passing of the resolution authorizing the increase; and the

Registrar shall record the increase and also make any alterations which may be necessary in

the company's memorandum or articles or both.

The notice to be given as aforesaid shall include particulars of the classes of shares

affected and the conditions, if any, subject to which the new shares have been or are to the

issued.

In default, the company and every officer of the company shall he punishable with

fine which may extend to five hundred rupees for every day during which the default

continues.

Auditor's Duty

(1) The auditor should inspect the Articles to ascertain that the procedure prescribed

therein has been followed and the alteration of Share Capital is authorized.

(2) He should see that the provisions of sections 94 and 95 of the Act have been duly

complied with.

(3) He should inspect the Minutes of the Shareholders authorizing the alteration.

(4) He should also refer to the Minutes of the Board of Directors for resolutions passed

pursuant to the resolution of the members.

(5) He should verify the records made in the financial books and in the Register of

Members with the help of allotment lists.

(6) The Cancelled Share Certificates should be examined and compared with the

counterfoils of new certificates issued.

(7) He should see that the Share Capital Account is correctly shown in the Balance Sheet.

(8) Lastly, he should confirm that the Registrar has been duly intimated.

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Reduction of Share Capital

The provisions of sections 100 to 105 have to be complied with if a company reduces

its Share Capital. As discussed above, under alteration of Share Capital, if a company

diminishes its Share Capital by cancelling its unissued shares, the confirmation by the Court

is not necessary for such a step, though it is also a way in which Share Capital may be

reduced

Under section 100, a company limited by shares or a company limited be guarantee

and having a Share Capital may reduce its Share Capital if :

(i) it is authorized by the Articles,

(ii) a special resolution has been passed for the purpose, and

(iii) the confirmation of the Court is obtained. To reduce the Share Capital, the company

may :

(a) extinguish or reduce the liability on any of its shares, in respect c Share Capital not

paid-up, e.g., Rs. 6 unpaid on a ten-rupee share may be totally extinguished or reduced to Rs.

2;

(b) either with or without extinguishing or reducing liability on any its shares as aforesaid

(i) cancel any paid-up share capital which is lost, or is unrepresented y available

assets [e.g., huge debit balance of Profit and Doss Account may e wiped off by reducing

nominal and paid-up value of shares from Rs. 10 to Rs. 5);

(ii) pay-off any Paid-up Share Capital which is in excess of the wants : the company

[e.g., out of the total Share Capital of Rs. 2,50,000; Rs. 50,000 being in excess of want of the

company may be returned to Shareholders); and may, if and so far as is necessary, after its

Memorandum by reducing the amount of its Share Capital and of its shares accordingly.

A special resolution under this section is in this Act referred to as "a resolution for

reducing share capital".

The Court may make an order directing that the company shall during a specified

period add to its name as the last words 'and reduced' which shall be deemed to be part of the

name of the company for such period.

The Registrar, on delivery to him of a certified copy of the Court's Order and of a

Minute approved by the Court, is required to register and certify the registration thereof. His

certificate shall be conclusive evidence that all the requirements of the Act with respect to the

reduction of Share Capital have been complied with, and that the Share Capital of the

company is such as is stated in the Minutes.

Auditor's Duty

228

(1) The auditor should study the Articles to ascertain that the reduction of Share

Capital is authorized by the Articles.

(2) He should then inspect the special resolution for reducing the Share Capital and

verify that the meeting for such a resolution was convened properly.

(3) He should examine the order of the Court confirming the reduction and see that a

copy of the Order and the Minutes have been filed with the Registrar of Companies.

(4) He should inspect the Certificate of the Registrar as regards the reduction of

capital.

(5) He should vouch the entries recorded in the Financial Books with the help of the

documentary evidence.

(6) If capital in excess of the wants of the company has been paid-off, the entries in

the Cash Book should be compared with those in the Pass Book.

(7) The adjustment so made in the Register of Members should be verified. He should

ensure that new certificates have been issued and the old ones have been cancelled.

(8) He should see that the assets affected as a result of the reduction of capital have

been properly shown in the Balance Sheet.

(9) He should confirm that the words 'and reduced' have been added to the name of

the company as required by the Court's Order.

(10) He should also ensure that the Memorandum and Articles of Association have

been suitably altered.

MANAGEMENT

The management of companies now includes : (1) Directors, (2) Managing Directors,

(3) Manager, (4) Legal Advisor, and (5) Auditors all of whom work under the control and

direction of the Board of Directors and are subordinate of management.

Sections 252 to 388 of the Companies Act deal with the appointment, rights and

duties, remuneration, etc., of these officers. An attempt has been made in the following lines

to put these provisions briefly so far as they relate to the subject in hand.

Directors

Appointment. Under section 252, every public company (other than a public company

which has become such by virtue of section 43A must have at least three Directors provided

that a public company having :

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(a) a paid-up capital of 5 crore rupees or more;

(b) one thousand or more small shareholders;

may have a director elected by such small shareholder in the manner as may be

presended.*

Explanation—for the purposes of this sub-section, small shareholder means a

sharehorder having shares of nominal value of twenty thousand or less in a public company

to which this section applies. Every other company shall have of least two directors.

Section 2(13) states that the term 'Director' includes any person occupying the

position of a Director by whatever name called, e.g., a Governor.

The Directors of a company are appointed by the Articles, by the company in General

Meeting, by the Board of Directors and by third parties (such as Government,

Debentureholders, a Financial Institution. Subscribers to the Memorandum, etc.).

Under section 253, no body corporate, association or firm shall be appointed directors

of a company and only an individual shall be so appointed.

Under section 254, in default of and subject to any regulations in the articles of a

company, subscribers of the memorandum who are individuals, shall be deemed to be the

directors of the company, until the directors are duly appointed in accordance with section

255 which provides:

(1) Unless the Articles provide for the retirement of all directors at every Annual

General Meeting, not less than two-thirds of the total number of directors of a public

company, or of a private company which is a subsidiary of a public company, shall :

(a) be persons whose period of office is liable to determination by retirement of

directors by rotation; and

(b) save as otherwise expressly provided in this Act, be appointed by the company in

General Meeting.

(2) The remaining directors in the case of any such company, and the directors

generally in the case of a private company, which is not a subsidiary of a public company,

shall, in default of and subject to any

Companies (Amendment) Act, 2000.

elations in the articles of the company, also be appointed by the impany in General

Meeting.

Duties. The Directors of a company have a dual role to play—that of he trustees and

of agents. As was held in the case of Lord Selbourne in .E. Rhje. Co. vs. Turner (1872), the

Directors are the mere trustees or orients of the company—trustees of the company's money

230

and property; 4ents in the transactions which are entered into on behalf of the company. In

the capacity of trustees of the company, they cannot enter in ) contracts with the company in

which they are interested and similarly as agents, they cannot sell goods to or purchase goods

from the company whose Directors they are.

Under section 301, a company is required to maintain one or more registers of

contracts in which its Directors are interested. This register shall be kept at the registered

office of the company and shall be open for inspection to the members.

Under section 297, the following restrictions have been imposed on the Directors who

wish to enter into contracts with the companies whose Directors they are :

(1) Except with the consent of the Board of Directors of a company, a Director of the

company or his relative, a firm in which such a Director or relative is a Partner, any other

Partner in such a firm, or a private company f which the Director is a member or Director,

shall not enter into any contract with the company :

(a) for the sale, purchase or supply of any goods, materials or services; or the

(b) after the commencement of this Act, for underwriting subscription of any shares

in, or debentures of, the company.

(2) Nothing contained in Clause (a) of sub-section (1) shall affect:

(a) the purchase of goods and materials from the company, or the sale of goods and

materials to the company, by any Director, relative, firm, partner or private company as

aforesaid for cash at prevailing market prices; or

(b) any contract or contracts between the company on one side and such Director,

relative, firm, partner or private company on the other for sale, purchase or supply of any

goods, materials and services in which either the company or the Director, relative, firm,

partner or private company, as the case may be, regularly trades or does business.

Provided that such contract or contracts do not relate to goods and materials the value

of which exceeds five thousand rupees in the aggregate in any year comprised in the period of

the contract or contracts; or

(c) in the case of a banking or insurance company any transaction in the ordinary

course of business of such company with any Director, relative, firm, partner or private

company as aforesaid.

(3) Notwithstanding anything contained in sub-sections (1) and (2), a Director,

relative, firm, partner or private company as aforesaid may, in circumstances of urgent

necessity, enter, without obtaining the consent of the Board, into contract with the company

for the sale, purchase or supply of any goods, materials or services the value of which

231

exceeds five thousand rupees in the aggregate in any year comprised in the period of the

contract; but in such a case, the consent of the Board shall be obtained at a meeting within

three months of the date on which the contract was entered into.

(4) Every consent of the Board required under this section shall be accorded by a

resolution passed at a Meeting of the Board and not otherwise; and the consent of the Board

required under subsection (1) shall not be deemed to have been given within the meaning of

that sub-section unless the consent is accorded before the contract is entered into or within

three months of the date on which it was entered into.

(5) If consent is not accorded to any contract under this section, anything done in

pursuance of the contract shall be voidable at the option of the Board.

(6) Nothing in this section shall apply to any case where the consent has been

accorded to the contract before the commencement of the Companies (Amendment) Act,

1960.

Auditor's Duty

(1) The auditor should confirm that the Directors do not enter into contracts unless they

are authorized to do so by the Articles, the Board and the Statute.

(2) He should ascertain from the Minutes of the Board of Directors whether the Director

had made it clear at the meeting about his being, interested in a particular contract,

and if so, whether he voted at such a meeting.

(3) He should examine the Register of Contracts maintained under the provisions of

section 301.

(4) He should ensure that the statutory restrictions have been duly obeyed.

(5) He should see that the qualification shares are held by Directors as laid down by the

Articles of Association.

Remuneration of Directors. Ordinarily, the Articles of Association provide for the

payment of remuneration to Directors. The Directors are not entitled to any remuneration as a

matter of right unless :

(i) there is an agreement to that effect; or

(ii) the Articles of Association provide; or

(iii) the shareholders so decide at the General Meeting to pay such a remuneration.

(1) The payment of remuneration to Directors will be governed by the provisions of

sections 198 and 309 of the Companies Act. Section 198(1) provides as follows :

The total remuneration payable by a public company or a private company which is a

subsidiary of a public company, to its directors and its manager in respect of any financial

232

year shall not exceed eleven percen: of net profits of that company for that financial year

computed in the manner laid down in section 349 and 350 except that the remuneration L the

directors shall not be deducted from the gross profits. Section 309 provides :

(2) The Directors are now paid their remuneration in the form of fees for attending

Meetings of the Board or a Committee of the Board. But if fees have been paid to the

Directors in the form of a monthly salary before the commencement of the Companies

(Amendment) Act, 1960, such a salary shall continue to be paid for a period of two years or

for the remaining term of Office of the Directors, whichever is less, but not longer.

(3) A Director is either in the wholetime employment of the company or a Managing

Director, may be paid remuneration either by way of a monthly payment or a specified

percentage of the net profits of the company or partly by one way and partly by the other. It is

provided that except with the approval of the Central Government, such remuneration shall

not exceed 5 per cent of the net profits for one such Director and if there is more than one

such Director, 10 per cent for all of them together.

(4) In case of a Director who is neither in the wholetime employment of the company

nor a Managing Director and whose remuneration does not include anything by way of a

monthly payment, the company may by way of a special resolution authorize payment to

such a Director, or where there is more than one Director, to all of them together :

(a) if the company has a wholetime Director, Managing Agent, etc., of a commission

not exceeding 1 per cent of the net profits of the company;

(b) in any other case, of a commission not exceeding 3 per cent of the net profits of a

company.

The company may increase the percentage by passing a special resolution in a

General Meeting.

(5) No Director of a company who is in receipt of any commission from the company

and who is either in the wholetime employment of the company or a Managing Director shall

be entitled to receive any commission or other remuneration from any subsidiary of such

company.

(6) If any Director draws or receives any remuneration in excess of the amount

mentioned above without the prior approval of the Central Government, he shall refund such

sums to the company and until such sum is refunded, hold it in trust for the company. The

company has no power to waive the recovery of any such refundable sum unless permitted by

the Central Government.

233

(7) The net profits referred to above shall be computed in the manner as prescribed in

sections 349 and 353.

The provisions of section 309 shall not apply to a private company unless it is a

subsidiary of a public company.

Section 310 of the Companies Act lays down in respect of increase in managerial

remuneration as follows :

"In the case of a public company or a private company which is a subsidiary of a

public company, any provision relating to the remuneration of any Director, including a

Managing or wholetime Director, or any amendment thereof, which purports to increase, or

has the effect of increasing whether directly or indirectly, the amount thereof, whether the

provision be contained in the company's Memorandum or Articles, or in agreement entered

into by it, or in any resolution passed by the company in General Meeting or by its Board of

Directors, shall not have any effect :

(a) in cases where Schedule XIII is applicable unless such increase is in accordance

with the conditions specified in that schedule; and

(b) in any other case, unless it is approved by the Central Government. and the

amendment shall become void if, and in so far as, it is disapproved by that Government:

"Provided that the approval of the Central Government shall not be required where

any such provision or any amendment thereof purports to increase or has the effect of

increasing, the amount of such remuneration only by way of a fee for each meeting of the

Board or a Committee thereof attended by any such Director and the amount of such fee after

such increase does not exceed such sum as may be prescribed."

Provided further that where in the case of any private company which converts itself

into a public company or becomes a public company under this provisions of sections 43A,

any provision relating to the remuneration of any director including a managing or wholetime

director as contained in its memorandum or articles or in any agreement entered into by it or

in any resolution passed by it in general meeting or by its Board of Directors includes a

provision for the payment of fee for each meeting of the Board or a committee thereof

attended by any such director which is in excess of the sum specified under the first proviso,

such provision shall be deemed to be an increase in the remuneration of such director and

shall not, after it ceases to be a private company or, as the case may be, become a public

company, have any effect unless approved by the Central Government.

234

Section 311 of the Act lays down the following provisions in respect of increase in

remuneration of Managing Director or re-appointment or appointment after Act to require

Government sanction.

"In the case of a public company or a private company which is a subsidiary of a

public company if the terms of any re-appointment or appointment of a Managing or

wholetime Director, made after the commencement of this Act, purport to increase or have

the effect of increasing, whether directly or indirectly, the remuneration which the Managing

or wholetime Director or the previous managing or wholetime director, as the case may be,

was receiving immediately before such re-appointment or appointment, the appointment or

reappointment shall not have any effect,

(a) in cases where Schedule XIII is applicable, unless such increase is in accordance

with the auditors specified in that Schedule; and

(b) in any other case, unless it is approved by the Central Government; and shall

become void if, and in so far as, it is disapproved by that Government."

Auditor's Duty

(1) The auditor should inspect the contract with the Directors, Articles of Association or

the Minutes Book of the Shareholders.

(2) He should refer to the Minutes of the Board of Directors if remuneration is paid on the

basis of their attendance at the Board's Meetings.

(3) He should vouch the account paid by way of remuneration.

(4) If the remuneration is paid on the basis of net profits of a company he should ascertain

whether such profits have been calculated according to sections 349 and 350.

(5) He should also examine the special resolution, if any, and also the approval of the

Central Government which is necessary at a time when the remuneration has been

paid in excess of the amount prescribed by the Companies Act.

(6) Where special remuneration has been paid to a Director, he should refer to the

Minutes Book of Directors and vouch the payments by examining that receipt.

(7) If the Directors waive their right of remuneration, he should refer to the Directors'

Minutes Book to ensure that all the Directors were present in the meeting called for

passing such a resolution.

(8) In case of increase in the managerial remuneration he should see that the provisions of

sections 310 and 311 have been complied with.

(9) Unless the Articles so provide, the Directors are not paid any travelling expenses. If

the Articles are silent, the shareholders may pass a resolution to sanction such

235

payment. However, if the journey has been undertaken by the Director for the work of

the company, the Directors may sanction such a payment. The auditor should examine

the Directors' Minutes Book. He should vouch such a payment.

(10) He should examine the records in the financial books and ascertain that the unpaid

remuneration has been shown distinctly in the Balance Sheet.

Loans to and from the Directors

Under section 295, no company, without obtaining the previous approval of the

Central Government in that behalf shall directly or indirectly make any loan to or give any

guarantee or provide any security in connection with a loan made by any other person to, or

to any other person by,

(a) any Director of the lending company or of a company which is the holding

company or any partner or relative of any such Director;

(b) a firm in which its Director or relative is a partner;

(c) a private company of which any such Director is a Director or member;

(d) any body corporate at a General Meeting of which not less than 25 per cent of the

total voting power may be exercised or controlled by any such Director or by two or more

such Directors together, or;

(e) any body corporate, the Board of Directors, Managing Director or Manager

whereof is accustomed to act in accordance with the directions or instructions of the Board or

of any Director or Directors of the lending company.

The above-mentioned provisions shall not apply to any loan made, guarantee given or

security provided by a private company unless it is a subsidiary of a public company, or by a

banking company. It will also not apply to any loan made by a holding company to its

subsidiary, or any guarantee given or security provided by a holding company in respect of

any loan made to its subsidiary.

This restriction shall also apply to any transaction represented by a book-debt which

was from its inception in the nature of a loan or an advance. (Section 296)

Auditor's Duty

(1) The auditor should ensure that the loans or advances to Directors have been made

strictly according to the provisions of law.

(2) He should verify the rate of interest which is charged from the Directors.

(3) He should see that such loans have been clearly stated on the assets side of the

Balance Sheet. If such a loan is repaid to the company by a Director, it should be mentioned

by way of a footnote in the Balance Sheet.

236

(4) If a loan has been advanced by a Director to the company, it must be separately

shown on the liability side of the Balance Sheet and not by way of deduction from the "Loan

to Directors and Officers of the company." The auditor should verify it and ensure that the

company has the power to borrow and the rate of interest charged is also normal.

The Companies (Amendment) Act, 2000 has introduced a new section 292A which

provides as follows :

Audit Committee

(1) Every public company having paid-up capital of not less than five crore of rupees

shall constitute a committee of the Board known as 'Audit Committee" which shall consist of

not less than three directors and such number of other directors as the Board may determine

of which two-thirds of the total number of members shall be directors, other than managing

or whole-time directors.

(2) Every Audit Committee constituted under sub-section (1) shall act in accordance

with terms of reference to be specified in writing by the board.

(3) The members of the Audit Committee shall elect a Chairman from amongst

themselves.

(4) The annual report of the company shall disclose the composition of the Audit

Committee.

(5) The auditors, the Internal auditor, if any, and the director-in-charge of finance

shall attend and participate at meetings of the Audit Committee but shall not have the right to

vote.

(6) The Audit Committee should have discussions with the auditors periodically about

internal control systems, the scope of audit including the observations of the auditors and

review the half-yearly and annual financial statements before submission to the Board and

also ensure compliance of internal control systems.

(7) The Audit Committee shall have authority to investigate into any matter in relation

to the items specified in this section or referred to it by the Board and for this purpose, shall

have full access to information contained in the records of the company and external

profassional advice, if necessary.

(8) The recommendations of the Audit Committee on any matter relating to financial

management including the audit report, shall be binding on the Board.

(9) if the Board does not accept the recommendations of the Audit Committee, it shall

record the reasons therefor and communicate such reasons to the shareholders.

237

(10) The chairman of the Audit Committee shall attended the annual General

Meetings of the company to provided any clarification on matters relating to audit.

(11) If a default is made in complying with the provisions of this section, the company

and every officer who is in deafult, shall be punishable with imprisonment for a term which

may extend to one year, or with fine which may extend to fifty thousand rupees, or with both.

Managing Director

If the Articles of Association of the company so authorize, the company in a General

Meeting or the Board may appoint one of the Directors as Managing Director to look into the

day-to-day affairs of the company for a period not exceeding five years (according to section

317). The remuneration payable to such a Managing Director may be on the basis of a

monthly payment or a percentage of profits which should not exceed 5 per cent of the net

profits of the company. In case of more than one Managing Director, the percentage should

not exceed 10 per cent. No increase in the remuneration is possible without getting it

confirmed by the Central Government under sections 310 and 311.

Auditor's Duty

(1) He should inspect the Articles of Association and also the Directors' Minutes

Book to confirm the appointment of Managing Director and the remuneration payable to him.

(2) He should see that the approval of the Central Government has been obtained.

(3) He should vouch the entries for payment with the help of receipts, etc.

(4) He should confirm that net profits for this purpose have been calculated in

accordance with sections 349 and 350.

(5) He should ensure that no Managing Director has been receiving any remuneration

from a subsidiary company.

Manager

A Manager is an individual (not being the Managing Agent) who, subject to the

superintendence, control and directions of the Board of Directors, has the management of the

whole, or substantially the whole, of the affairs of a company, and includes a Director or any

other person occupying the position of a Manager, by whatever name called, and whether

under a contract of service or not.

Section 384—No company shall, after the commencement of this Act, appoint or

employ, or after expiry of 6 months from such commencement continue the appointment or

employment of any firm, body corporate or association as its manager.

Section 385—No company shall appoint or employ, or continue the appointment or

employment of any person as its Manager who :

238

(a) is an undischarged insolvent, or has at any time within the preceding five years

been adjudged as insolvent; or

(b) suspends, or has at any time within the preceding five years suspended, payment

to his creditors; or makes, or has at any time within the preceding five years made a

composition with them; or

(c) is, or has at any time within the preceding five years been convicted by a Court in

India of an offence involving moral turpitude.

The Central Government may, by notification in the Official Gazette, remove the

disqualification incurred by any person either generally or in relation to any company or

companies specified in the notification.

Section 387—The Manager of a company may, subject to the provisions of section

198, receive remuneration either by way of a monthly payment, or by way of a specific

percentage of the net profits of the company calculated in the manner laid down in sections

349, 350 or partly by one way and partly by the other.

Provided that except with the approval of the Central Government, such remuneration

shall not exceed in the aggregate five per cent of the net profits.

Section 388—The provisions of sections 269, 310, 311 and 317 shall apply in relation

to the Manager of a company as they apply in relation to a Managing Director thereof, and

those of section 312 shall apply in relation to the Manager of a company as they apply to a

Director thereof.

Auditor's Duty

(1) He should ensure that the provisions of the relevant sections have been complied

with.

(2) He should examine the contracts.

(3) He should vouch the payments by reference to the receipts.

(4) If the remuneration exceeds 5 per cent of the net profits, approval of the Central

Government should be taken. He should see that it is done.

Managerial Remuneration

According to section 309, the remuneration payable to directors shall be determined

either by the articles of the company or by a resolution of the company in general meeting.

The resolution may be ordinary or special, as the articles may require.

As per section 198 the maximum limit of managerial remuneration is 11% of net

profits (computed in the manner laid down in section 339 and section 350), which can be paid

by public company or a subsidiary of a public company. The percentage shall be exclusive of

239

the fees payable to the directors for attending the meeting of the Board of Directors or a

committee thereof.

Within 11% of the maximum remuneration, a company may pay monthly remuneration to its

(a) Managing or whole-time director in accordance with the provisions of section 309.

Such remuneration should not exceed 5% of the net profit.

(b) Manager in accordance with the provisions of section 387. The remuneration

payable to a manager shall not exceed 5% of the net profits.

However, the above mentioned limit of 5% can be exceeded only with the approval of

the Central Government.

If there is more than one such managerial persons, Le., managing director, whole-time

director, manager, maximum remuneration to managerial persons can be 10% for all of them

together.

Remuneration in case of nil or inadequate profits

In any financial year a company has no profits or its profits are inadequate, the

company shall not pay to its directors, including any managing or whole- time director or

manager by way of remuneration any sum by way of remuneration (excluding directors' fees)

except with the previous approval of the Central Government. However, such approval of the

central government is not required if the appointment has been made in accordance with the

terms and conditions specified in Parts I and II of Schedule XIII.1 [Section 269(2)]

However, a managerial person has been allowed to draw remuneration from one or more

companies, provided that the total remuneration drawn from the companies does not exceed

the higher maximum limit admissible from any one of the companies of which he is a

managerial person. For overall limit, the remuneration drawn from all such companies shall

be clubbed.

Meaning of the term 'Remuneration'

In order to make this limit meaningful and to prevent directors from drawing more

money in the guise of collateral benefits, the explanation to section 198 provides that the

word 'remuneration' shall include the following:

(i) any expenditure incurred by the company for providing rent-free accommodation

or any other benefit or amenity in respect of accommodation or otherwise free of charge.

(ii) any expenditure incurred by a company in providing any other benefit or amenity

either free of charge or at a concessional rate.

(iii) any expenditure incurred by the company in respect of any obligation or service

which otherwise would have been incurred by the directors or manager.

240

(iv) any expenditure incurred by the company to effect any insurance on the life of the

person, or his spouse or in providing any pension, annuity or gratuity.

As stated earlier, the 'remuneration' does not include the fees paid to directors for

attending Board or Committee meetings.

Payment of Remuneration to Directors

Mode of Payment : A director who is neither in the wholetime employment of the

company nor a managing director may be paid remuneration either :

(i) by way of a monthly, quarterly or annual payment with the approval of the Central

Government; or

l Schedule XIII has been given as annexure at the end of this chapter.

(ii) by way of commission if the company by special resolution authorises such

payment. Maximum Remuneration to such Director : The remuneration paid to such

director, or where there is more than one such director to all of them together, shall not

exceed :

(i) one percent of the net profits of the company, if the company has a managing or

whole-time director or manager;

in general meeting may, with the approval of

the Central Government, increase these rates of remuneration.

[Sec. 309 (4)]

Remuneration for Professional Services [Sec. 309(1)]

Remuneration payable to a director shall include any remuneration payable to him, for

services rendered by him in any other capacity. But where the services are of professional

nature and in the opinion of Central Government, the director rendering them possess the

requisite qualifications for the practice of that profession, extra remuneration may be paid for

such services, it shall not be counted for the purposes of overall ceiling.

Chart Showing the Overall Picture of Managerial Remuneration

Different categories of Managerial Personnel

entitled to Remuneration

Maximum Percentage of net Profits

All directors when there is a manager or managing

director or a whole-time director 1%

All directors when there is no manager or managing

director or whole-time director 3%

Managing director (when there is one managing 5%

241

director)

Manager (there is no provision of having more than

one

manager) 5%

Whole-time director (when there is one such director) 5%

Managing directors and whole-time directors taken

together 10%

Total managerial remuneration to all directors

managing

director(s) or manager and/or whole-time director(s) 11%

New ceiling limits now applicable

The different situations discussed for applying different ceiling limits in section II of the

Schedule XIII may broadly be classified into :

(1) Remuneration in case of nil or inadequate profits, where neither Central

Government approval nor special resolution required;

(2) Cases where Government approval is not required, but payment of remuneration

requires approval through special resolution; and

(3) Cases where the approval of the Central Government as well a? approval through

a special resolution are required.

Situation 1

Remuneration in case of nil or inadequate profits, where neither the Central

Government approval nor the Special Resolution required :

Under the amended provisions of section II of Schedule XIII, where a company has

no profits or inadequate profits the maximum remuneration:

payable depending upon the effective capital shall not exceed Rs. 2 lakhs per month

or Rs. 24 lakhs per annum calculated on the following scale based on the effective capital of

the company :

Effective Capital of the Company is Monthly Remuneration

payable shall not exceed

Rupees

242

Less than Rs. 1 Crore

Rs. 1 Crore or more but less than Rs. 5 Crore

Rs. 5 Crore or more but less than Rs. 25 Crore

Rs. 25 Crore or more but less than Rs. 50

Crore Rs. 50 Crore or more but less than Rs.

100 Crore Rs. 100 Crore and more

75,000 1,00,000 1,25,000

1,50,000 1,75,000

2,00,000

Eligible perquisite—A managerial person shall also be eligible to the following

perquisites which shall not be included in the computation of the ceiling on remuneration

specified above :

(a) contribution to provident fund, superannuation fund or annuity fund to the extent

these either singly or put together are not taxable under the Income Tax Act, 1961,

(b) gratuity payable at a rate not exceeding half a month's salary for each completed

year of service, and

(c) encashment of leave at the end of the tenure.

However, the amended notification has introduced the following two new conditions

for payment of managerial remuneration on the above lines :

(a) Approval by Remuneration Committee : The Remuneration Committee of the

Company should approve the remuneration by a resolution.

"Remuneration Committee" means,

(i) in respect of a listed company, a committee which consists of at least three non-

executive independent directors including nominee director or nominee directors, if any; and

(ii) in respect of any other company, a Remuneration Committee of Directors";

(b) Repayment of Debts : There should not be any default in repayment of any of its

debts (Including public deposits) or debentures or interest payable thereon for a continuous

period of thirty days in the preceding financial year before the date of appointment of such

managerial person.

Remuneration Committee means that a Committee which consists of at least three

non-executive independent directors including nominee director(s), if any.

Relevant date of calculation of effective capital : Where the appointment of the

managerial person is made in the year in which company has been incorporated, the effective

capital shall be calculated as on the date of such appointment. In any other case, the effective

capital shall be calculated as on the last date of the financial year preceding the financial year

in which the appointment of the managerial person is made Situation 2

243

Cases where special resolution is required but Government approval is not required

The notification has introduced a new situation where an eligible company can fix

remuneration at higher ceiling limits.

Monthly remu- aera-

Effective Capital of the Company tion payable shall

not exceed

Less than Rupees 1 Crore 1,50,000

Rupees 1 Crore or more but less than Rupees 5 Crore 2,00,000

Rupees 5 Crore or more but less than Rupees 25 Crore 2,50,000

Rupees 25 Crore or more but less than Rupees 50

Crore

3,00,000

Rupees 50 Crore or more but less than Rupees 100

Crore

3,50,000

Rupees 100 Crore or more 4,00,000

On one hand the Department of Company Affairs allows payment of remuneration at

enhanced limits and on the other, to ensure stringent control over corporate governance, it

imposes certain additional conditions to be fulfilled to avail the enhanced limits. These

conditions are in addition to conditions (a) and (b) discussed in situation 1, Le., (1) Approved

by Remuneration Committee, (2) Repayment of Debts.

(a) Approved by Special Resolution. A special resolution has to be passed at the

General Meeting for the payment of remuneration for a period not exceeding three years.

(b) Notice of General Meeting should have a statement containing the prescribed

information : A statement containing the following information should be given along with

the notice calling for the General Meeting to every shareholder.

(i) General information about the industry and the company on prescribed lines,

(ii) Information about the appointee, including background, pay remuneration etc.,

(iii) Other information, pertaining to reasons for loss or inadequate profit, steps taken

or proposed to be taken for improvement, expected increase in productivity and profits in

measurable terms, etc.,

(iv) Disclosure requirement in the Directors' report under the heading 'Corporate

Governance', if any, attached to the annual report regarding all elements of remuneration

packages such as salary benefits, bonuses, stock options, pension etc.

Situation 3

244

Cases where special resolution and Central Government Approval are required :

In the following instances, the company is required to obtain the prior approval of the

Central Government in addition to fulfil all the condition listed in situation 1 and 2 above,

Le., (i) Repayment of Debts, (ii) Approval by Remuneration Committee, (iii) Approval by

Special Resolution (a) When the effective capital of the company is negative, (bj When the

remuneration is more than the ceiling limits (depending upon the effective capital) of Rs.

48,00,000 per annum or Rs. 4,00,000 per month. However, in respect of companies in Special

Economic Zones (SEZ) Notification GSR No. 565(E) dated 14.08.2002 is applicable.

So where a company intends to pay a remuneration higher than that prescribed in the

Companies Act read with the necessary schedule, an application may be made to the

Department of Company Affairs giving in detail the justification alongwith a copy of the

resolution passed by the Board/General meeting as the case may be.

Special provision to Companies located in Special Economic Zone

A new clause (D) in Para 1 of section II of Part II of Schedule XIII was inserted by

the DCA through Notification GSR No. 565(E) dated 14.08.2002 empowering companies in

Special Economic Zone notified by the Department of Commerce, to pay managerial

remuneration not exceeding Rs. 240 lakhs per annum or Rs. 20 lakhs per month. No prior

approval of the Central Government is required in this regard.

However the following conditions are to be satisfied :

(a) the company should not have raised any money by public issue of shares or

debentures; and

(b) the company should not have committed any default in India in repayment of its

debts or debentures or interest payable thereon for a continuous period of 30 days in any

financial year.

Further as per Notification GSR No. 670(E) dated 30.09.2002, which brought in a

modification to GSR No. 565(E), no non-resident can be appointed as managerial personnel,

unless he holds a proper employment visa from the concerned Indian mission abroad.

No Sitting Fees. Managing Director or Wholetime Directors are not entitled to sitting

fees. If any sitting fee is paid, it will be treated as other allowances and the overall managerial

limit shall be including such sitting fee.

245

Ceiling on Sitting fee.1 The maximum amount of remuneration by way of fee for each

meeting of the Board of Directors or Committee thereof, shall be as under :

(a) Companies having paid up capital and

free reserves of Rs. 10 crore and above

or turnover of Rs. 50 crore and above.

Sitting fee not to exceed

the sum of Rs. 20.000.

(bj Other companies Sitting fee not to exceed

the sum of Rs. 10,000.

l Circular of DCA No. F. No. 2.12.2003-CL-V. Dt. 24-7-2003

246

Calculation of Net Profits

Section 349—(1) In computing the net profits of a company in any financial year :

247

(a) credit shall be given for the sums specified in sub-section (2) and credit shall not

be given for those specified in sub-section (3); and

(b) the sums specified in sub-section (4) shall be deducted and those specified in sub-

section (5) shall not be deducted.

(2) In making the computation aforesaid, credit shall be given for the owing sums:

bounties and subsidies received from any Government or public authority constituted or

authorized in this behalf, by any ernment unless and except in so far as the Central

Government erwise directs.

(3) In making the computation aforesaid, credit shall not be given for following sums:

(a) profit, by way of premium, on shares or debentures of the company, which are

issued or sold by the company;

(b) profits on sales by the company of forfeited shares;

(c) profits of a capital nature including profits from the sale of the undertaking or any

of the undertakings of the company or any part thereof;

(d) profits from the sale of any immovable or fixed assets of a capital nature

comprised in the undertaking or any of the undertakings of the company unless the business

of the company consists, whether wholly or partly, of buying and selling any such property or

assets.

Provided that where the amount for which any fixed assets is sold ceeds the written-

down value thereof referred to in section 350, credit - .all be given for so much of the excess

as is not higher than the differences :etween the original cost of that fixed asset and its

written-down value. (4) In making the computation aforesaid, the following sums shall be

ducted :

(a) all the usual working charges;

(b) Directors' Remuneration;

(c) Bonus or Commission paid or payable to any member of the company's staff, or to

any engineer, technician employed or engaged by the company, whether on a whole-time or

on a part-time basis;

(d) any tax notified by the Central Government as being in the nature of a tax on

excess or abnormal profits;

(e) any tax on business profits imposed for special reasons or in special circumstances

and notified by the Central Government in this behalf;

(f) interest on debentures issued by the company;

248

(g) interest on mortgages executed by the company and on loans and advances

secured by a charge on its fixed or floating assets;

(h) interest on unsecured loans and advances;

(i) expenses on repairs, whether to immovable or to movable property, provided the

repairs are not of a capital nature; (j) outgoings inclusive of contributions made under Clause

(e) of sub-section (1) of section 293;1 (k) depreciation to the extent specified in section 350;

Section 293A has been amended by Companies (Amendment) Ordinance, 1979 (No. 9 of

1979) issued on September 25, 1979. This relates to banning contributions by companies

to political parties.

(1) the excess of expenditure over income, which had arisen in computing the net

profits in accordance with the section in any year which begins at or after the commencement

of the Act, in so far as such excess has not been deducted in any subsequent year preceding

the year in respect of which the net profits have to be ascertained;

(m) any compensation or damages to be paid by virtue of any legal liability, including

a liability arising from a breach of contract;

(n) any sum paid by way of insurance against the risk of meeting any liability such as

is referred to in Clause (m);

(0) debts considered bad and written-off or adjusted during the year of account;

(5) In making the computation aforesaid, the following sums shall m be deducted :

(a) Income-tax and Super-tax payable by the company under tl Indian Income-tax

Act, 1922, or any other tax on the income of th company not failing under clauses (d) and (e)

of subsection (4);

(b) any compensation, damages, or payments made voluntarily, tha is to say,

otherwise than by virtue of a liability such as is referre to in clause (m) of sub-section (4);

(c) loss of a capital nature including loss on sale of the undertakii. i or any of the

undertakings of the company or any part there including any excess referred to in the proviso

to section 350 of th written-down value of any asset which is sold, discarde demolished or

destroyed over its sale proceeds or its scrap valu-

Section 350—The amount of depreciation to be deducted in pursuan of clause (k) of

sub-section (4) of section 349 shall be the amount calculate with reference to the written-

down value of the assets as shown by t books of the company at the end of the financial year

expiring at th commencement of this Act or immediately thereafter and at the end each

subsequent financial year at the rate specified in Schedule XTV.

249

Provided that if any asset is sold, discarded, demolished or destroy for any reason

before depreciation of such asset has been provided for full, the excess, if any, of the written-

down value, shall be written-off in the financial year in which the asset is sold, discarded,

demolished destroyed.

250

AUDITORS REPORT

"A report is a statement of collected and considered facts, so drawn up as to give

clear and concise information to persons who are not already in possession of the full facts of

the subject-matter of the report." —Lancaster

An auditor is appointed by the shareholders of a company to audit accounts and, as

such, he makes a report to them about the affairs of t'r. -company. Sometimes, the auditor is

appointed by the Directors as the Bra auditor of a company and in case of casual vacancy, but

still then, submits his report to the shareholders.

Under section 227(2) of the Companies Act, 1956, the auditor required to make a

report to the members of the company on the accour.-examined by him and on every Balance

Sheet and Profit and Loss Accou: and on every other document declared by the Act to be

annexed to tht Balance Sheet or Profit and Loss Account which are laid before : company in

General Meeting during his tenure of office. Such a report • known as the Auditor's Report.

It is, however, the duty of the Directors to prepare the accounts : presentation to the

auditor. The manner in which these accounts are to be approved by the Directors is laid down

in section 215 of the Companies Act.

Importance of Auditor's Report to Shareholders

As stated earlier, an auditor is the agent of the shareholders who ha. -virtually no

knowledge of the material facts about the affairs of the company. The chief value of the

Auditor's Report lies in its check on the accuracy of the figures presented, though, of course,

it does not adc anything to the information disclosed. The auditor is required to conduc: a

sufficient examination of the books and other records including the Balance Sheet and Profit

and Loss Account. On the basis of this security he makes a report to the members of the

company and thus, acquaints them with true and fair state of the company's affairs. Hence,

the auditor is appointed for their benefit and not for the benefit of the Directors.

An auditor is, therefore, not expected to guarantee the accuracy o: every detail of the

company's books. He cannot bring all the errors and fraud to light and act against those who

are found guilty of some fraudulent manipulation. He is a watch-dog and not a blood-hound.

His duty is simply to make a report to the members that the company's financial position is

truly exhibited by the Balance Sheet and Profit and Loss Account.

251

The Companies Act has specifically mentioned the duties of an auditor. They are in

no case subject to anything which the members of the company may agree or the Articles

may prescribe.

Contents of the Audit Report

According to section 227(3) of the Companies Act, the Auditor's Report shall state:

(1) "Whether, in his opinion and to the best of his information and according to the

explanations given to him, the said accounts give the information required by this Act

in the manner so required and give a true and fair view :

(i) in the case of the Balance Sheet, of the state of the company's affairs as at the end of

its financial year; and

(ii) in the case of the Profit and Loss Account, of the profit or loss for its financial year."

Explanation. This reveals a set of two duties to be performed by the auditor. On the

one hand, he has to certify that the accounts give the information required by the

Companies Act, 1956 in the manner so required, and on the other hand, he has to

declare that the accounts give a true and fair view of the company's affairs and its

profit or loss for its financial year.

These are two important duties of an auditor. He must ascertain that the information

as required by Schedule VI has been disclosed in the Balance Sheet and the Profit and Loss

Account. So far as his second duty relates, he has to certify that the accounts reveal a true and

fair view of the company's affairs. The Auditor's Report shall also state:

(2) "Whether he has obtained all the information and explanations which to the best of his

knowledge and belief were necessary for the purpose of his audit."

Explanation. The Act has empowered the auditor to inspect all the books, accounts

and vouchers of the company at all times whether they are kept at the Head Office of the

company or elsewhere and the auditor shall be entitled to require from the officers of the

company such information and explanations as he may think necessary for the performance

of his duties as an auditor.

What type of information and explanations the auditor thinks necessary to obtain from

the officers of the company will depend upon the circumstances of a particular case. He may

rely on them if he gets them from the responsible officers of the company.

(The concept, 'true and fair' has already been explained in the preceding Chapter.)

252

(3) "Whether in his opinion, proper books of accounts as required by law have been kept

by the company so far as appears from the examination of those books and proper returns

adequate for the purpose of his audit have been received from branches not visited by him."

Explanation. Here, again, a company is required to keep proper books of accounts as

prescribed by the Act and the auditor should, therefore, report specifically whether it has been

done so. In case of non-compliance he should qualify his report.

Secondly, he should confirm and report that proper returns are bein_ submitted by the

branches and these returns are adequate for the purpos of his audit. This provision is

applicable for those branches which have nol been visited by him.

(4) "Whether the report on the accounts of any Branch Office audited under section 228

by a person other than the company's auditor has been forwarded to him as required by

Clause (c) of sub-section (3) of that section and he has dealt with the same in preparing the

Auditor's Report."

Explanation. Further, the auditor should confirm that the accounts any Branch Office

have been audited under section 228 by a person other than the company's auditor and the

report of such an auditor has bee: forwarded to him.

He has to state clearly that he has taken full note of the said report h preparing his own report.

(5) "Whether the company's Balance Sheet and Profit and Loss Accou: dealt with by the

report are in agreement with the books of accounts an returns."

Explanation. Lastly, he has to confirm in his report whether t Balance Sheet and Profit

and Loss Account of the company are in 1 agreement with its books, accounts and returns.

This needs no comment. In every business, the final accounts an prepared in

accordance with the books of accounts, returns, etc. T: auditor of every company is required

specifically to mention this fact in hi -report that it has been actually done.

(6) "Whether, in his opinion, the profit and loss account and balar. sheet comply with the

accounting standards referred to in sub-section (3 of section 211."*

"Accounting Standards" are to be recommended by the institute Chartered

Accountants of India as may be prescribed by the Cent: Government in consultation with the

National Advisory Committee Accounting Standards established under sub-section (I) of

section 21OA

Practically, it is rather very difficult for an auditor to report agai: s the Directors of the

company. But after all, it is his responsibility to subrr his correct report to the shareholders

whose interests he has to safegua: This is why an auditor should be prudent, tactful and

courageous.

253

Signature on Audit Report

Section 229 provides that only the person appointed as auditor of 11 company, or

where a firm is so appointed in pursuance of the provi'-sub-section (1) of section 226, only a

Partner1 in the firm practising in Int. may sign the Auditor's Report or sign or authenticate

any other docume: of the company required by law to be signed or authenticated by ti auditor.

"We have auditi 19..... and also the ended on that date

1. We have obc best of our knowfc audit.

2. In our optni been kept by the « books.

3. The Balance are in agreement w:

4. In our opining the explanations gfr the information rec required and give a

(a) in the case o as at.........19...

(b) in the case i ended on that date.

Signature

• Companies (Amendment) Act, 1999 (w.e.f. 31.10.1998). l Signature

Form of Audit Report

[Under section 227(2) of the Companies Act, 1956]

"We have audited the Balance Sheet of........Co. Ltd. as at 31st March,

19..... and also the Profit and Loss Account of the company for the year ended on that

date and we report that :

1. We have obtained all the information and explanations which to the best of our

knowledge and belief were necessary for the purpose of our audit.

2. In our opinion, proper books of accounts as required by law have been kept by the

company so far as appears from our examination of the books.

3. The Balance Sheet and Profit and Loss Account dealt by this report are in agreement

with the books of accounts and returns.

4. In our opinion and to the best of our information and according to the explanations

given to us the accounts subject to the notes thereon give the information required by

the Companies Act, 1956, in the manner so required and give a true and fair view :

(a) in the case of the Balance Sheet of the state of affairs of the company as at.........19...

(b) in the case of the Profit and Loss Account of the profit for the year ended on that date.

Signatures for X, Y & Co. Chartered Accountants A. Smith Partner Chartered Accountant

Companies (Auditor's Report) Order, 2003

254

PUBLISHED IN THE GAZETTE OF INDIA EXTRA ORDINARY PART II,

SECTION 3-SUB-SECTION (i) MINISTRY OF FINANCE (DEPARTMENT OF

COMPANY AFFAIRS)

New Delhi, the 21th June, 2003 G.S.R. 480(E).-In exercise of the powers conferred

by sub-section (4A) of Section 227 of the Companies Act, 1956 (1 of 1956), read with the

Notification of the Government of India in the Department of Company Affairs, number

G.S.R. 443(E), dated 18th October, 1972, as amended from time to time and in supersession

of order number G.S.R. 909(E), dated 7 September, 1988, published in the Gazette of India,

part II, section 3, sub section (i), except as respects things done or omitted to be done before

the supersession, and after consultation with the Institute of Chartered Accountants of India

[constituted under the Chartered Accountants Act, 1949 (38 of 1949)], in regard to class of

companies to which this order applies and other ancillary matters, the Central Government

hereby makes the following Order, namely :

1. Short title, application and commencement : (1) This order may be called the

Companies (Auditors Report) Order, 2003.

(2) It shall apply to every company including a foreign company as defined in section

591 of the Act, except the following :

(i) a Banking company as defined in clause (c) of section 5 of the Banking Regulation

Act, 1949 (10 to 1949);

(ii) an insurance company as defined in clause (21) of section 2 of the Act;

(iii) a company licensed to operate under section 25 of the Act; and

(iv) a private limited company with a paid up capital and reserves tic more than fifty

lakh rupees and has not accepted any publ: deposit and does not have loan outstanding ten

lakh rupees cr more from any bank or financial institution and does not have a turnover

exceeding five crore rupees.

(3) It shall come into force on the 1st day of July, 2003.

2. Definitions : In this Order, unless the context otherwise requires.

(a) "Act" means the Companies Act, 1956 (1 of 1956);

(b) "chit fund company", "nidhi company" or "mutual beneir company" means a

company engaged in the business of managing conducting or supervising as a foreman or

agent of any transactk c or arrangement by which it enters into an agreement with a number

of subscribers that every one of them shall subscribe a certain sum of instalments for a

definite period and that each subscriber, in his turn, as determined by lot or by auction or by

255

tender or in such other manner as may be provided for in the agreement, shall be entitled to a

prize amount, and include-companies whose principal business is accepting fixed deposit-

from, and lending money to, members;

(c) "finance company" means a company engaged in the business of financing,

whether by making loans or advances or otherwise, any industry, commerce or agriculture

and includes any company engaged in the business of hire-purchase, lease financing anc

financing of housing;

(d) "investment company" means a company engaged in the business of acquisition

and holding of, or dealing in, shares, stocks, bonds debentures stocks, including securities

issued by the Central or any State Government or by any local authority, or in other

marketable securities of a like nature;

(e) "manufacturing company" means a company engaged in any manufacturing

process as defined in the Factories Act, 1948 (63 of 1948);

(f) "mining company" means a company owning a mine, and includes a company

which carries on the business of a mine either as a lessee or occupier thereof;

(g) "processing company" means a company engaged in the business of processing

materials with a view to their use, a sale, delivery or disposal;

(h) "service company" means a company engaged in the business of supplying,

providing, maintaining and operating any services, facilities, conveniences, bureaux and the

like for the benefit of others;

(i) "trading company" means a company engaged in the business of buying and selling

goods.

3. Auditor's report to contain matters specified in paragraphs 4 and 5 : Every report

made by the auditor under section 227 of Act, on the accounts of every company

examined by him to which his Order applies for every financial year ending on any

day on or after the commencement of this Order, shall contain the matters specified in

paragraphs 4 and 5.

4. Matters to be included in the auditor's report : The auditor's report on the account of a

company to which this Order applies shall include a statement on the following

matters, namely :

(i) (a) whether the company is maintaining proper records showing full particulars,

including quantitative details and situation of fixed assets;

256

(b) whether these fixed assets have been physically verified by the management at

reasonable intervals; whether any material discrepancies were noticed on such verification

and if so, whether the same have been properly dealt with in the books of account;

(c) if a substantial part of fixed assets have been disposed off during the year, whether

it has affected the going concern;

(ii) (a) whether physical verification of inventory has been conducted at reasonable

intervals by the management;

(b) are the procedures of physical verification of inventory followed by the

management reasonable and adequate in relation to the size of the company and the nature of

its business. If not, the inadequacies in such procedures should be reported;

(c) whether the company is maintaining proper records of inventory and whether any

material discrepancies were noticed on physical verification and if so, whether the same have

been properly dealt with in the books of account;

(iii) (a) has the company either granted or taken any loans, secured or unsecured

to/from companies, firms or other parties convered in the register maintained under section

301 of the Act. If so, give the number of parties and amount involved in the transactions.

(b) whether the rate of interest and other terms and conditions of loans given or taken

by the company, secured or unsecured, are prima facie prejudicial to the interest of the

company;

(c) whether payment of the principal amount and interest are also regular;

(d) if overdue amount is more than one lakh, whether reasonable steps have been

taken by the company for recovery/payment of the principal and interest;

(iv) is there an adequate internal control procedure 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. Whether there is a continuing failure to correct major weaknesses in

internal control;

(v) (a) whether transactions that need to be entered into a register in pursuance of

section 301 of the Act have been so entered;

(b) whether each of these transactions have been made at prices which are reasonable

having regard to the prevailing market prices at the relevant time;

(This information is required only in case of transactions exceeding the value of five

lakh rupees in respect of any party and in any one financial year).

(vi) in case the company has accepted deposits from the public, whether the directives

issued by the Reserve Bank of India and the provisions of section 58A and 58AA of the Act

257

and the rules framed there under, where applicable, have been complied with. If not, the

nature of contraventions should be stated; If an order has been passed by Company Law

Board whether the same has been complied with or not?

(vii) 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;

(viii) where maintenance of cost records has been prescribed by the Central

Government under clause (d) of sub-section (1) of section 209 of the Act, whether such

accounts and records have been made and maintained;

(ix) (a) is the company regular in depositing undisputed statutory dues including

Provident Fund, Investor Education and Protection Fund, Employees' State Insurance,

Income-tax, Sales-tax, Wealth Tax, Custom Duty, Excise Duty, cess and any other statutory

dues with the appropriate authorities and if not, the extent of the arrears of outstanding

statutory dues as at the last day of the financial year concerned for a period of more than six

months from the date they became payable, shall be indicated by the auditor, (b) in case dues

of sales tax/income tax/customs tax/wealth tax/excise duty/cess have not been deposited on

account of any dispute, then the amounts involved and the forum where dispute is pending

may please be mentioned.

(A mere representation to the Department shall not constitute the dispute.)

(x) whether in case of a company which has been registered for a period not less than

five years, its accumulated losses at the end of the financial year are not less than fifty per

cent of its net worth and whether it has incurred cash losses in such financial year and in the

financial year immediately preceding such financial year also;

(xi) whether the company has defaulted in repayment of dues to a financial institution

or bank or debenture holders? If yes, the period and amount of default to be reported;

(xii) whether adequate documents and records are maintained in cases where the

company has granted loans and advances on the basis of security by way of pledge of shares,

debentures and others securities; If not, the deficiencies to be pointed out.

(xiii) whether the provisions of any special statute applicable to chit fund have been

duly complied with? In respect of nidhi/mutual benefit fund /societies;

(a) whether the net-owned founds to deposits liability ratio is more than 1 : 20 as on

the date of balance sheet;

258

(b) whether the company has complied with the prudential norms on income

recognition and provisioning against sub-standard/default/loss assets;

(c) whether the company has adequate procedures for appraisal of credit

proposals/requests, assessment of credit needs and repayment capacity of the borrowers;

(d) whether the repayment schedule of various loans granted by the nidhi is based on

the repayment capacity of the borrower and would be conducive to recovery of the loan

amount;

(xiv) if the company is dealing or trading in shares, securities, debentures and other

investments, whether proper records have been maintained of the transactions and contracts

and whether timely entries have been made therein; also whether the shares, securities,

debentures and other securities have been held by the company, in its own name except to the

extent of the exemption, if any, granted under section 49 of the Act;

(xv) whether the company has given any guarantee for loans taken by odiers from

bank or financial institutions, the terms and conditions whereof are prejudicial to the interest

of the company;

(xvi) whether term loans were applied for the purpose for which the loans were

obtained;

(xvii) whether the funds raised on short-term basis have been used for long term

investment and vice versa; If yes, the nature and amount is to be indicated;

(xviii) whether the company has made any preferential allotment of shares to parties

and companies covered in the Register maintained under section 301 of the Act and if so

whether the price at which shares have been issued is prejudicial to the interest of the

company;

(xiv) whether securities have been created in respect of debentures issued?

(xx) whether the management has disclosed on the end use of money raised by public

issues and the same has been verified;

(xxi) whether any fraud on or by the company has been noticed or reported during the

year, If yes, the nature and the amount involved is to be indicated.

5. Reasons to be stated for unfavourable or qualified answers :

Where, in the auditor's report, the answer to any of the questions referred to in

paragraph 4 is unfavourable or qvialified, the auditor's report shall also state the reasons for

such unfavourable or qualified answer, as the case may be. Where the auditor is unable to

express any opinion in answer to a particular question, his report shall indicate such fact

together with the reasons why it is not possible for him to give an answer to such question.

259

Types of Auditor's Report

The Auditor's Report may be of two types: (1) Clean or Unqualified Report, and (2)

Qualified Report.

(1) Clean or Unqualified Report. A clean or unqualified report is one in which the

auditor does not insert any qualification, or modification or reservation. If he finds it

necessary to do so, he must state the reasons for it. Section 227 (2) of the Companies Act lays

down certain questions which the auditor of a company must answer in his report to the

members of the company on the accounts examined by him and on every Balance Sheet and

Profit and Loss Account and on every other document declared by law to be annexed to the

Balance Sheet or the Profit and Loss Account which are laid before the company in General

Meeting during his tenure of office.

Where any of these questions is answered in the positive or without a qualification,

the auditor has to submit a clean or unqualified report. It is so done by him when he finds the

accounts exhibiting a true and fair view of the state of the company's financial affairs.

(2) Qualified Report. A qualified report is one in which the matters referred to in

section 227(2) are answered in the negative in full or in part and, as a result, the auditor has to

state the reasons for such qualifications or reservations.

Before giving any qualifications, the auditor should note the following :

1. For which item is it necessary to qualify his report?

2. Whether the auditor is not satisfied with a particular matter of the company or he is

unable to express his proper opinion on a particular matter in the absence of some

adequate information?

3. Whether certain matters are so important that they affect the true and fair presentation

of the affairs of the company?

4. Whether the matter relating to the qualification is concerned with the violation of an

important provision of the Companies Act, 1956.

He is expected to report to the shareholders of the company the violations or

contraventions of the provisions of the Companies Act, 1956 and other rules in regard to the

working of a company. Some of such examples are given below :

(a) Inadequate or no provision of depreciation on assets;

(b) Incorrect valuation of Stock-in-trade;

260

(c) Insufficient provision for bad and doubtful debts;

(d) Disclosure of the value of raw materials consumed not properly made;

(e) Wrong treatment of a transaction in the accounts;

(f) Non-receipt of the report for audit of branch accounts;

(g) Any other contravention of laws or procedural mistakes.

As a matter of fact, it is the sole responsibility and discretion of the fact together with

the reasons why it is not possible for him to give an answer to such questions.

S. Kumar Member, Company Law Board

Case for Social Audit

The 'Manufacturing and other Companies (Auditor's Report) Order, 1988' has actually

begun a new era in the field of audit by enlarging the scope of the statutory audit and thus,

has increased the responsibility of an auditor to a very great extent. For the first time, the

element of 'Propriety Audit' has been introduced into the Auditor's Report. An auditor will

now probe into the financial transactions to satisfy himself that the same are not prejudicial to

the interests of the company. This is too onerous a responsibility cast on the auditor. This will

also require considerable improvement in the company administration from within by

introducing and consolidating internal control and internal audit systems.

The order has, therefore, made it clear that the clarity of the final picture depends not

only so much on the proficiency of a single individual is on the collective efforts of all

engaged in the adminis-trative and accounting control of a company. With the necessary co-

operation and auditor to decide matters and issues which he thinks important for

qualifications to be given in his report. He is expected to provide full information in regard to

qualifications which he wants to give in his report.

Illustrations

(1) Clean Report

(a) For a company having no branches : To,

The Members of

'XYZ' Cotton Textile Industry Co. Ltd.

We have audited the attached Balance Sheet of 'XYZ' Cotton Textile Industry Co.

Ltd. as at 31st March, 2001 and also the Profit and Loss Account of the company for the year

ended on the date and as required by the Manufacturing and other Companies (Auditors

261

Report) Order, 1988 issued by the Central Government in terms of Section 227 (4A) of the

Companies Act, 1956, we report that:

1. We have obtained all the information and explanations which to the best of our

knowledge and belief were necessary for the purpose of our audit.

2. In our opinion, proper books of accounts as required by law have been kept by the

Company so far as appears from our examination of the books.

3. In our opinion, the Balance Sheet and Profit and Loss Account dealt with by this

report are in agreement with the books of account and accounting standards referred

to in sub-section (3C) of section 211.

4. The company is maintaining proper records to show full particulars including

quantitative details and situation of fixed assets. These assets have been physically

verified by the management.

5. The fixed assets have not been revalued during the year.

6. Management has conducted physical verification at reasonable intervals in respect of

finished goods, stores, spare parts and raw materials and no discrepancies have been

noticed on such verification as compared to book records. We are satisfied with the

valuation of stocks.

7. The company has not taken any loans, secured or unsecured from companies, firms or

other parties listed in the register maintained under the Sections 301 and 370 (1-C) of

the Companies Act.

8. The parties to whom the company has given loans or advances are repaying principal

amount as stipulated and are also regular in payment of the interest.

9. The company has not granted any loans to companies listed in the Register

maintained under section 301 and/or to the companies under the same management

under sub-section (1-B) of section 370 of the companies Act, 1956.

10. There is an adequate internal control procedure for the purchase of stores, raw

materials including components, plant and machinery, equipment and other assets.

11. These are no transactions of purchase of goods and materials and sale of goods,

materials and services in pursuance of contracts or arrangements entered in the

Register under section 301 of the Companies Act, 1956 and aggregating during the

year to Rs. 50,000 (Rupees Fifty Thousand only) or more in respect of any party.

12. Stores, raw materials or components exceeding Rs. 10,000 in value have not been

purchased from the subsidiaries, firms or companies or other parties in which

directors are interested.

262

13. Unserviceable or damaged stores and raw materials are determine? and provision for

the loss has been made in the accounts.

14. The company has not accepted deposits from the public.

15. No undisputed amounts payable in respect of Income Tax, Sale-Tax, Customs Duty

and Excise Duty were outstanding as on 31.3.2001 for a period of more than six

months from the date they became payable.

16. The company has been maintaining reasonable records for the sal and disposal of

realizable bye-products and scraps.

17. The paid-up capital of the company at the commencement of tl. financial year exceeds

Rs. 25 lakh and company has an internal audit system commensurate with its size and

nature of its business.

18. The company has maintained the cost records as prescribed ! the Central Government

under Section 209 (l)(d) of the Companies Act 1956.

19. The company is not a sick industrial company within the meaning of clause (0) of the

subsection (1) of section 3 of the Sick Industrial Companies (Special Provisions) Act,

1985.

20. The company is regular in depositing provident fund dues with tl appropriate

authority.

21. In our opinion and to the best of our information and according I the explanations

given to us the accounts subject to the notes thereon give the information required by

the Companies Act, 1956 in the manner sc required and give true and fail view (a) in

the case of the Balance Sheet of the state of the affairs of the Company at 31st

March, 2001, and (b) in the case of the Profit and Loss Account, of the profit for the

year ended on that date.

Mumbai ...........

May 31, 2001 Chartered Accountants

(b) For a company having a Branch : To,

The Members of

'XYZ' Cotton Textile Co. Ltd.

1. We have audited the attached Balance Sheet of'XYZ' Cotton Taxtile Co. Ltd. as at

31st March, 2001 and also the Profit and Loss Account of the company for the year ended on

that date and as required by the Manufacturing and other Companies (Auditor's Report)

Order, 1988 issued by the Central Government in terms of Section 227 (4A) of the

Companies Act, 1956, we report that :

263

(i) The company has maintained proper records to show full particulars including

quantitative details and situation of fixed assets. These fixed assets have been physically

verified by the management during the year and there is a regular programme of verification

which in our opinion is reasonable having regard to the size of the company and the nature of

assets, and no serious descrepancies have been noticed on such verification.

(ii) The fixed assets have not been revalued during the year.

(iii) The physical verification has been conducted by the management at reasonable

periods in respect of finished goods, stores, spare parts and raw materials, and if any

significant discrepancies have been noticed on such verification as compared to book records

and the same have been properly dealt with in the books of accounts. We are satisfied that the

valuation of stocks is fair and proper in accordance with the normally accepted accounting

principles and is on the same basis as in the earlier years.

(iv) The company has taken loans, secured or unsecured from companies, firms or

other parties listed in the register maintained under sections 301 and 370 (1-C) of the

Companies Act, 1956 and the rate of interest and the terms and conditions of such loans are

prima facie not prejudicial to the interests of the company.

(v) The parties to whom the loans or advances in the nature of loans have been given

by the company are repaying the principal amounts as stipulated and are also regular in

payment of the interest.

(vi) There is an adequate internal control procedure commensurate with the size of the

company and nature of its business for the purchase of stores, raw materials including

components, plant and machinery, equipment and other assets.

(vii) In our opinion, the stores, raw materials or components exceeding Rs. 10,000 in

value for each type thereof are purchased during the year from the subsidiaries, firms or

companies or other parties in which the directors are interested and the prices paid for such

items are reasonable as compared to the prices of similar items supplied by other parties.

(viii) There is a regular procedure for the determination of unserviceable or

damaged stores and raw materials and provisions for the loss have been made in the accounts.

(ix) In our opinion, the company has accepted Deposits from the public under

directions issued by the Reserve Bank of India and the provisions of section 58A of the rules

made thereunder have been complied with.

(x) The company has been maintaining reasonable records for the sale and disposal of

realisable bye-products and scraps.

264

(xi) The Paid-up Capital of the company at the commencement of the financial year

concerned exceeds Rs. 25 lakh and the company has an Internal Audit System commensurate

with the size and nature of its business.

(xii) The company has maintained cost accounts and records as prescribed by the

Central Government under section 209(1)(d) of the Companies Act, 1956.

(xiii) The company is not a Sick Industrial Company within the meaning of clause (0)

of the sub-section (1) of section 3 of the Sick Industrial Companies (Special Provisions) Act,

1985.

(xiv) The company is regular in depositing Provident Fund dues with the appropriate

authority and there are no arrears of Provident Fund dues as at 31st December, 2000.

2. We have obtained all the information and explanations which to the best of our

knowledge and belief were necessary for the purpose of our audit.

3. In our opinion, proper books of accounts as required by law have been kept by the

company so far as appears from our examination of the books and proper returns adequate for

the purpose of our audit have been received from branches not visited by us.

4. The accounts of......Branch Offices have been audited under section 228 of the Act

by ...... The report on the said accounts which has been forwarded to us have been dealt with

by us, in the manner we have considered necessary, while preparing this report.

5. In our opinion, the Balance Sheet and Profit and Loss Account dealt with by this

report are in agreement with the books of account and accounting standards referred to in

sub-section (3C) of section 211.

6. In our opinion, and to the best of our information and according the explanations

given to us, the said accounts give the information required by the Companies Act, 1956, in

the manner so required and gr. a true and fair view (a) in the case of the Balance Sheet of the

state of affair-of the company as at 31st March, 2001, and (b) in the case of the Pro!: and

Loss Account, of the profit for the year ended on that date.

Mumbai ...............

vear otho

May 31, 2001

Chartered Accountants

(2) Qualified Report To,

The Member of 'XYZ' Mill Co. Ltd.

1. We have audited the attached Balance Sheet of the 'XYZ' Mill Co. Ltd. as at 31st

March, 2001 and also the Profit and Loss Account of the company for the year ended on that

265

date, and as required by the Manufacturing and other Companies (Auditor's Report) Order,

1988, issued by the Central Government in terms of Section 227 (4A) of the Companies Act,

1956, we report that :

(i) The company has maintained proper records to show full particulars including

quantitative details and situation of fixed assets. These fixed assets have been physically

verified by the management during the year.

(ii) The fixed assets have not been revalued during the year.

(iii) The physical verification has been conducted by the management at reasonable

periods in respect of finished goods, stores, spare parts and raw materials and if any

significant discrepancies have been noticed on such verification as compared to books

records and the same have been properly dealt with in the books of accounts. We are satisfied

that the valuation of stocks is fair and proper in accordance with the normally accepted

accounting principles and is on the same basis as in the earlier year.

(iv) The company has taken loans, secured or unsecured from companies, firms or

other parties listed in the register maintained under sections 301 and 370 (1-C) of the

Companies Act, 1956 and the rate of interest and the terms and conditions of such loans are

prima facie not prejudicial to the interests of the company.

(v) The parties to whom the loans or advances in the nature of loans have been given

by the company are repaying the principal amounts as stipulated and are also regular in

payment of interest.

(vi) There is an adequate internal control procedure commensurate with the size of the

company and nature of its business for the purchase of stores, raw materials, including

components, plant and machinery, equipment and other assets.

(vii) In our opinion, the stores, raw materials or components exceeding Rs. 10,000 in

value for each type thereof are purchased during the year from the subsidiaries, firms or

companies or other parties in which the Directors are interested and the prices paid for such

items are reasonable as compared to the prices of similar items supplied by the parties.

(viii) There is a regular procedure for the determination for unserviceable or damaged

stores and raw materials and provision for the loss has been made in the accounts.

(ix) In our opinion, the company has accepted deposits from the public under

directions issued by the Reserve Bank of India and the provisions of section 58A of the

Companies Act, 1956, and the rules made thereunder have been complied with.

(x) The company has been maintaining reasonable records for the sale and disposal of

realisable bye-products and scraps.

266

(xi) The Paid-up Capital of the company at the commencement of the financial year

concerned exceeds Rs. 25 lakh and the company has an internal Audit System commensurate

with the size and nature of its business.

(xii) The company has maintained cost accounts and records as prescribed by the

Central Government under section 209(l)(d) of the Companies Act, 1956.

(xiii) The company is not a Sick Industrial Company within the meaning of clause (0)

of the subsection (1) of section 3 of the Sick Industrial Companies (Special Provisions) Act,

1985.

(xiv) The Company is regular in depositing Provident Fund dues with the appropriate

authority and there are no arrears of Provident Fund dues as at 31st December, 2000.

Further to our comments in paragraph 1 above :

2. We have obtained all the information and explanations which to the best of our

knowledge and belief were necessary for the purpose of our audit.

3. In our opinion proper books of accounts as required by law have been kept by the

company so far as appears from our examination of the books.

4. In our opinion, the Balance Sheet and Profit and Loss Account dealt with by this

report are in agreement with the books of account and accounting standards referred to in

sub-section (3C) of secrjpn 211.

5. Subject to the reservations noted below, in our opinion and to the best of our

information and according to the explanations given to us, the accounts give the information

required by the Companies Act, 1956, in the manner so required and give a true and fair view

(a) in the case of the Balance Sheet, of the state of the affairs of the company as at 31st

March. 2001 and (b) in the case of the Profit and Loss Account, of the profit for the year

ended on that date :

(i) The provision for depreciation of fixed assets is inadequate.

(ii) The stock of the company has been valued at market price which is in excess of

the actual cost price.

(iii) A sum of Rs. 20,000 has been advanced to a Director of the company in

contravention of the relevant provisions of the Companies Act, 1956.

Mumbai ..............

May 31, 2001 Chartered Accountants

(3) Clean Report

Where the Manufacturing and other Companies (Auditor's Report) Order, 1988 does

not apply: To,

267

The Members of 'XYZ' Ltd.

We have audited the attached Balance Sheet of the 'XYZ* Ltd. as at 31st December,

2000 and also the Profit and Loss Account of the company for the year ended on that date and

report that:

1. We have obtained all the information and explanations which to the best our

knowledge and belief were necessary for the purpose of our audit.

2. In our opinion, proper books of accounts as required by law have been kept by the

company so far as appears from our examination of books.

3. The Balance Sheet and Profit and Loss Account dealt with by this report are in

agreement with the books of accounts.

4. In our opinion and to the best of our information and according to the explanations

given to us, the said accounts give the information required by the Companies Act, 1956, in

the manner so required and give a true and fair view (a) in the case of Balance Sheet of the

state of affairs of the company as at 31st December, 2000 and (b) in the case of the Profit and

Loss Account, of the profit for the year ended on that date.

Mumbai .......................................

May 31, 2001 Chartered Accountants

(4) Qualified Report

Where the Manufacturing and other Companies (Auditor's Report) Order, 1988 does

not apply : To,

The Members of 'XYZ Ltd.

We have audited the attached Balance Sheet of the 'XYZ' Ltd. as at 31st December,

2000 and also the Profit and Loss Account of the company for the year ended on that date and

report that:

1. We have obtained all the information and explanations which to the best of our

knowledge and belief were necessary for the purpose of our audit.

2. In our opinion proper books of accounts as required by law have been kept by the

company so far as appears from our examination of books.

3. The Balance Sheet and Profit and Loss Account dealt with by this report are in

agreement with the books of accounts.

4. Subject to the reservations noted below, in our opinion and to the best of our

information and according to the explanations given to us, the accounts give the information

required by the Companies Act, 1956, in the manner so required and give a true and fair view

(a) in the case of the Balance Sheet, of the state of affairs of the company as at 31st

268

December, 2000 and (b) in the case of the Profit and Loss Account, of the profit for the year

ended on that date:

(i) The company has not fully disclosed the value of Materials (amounting to Rs. 20,000)

as consumed.

(ii) There has been a change in the system of valuation of stock of finished goods, from

'at lower of cost or market value' to 'at cost and subsequently the profit for the year is more by

Rs. 2,40,000

(iii) A sum of Rs. 10,000 has been given as an advance to the Managing Director in

contravention of the relevant provisions of the Companies Act, 1956.

269

DIVISIBLE PROFITS AND DIVIDEND

"..........If the Total Assets of the business at the two dates be compared, the increase which

they show at the later date as compared with the earlier date (due allowance, of course,

being made for any capital introduced into or taken out of the business in the meanwhile)

represent in strictness of the profits of the business during the period in question....The strict

meaning of 'Profit' is rarely observed in drawing up the accounts of firms and

companies....certain assumptions have become so customary in drawing up Balance Sheet

and Profit and Loss Account, that it may almost be said to require special circumstances to

induce parties to depart therefrom..."

—Fletcher Moulton, L.J., in re. Spanish Co. Ltd. (1911)

Meaning of Profit

In the judgment given in the case of re: The Spanish Prospecting Company Limited

(cited above), it has been accepted that the profit of a business in its broadest sense is the

increase in the net worth of a business found by taking the amount of the assets less

liabilities, at the end of the period and deducting thereon the assets and liabilities, at the

commencement of that period (any withdrawals to be added and new capital introduced to be

deducted).

It is to be noted that the determination of profits of a business for a particular year is

of paramount importance. In case of businesses owned by Individuals and Partners, it is

entirely their discretion to ascertain profits in their own way but it is not so in the case of

Limited Companies. Besides shareholders of a company, there are other parties such as the

Prospective Shareholders, Creditors, Lenders and Debentureholders, etc., who are interested

in its profits. The determination of profits is also a matter of concern for Income-tax

authorities as well as the Managers and Directors who are very often paid a percentage of net

profits. There is not a consensus of opinion so far as the definitions of the word, 'profits' is

concerned. Generally, there is the prevalent notion that profit means the excess of income

over expenditure during a given period.

l "Profits are ascertained by setting against the income earned, the cost of earning it."

—Lord Herschell fin Gresham Life Insurance Society vs. Styles, 1892).

270

Effects of Wrong Calculations of Profits

(a) If Profits are overstated, i.e., more profits are incorrectly determined than the actual

ones.

(1) If more profits are calculated incorrectly than the actual figures thereof, and

accordingly, dividends are paid out of them, it will mean the payment of dividends out

of capital leading to the reduction of capital without the sanction of the Court which is

in contravention of section 100 of the Companies Act. For such an act, the Directors

of the company will be jofntly and severally liable.

(2) If dividends are paid out of capital, the assets will be consequently reduced. This will

affect the interest of Debentureholders and Creditors adversely who hold these assets

as security for their loans.

The reduction in the value of assets will lead to their complete exhaustion and the

entire capital will thus be sunk by and by. The company will go into liquidation.

(3) If more profits are shown, the Directors, Managing Agents and Managers will get

more commission if such a commission is paid as a percentage of profits.

(4) If profits are inflated as a result of over-valuation of assets, the Balance Sheet will not

disclose a true and fair view of a company's financial state of shares.

(b) If profits are understated, i.e., less profits are uncorrectly shown than the actual ones.

(1) Under-statement of profits will deprive the present shareholders of dividends to which

they are entitled and thus, their interests will be adversely affected.

(2) The value of shares will fall in the market and the Goodwill of the company will be

adversely affected.

(3) The Directors, Managing Agents and Managers wfll get less commission than what

they are actually entitled to as a result of under-statement of profits.

(4) Under-statement of profits is usually a result of under-valuation of assets or over-

valuation of liabilities and therefore, secret reserve will be created which may be

made misuse of by the Dfrectors and Managers.

(5) Under-statement of profits is a result of wfndow-dressing and, therefore, the Balance

Sheet will not exhibit the real position of a company's financial affairs.

Profits vs. Divisible Profits

There is some clear distinction between 'profits' and 'divisible profits'. All the profits

of a company cannot be said to be divisible. Only those profits which can legally be

271

distributed to the shareholders of the company in the form of dividend are called as 'Divisible

Profits'. Two principles should be observed before divfdend is declared to the shareholders :

1. Dividend must be paid according to the requirements of the Companies Act and the

Articles of Association of the company. If the Articles of Association do not provide for it, it

must be paid according to Clauses 85 to 94 of Table A of Schedule 1 appended to the

Companies Act.

2. In no case, dividend should be paid at the cost of the creditors of he company.

The Clauses 85 to 94 of Table A are produced below to provide a bird's . e-view

thereof to the readers:

lause 85 of Table A

The company in General Meeting may declare dividends, but no nvidend shall exceed

the amount recommended by the Board. 'lause 86 of Table A

The Board may, from time to time, pay to the members such interim ividends as appear to it

to be justified by the profits of the company. lause 87 of Table A

1. The Board may, before recommending any dividend, set aside out f the profits of

the company such sums as it thinks proper as a reserve r reserves which shall, at the

discretion of the Board, be applicable for any purpose to which the profits of the company

may be properly applied, including provisions for meeting contingencies or for equalising

dividends; and pending such application, may at the like discretion, either be employed in the

business of the company or be invested in such investments (other than shares of the

company) as the Board, may from ime to time, think fit.

2. The Board may also carry forward any profits which it may think prudent not to

divide without setting them aside as a reserve.

Clause 88 of Table A

1. Subject to the rights of persons, if any, entitled to shares with special rights as to

dividends, all dividends shall be declared and paid according to the amounts paid or

credited as paid on the shares in respect whereof the dividend is paid, but if and so

long as nothing is paid upon any of the shares in the company, dividends may be

declared and paid according to the amounts of the shares.

2. No amount paid or credited as paid on a share in advance of calls shall be treated for

the purpose of this regulation as paid on the shares.

3. All dividends shall be apportioned and paid proportionately to the amounts paid or

credited as paid on the shares during any portion or portions of the period in respect of

which the dividend is paid; but if any share is issued on terms providing that it shall

272

rank for dividend as from a particular date, such share shall rank for dividend

accordingly. Clause 89 of Table A

The Board may deduct from any dividend payable to any member all sums of money,

if any, presently payable by him to the company on account of calls or otherwise in relation

to the shares of the company. Clause 91 of Table A

1. Any dividend, interest or other moneys payable in cash in respect of shares may be

paid by cheque or warrant sent through the post direct to the registered address of the

holders or, in the case of joint holders, to the registered address of that one of the joint

holders who is the first named on the Register of Members, or to such person and to

such address as the holder or joint holder may in writing direct.

2. Every such cheque or warrant shall be made payable to the order of the persons to

whom it is sent. Clause 92 of Table A

Any one of two or more joint holders of shares may give effectual receipts for any

Dividends, Bonuses or other moneys payable in respect of such shares. Clause 93 of

Table A

Notice of any dividend that may have been declared shall be given to the persons

entitled to shares therein in the manner mentioned in the Act.

Clause 94 of Table A

No dividend shall bear interest against the company.

DIVISIBLE PROFITS

It is rather difficult to give a precise definition of the term 'Divisible Profits'. The

following arguments may, however, be examined :

"Profits of the company mean profits available for recommendation and distribution

as dividends after setting aside to reserve or after carrying forward such amounts as the

Directors deem fit, even the whole of the profits for the year can be carried forward."

—In re: Buenos Aires Great Southern Railway Co. Ltd.

vs. Preston (1947)

"Profits mean profits realized."

—The Union Bank of Allahabad Ltd. (1925

"Profits available for Dividend" mean "net profits after making any deductions which

the Directors can duly make."

—Fisher vs. Black & White Publishing Company (1901

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Different opinions are given on the subject. Even if the profits are arrived at, it is not

easy to say that all of these are Divisible Profits. Thus all profits are not and cannot be

Divisible Profits. Only those which can 1; legally distributed amongst the shareholders are

'Divisible Profits'.

The net profits of a business may be defined as the surplus of income for a given

period over current expenditure for that period after makm.. good any losses on floating

assets and after providing depreciation on fixe assets.

The Companies Act does not lay a clear meaning of the term, 'profits It is practically

silent on the issue. Till 1956, there was no provision defining the Divisible Profits except

Clause 97 of Table A.

Section 205 of the Companies Act, 1956 has made provisions in this behalf and it has

subsequently been amended by the Company -(Amendment) Act, 1960, which has made the

position very much clear.

The following four considerations may govern the determination Divisible Profits :

(1) Principles of Accountancy,

(2) Provisions of Memorandum of Association and Articles Association,

(3) Legal Decisions, and

(4) Legal Aspect (as per the provisions of the Companies Act).

1. Principles of Accountancy

Divisible Profits were calculated as a surplus of income over xpenditure for a given

period. For this purpose, all transactions were distinguished as capital and revenue. Such a

distinction was very rnportant from the accountancy point of view, but a modified basis is

now d opted to calculate Divisible Profits and old practice has been recognized is inadequate

and out of date.

To calculate Divisible Profits, the difference between assets and labilities plus capital

at the commencement of a year [Le., net worth of a business at the beginning) is found out. If

assets are more, there is surplus, otherwise there will be deficiency. Similarly, the surplus or

deficiency at :he end of a year is calculated after considering in connection therewith the

increase or return of capital, etc. If there is a surplus, it is a profit and if there is deficiency, it

is loss. This is now a well-recognized principle for the determination of profits.

So far as the valuation of assets is concerned, fixed assets are valued at cost less

depreciation and similarly, floating assets are valued at cost price or market price, whichever

is lower. Besides this, necessary provision is made for losses of the current year and of the

years to come.

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According to the Principles of Accountancy, it is not proper to distribute capital

profits as dividends and it is also not advisable to distribute the profits of the current year

without providing for the losses of the previous years. Principles of Accountancy also

advocate that proper reserve should be created before profits are distributed among the

shareholders by way of dividends.

2. Provisions of Memorandum of Association and Articles of Association

These two documents are quite important and the amount of Divisible Profits is

ascertained in accordance with the provisions of Memorandum of Association and Articles of

Association which contain directions to be followed by the Directors for the determination of

Divisible Profits. It is, however, certain that the distribution of profit, which would affect the

interest of third parties or which would lead to the return of capital is against the principles

and illegal. The Directors recommend the distribution or profits as dividends after making

necessary reserves and provisions as required under the provisions of Memorandum of

Association and Articles of Association. This is usually the way that have to pursue.

Payment of dividends out of capital is a breach of trust and the company may require

the Directors to replace it [K. Madhava vs. Popular Bank, 1970). Of course, they may

recover indemnity from the shareholders who have received the dividends {Moxkamvs.

Grant, 1900). Thus, in the well-known Flitcroft's case (re: Exchange Banking Co., 1882)

certain bad debts were credited to the accounts and fictitious profits thus created were paid

away as dividends. The directors were held liable.

The law will not tolerate even an indirect attempt to pay back capital by way of

dividends. In re: Walters, Deed of Guarantee, 1933. W guaranteed the payment of preference

dividends, for a period of three years and the company agreed to pay him any sums that he

might pay under the guarantee. The agreement was held to be void and W could not recover

the amounts paid by him in pursuance of the guarantee.

The decisions made in the various cases have impressed upon the issue that the

provisions of Articles of Association should be fully observed and anything done against

these rules will be illegal. It is, thus, clear that the provisions of Articles of Association must

provide a base for the determination of Divisible Profits in case of a joint stock company.

The provisions in Memorandum and Articles differ from company to company in

accordance with the nature and character of the business, though, of course, arrangements

made thereby are more or less similar as required by the law. Hence, nothing more can be

said at this stage in this connection.

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3. Legal Decisions, and 4. Legal Aspect

Besides knowing the opinion of Courts expressed in different cases, the legal aspect

of the issue as provided by the Companies Act is quite important. The legal position has been

made clear by the Companies (Amendment) Acts, 1960 and 1974. The provisions of law are

now a 'must' for all limited companies in India and serve as a guideline in the determination

of Divisible Profits and distribution of dividends.

In the pages that follow, an effort has been made to explain the legal aspect of the

subject along with the legal decisions so that both the aspects may be comparatively studied.

We proceed with the reproduction of section 205 hereunder:

Dividend to be paid only out of Profits (Sec. 205)

(1) No Dividend shall be declared or paid by a company for any financial year except

out of the profits of the company for that year arrived at after providing for depreciation in

accordance with the provisions of sub-section (2) or out of the profits of the company for any

financial year or years Arrived at after providing for depreciation in accordance with those

provisions and remaining undistributed or out of both or out of moneys provided by the

Central Government or a State Government for the payment of dividend :: pursuance of a

guarantee given by the Government.

Provided that :

(a) if the company has not provided for depreciation for any previous financial year or

years which falls or fall after the commencement of th-Companies (Amendment) Act, 1960,

it shall, before declaring or paying dividend for any financial year provide for such

depreciation out of tbj profits of that financial year or out of the profits of any other previo-

financial year or years;

(b) if the company has incurred any loss in any previous financial ye or years, which

falls or fall after the commencement of the Company (Amendment) Act, 1960, then, the

amount of the loss or an amount wh: Is equal to the amount provided for depreciation for that

year or those yea -which is less, shall be set off against the profits of the company for the ye

for which dividend is proposed to be declared or paid or against the pro:, of the company for

any previous ffnancfal year or years, arrived at in b(: cases after providing for depreciation in

accordance with the provisions : sub-section (2) or against both;

(c) the Central Government may, if it thinks necessary so to do in the iblic interest,

allow any company to declare or pay dividend for any nancial year out of the profits of the

276

company for that year or any previous nancial year or years without providing for

depreciation.

Provided further that it shall not be necessary for a company to provide r depreciation

as aforesaid where dividend for any financial year is declared or paid out of the profits of any

previous financial year or years hich falls or fall before the commencement of the

Companies Amendment) Act, 1960.

The Companies (Amendment) Act, 2000 has inserted sub-section 205(1A) which

provides :

"(1A) The Board of directors may declare interim dividend and the amount of

dividend including interim dividend shall be deposited in a separate bank account within five

days from the date of declaration of such dividend.

(IB) The amount of dividend including interim dividend so deposited under sub-

section (1A) shall be used for payment of interim dividend.

(IC) The provisions contained in sections 205, 205A, 205C, 205C, 206, 206A and 207

shall, as far as may be, also apply to any interim dividend."

(2) For the purpose of sub-section (1), depreciation shall be provided either :

(a) to the extent specified in section 350; or

(b) in respect of each item of depreciable assets for such an amount as is arrived at by

dividing ninety-five per cent of the original cost thereof to the company by the specified

period in respect of such asset; or

(c) on any other basis approved by the Central Government which has the effect of

writing-off by way of depreciation ninety-five per cent of the original cost of the company of

each depreciable asset on the expiry of the specified period; or

(d) as regards any other depreciable asset for which no rate of depreciation has been

laid down by this Act or any rules made thereunder on such basis as may be approved by the

Central Government by any general order published in the Official Gazette or by any special

order in any particular case:

Provided that where depreciation is provided for in the manner laid down in Clause

(b) or Clause (c), then, in the event of the depreciable asset being sold, discarded, demolished

or destroyed, the written-down value thereof at the end of the financial year in which the

asset is sold, discarded, demolished or destroyed, shall be written-off in accordance with the

proviso to section 350.

(2-A) Compulsory Reserves to be created. Notwithstanding anything contained in

sub-section (1), on and from the commencement of the Companies (Amendment) Act, 1974,

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(w.e.f. 1.2.75), no dividend shall be declared or paid by a company for any financial year out

of the profits of the company for that year arrived at after providing for depreciation in

accordance with the provisions of sub-section (2), except after the transfer to the reserves of

the company of such percentage of its profits for that year, not exceeding ten per cent, as may

be prescribed.

Provided that nothing in this sub-section shall be deemed to prohibit the voluntary

transfer by a company of a higher percentage of its profits to the reserves in accordance with

such rules as may be made by the Central Government in this behalf.

(2-B) A company which fails to comply with the provisions of section 80A shall not,

so long as such failure continues, declare any dividend on its equity shares.

(3) No dividend shall be payable except in cash:

Provided that nothing in this sub-section shall be deemed to prohibit the capitalization

of profits or reserves of a company for the purpose of issuing fully paid-up Bonus Shares or

paying up any amount for the time being unpaid or any shares held by the members of the

company.

(4) Nothing in this section shall be deemed to affect in any manner the operation of

section 208.

(5) For the purposes of this Section :

(a) 'specified period' in respect of any depreciable asset shall mean th number of years

at the end of which at least ninety-five per cent of origin;: cost of that asset to the company

will have been provided for by way depreciation if depreciation were to be calculated in

accordance with tr. provisions of section 350.

(b) any dividend payable in cash may be paid by cheque or warra: sent through the

post directed to the registered address of the shareholdc entitled to the payment of the

dividend or in the case of joint shareholder-to the registered address of that one of the joint

shareholders which is firs named on the register of members, or to such person and to such

addr -as the shareholder or the joint shareholders may in writing direct.

Unpaid Dividend to be Transferred to Special Dividend Account (Se i 205A)

(1) Where, after the commencement of the Companies (Amendmr Act, 1974, [w.e.f.

1.2.75), a dividend has been declared by a company has not been paid, or claimed within

thirty days from the date of LT -declaration, to any shareholder entitled to the payment of the

dividend company shall within seven days from the date of expiry of the said per of thirty

days, transfer the total amount of dividend which remains un;

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or unclaimed within the said period of thirty days, to a special accc be opened by the

company in that behalf in any Scheduled Bank. : called "Unpaid Dividend Account

of..................Company Limi; Company (Private) Limited."

(2) Where the whole or any part of any dividend, declared by a com before the

commencement of the Companies (Amendment) Act, 1974 u 1.2.75), remains unpaid at such

commencement, the company s within a period of six months from such commencement,

transfer sod unpaid amount to the account referred to in sub-section (1).

(3) Where, owing to inadequacy or absence of profits in any yea: company proposes

to declare dividend out of the accumulated pr earned by the company fn prevfous year and

transferred by it reserves, such declaration of dividend shall not be made exc accordance with

such rules as may be made by the Central Gover:

In this behalf, and, where any such declaration is not in accordance with -uch rules;

such declaration shall not be made except with the previous approval of the Central

Government.

(4) If the default is made in transferring the total amount referred to n sub-section (1)

or any part thereof to the Unpaid Dividend Account of he concerned company, the company

shall pay, from the date of such default, interest on so much of the amount as has not been

transferred to "he said account, at the rate of twelve per cent per annum and the interest

accruing on such amount shall ensure to the benefits of the members of :he company in

proportion to the amount remaining unpaid to them.

(5) Any money transferred to the Unpaid Dividend Account of a ompany in pursuance

of this section which remains unpaid or unclaimed for a period of seven years from the date

of such transfer shall be transferred y the company to the Fund established under sub-section

(1) of section 205C.

(6) The company shall, when making any transfer under sub-section (5) to the Fund

established under section 205C, any unpaid or unclaimed dividend, furnish to such authority

or committee as the Central Government may appoint in this behalf a statement in the

prescribed form setting forth in respect of all sums included in such transfer, the nature of tire

sums, the names and last known addresses of the persons entitled to receive the sum, the

amount to which each person is entitled and the nature of his claim thereto and such other

particulars as may be prescribed.

(7) The company shall be entitled to a receipt from the authority or committee under

sub-section (4) of section 205C or any money transferred by it to the Fund and such a receipt

shall be an effectual discharge of the company in respect thereof.

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(8) If a company fails to comply with any of the requirements of this section, the

company and every officer of the company who is in default, shall be punishable with fine

which may extend to five thousand rupees for every day during which the failure continues.

Payment of Unpaid or Unclaimed Dividend (Sec. 205-B)

Any person claiming to the entitled to any money transferred under subsection (5) of

section 205-A to the General Revenue Account of the Central Government, may apply to the

Central Government for an order for payment of the money claimed; and the Central

Government may, if satisfied, whether on a certificate by the company or otherwise, that such

person is entitled to the whole or any part of the money claimed, make an order for the

payment to that person of the sum due to him after taking such security from him as it may

think fit.

"Provided that nothing contained in this section shall apply to any person claiming to

be entitled to any money transferred to the Fund referred to in section 205C on and after the

commencement of the Companies (Amendment) Act, 1999."

Establishment of Investor Education and Protection Fund [Sec. 205C)

(1) The Central Government shall establish a fund to be called Investor Education and

Protection Fund (hereafter in this section referred to as the "Fund").

(2) There shall be credited to the Fund the following amounts, namely:

(a) amounts in the unpaid dividend accounts of companies;

(b) the application moneys received by companies for allotment of any securities and

due for refund;

(c) matured deposits with companies;

(d) matured debentures with companies;

(e) the interest accrued on the amounts referred to in clauses (a) to (d):

(f) grants and donations given to the Fund by the Central Government. State

Governments, companies or any other Institutions for the purposes of the Fund; and

(g) the interest or other income received out of the investments made from the Fund;

Provided that no such amounts referred to in clauses (a) to (d) shall form part of the Fund

unless such amounts have remained unclaimed and unpaid for a period of seven years from

the date they became due for payment.

Explanation : For the removal of doubts, it is hereby declared that n claims shall lie

against the fund or the company in respect of individual amounts which were unclaimed and

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unpaid for a period of seven years from the dates that they first became due for payment and

no paymeiv shall be made in respect of any such claims.

(3) The Fund shall be utilised for promotion of investors' awarenes^ and protection of

the interests of the investors in accordance with sue 1 rules as may be prescribed.

(4) The Central Government shall, by notification in the Official Gazette, specify an

authority or committee, with such members as the Central Government may appoint, to

administer the Fund and rnaintai: separate accounts and other relevant records in relation to

the Fund .: such form as may be prescribed in consultation with the Comptroller an Auditor-

General of India.

(5) It shall be competent for the authority or committee appoints under sub-section (4)

to spend moneys out of the Fund for carrying out th objects for which the Fund has been

established.

The entire subject has been kept into the following seven main hear,

for the purpose of study :

(1) Depreciation,

(2) Arrears of Depreciation,

(3) Past Losses,

(4) Capital Profits,

(5) Capital Losses,

(6) Compulsory Reserve, and

(7) Other Issue

1. DEPRECIATION

As is stated earlier, depreciation on assets must be provided for. If it is not done so,

the books will contain misleading records and by the time the asset becomes valueless,

nothing will be left with the company to replace it.

Legal Decisions

(a) Depreciation on Fixed Assets. (1) It was held that a company can declare a

dividend out of current profits without providing for depreciation on fixed assets. —

Wilmarvs. McNamara & Co Ltd. (1895)

Brief Facts of the Case. The company was engaged in a business of carrying mails,

etc. The company made a profit of £ 5,816, 12s. 6d. for the year ended 31st July, 1894.

During the year, the company did not provide for depreciation on its assets, viz., leases,

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Goodwill, premises, houses, vans, etc., though it had been providing for depreciation on these

assets in the past.

The company passed a resolution to distribute the profit and to declare a dividend to

the Preference Shareholders without providing any depreciation on its fixed assets. This was

objected to by Mr. Wilmer, an ordinary shareholder who requested the Court to issue an

injunction against the Directors to retain them from giving effect to the resolution.

Decision. Sterling, J., delivered the judgment and refused the injunction. It was held

that the Directors of a company cannot be restrained from declaring a dividend out of the

current profits on the ground that no provision has been made for depreciation on fixed

assets.

(2) Depreciation must be provided for on power machinery or trade machinery, which

is necessary in order to perform the work of the business in addition to all sums actually

expended in repairing the machinery or in renewing parts. —Crabtree Thomas vs. Crabtree

(1912)

Brief Facts of the Case. A testator authorized his trustees to carry on business and pay

its profits to his wife during her lifetime. The trustees provided for depreciation at the rate of

7Vt2 per cent on the original cost of machinery in addition to the cost of repairs before

arriving at profits. The wife of the testator contended that this ought to be disallowed. (In this

case no joint stock company was involved).

Decision. "But in the ordinary course of ascertaining the profits of a business where

there is power machinery or trade machinery which is necessary in order to perform the work

of the business, it is, in my opinion, essential that in addition to all sums actually expended in

repairing the machinery, or in renewing parts, there should also be written-off a proper sum

for depreciation and that sum ought to be written-off before you can arrive at the net profits

of the business, and it is not profit until a proper sum, varying with the class of machinery,

has been written-off for depreciation."

(b) Fixed Capital may be sunk and lost and yet the excess of current receipt over

current payments may be divided, but Floating or Circulating Capital must be kept up, as

otherwise it will enter into and form part of such excess, in which case to divide such excess

without deducting the capital which forms part of it will be contrary to law.

Depreciation or loss of floating assets must be provided for before arriving at the

profits available for dividend.

—Verrter vs. General & Commercial Investment Trust Ltd. (1894)

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Brief Facts of the Case. The trust company had an issued capital of £ 6,00,000 and

had borrowed £ 3,00,000 on the security of debenture stock and the market value of these

securities in a particular year diminished to the extent of about £ 2,40,000. It was estimated

that about £ 75,000 was totally irrecoverable within any reasonable period of time. During the

last financial year, the current income from investments had exceeded the current expenditure

by more than £ 23,000. The question for the Court to decide was whether such excess be

utilized for the purpose of dividend without making good the loss of capital amounting to £

75,000.

Decision. It was decided that a Trust Company, subject to its Articles, may distribute

dividend out of the current profits without making good the loss of capital arising from

diminution in the value of its investment provided :

(i) that assets are sufficient to pay-off the liabilities, and

(ii) the Articles of Association permit.

(c) A Company, if permitted to do so by its Articles of Association, may distribute

dividends without making good the depreciation on wasting assets.

—Lee vs. Neuchatel Asphalte Co. Ltd. (1889)

Brief Facts of the Case. The Articles of Association of the company provided that the

Directors would not be bound to reserve moneys for the renewal or replacement of any lease

or of the company's interest in any property or concession. Mr. Lee on behalf of himself and

other ordinary shareholders sought an injunction to prevent the Directors from distributing

dividend to the Preference Shareholders without first charging depreciation on the company's

assets.

Decision. It was held that "Where the Articles of Association specially stated that it

was not necessary to provide for the depreciation of wasting assets, there was nothing in the

Companies Act to compel the company to do so."

According to the legal decisions given above, it will, thus, appear that depreciation on

floating assets must be provided for but it is not necessary to provide depreciation on fixed

and wasting assets.

Legel Position. The controversy over the issue of providing depreciation as aforesaid

has come to an end with the commencement of the Companies (Amendment) Act, 1960.

Under section 205, dividend cannot be declared or paid by a company for any financial year

except :

(1) out of the profits of the company for that year arrived at after providing for

depreciation subject to the proviso (b) to section 205(2); or

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(2) out of the profits of the company for any previous financial year or years arrived at

after providing for depreciation subject to the proviso (b) to section 205(1) and remaining

undistributed; or

(3) out of the aggregate of profits as in (1) and (2) above; or

(4) out of the moneys provided by the Central Government or State Government for

the payment of dividend in pursuance of a guarantee given by that Government; or

(5) after transfer to the reserves the prescribed percentage of the net : rofits after

depreciation of the financial year.

Under section 205(2), depreciation must be provided for as stated .erein above and

hence, the judgments given in the above cases do not old good now in India.

Quantum of Depreciation. Depreciation must be provided either :

(a) to the extent specified in section 350;1 or

(b) in respect of each item of depreciable asset, for such an amount as Is arrived at by

dividing ninety-five per cent of the original cost by the specified period; or

(c) on any other basis as approved by the Central Government to which ninety-five

per cent of the original cost of each such depreciable asset can be written-off on the expiry of

the specified period; or

(d) as regards any other depreciable asset for which no rate of depreciation has been

laid down by this Act, or any rules made thereunder, on such basis as may be approved by the

Central Government by any general order published in the Official Gazette or by any special

order in any particular case.

Under section 205(l)(c), the Central Government may, in the public interest, allow

any company to declare or pay dividend out of the profits of the current year and of any

previous financial year or years without providing for depreciation.

2. ARREARS OF DEPRECIATION

(1) According to section 205(1), it shall be necessary to provide for depreciation

prescribed above in respect of the current financial year.

(2) It shall not be necessary for a company to provide for depreciation where a

dividend for any financial year is declared out of the profits of any previous financial year or

years which fall before the commencement of the Companies (Amendment) Act, 1960, le..

before 28th December, 1960.

(3) But for any previous financial year or years falling after 27th December, 1960, it

must provide for all arrears of depreciation to be made good before declaring dividend for

any financial year. {Section 205(l)(a)]

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3. PAST LOSSES

As a matter of principle, it is prudent to provide for any past losses before distributing

profits to the shareholders. But there are case laws which provide contrary to this.

l Section 350 is reproduced hereunder :

The amount of depreciation to be deducted in pursuance of Clause (k) of sub-section

(4) of section 349, shall be the amount calculated with reference to the written-down value of

the assets as shown by the books of the company at the end of the financial year expiring at

the commencement of this Act or immediately thereafter and at the end of each subsequent

financial year at the rate specified in schedule XIV.

Provided that if an asset is sold, discarded, demolished or destroyed for any reason

before depreciation of such asset has been provided for in full, the excess, if any, of the

written-down value of such asset over the sale proceeds or, as the case may be, its scrap value

shall be written-off in the financial year in which the asset is sold, discarded, demolished or

destroyed.

Legal Decisions

(1) It is not necessarily illegal for Directors of a company to pay dividends out of

current profits without making good a debit balance of the Profit and Loss Account

occasioned by losses in previous years. It may write up the debit balance of the Profit and

Loss Account out of an increase ir. the value of its fixed assets which may arise as a result of

a bona fide revaluation.

—Ammonia Soda Co. Ltd. vs. Arthur Chamberlain & Others (1918

Brief Facts of the Case. The Directors of the company, Mr. Chamberlain and Mr.

Cocking, appreciated the value of the land held by the company to write-off a debit balance

in the Profit and Loss Account which was £ 19,028. The value of land was raised in the

Balance Sheet of 31st July 1911 from £ 63,264 to £ 83,788, by the addition of a sum of £

20,542. This sum was credited to a Reserve Account and used to wipe off £ 12,990 o: the

debit balance amounting to £ 19,028. The remainder was written-of^ out of net profits.

In the subsequent years, the company made profits and declared a dividend. This was

a case brought by the company against the Directors making them liable to refund all money

paid away as dividend which was improperly paid.

Decision. It was held that the revaluation of the land was bona fidt and that Directors

were not liable to refund any of the dividends. The Cour was satisfied that the Directors acted

honestly.

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(2) A company which has excessively written-down its assets out profits in the

previous years may write up such assets again to the exten: of such excess and apply such an

amount for paying dividends.

—Stapley vs. Read Bros. Ltd. (1924

Brief Facts of the Case. In 1918, the company had written-off Its Goodwill which was

then standing at £ 51,000 against a Reserve Accoun: which had been built up out of profits.

In two years, 1921 and 1922, there were losses resulting in a debit balance on Profit and Loss

Account of £ 25,500.

In 1923, there was a profit of £ 13,430 but since it was not sufficien to pay the

dividend on the Preference Shares for the year 1923, and the arrears for 1921 and 1922, the

Directors proposed to redebit Goodwill Account with £ 40,000 and to credit this sum to a

Reserve Account and thus, to write-off the former debit balance of Profit and,Loss Account

by transfer to the Reserve Account.

The Court was moved to restrain the Directors from treating as profit available for

distribution any profits previously used for writing-down the company's assets subsequently

written back.

Decision. In the course of his judgment, Russell, J., said, "...In n opinion, unless there

is anything in the Companies (Consolidation) Act 1908 or in the constitution of the company

to prohibit it, the shareholders may, if they think fit, write back to Profit and Loss Account so

much of the depreciation written-off, Goodwill as has proved to have been in excess at proper

requirements."

Thus, it will appear from the judgment given above that it is not cessary to make

provision for past losses before distributing profits as idends. These decisions do not hold

good now in India as under section 105(l)(b), past losses must be set-off against profits of

subsequent years.

Legal Position. [Under section 205{l)(b)]. If a company has incurred any oss in a

previous financial year or years falling after 27th December, 1960, "hen :

(1) the amount of loss, or

(ii) an amount which is equal to the amount provfded for depreciation for that year or

those years, whichever is less, shall be set-off against :

(a) the profits of the company for the year for which dividend is proposed to be

declared or paid after provfding for the prescrfbed depreciation, or the profits of the company

for any previous financial year or years, arrived at in both case after providing for

deprecfation in accordance with the provisions of subsection (2), or , the aggregate of (a) and

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(b) together. Summary. (1) It is not necessary to write-off losses and arrears of epreciation in

respect of previous years falling before 28th December, :960.

(2) But for years ending after 27th December, 1960.

(i) all arrears of depreciation must be provided for against the profits, and

(ii) the losses of such years must be set-off to the extent to which depreciation has

been provided in the books.

Illustration 1

Pertaining to Year falling after 27th December, 1960

(Lakh of Rupees)

Years Profit or Loss

before

Depreciation

Depreciatio

n provided

-.-

Depreciation

as prescribed

(Sec. 205)

Profit or

Loss after

Deprecia-

tion

Profit or Loss after

Deducting the

prescribed

Depreciation

(1) (2) (3) (4) (5)

I -20 -2 (- 16) -22 -36

II - 10 -2 (- 14) - 12 -24

III + 50 -6 • (- 12) + 44 + 38

Total + 20 -10 (- 42) + 10 r _22

(2) Past losses for 3rd year are 34 lakh. i.e., - 22 and - 12 = - 34 lakh as per (4).

(3) Depreciation provided during the previous year is 4 lakh as per (2).

(4) Arrears of Depreciations (not provided in previous years) are : (in lakh)

I year II year III year

Total

(5) Divisible Profits for 3rd year : Total Profit Less : Depreciation

Less : Arrears of Depreciation

Less

44 - 32 12

Amount of past losses (34 lakh) or depreciation

(4 lakh), whichever is less 4

Divisible Profits for 3rd year 8

(6) This can be arrived at like this : (in lakh)

Profit for 3rd year before

providing for depreciation 50

287

Less : Prescribed depreciation as

per (3) in respect of three years 42

Divisible Profits 8

(7) It is clear that before arriving at the Divisible Profits in respect years falling after

27th December, 1960, depreciation will have be provided for Arrears of depreciation will

also be provided l -the extent laid down by section 205(l)(a).

(8) In respect of years falling before 28th December, 1960, the-provisions will not

apply but the case laws on the subject will 1 applicable.

Illustration 2

The following are the profits for the 5 years ended 31st December 1962:

(a) For the year ended 31st December, 1958 Profit Rs. 18 lakh.

(b) For the year ended 31st December, 1959 Profit Rs. 20 lakh.

(c) For the year ended 31st December, 1960 Profit Rs. 20 lakh.

(d) For the year ended 31st December, 1961 Loss Rs. 10 lakh.

(e) For the year ended 31st December, 1962 Profit Rs. 2 crore. The amount to be

provided for depreciation in respect of each of *:

five years calculated under section 205(2) of the Companies Act is Rs lakh.

In this case, it will be necessary for the company to make the follow.: . provisions out

of the profits for the year ended 31st December, 1962 f arriving at the amount to distribute as

a dividend :

(a) Arrears of depreciation for the years ended 31st Rs. December, 1960 (Rs. 30 lakh

less Rs. 20 lakh) 10 lakh

(b) Arrears of depreciation for the year ended

31 st December, 1961 30 lakh

(c) Depreciation for the year ended

31st December, 1962 30 lakh

Hence, the distributable profits of the company for the year ended 31st December,

1962 would be Rsyl?crore and 30 lakh.

CAPITAL PROFITS Capital Profits are not ordinary profits. They arise out of a bona

fide revaluation of fixed assets or from receipt of premium on issue of shares, etc. Ordinarily,

therefore, such profits are not made available for distribution as dividends; but they can be so

distributed under certain conditions.

288

Legal Decisions

(1) If the Articles of a company so permit, a profit made on the sale of a part of its

undertaking is available for dividend.

—Lubbock vs. The British Bank of South America (1892) Brief Facts of the Case. The

Bank was set up to carry on business in Brazil and other countries. It sold its Goodwill and

property in Brazil to another bank for £ 8,75,000 and earned a net profit to the extent of about

£ 2,05,000. The Directors of the Bank wanted to credit the Profit and Loss Account with this

sum and to pay dividend to its shareholders.

Decision. Under the Articles, the Directors were justified in carrying over the sum of

£ 2,05,000 to the Profit and Loss Account and having appropriated to the Reserve Fund so

much of the sum as they thought fit, they could distribute the balance as dividends. It was

plainly profit on capital and not part of the capital itself and hence, the Directors could

distribute it by way of dividends to the shareholders.

(2) Capital Profits cannot be distributed as dividends unless all other assets have been

revalued, depreciation has been provided for, such profits are actually realized and the

Articles of Association permit.

—Foster vs. The New Trinidad Lake Asphalte

Company Ltd. (1901)

Brief Facts of the Case. In this case, a debt of £ 1,00,000 (shown as an asset) was

written-off as irrecoverable. Subsequently, it was paid in full, together with interest accrued,

realizing £ 26,258 16s. The amount received was treated as a profit. The Directors proposed

to distribute it as dividend. This was objected to by the Debentureholders.

Decision . It was held that a realized appreciation in the value of a book debt cannot

be distributed as dividend unless surplus remains after a revaluation of all the assets.

(3) A company can set-off an appreciation in value of the Capital Assets as

ascertained by a bona fide valuation against losses on Revenue Accounts. —Ammonia Soda

Co. Ltd. vs.

Arthur Chamberlain & Others (1918)

(The brief facts of the case and the decisions have been discussed earlier in this

chapter.)

On the basis of judgments delivered in the above case, it can be laid down that the

Capital Profits can be distributed as dividends, if

(i) the Articles of a company permit;

(ii) such profits are realized in cash;

289

(iii) they remain after a proper valuation of all the assets; and (iv) capital losses have

been made good.

A capital appreciation cannot be made available for distribution by way of dividend

but can be transferred to Capital Reserve Account.

It is, however, to be noted that in the case of Dimbula Valley (Ceylon) Tea Co. Ltd.

vs. Lausie (1961) (All E.R. 769). Buckley, J., expressed the view that a surplus on capital

account resulting from a bona fide revaluation made by competent valuers was available for

paying up bonus shares to be issued to the members even though it was not realised. The

judge did, however, point out that a distribution from such a source would not be normally

regarded as wise from the commercial point of view.

Legal Position. Section 205 of the Companies Act simply lays down that no dividend

shall be paid except out of the profits of a company and hence, Capital Profits may also be

made available for dividend provided the above-mentioned conditions are fulfilled.

5. CAPITAL LOSSES

Legal Decisions

(1) A company may declare a dividend out of current profits without making good the

Capital Losses.

—Bolton vs. Natal Land and Colonization Co. Ltd. (1892)

Brief Facts of the Case. In the year 1882, the company charged to its Profit and Loss

Account £ 70,000 in respect of bad debts while a similar sum representing an increase in the

value of lands held by the company was credited in the Profit and Loss Account. In 1885, a

profit was made and a dividend was subsequently declared.

The basis of the case was that the Directors should be restrained from paying the

dividend on the ground that the value of the land was far below its book value and the

difference must be charged to Profit and Loss Account before arriving at profits available for

dividend.

Decision. In the opinion of the Court, "assuming that a part of the capital had in fact

been lost and not subsequently made good, no sufficient ground was thereby afforded for

restraining the payment of dividend; that the fact of the company having written up the value

of their lands in 1882 and credited the increase to the profit of that year in the manner

described. did not place them under obligation to bring into account every subsequent year

the increase or decrease in the value of their lands."

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(2) Fixed Capital may be sunk or lost and yet the excess of current receipts over

current payments may be divided. Thus, dividends can be distributed out of the surplus

without making good the loss of capital.

—Vernervs. General & Commercial Investment Trust Ltd. (1894)

(The facts of the case are given earlier in this chapter.) Thus, it will appear that it is

not necessary to make good the loss i capital before distributing profits as dividend.

6. COMPULSORY RESERVES

Under Clause 87 of Table A (quoted earlier in this chapter), the Board may, before

recommending any dividend, set aside out of the profits of the company such sums at it

thinks proper as a reserve or reserves which shall, at the discretion of the Board, be applicable

for any purpose to whfch the profits of the company may be properly applied (including

provision for meeting contingencies or for equalizing dividends) and pending such

application, may, at the like discretion, efther be employed in the business of the company or

be invested in such investments (other that shares of the company) as the Board may, from

time to time, think fit.

The Board may also carry forward any profits which it may think prudent not to

divide without setting them aside as a reserve.

Now, under section 205(2-A) added by the Companies (Amendment) Act, 1974, it has

been provided that no dividend1 shall be declared or paid by a company for any financial year

out of the profits of the company for that year arrived at after provfdfng for depreciation in

accordance with the provisions of sub-section (2), except after the transfer to the reserves2 of

the company of such percentage of its profits3 for that year, not exceeding ten per cent, as

may be prescribed. The company may, however, create greater reserve by voluntary transfer

of a higher percentage of proffts in accordance with such rules as may be made by the Central

Government in thfs behalf.4

7. OTHER ISSUES (TO BE CONSIDERED)

(1) A company cannot distribute profits earned on the redemption of debentures, if the

Articles do not provide contrary to this.

—Wall vs. The London & Provincial Trust Co. Ltd. (1919)

(2) A company may pay dividends out of current profits when a debit balance on

Profit and Loss Account has been wiped off by writing back to the credit of Profit and Loss

Account an amount of Goodwill previously written-off out of profit. (Already discussed

earlier)

—Stapleyvs. Read Brothers Ltd. (1924)

291

Auditor's Duty

The question of Divisible Profits fs peculiar in the sense that it depends to a large

extent on the circumstances of a particular case. The auditor should see that the legal

decisions and legal aspects of the issue have been properly complied with. He should

examine the question on the basis of general principles and norms enunciated heretofore, a

summary of which is given hereunder :

(1) No dividend is to be paid except out of profits, i.e., excess of income over

expenditure.

1 "The reference is to Equity Dividend and also to the portions of dividend relating to

participating shares over and above the fixed state of Preference Dividend."

—Department of Company Affairs, vide Nos. 1/1/76-CL-V and 6/11/76-CL-XTV,

dated 10th June, 1976.

2 "Reserves mean only free reserves." —Vide Department of Company Affairs—

Circular No. 8/30 (205A) 75-CL-V, dated 19.7.76 (Circular No. 21/76).

3 "Profits refer to profits after tax." —Vide Ministry of Law, Justice and Company

Affairs,

Department of Company Affairs, Letter No. 6/13/75 CL-XIV, dated 27th February,

1976.

4 Section 205 (2-A) has been reproduced earlier in this chapter.

(2) Depreciation and arrears of depreciation must be provided for (ref. to sections 205

and 305 of the Companies Act) in respect of years ending after 28th December, 1960.

(3) Arrears of depreciation on fixed assets need not be taken into account in respect of

years ending before 27th December, 1960.

(4) Capital Profits may be divisible, if

(i) Articles provide,

(ii) such profits are realised in cash,

(iii) they remain after a bona fide revaluation of all the assets,

(iv) Capital Losses are made good.

(5) Revenue Losses must be made good before Revenue Profits are distributed, Le.,

dividends must not be paid or declared if there is a debit balance of Profit and Loss Account.

(6) Capital Losses must be made good before Capital Profits are distributed.

(7) Capital Losses need not necessarily be made good before Revenue Profits are

distributed. .

292

(8) Past losses need not necessarily be made good but to the extent and in the manner

as laid down by section 205 of the Companies Act.

(9) If any asset (Goodwill or other) has been excessively written-down in the past, the

excess may be written back to the Profit and Loss Account and thus, made available for

distribution as dividend.

(10) The Board of Directors may set aside a certain sum of money to reserve or

reserves as under Clause 87 of Table A appended to the Companies Act.

The auditor should see that these provisions are fully complied with and if it is not

done, he is at liberty to mention this fact in his report to be submitted to the shareholders.

The auditor has no more liability than this.

DIVIDEND

After discussing the Divisible Profits of a company, it would be apt now to reproduce

that relevant sections of the Companies Act in connection with the declaration and payment

of dividends.

Section 205(3). No dividend shall be payable except in cash. This provision, in no

way, shall prohibit the capitalization of profits or reserves of a company for the purpose of (i)

issuing fully paid-up Bonus Shares or (ii) paying up any amount for the time being unpaid on

any shares held by the members of the company.

Section 205(4). Nothing in this section shall be deemed to affect in any manner the

operation of section 208 [Le., power of the company to pay interest out of capital in certain

cases).

Section 205(5){a). "Specified period" in respect of any depreciable asset shall mean

the number of years at the end of which at least 95% of the original cost of that asset to the

company will have been provided for by way of depreciation if depreciation were to be

calculated in accordance with the provisions of section 350.

Section 205(5){b). Any dividend payable in cash may be paid by Cheque or Warrant

sent through the post directed to the registered address of the shareholder entitled to the

payment of the dividend or in the case of joint shareholders, to the registered office of that

one of the joint shareholders which is first named on the register of members, or to such

person and to such address as the shareholders or the joint shareholders may in writing direct.

Section 206(1). No dividend shall be paid by a company in respect of any share

therein, except :

293

(a) to the registered holder of such share or to his order or to his bankers; or

(b) In case a Share Warrant has been issued in respect of the share in pursuance of

section 114, to the bearer of such warrant or to his bankers.

(2) Nothing contained in sub-section (1) shall be deemed to require the bankers of a

registered shareholder to make a separate application to the company for the payment of

dividend.

Penalty for failure to distribute dividend within thirty days (Section 207.l) Where

a dividend has been declared by a company but has not been paid, or the warrant in respect

thereof has not been posted, within thirty days from the date of declaration, to any

shareholder entitled to the payment of the dividend, every director of the company shall, if he

is knowingly a party to the dafault, be punishable with simple imprisonment for a term which

may extend to three years and shall also be liable to a fine of one thousand rupees for every

day during which such deafult continues and the company shall be liable to pay simple

interest at the rate of eighteen per cent per annum during the period for which such default

continues :

Provided that no offence shall be deemed to have been committed within the meaning

of the foregoing provisions in the following cases, namely :

(a) where the dividend could not be paid by reason of the operation of any law;

(b) where a shareholder has given directions to the company regarding the payment of

the dividend and those directions cannot be complied with;

(c) where there is a dispute regarding the right to receive the dividend,

(d) where the dividend has been lawfully adjusted by the company against any such

due to it from the shareholder; or

(e) where, for any reason, the failure to pay the dividend or to post the warrant within

the period aforesaid was not due to any deafault on the part of the company.

Declaration of Dividend

As per Clause 85 of Table A, the company in General Meeting may declare dividend,

but no dividend shall exceed the amount recommended by the Board. Hence, Directors are

regarded as the authority to recommend the amount of dividend to be paid to the

shareholders. It was decided that the case of Savern vs. Wye Railway Co. (1896) that a

dividend once l The Companies (Amendment) Act, 2000.

DIVISIBLE PROFITS AND DIVIDEND

declared payable is a debt and the shareholders may sue the company for the payment

of such dividend.

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Restrictions on Dividends

The Companies (Temporary Restrictions on Dividends) Act, 1974 imposes

restrictions on payment of dividends which are applicable to companies, specified in section

3 of the said Act, for a period of 2 years with effect from 6th July, 1974.

Dividends are restricted to 'distributable profits' which means:

(i) one-third of the net profits of the company; or

(ii) the amount required to pay 12% dividend on the face value of the equity shares

and dividend payable on the preference shares, whichever is lower.

'Net Profits' have been defined in section 2(e) of the Act. Similarly in respect of other

distributions, the specified companies, for a period of two years with effect from 6th July,

1974 cannot:

(a) make any distribution out of its assets;

(b) assume, whether conditionally or otherwise, any obligation to, make distribution

out of its assets;

(c) grant any loans to any shareholder of the company, except with the previous

approval of the Central Government, by general or special order.

Dividend—A Liability

As stated earlier, a dividend becomes a liability for a company when it is declared by

the company at the Annual General Meeting.

For paying dividend, a Dividend List is prepared containing names and addresses of

the shareholders, their shareholdings, paid-up amount thereon, tax to be deducted, etc. With

the aid of the Dividend List, Dividend Warrants are prepared and sent to the shareholders

who can receive dividend's amount from the bank on the production of Dividend Warrants.

The shareholders return the Dividend Warrants to the bank which duly cancels them

after the payment of dividend to the shareholders. The equivalent amount is deposited with

the bank by the company. The balance of Dividend Account remaining unpaid on the date of

the Balance Sheet appears as a liability in the Balance Sheet. Auditor's Duty

(1) He should examine the documents of the company to ascertain the rights and

privileges of the various categories of the shareholders.

(2) He should examine the Minutes of the Directors for their recommendation and the

Minutes of the Shareholders to ascertain the amount of dividend finally declared by them as

per their resolution.

(3) He should check the Bank Pass Book of the Dividend Account with the Dividend

Warrants which have been returned duly cancelled.

295

(4) He should check the Dividend List with the help of the Register of Members.

(5) If a part of the Dividend Equalization Fund has been transferred to the Dividend

Account to regularize the rate of dividend, such a transfer should be checked by the auditor.

(6) He should confirm that the unclaimed dividend has been shown as a liability in the

Balance Sheet. If the Directors have forfeited the unclaimed dividends he should inspect the

Articles and the Minutes Book of the Directors.

(7) He should ascertain that the provisions of law as contained in section 205 have

been duly complied with.

(8) If Bonus Shares are issued for payment of dividend, such a step is duly authorized

by the company's Articles of Association.

INTERIM DIVIDEND

As the Companies Act did not have any provision for interim dividend, several

company managements followed such procedure as suited their interest, rather than the larger

interests of all the shareholders. Now, the Companies (second Amendment) Act, 1999 has

brought uniformity by making specific provisions under section 205 for declaration and

payment of interim dividend similar to those relating to final dividend.

Hence, now the companies will have to treat the issue of interim dividend with all the

seriousness if they wish to avoid penal consequences. Morever the period for payment of

dividend has been reduced from forty-two days to thirty days from the date of declaration.

The Articles of the Association of a company often authorize the Directors to declare

Interim Dividend. It is a dividend which is declared between two Annual General Meetings.

As per Clause 86 of Table A, the Board may from time to time pay to the members such

interim dividends as appear to it to be justified by the profits of the company.

The following points should be considered by the Directors before declaring Interim

Dividend :

(1) The assets should be valued.

(2) It is prudent to think of losses which might arise in future.

(3) If should be seen that the payment of Interim Dividend will not adversely affect

the working capital of the company.

(4) The rates at which the dividends have been paid in the previous years should also

be considered.

296

(5) The Directors must also take into consideration the future prospects of the profits.

It may be possible that heavy losses occur in the remaining period of the year.

(6) Cash resources should also be taken into account.

(7) The rate of interim dividend should be in proportion to the expected final

dividend.

The Directors, if so empowered by the Articles of Association of the company,

declare Interim Dividend after taking into consideration the above points. Since Interim

Dividend is declared by the Directors, there is no necessity of calling a Meeting of the

Shareholders to sanction such a payment. However, the approval of the Central Government

is necessary when it is proposed to pay Interim Dividend. There is a practice on the part of

Directors to seek the advice of the auditor. Under the Companies (Temporary Restriction on

Dividend) Act, 1974, no company is allowed to declare and pay Interim Dividend without the

approval of the Central Government. Usually, final accounts are prepared to arrive at the

correct figure of profits earned. If the Directors are not cautious in this respect, they are held

liable to pay back the amount so distributed to the shareholders by way of Interim Dividend.

The Companies Act did not have any provision for interim dividend, several company

managements followed such procedures as suited their interest, rather than the larger interest

of all the shareholders.

Now, the Companies (Amendment) Act, 2000 has brought uniformity by making

specific provisions under section 205 for declaration and payment of Interim Dividend

similar to those relating to final dividend.

Such provisions are :

Section 205 (1A). The Board of Dfrectors may declare interim dividend and the

amount of dividend including interim dividend shall be deposited in a separate bank account

within 5 days from the date of declaration of such dividend.

Section 205(1B). The amount of dividend including interim dividend so deposited

under sub-section (1A) shall be used for payment of interim dividend.

Section 205 (1C). The provisions contained in sections 205, 205A, 205C, 206, 206A

and 207 shall, as far as may be, also apply to any interim dividend. Auditor's Duty

(1) The auditor should, first of all, examine the Articles of Association to confirm that

they sanction the payment of Interim Dividend.

(2) He should confirm that the profits are arrived at correctly. It means that the

necessary adjustments fn regard to reserve for bad and doubtful debts, depreciation, etc., have

been made before arriving at the figures of current profits.

297

(3) He should examine the resolution of the Directors in this respect. Before passing a

resolution in this respect, the Directors must take into consideration the future prospects of

profits, e.g., business environments, prospects of earning profits in the years to come, etc.

The auditor should give advice to Directors to declare Interim Dividend if he thinks that there

is no likelihood of loss in trade in the remaining period of the year otherwise Directors and

Auditor will be held liable for payment of such an interfm dividend out of capital.

(4) It should be seen that the approval of the Central Government has been obtained to

declare and pay an interim dividend as provided under the Companies (Temporary

Restrictions on Dividend) Act, 1974.

(5) He should verify the rate of interim dividend specially. The rate of interim

dividend should usually be lower than the expected rate of final dividend as, otherwise, the

value of shares fn the market may fall down as a result thereof and the Goodwtll of the

business may be affected adversely.

(6) It is to be examined that there is no likelihood of being heavy loss arising out of

forward contracts etc., in future.

(7) It should be seen that cash resources have been taken into account while deciding

to declare an interim dividend. If small cash balance is left after payment of interim dividend,

the working capital would be insufficient.

(8) He should see that the payment of interim dividend is intra vires, Le., within the

powers of the company to declare it.

(9) It is to be seen that the interim dividend declared by the Directors is within the

limits of the financial prudence. If it is otherwise, he should mention this fact in his report.

(10) He should ensure that the declaration of interim dividend does not in any way

affect the liabilities position and the working capital.

(11) He should check the records made in the financial books for the payment of

interim dividend. The payment should also be vouched.

Dividend Paid out of Capital ^

As is held earlier, dividend must never be paid out of capital and if the Memorandum

or Articles of Association give power to the company to do so, such power is invalid.

—Verner vs. General & Commercial Investment Trust Ltd. (1894)

Directors who knowingly pay dividends out of capital are personally liable to make

good the amount of such dividends of the company.

—Oxford Benefit Building Society (1886); re: London & General Bank (1895); re:

Kingston Cotton Mill Company (1896)

298

But where such payment has been made on the faith of a bona fide valuation of a

company's assets, which subsequently proved to be an over-estimate, the Directors are not

liable. —Stringer's Case (1869)

It has also been made clear in the legal decisions on the subject that if dividends are

received by members, knowing that they are paid out of capital, the Directors may have a

right of indemnity against such members to the extent to which they have received dividend.

If an interim dividend has been paid out of capital due to a bona fide mistake and the

Directors want to recoup such dividend out of profits before any further dividends are paid, a

member who has received such dividend cannot maintain any action against the Directors.

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LIABILITIES OF AN AUDITOR

The Liability of a Company Auditor

A company auditor is appointed under the Companies Act, 1956, and hence, his

position differs from that of one appointed by a private concern. His appointment,

remuneration, rights and duties, liabilities and responsibilities, etc., are defined and laid down

by the Companies Act. His liabilities may be kept under the following heads :

Liabilities of a Company Auditor

Civil Liability Criminal Liability

Liability for Negligence Liability for Misfeasance

1. Liability for Negligence

An auditor appointed by a company is expected to safeguard the interests of the

shareholders and, as such, he performs his duties as an agent of the shareholders. He must

exercise his reasonable care and diligence in the performance of his duties as laid down under

the statute. If he fails to do so and as a consequence thereof, the principal suffers a loss, the

auditor is held liable to make good the loss under the Law of Agency. Thus, he can be

compelled to compensate loss caused to the company resulting from his negligence.

But it has to be remembered that the auditor cannot be held responsible to compensate

the loss if his negligence is proved without, in any way, causing loss to the company. He is

liable for damages if the company has suffered any loss due to his negligence in the

performance of his duties as was held in the case of Liverpool & Wigan Supply Association

Ltd. (1907). The situation can be briefly put as given hereunder :

— (1) Loss without negligence An auditor is not liable for- and

-- (2) Negligence without loss

Legal Decisions

(1) Leeds Estate Building & Investment Society vs. Shepherd (1887)

It was held in the case that if an auditor is found negligent in the performance of his

duties as an auditor, he is liable for damages. In this case, the auditor could not see that:

1. The Articles of Association had not been fully complied with, and

2. Dividends had been paid out of capital.

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Decision. "It is the duty of an auditor not to confine himself merely to the task of

ascertaining the arithmetical accuracy of the Balance Sheet, but to see that it is a true and

accurate representation of the company's affairs. It was no excuse that the auditor had not

seen the Articles when he knew of their existence. The Statute of Limitations had been

pleaded on his behalf, and the plea had not been resisted so that his liability would be limited

to the dividends paid within six years of the commencement o:" the action."

(2) Irish Wollen Company Ltd. vs. Tyson and Others (1900)

In this case it was held that an auditor who by reasonable care and skill could detect

falsification of accounts is liable for dividend paid out of capital due to such falsification.

Decision. In the course of his judgment, Holmes, L.J. said: 'There Is no doubt that

both the suppression and carrying over of invoices would have been detected if the auditor

had called for the creditors' Statement of Accounts upon which payment was ordered, and

compared them with the Ledge. I do not understand how the carrying over of the invoices

could have escaped detection by the accountant, who should have used due care and skill and

who was not a mere machine. The invoices carried over were ultimately posted to the Ledger.

If they were posted to their true dates, i: would be at once apparent that they were not entered

in at the proper time If they were posted under false dates, why was this not detected when

the Ledger Accounts were checked with the invoices... For these reasons, I am of the opinion

that if due care and skill had been exercised, the carrying over and suppression of invoices

would have been discovered and the auditor is liable for any damage, the company has

sustained from the under-statement of liabilities in the balance sheet...."

(3) London Oil Storage Co. vs. Seear Hasluck & Company (1904)

It was held that an auditor who fails to verify the existence of assei? as shown in the

Balance Sheet of the company is liable for damages bu" assessment of such damage is

dependent on how far the negligence of the administration is contributory to such loss.

Alberstone, C. J. observed :

'The plaintiffs must satisfy you that the damage has been occasion e to whatever

extent you think it was occasioned, by the breach of duty or the part of an auditor..........You

must not put upon him the loss by reason of theft occurring afterwards or before but you must

put upon him such damages as you consider in your opinion were really caused by his dur as

an auditor of the company.

(4) Arthur E. Green & Company vs. The Central Advance & Discoir Corporation Ltd.

(1920)

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It was held that an auditor is guilty of negligence, if he fails, to dete time-barred debts

within the schedule of debtors.

An auditor may, thus, be liable the previous losses, and he may al-be held responsible

for the consequential losses. In fact, damages which are the direct result of negligence are

only recoverable. Remote damages are not recoverable.

On the question of consequential damages, the Accountant of England referring to the

Armitage vs. Brewer & Knott wrote : 'The case gives a looting disadvantage to the profession

in applying the principle of consequential damages to audit claims...Thus, if an auditor omits

to detect the defalcation by an employee and in the following year, before there is chance of

any further audit, the employee emboldened by having escaped detection embezzles a larger

sum, is the auditor liable both for the original embezzlement which he failed to detect and for

the subsequent losses to the employer as well?"

"A mere mistake will not render a professional man liable for the consequence, but if

the negligence was of the type where omission was to detect a fraud which by the exercise of

a reasonable care an accountant would have detected, then we are inclined to think that a jury

would take into account the consequential losses in their award of damages. On the other

hand, if the auditor's failure to detect defalcation was not blameworthy, and he could not

reasonably be expected to detect such a defalcation, then he might not, in our opinion, be

liable."

Thus, to hold the auditor liable for negligence, the following three things must be

proved :

1. That he was negligent,

2. That, as a result of his negligence, the client suffered a loss, and

3. That the loss was suffered by the person to whom the auditor owed a duty.

The company may indemnify the auditor for any expense that he incurs in defending

himself provided the judgment was in his favour.

2. Liability for Misfeasance

As an auditor is held for damages caused to a company on account of his negligence,

similarly, he is negligent in the performance of his duties if he commits a misfeasance, Le., a

breach of trust or duty. Misfeasance implies a wrong done. If an auditor does something

wrongfully in the performance of his duties resulting in a financial loss to the company, he is

guilty of misfeasance. The Directors, Managing Agents and other officials of a company may

also be held liable for misfeasance.

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Legal Position

Section 62. Where the consent of a person is required to the issue of a prospectus and

he has given such consent, he shall not be liable as a person who has authorised the issue of

the prospectus. However, he remains liable in respect of an untrue statement, if any,

purporting to be made by him as an expert. As such the expert remains liable for untrue

statements by him and included in the prospectus with his consent as if he had authorised the

issue of the prospectus.

This section provides for the Civil liability of an auditor for mis-statements in the

prospectus of the company.

Section 543. If in the course of winding up of a company, it appears that any officer

(including the auditor) of the company has misapplied or retained or become liable for any

money or property of the company or has been guilty of any negligence or breach of trust in

relation to the company,

LIABILITIES OF AN AUDITOR

The can be held liable for damages caused to the company. (Ref. to original Section in

the Act.)

Legal Decisions

(1) London and General Bank Case (1895)

An auditor is liable for misfeasance [Section 543 of the Companies Act if he fails to

bring to the notice of the shareholders in clear terms, the unsatisfactory state of affairs of the

company when he himself had not been satisfied.

In the course of the judgment, Lindley, L.J. said :

"It is no part of an auditor's duty to give advice either to Directors or Shareholders as

to what they ought to do. His business is to ascertain and state the true financial position of

the company at the time of the audi: and his duty is confined to that. But then comes the

question: How is he to ascertain such position? The answer is: By examining the books of th

company..He must take reasonable care to ascertain that they do. Unles-he does this, his duty

will be worse than a farce.."

"Such I take to be the duty of the auditor: he must be honest, that is he must not

certify what he does not believe to be true and he must u-reasonable care and skill before he

believes what he certifies is true...."

(2) Kingston Cotton Mill Co. Ltd. (1896)

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An auditor is not liable if in the absence of suspicious circumstance-he relies on

trusted officials of the company.

In the course of the judgment, Lopes, L. J. remarked : "An auditor is not bound to be

detective or, as was said, to approat his work with suspicions or with a foregone conclusion

that there is something wrong. He is a watch-dog and not a blood-hound. He is justifie in

believing tried servants of the company in whom confidence is placed ':: the

company...Auditors must not be made liable for not tracking o ingenious and carefully laid

schemes of fraud, when there is nothing I arouse their suspicion and when these frauds are

perpetuated by tn servants of the company and are undetected for years by the Directors.

(3) The City Equitable Fire Insurance Co. Ltd. (1924)

It was held that an auditor is liable for misfeasance if he omits to ver. investments and

accepts the certificate of a stock broker in lieu. An audit is liable only when he accepts the

certificate for investments from perso: -who are not in the usual course of their business to

hold others' securit and are not trustworthy, irrespective of the fact that they are Banker-Sale-

Deposit Company or Stock-Brokers.

(4) Republic of Bolivia Exploration Syndicate Ltd. (1913)

It was held in the case that it is the duty of the auditors to ascerta. the scope of thefr

work from the Articles and the statues, and in cas damages suffered by the company on

account of misleading Balance She-the onus to show that the damage is not caused by their

negligence is the auditor. The auditors are prima facie responsible for such loss but : -extent

depends on the circumstances of each case.

(5) The Westminster Road Construction & Engineering Co. Ltd. (1932

If an auditor fails to utflize the evidence reasonable available fr -which the

overvaluation of work-in-progress could be detected, he is lia: for negligence. He must make

full use of the evidence available and the acceptance of certificate without question in such a

case is amounting to negligence.

(6) Union Bank (in liquidation), Allahabad (1925)

It was held that the Directors, who have trusted a dishonest Manager, were guilty of

misfeasance and an auditor was similarly held liable.

".....It is nothing to him whether dividends are properly or improperly declared,

provided he discharges his own duty to the shareholders. His business is to ascertain and state

the true financial position of the company at the time of the audit and his duty is confined to

that...If he fails in his duty, he will be jointly and severally liable with those who are

responsible for the management of the company, although he is not guilty of any dishonesty."

304

(7) L. Hudson vs. Official Liquidator of Dehradun-Mussoorie Electric Tramway Co. (1930)

It was held that under the Act, where auditors pass over illegal payments without

demanding explanation and the facts disclose that there are deliberate abstentions from

performing plain and manifest act and there was absolute duty cast upon them to enquire into

the illegal payments and think over the real meaning of dubious transactions, they are guilty

of misfeasance unless there is anything to the contrary in the Articles of Association.

3. Criminal Liability

As is stated earlier, an auditor is an officer of the company and in that capacity, he is

liable for his acts of omission/commission which can be construed as an offence under the

provisions of the Companies Act, Penalties for such offences may be imprisonment and /or

fine.

Legal Position

Section 63. Where a prospectus issued after the commencement of this Act includes

any untrue statement, every person who authorised the issue of the prospectus shall be

punishable with imprisonment for a term which may extend to two years or with fine which

may extend to fifty thousand rupees, or with both, unless he proves either that the statement

was immaterial or that he had reasonable ground to believe, that the statement was untrue.

For the purpose of this section, an auditor may be punished if he authorised the issue

of the prospectus.

Section 233. If an Auditor's Report is made, or any document of the company is

issued or authenticated otherwise that in conformity with the requirements of sections 227

and 229, the auditor concerned, and the person, if any, other than the auditor, who signs the

report or signs or authenticates the document, shall, if the default is wilful, be punishable with

fine which may extend to ten thousand rupees.

Section 240. The auditor of a company is required to give assistance to an Inspector

appointed by the Central Government to investigate the affairs of the company. If he does not

do so, he is punishable with imprisonment up to six months or with fine up to twenty

thousand rupees or with both and also with a further fine which may extend to two thousand

rupees for every day after the first during which the failure or refusal continues.

Section 242. When on the basis of the report submitted by an Inspector, the Central

Government takes action and prosecutes any person connected with the affairs of the

company, the auditor is required to assist the prosecution. If he does not do so, he is guilty of

Contempt of Court and punishable.

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Section 477. In the course of winding up of a company, the auditor is subject to a

private examination of the Court and is required to return to the Court any documents in his

possession. If he fails to appear before the Court, he can be arrested.

Section 478. The auditor of a company, on the application of the Official Liquidator,

can be publicly examined in the High Court. The notes shall be taken down and be signed by

an auditor. Such notes may be used in evidence against him in any civil or criminal

proceeding.

Section 539. If an auditor destroys, mutilates, alters, falsifies or secrets, or is privy to

the destruction, mutilation, alteration, falsification or secreting of any books, papers or

securities or makes, or is privy to the making of any false or fraudulent entry in any register,

book of account or document belonging to the company, he shall be punishable with

imprisonment for a term which may extend to seven years, and shall also be liable to fine.

Section 545. The Court may direct the Liquidator of a company :: winding up to

prosecute the auditor if he is found guilty of any criminal offence in relation to the company.

Section 628. If an auditor of a company makes a statement in an Return, Report,

Certificate, Balance Sheet, Prospectus, etc., which is false in any material particular, knowing

it to be false or omits any material fac-knowing it to be material, he shall be punishable with

imprisonment for a term which may extend to two years and shall also be liable to fine.

Section 629. If any person (including an auditor) intentionally giv false evidence upon

any examination on oath or solemn affirmation authorised under the Act; or in any affidavit,

deposition or solemn affirma tion, in or about the winding up of any company under the Act

or otherwise in or about any matter arising under the Act, he shall be punishable wi

imprisonment for a term which may extend to seven years, and shall be liable to fine.

Under the Indian Penal Code

Section 197 of the Indian Penal Code (IPC) lays down: "whosoev issues or signs any

certificate required by law to be given or signed -relating to any fact which such certificate

is false in any material po:: shall be punishable in the same manner as if he gives a false

evidence.

Powers of the Court to grant relief to the Auditor

Section 633. If it appears to the Court that an auditor is or may be liable in respect of

the negligence, default, breach of duty, misfeasance i breach of trust but that he has acted

honestly and reasonably, it can reh-him either wholly or partly from his liability on such

terms as it may th:: fit.

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Provided that in a criminal proceeding under this sub-section, the Court shall have no

power to grant relief from civil liability which may attach to an officer in respect of such

negligence, default, breach of duty, misfeasance or breach of trust.

LIABILITY OF AN AUDITOR TO THIRD PARTIES

So far we were discussing the liability of an auditor to the company, now we shift to

another vital question as to how far he is liable to those who are creditors, bankers, lenders,

debenture holders and other persons or institutions having dealings with the company but are

outsiders. If they suffer any loss by relying on the Balance Sheet or other Statements or

Documents signed by him, can he be held liable for damages so caused to any of them?

The answer is obviously, 'No'. An auditor is never appointed by the third party and as

such, he has nothing to do with such a party. There is virtually no contract between the

auditor and the third party.

'The auditor owes no duty of care to anybody but his client and he cannot be held

responsible for any loss suffered by third parties through reliance on accounts which have

been audited by him, even though negligence may be proved." —Candler vs. Crane,

Christmas & Co. (1951)

According to the judgment given in the case of Le Lievre & Dennes vs. Gould (1893)

it becomes clear that the Court cannot hold an expert responsible for negligence unless a

fraud is established against him.

It should first be proved that:

(i) the statement signed by him was untrue in fact;

(ii) the person making it knows that it was untrue or was recklessly and consciously

ignorant whether it was true or not;

(iii) the Statement was made intentionally for the plaintiff to act upon it; and

(iv) the plaintiff acted in reliance to it and suffered damages. Thus, only in case of

fraud in the Court of Law against an auditor, he can be held liable for damages. Whatever the

case, he should exercise reasonable skill, care and tact.

Briefly, it can be stated that an auditor owes no duty towards third parties. He is liable

only when he has knowingly committed some fraud and due to this, they are put to some

damages. Under the Hedley Byrne case, it was indicated that actions for professional

negligence may arise if financial loss is suffered by third parties.

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However, the legal position in India on the issue of the liability of an auditor to third

parties has changed under section 63(1) of the Companies Act, 1956 subject to the conditions

as laid down under such section (2) of the said Act. Under the circumstances an auditor can

be held liable for the damages to a third party if the auditor had authorised the issue of such a

prospectus which contains misleading statement. The situation was different prior to the

introduction of the Companies Act, 1956.

Conclusion. It would be needless to repeat and reproduce the decisions given above

but it can be laid down here that there are no universal and firm norms or principles on the

basis of which the liability of an auditor to third parties can be in particular defined and

established. Circumstances differ, the regulations of Articles of Association vary and more

so, the terms of contract between an auditor and his client vary widely. Hence, it does not

seem feasible to lay down uniform laws and rules in this regard.

However, to make an auditor liable for the loss suffered by any third party by relying

on his report and taking action thereafter, some principles normally accepted can be

enunciated and they are:

1. It is proved that the auditor showed negligence in his duty and as a result, the third

party suffered a loss, and/or

2. His report is fraudulent.

Thus, some liability may arise when the auditor performs his duty knowing that his

work would be relied upon by some third party which may suffer financial loss as a result

thereof.

But it has always to be remembered that an auditor must be honest. He must exercise

reasonable care, caution and skill. Unless he is fully satisfied, he must not certify as correct

the Profit and Loss Account or Balance Sheet or any other statement. What amount of care

and skill will be reasonable will depend upon the circumstances of individual case. It is

certain that if the negligence is proved in the Court and the company is put to a loss as an

effect thereof, he will be liable for damages.

He must be honest and submit his report after proper scrutiny of accounts in a free and

frank way. This is all that he can do.

Liability of an Honorary Auditor

So far as the liability of an honorary auditor is concerned, he is equally well

responsible for negligence or misfeasance as a salaried auditor. He cannot be relieved of his

liability on the ground that the agreement between him and his chief was not supported by

consideration and hence it was void. He should not undertake the work of an auditor if he

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wishes to be free from any sort of liability with his taking over the responsibility of audit

work and submitting his report, he is as responsible for his acts as a paid auditor. On this

issue, there is actually no difference between the two.

—Fairdeal Corporation, Bombay vs. K. Gopal Krishna Rao (1957

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COST AUDIT

With the growth and development of cost accounting system, it became necessary to

maintain cost records and cost books to record costs and the related transactions correctly. It

is necessary that either in financial accounting or in cost accounting or in management

accounting system, wherever books and records are kept, they must be examined

independently to ensure that they have been kept and recorded fairly and correctly and that

there are no errors of omission and commission and there are no defalcation. So once the cost

accounts are prepared, they should be audited in all fairness.

DEFINITIONS AND CONCEPT OF COST AUDIT

Cost audit means audit of cost accunts, which is related with deep checking and

verification of accuracy of cost techniques, methods and accounts. Some of its definitions are

as follows :

(1) "Cost audit is the verification of cost accounts and check on the adherence to the

cost accounting plan." —I.C.M.A., London

(2) "Cost audit means the detailed checking of the costing system, technique and

accounts to verify their correctness and to ensure adherence to the objective of cost

accounting." —Smith & Day

(3) "Cost audit can be defined as verification of the correctness of cost accounts and

adherence to the cost accounting principles, plans and procedures. —I.C.W.A., India

Like financial audit, cost audit is also an attest function. It is a systematic and accurate

recording of detailed transactions and operations of manufacturing, processing, contracting,

extracting, transporting, supplying, etc., so as to show the actual cost of each individual piece

of work, service or process or operation.

The cost auditor is expected to examine the cost books, cost accounts, cost statements

and all other relevent documents to see not only that they have been correctly written and

recorded but that they also give a fair and correct picture of the business with regard to

costing operations.

From the definitions of cost audit, it is evident that cost audit aims

at :

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(a) verifying that the cost books, cost accounts and cost-records have been correctly

maintained as per costing system adopted; J. G. Tikhe 'Cost Audit and Management Audit'

(Mumbai).

(b) verifying that the cost plan Le., the prescribed routine and procedure, has been

adhered to; and

(c) detecting errors and preventing fraud, misappropriations and defalcations.

DIFFERENCE BETWEEN COST AUDIT AND FINANCIAL AUDIT

Financial accounting and cost accounting are the two main branches of accounting

system. The same criteria and principles of audit hold good in both the systems of accounting

and sometimes it becomes difficult to make clear-cut distinction between the two audits.

However, an auditor of financial accounting is more concerned with financial aspects,

recording of cash and bank transactions, capital, debtors, creditors, assets & liabilities, etc,

while the cost auditor is more concerned with correct recording, ascertainment, presentation

and control of costs. This leads to the following points of distinction :

1. Presentation of Report : In financial audit, the audit report is addressed and placed

before the shareholders of the company, but the cost audit report is addressed to the

appointing authority. In financial audit, auditor is the representative of the shareholders while

in cost audit, he is the nominee of the appointing authorities and reports to them on cost

effectiveness.

In statutory cost audit, the report is to be submitted by the cost auditor to the Central

Government, with a copy to the company.

2. Statutory Compulsion : Audit of Financial accounts has been made statutorily

compulsory by the Companies Act while Cost audit is not compulsory except in certain cases

Le., in case of companies which carry on manufacturing or mining business and which are

required to maintain Cost Accounts under Section 209(1) (d) of the Companies Act and are

asked to get their accounts audited under Section 233(B) by the Central Government.

3. Details in the Annexures : The audit examination of financial accounts is not as

detailed as that of cost accounts. In case of statutory cost audit, the cost auditor has to furnish

details in the annexures along with Cost Audit Report.

4. Focus of Audit: In financial audit, the auditor is required to report on the Profit &

Loss A/c and the Balance Sheet whether they exhibit a true and fair view of the state of

affairs of the company. In the cost audit, the auditor has to report whether company's cost

accounting records have been properly kept as to give a true and fair view of the cost of

311

production, processing, manufacturing or mining activities, and the marketing of the product

under reference.

5. Focus of Examination : The financial auditor is required to examine that the

business transactions have been recorded correctly but the cost auditor has also to see that

inventory management and control, inventory limits, E.O.Q. etc., have been properly adhered

to.

6. Relation with Decision-making : The financial audit is not so much related to

decision-making aspects as the cost audit is related. The cost auditor points out errors and

irregularities in managerial decision-making.

7. Stock Valuation : The financial auditor has to verify the correct valuation of the

closing stocks but the cost auditor has also to see that there is sufficient closing stock to meet

the needs of the manufacture.

8. Correct Profit us. Potential Profit : The financial audit exhibits whether correct

profits have been arrived at or not but in cost audit, the possibility of earning more profits are

explored and advice is made available for the future for better results on the basis of previous

records and experiences.

9. Instance of Audit : Financial audit is conducted at the instance of owners of the

business but cost audit can also be done at the instances of Government, Banks and Investors,

Industrial Tribunals and Customers, etc.

10. Aspects of Audit : Financial audit is concerned with the financial aspects but the

cost audit is more related to cost aspects. The cost auditor has to examine carrying and non-

carrying costs, engineering and works studies, variances, budgetary control and ratio studies,

etc.

OBJECTS OR FUNCTIONS OF COST AUDIT

The objects or functions of cost audit are the following :

(I) Protective Objects

1. Accuracy of Cost Accounting : To check accuracy of cost accounting records and to

verify that they have been maintained in accordance and in conformity with the cost

accounting principles.

2. Adherence of Principles and Procedures : To verify that the management is

adhering to the accepted procedures and processes of cost accounting.

3. Detection of Errors : To detect errors and frauds, if any.

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4. Examining the Adequacy of the System : To see how far the present practices of

maintaining cost records, submission of reports and returns are helpful and adequate.

Changes may be suggested where necessary to make them more meaningful and decision-

oriented.

5. Pinpointing Deficiencies : To pinpoint the deficiencies or the inefficiencies in the

use of materials, labour and machines and to assist the management thereby.

6. Verification of Correctness : To verify that the cost has been ascertained correctly

and rightly presented.

7. Enforcement of Cost Control : To see that the cost control and cost reduction

programmes have been rightly enforced.

8. Comparison with Budgets and Standards : To, examine whether the expenditure

incurred upto date is within the budget-estimates and standards determined.

9. Guidance to Management : To guide the management by giving positive

suggestions to improve the working of cost accounting department.

10. Others : (i) To develop cost consciousness in the enterprise; (ii) To develop the

process of moral check on staff from the view of cost control and cost reduction; (ill) To

promote efficiency in the methods, techniques and processes of cost accounting; (iv) To

develop an effective system of internal cost audit.

(II) Constructive Objects

(1) To provide useful information and data to management for regulating production.

(2) To assist in selection of economical methods of operation.

(3) To present suggestions for reducing operational costs.

(4) To give suggestions to resolve errors in cost accounts.

(5) To provide suggestions and consultancy for cost control.

ADVANTAGES OF COST AUDIT

The advantages of cost audit are the following :

(I) To the Management

1. Reliable Data : The management feels assured that its cost accounting is true and

fair and cost data are reliable. It all assists in taking various decisions related to price

determination and control.

2. Check on Wastages : Cost audit helps in continuous knowledge, check and control

of all types of wastages in production.

313

3. Knowledge of Inefficiency : Cost audit brings to light various inefficiencies in the

working of the company, which does help in taking corrective action at proper time.

4. Useful in Advanced Techniques : Cost audit promotes the use of advanced

techniques of costing such as standard costing, budgetary control, etc.

5. Cost Consciousness : Audit suggestions make the management cost conscious and

future plans and policies can be drawn in a better perspective.

6. Proper Valuation of Stock : Cost audit does help in developing a proper system of

valuation of closing stock and work-in-progress.

7. Detection of Errors and Fraud : Cost audit helps in the detection of errors and

fraud in cost accounting and records.

8. Others : (a) It helps the management to reduce costs and control costs in a more

effective way. (b) Audited cost accounts are useful for inter-firm comparison.

In brief it can be said that "A cost audit is a process of ascertaining whether the

production, marketing and sales processes of a business have been managed in the most cost

effective manner. The audits reveal the extent of efficiency and profitability of a company as

well as the sector."

(II) To the Shareholders

1. Faith in Management: Cost audit inculcates a sense of goodwill and faith towards

the company's production-management and marketing-management in the minds of the

shareholders.

2. Satisfaction with the Amount of Profit : As the cost audit examines the valuation of

closing stocks and work-in-progress, the shareholders feel satisfied with the profit shown by

the company, on this account.

3. Knowledge of Efficiency of Management : The cost audit brings to the knowledge

of the shareholders the efficiency of the management, proper utilization of man, material and

resources, productivity and weak points of the organisation.

(III) To the Investors

1. Faith in the Position of the Company : After cost audit, investors feel that the

statement presented before them is correct and accurate and it inculcates a feeling of faith

among them about the position of the company. On this basis they can also decide whether

more investment in the company will be beneficial or not?

2. Assistance in Lending : Banks and corporations give preference in granting loans to

such companies which adopt cost audit.

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(IV) To the Society and Consumers

1. Better Quality at Reduced Cost: Cost audit is generally introduced for the purpose

of fixation of price. The prices so fixed are based on the correct costing data and so the

consumers are assured to get better quality' of goods at reasonable cost. Quality is assured on

account of better use of resources.

2. Maintenance of Standard of Living : Since price increase by the industry is not

allowed without proper justification for it, consumers can maintain their standard of living.

(V) To the Government

1. Reliable Data of Production and Cost: Country's economic planning based on data

of production, cost, imports, exports, etc., can be better decided on the basis of reliable cost

data available on the basis of cost audit.

2. Convenience in Contract Pricing : Where the Government enters into a cost-plus

contract, cost audit does help the Government to determine the price of the contract.

3. Assistance in Protection Decision : In matters of tariff protection to certain

industries, audited cost accounts presents reliable cost structure to the Government.

4. Control on Profiteering : Cost audit helps in the fixation of selling prices of

essential commodities and thus, profiteering can be checked and controlled.

5. Knowledge of Inefficient Units : Cost audit enables the Government to identify

inefficient endustrial units and to focus its attention in resolving their problems.

6. Settlement of Industrial Disputes : Cost audit facilitates the Government in settling

trade disputes related to wages, allownaces, etc.

7. Creation of Healthy Competition : Cost audit ensures efficient running of business

and availability of correct and accurate cost data. It promotes healthy competition among the

various units in an industry and imposes an automatic check on inflation.

ASPECTS OR SCOPE OF COST AUDIT

There are two main aspects of cost audit—(1) Propriety Audit, and (2) Efficiency

Audit.

1. Propriety Audit: It has been defined as an "audit of executive action and plans

bearing on the finance and expenditure of the company".

(Management Accounting, Feb., 1965

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This audit is related to the propriety, i.e., fitness or lightness 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 :

(a) the expenditure has been planned in a way as to give the optimum results;

(b) the planned expenditure, its size and channels have produced the optimum results;

and

(c) 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:

(a) every unit of money invested must give the optimum or the best result, and

(b) 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 efficfency 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 AND CLASSIFICATION OF COST AUDIT

Types of Cost Audit

Following are the 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 correct and reliable cost

information to management for taking managerial decisions and to ensure that the costing

department is functioning according to the plan.

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The Cost Auditor is appointed by the management for thfs audit.

2. Statutory Audit : Under Section 233B of the Companies Act, 1956, Sub-Section 1, it

has been laid down that where in the opinion of the Central Government it is necessary so to

do in relation to any company required under clause (d) of Sub-Section (1) of Section 209 to

include in its books of account the particulars referred to therein, the Central Government

may, by order, direct that an audit of cost accounts of the company shall be conducted in such

manner as may be specffied in the order, by an audftor who shall be a cost accountant within

the meaning of the Cost and Works Accountants Act, 1956.

3. Cost Audit by the Government : Besides the Statutory audit, the audit can be

instituted by any Government—Central or State—for the following purposes :

(a) 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,

(b) to ascertain costs in order to fix maximum prices of products,

(c) to ascertain cost of contracts to be given to contractors under Cost-plus contracts,

and

(d) 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.

4. Cost Audit by Contractees : Where it it 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.

5. 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.

6. 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.

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Classification of Cost Audit

Cost Audit can be classified as (1) Internal audit and (2) External or Statutory audit.

(1) Internal Audit: Internal audit is done by the auditor who is in the employment of

the business, with the help of his departmental staff. The objectives and scope of internal

audit differ from concern to concern depending on the requirements of the management. The

objectives of internal audit are the following :

1. to ensure that the business is being run according to plan;

2. to verify the correctness of accounts by vouching;

3. to check that the budgets have been prepared correctly;

4. to detect errors of omission, commission and errors of principle and to prevent

frauds and defalcations;

5. to check that forms and documents are executed regularly and submitted

punctually;

6. to ensure that accounting is done daily, as per schedule;

7. to check whether the routine and procedures are being followed as per cost plan;

8. to detect weaknesses of the system and remove them;

9. to see that there is no communication gap between top management and the

executives; the business policy and instructions are communicated to the workers as

scheduled and the managerial reports are submitted in time to the management;

10. to verify the inventory control and physically check the stocks;

11. to compare the costs of products from period to period, analyse the causes of

variations and suggest ways and means to reduce and control costs; and

12. to effect moral check and improve efficiency.

(2) External or Statutory Audit: The external audit is conducted with a particular

object in view, by the outside auditors, and thus, has a limited scope. It may be conducted by

the Tribunal, Government, Contractee, or Trade Association, but in each case the object is

specific and limited. The external auditor is not an employee of the company but an outside

party and he is responsible not to the company but to his appointing authority to whom he

submits his report.

It may be mentioned that statutory cost audit was introduced with the objectives (a) to

make management cost conscious, and (b) to help in improving industrial efficiency all round

and to maximise production. However, such audit may be required under following

conditions also :

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1. For fixation of retention price in case of materials of national importance such as

steel, cement, etc.

2. To check excessive profiteering.

3. To find the reasons of cost variation from unit to unit in the same industry.

4. For settling trade disputes about claim for higher wages, bonus, etc.

5. To determine the correct cost of production, where a duty or tax is levied on

products based on the cost of production.

6. To find out the correct position of inefficient and uneconomic industrial units.

TECHNIQUE AND PROCEDURE OF COST AUDIT

In order to reap the benefit of cost audit, it is necessary that it should be done in its

entirety and should be done continuously. Before commencement of audit, the costing

method and technique adopted should be examined. The list of various sheets, documents,

schedules, statements, etc., related to cost and cost records and books should be obtained. It

should be examined whether the work of internal control is effectively being done. It should

also be seen that what is the object for conducting the audit, scope of audit, nature and size of

business. In case if the size of the business is very large, then the function of book-keeping

and accounting and internal control system should be very effectively organized.

After examining the above aspects, the cost auditor makes his cost audit programme

which is similar to that of financial audit. The work of vouching, checking and ticking is also

similar to financial audit.

Generally, the technique of cost audit should be as follows :

(1) All the receipts and payments should be vouched i.e., each transaction should have

a voucher, so as to verify the reliability of transactions.

(2) All the calculations, postings should be verified. For this special tick mark should

be adopted. If the work is more and time is less then test check should be applied.

(3) The items of suspense account should be examined very carefully. All the

adjustment entry should be well examined.

(4) The comparison of actual data with budgeted data should be made and any

variance should be carefully analyzed.

(5) As regards to technique the following points are to be considered : (i) Physical

Examination, (ii) Physical Count, (iii) Confirmation, (iv) Examination of original document,

(v) Scanning, (vi) Enquiry.

(6) He should note down all those points in his note book which he considers

reasonable.

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COST AUDIT PROGRAMME

The procedure and programme for cost audit should be recorded in Audit Manual and

the following points should be examined by the cost auditor :

1. Materials

(i) Inventory Control—size, maximum and minimum stocks, material limits. Re-order

points, Safety stocks, ABC Analysis, etc.

(ii) Purchase schedule—Selection of Suppliers, Approval of quotations, Terms of

supply, Order placing and follow-up. Economic Order Quantity, Carrying and non-carrying

costs, Lead Time, etc.

(iii) Receipt of materials and storage—Receipt, inspection, approval or rejection of

material received, use of forms and documents with proper authorization, Bin cards, Stores

Ledger, their reconciliation, etc.

(iv) Perpetual inventory system, physical stock checking and accounting for

differences.

(v) Detection and prevention of pilferage or loss of stocks.

(vi) Issue of materials from stores to workshops or departments, authorization of

Stores Requisitions, Weighing system, checking of weighing balances and measurements.

(vii) Checking of materials transferred from one job to the other or materials returned

to stores, with the relevent documents and entries made in the cards and accounts.

(viii) Method of pricing the issues—whether it is in accordance with the system

approved.

(ix) Wastage, scrap, spoilage and defectives—whether they are in reasonable limits,

their Reports should be examined.

(x) Correct valuation of closing stocks and work-in-progress.

(xi) Accounting of materials received, issued, transferred, returned, etc. and accounting of

materials consumed by jobs, products, etc.. should be examined.

(xii) Budgetary control for materials and variances from standards should be examined for

material cost control.

2. Labour

(i) Application of labour cost control factors and devices and optimum utilisation of

labour, by production planning, budgets, standards, performance reports, and study of

effective wage policy.

(ii) Method of selection, appointment, and discharge; Labour turnover, and

functioning of Personnel department.

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(iii) Labour efficiency and productivity and their comparison with the standards fixed.

(iv) Standards fixation—whether the standards are attainable or not.

(v) Time-keeping system and correct booking of labour cost with regard to job/time

cards.

(vi) Preparation of wage sheets and examining that correct wage amounts are

disbursed to right workers and no frauds are perpetuated by inclusion of names of dummy

workers.

(vii) Idle time and over-time—their control and treatment in accounting.

(viii) Forms, cards, sheets and other documents used for time-keeping, time-booking

and wage-payments should be properly authenticated and checked.

(ix) Wage-policy and method of remuneration—whether the system is working

satisfactorily to the benefit of management and labour.

3. Overheads

(i) Proper classification of overheads into factory, administration, selling and

distribution should be examined.

(ii) Allocation, apportionment and absorption of overheads on sound bases should be

ensured.

(iii) Preparation of overhead budgets, comparison of actuals with the budgets and

standards and analysis of variances.

(iv) Comparison of overhead expenditure to the volume of production.

(v) Correct allocation of overheads to the work-in-progress.

(vi) The method of charging depreciation should be carefully examined.

(vii) Treatment of items of overhead, e.g., factory rent, interest on capital, discounts,

etc., should be examined whether they are treated on sound and accepted principles.

(viii) The administration, selling and distribution overheads require different

treatment from factory overheads, in respect of their allocation and apportionment. Their

proper accounting should be ensured.

The Cost Auditor should examine the above points mentioned under sub-heads

carefully for completed audit. He should take note of the discrepancies and remove his

doubts. It is essential that before audit is started, all the books of accounts and records should

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be posted up-to-date and vouchers filed serially. All relevant documents and informations

should be made available to the auditor and full cooperation be extended to him by the staff.

COST AUDIT UNDER INDIAN COMPANIES ACT

(1) Statutory Requirement of Cost Audit as per Companies Act, 1956 The Statutory

cost audit was introduced for the first time in India by an amendment of the Companies Act

in 1965.

According to Section 209(l)(d) of the Companies Act, the Central Government may

require certain companies engaged in manufacturing processing, production or mining, to

keep books of accounts pertaining tc utilization of materials, labour and other items of cost as

may be prescribed

It is clear that all the industries engaged in manufacturing, processii_ or mining, etc.,

are not required to keep the books of account, but only such companies or class of companies

would do so as are required by the Central Government, as a regular feature. The Central

Government has by now directed some 42 industries to keep books and maintain cost

accounts To name a few, such industries are: Cement, Cycle, Caustic soda, Tyres and tubes,

Room air-conditioners, Refrigerators, Electric lamps, Electric fans, Electric motors,

Fluorescent tubes, Automobile batteries. Motor vehicles, Tractors, Aluminium, Vanaspati,

Bulk drugs, Sugar, Infant milk food, Industrial alcohol,. Jute goods, Paper, Rayon, Dyes,

Soda ash, Cotton Textiles, Polyester, Nylon, Dry cell batteries, Sulphuric Acid, etc. Many

more industries will be covered in course of time if the Central Government so desires.

It is worth mentioning that the scope of statutory requirement of a -audit has been

much widened with effect from April 2011. According tc communique of Ministry of

Corporate Affairs, "All companies manufacturing bulk drugs, fertilisers, sugar, industrial

alcohol, electricity petroleum and telecom equipments and having an annual turnover of more

than Rs. 20 crores, will have to carry out a cost audit. For companies manufacturing cement,

tyres, steel, paper and insecticides, the annual turnover threshold has been fixed Rs. 100

crore.

Any company that has its debt or equities listed on stock exchanges or is in the

process of doing so, will also have to carry out cost audit ever, if it does not fall within the

turnover criterea. These companies will hav-r to file cost audit reports for fiscal year 2011-12.

(2) Cost Accounting Records Rules : These rules, as referred to abo\ provide

guidelines to the companies to maintain their cost records. Thesr rules may differ from

industry to industry according to the nature of the industry. Some of the main heads under

which the cost data are to be compiled are given below :

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1. Materials: The records of material received, issued, consumed, 1< -in transit or

wasted in storage, their pricing or valuation are to t given.

2. Consumable Stores, small tools and machinery, spares, etc.: Th receipts, issues,

balances, losses, etc., are to be recorded. Items which have not moved for more than 24

months are to be reported.

3. Power, fuel, steam etc.: Full records are to be kept to ascertain th costs of

consumption. In the case of purchase of power or stean purchase cost is to be shown

separately. The allocation of cost power to departments is also to be shown.

4. Wages and salaries: Attendance of workers and staff, departments where each is

working, system of remuneration and bonus, allocation of wages, idle-time costs, over-time

costs etc., are to be shown.

5. Service department costs: These cost are to be worked out and their apportionment

to production are to be shown.

6. Depreciation: Depreciation charged should not be less than what is provided in

Section 205(2) of the Companies Act.

7. Royalty and payment of technical assistance: The basis of calculating and charging

royalty and other payments should be shown.

8. Overheads: Their classification, basis of apportionment, method of absorption are

to be shown separately for production, administration, selling and distribution, along with

overhead costs attributable to each type of product.

9. Work-in-progress: Opening and closing W.I.P., their valuation method and costs,

physical checking records, etc.

10. Reconciliation of cost and financial books: It is to be done periodically and

recorded.

11. Stock-verification: Tallying of balances shown by Bin-Cards and Stores Ledger

Accounts, physical checking reports, perpetual inventory system, stock valuation, wastage or

loss or pilferage, etc.

(3) Provisions Regarding Statutory Audit : Section 233B of the Companies Act

empowers the Central Government to institute Statutory Cost Audit in any company to which

Section 209(l)(d) applies. It should be noted that all the companies covered under Section 209

are not subject to statutory audit. Only such companies are subject to cost statutory audit as

are required by the Central Government to do so and which are covered by Section 209(l)(d).

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(4) Appointment of Cost Auditor : The auditor under this section shall be appointed by

the Board of Directors of the company in accordance with the provisions of Sub-Section (IB)

of Section 224 and with the previous approval of Central Government :

Provided that before the appointment of any auditor is made by the Board, a written

certificate shall be obtained by the Board from the auditor proposed to be so appointed to the

effect that the appointment, if made, will be in accordance with the provisions of Sub-Section

(IB) of Section 224.

An audit, conducted by an auditor under this Section shall be in addition to an audit

conducted by an auditor appointed under Section 224.

(5) Qualification of a Cost Auditor : A Cost Accountant within the meaning of the

Cost and Works Accountants Act, 1959 is eligible to be appointed as cost auditor.

In the event of shortage of cost auditors possessing requisite qualifications, as above,

the Central Government may, by notification, direct that Chartered Accountants with

prescribed qualifications may be appointed for such period as may be specified in the

notification, to carry out cost audit.

COST AUDIT

(6) Disqualifications of Cost Auditor: A person referred to in Sub-Sectior

(3) or Sub-Section 4 of Section 226 shall not be appointed or re-appointec for

conducting the audit of cost accounts. [Sec. 233 (B)(5a)]

As regards to above Section, following are some disqualifications i : appointment of

cost auditor :

1. An employee of the company cannot be appointed as an auditor.

2. Any person who has been appointed as a financial auditor cannot be appointed as a

cost auditor.

3. A company cannot be appointed as a cost auditor.

4. A person who is indebted for the company for Rs. 1,000 cannc be appointed as a

cost auditor.

(7) Powers and Duties of Auditor : An auditor shall have the same powers and duties

in relation to an audit conducted by him under this Section as an auditor of a company has

under Sub-Section (1) of Section 227 and such auditor shall make his report to the Central

Government in such form and within such time as may be prescribed and shall also at the

same time forward a copy of the report to the company.

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(8) Facilities to the Auditor: Upon receipt of an order under Sub-Sectic-(1), it shall be

the duty of the company to give all facilities and assistance to the person appointed for

conducting the audit of the cost accounts of the company.

(9) Informations and Explanations : The company shall, within thir days from the date

of receipt of a copy of the report referred to in Sub-Sectior

(4) furnish the Central Government with full information and explanations on every

reservation or qualifications contained in such report.

If, after considering the report referred to in Sub-Section (4) and th information and

explanations furnished by the company under Sub-Sectior. (7), the Central Government is of

the opinion that any further information or explanation is necessary, that Government may

call for such further information and explanation and thereupon the company shall furnish the

same within such time, as may be specified by that Government.

(10) Action by Government : On receipt of the report referred to .: Sub-Section (4) and

the informations and explanations furnished by the company under Sub-Section (7) and Sub-

Section (8), the Central Government may take such action on the report, in accordance with

the provisions of this Act or any other law for the time being in force, as it may consider

necessary.

The Central Government may direct the company whose cost accourv -have been

audited under this Section to circulate to its members, along with notice of annual general

meeting to be held for the first time after the submission of such report, the whole or such

portion of the said report as it may specify in this behalf.

(11) Penalty : If default is made in complying with the provisions this Section, the

company shall be liable to be punished with fine whic b may extend to five thousand rupees,

and every officer of the company whc is in default, shall be liable to be punished with

imprisonment for a term which may extend to three years, or with fine which may extend to

five thousand rupees, or with both.

COST AUDIT REPORT

The Cost Auditor makes his report (triplicate) In the prescribed form to the Central

Government within such time from the end of the financial year (presently it is 180 days) and

copy of the said report is forwarded to the company in the prescribed period.

The Cost Audit (Report) Rules 2001

The Central Government has framed 'The Cost Audit (Report) Rules 2001" which

have come into force w.e.f. 1.10.2002

The salient features of the Cost Audit (Report) Rules, 2001 are given below :

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1. The Cost Audit Report is required to be submitted to the Central Government, in

the prescribed form, with a copy thereof to the company which is subject to Cost Audit,

within one hundred eighty days from the end of the company's financial year to which the

Cost Audit Report relates.

2. The clarifications, if any, required by the Central Government on the Cost Audit

Report shall be furnished by the Cost Auditor within thirty days of the receipt of the

communication in that regard.

3. The concerned company shall make available the cost accounting records to the

Cost Auditor within one hundred and thiry-five days from the end of the financial year of the

company.

4. In case of failure of Cost Auditor to submit his report within 180 days and/or to

furnish the clarification(s) sought by the Central Government within 30 days of the receipt of

the communication in that behalf, he shall be liable for fine which may extend to five

thousand rupees.

If the company fails to furnish the cost accounting records to the cost auditor within

135 days from the end of financial year of the company, the company and every officer of the

company [including person referred to in Sub-Section (6) of Section 209 of the Act) who is in

default shall subject to the provisions of Section 223B, be punishable with fine which may

extend to five thousand rupees and when the contravention is continuing, with further fine

upto five hundred rupees for each day of default.

5. The cost audit report is required to be accompanied by the Annexure thereto

containing the information and data as prescribed.

In the Cost Audit Report, the cost auditor has to state whether he has examined the

books of account maintained under clause (d) of Sub-Section (1) of Section 209 of the

Companies Act and other relevant records. The Cost Auditor has also to report on certain

matters, viz. :

1. Whether he has obtained all information and explanations necessary for the purpose

of audit.

2. Whether proper cost accounting records as required under Section 209(1) (d) have

been kept by the company.

3. Whether proper returns adequate for the purpose of cost audit have been received

from branches not visited by him.

4. Whether the books and records give the information required by the Companies

Act, 1956 in the manner required.

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5. Whether the company's cost accounting records have been properly kept so as to

give a true and fair view of the cost of production, processing, manufacturing or mining

activities and marketing of the product.

6. Whether the cost statement as specified in the Annexures/ Proforma of Schedules I

to HI as applicable of Cost Accounting (Records) Rules duly audited by him are kept in the

company.

COST AUDIT REPORT

I/We*.....................having been appointed as auditor(s) under Section 233B of the

Companies Act, 1956 (1 to 1956) hereinafter referred to as that 'Cost Auditor(s)' of

Messrs...........Ltd. (hereinafter referred to as the company), have examined the books of

accounts prescribed under clause (d) of Sub-Section (1) of Section 209 of the said Act and

other relevant records for the year ended............relating to".............maintained by the

company and report that :

(a) I/We* have obtained all the informations and explanations which to the best of

my/our knowledge and belief were necessary for the purposes of this audit;

(b) proper cost accounting records as required under clause (d) of Sub-Section (1) of

Section 209 of the Companies Act, 1956 (1 of 1956) have been kept by the company;

(c) proper returns adequate for the purpose of my/our 'cost audit have been received

from branches not visited by me /us ;

(d) the said books and records give the information required by the Companies Act,

1956 (1 of 1956) in the manner so required; and

(e) in my/our* opinion the company's cost accounting records have been properly kept

so as to give a true and fair view of the cost of production, processing, manufacturing or

mining activities, as the case may be, and marketing of the product under reference.

The matters contained in the Annexure to this report form part of this report which is

also subject to my/our* observations made therein.

Dates this.............day of............20......at..........@ Cost.Auditor(s).

* Delete inapplicable words. ** Here specify the product under reference. P255D

Note : There is a list of 16 Annexures to be submitted with Cost Audit Report. These

annexures are (1) General, (2) Cost Accounting System, (3) Financial positior. (4)

Production. (5) Process of Manufacture, (6) Raw Materials, (7) Power and Fu (8) Wages and

Salaries, (9) Stores and Spare Parts, (10) Depreciation, (11) Overhead.-(12)

Royalty/Technical aid payments, (13) Sales, (14) Abnormal Non-recurri:.. costs, (15) Other

items, (16) Auditor's observations and conclusions.

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MANAGEMENT AUDIT

So far we have confined ourselves chiefly to the rights and duties of the auditor

arising either out of the written agreements between him and his clients or under Statute and

case laws. But the latest developments which are visible in the field of auditing have made all

the more conscious to prepare the auditor to adopt the techniques and procedures so as to

enable him to probe more deeply and intelligendy into the internal organization of a business

concern than heretofore. He is confined to examine whether the balance sheet and the profit

and loss account have been properly drawn up as per the provisions of the Companies Act

and that they exhibit a true and fair view of the state of affairs of the company. He can do all

this as his duty of conventional routine and nothing more.

But the statutory auditor is not expected to go into the question whether the policies

which have been laid down by the management are being carried out in their proper

perspective and in the right direction. He has not to advise and suggest the management the

ways and means through which the profits of the concern can be maximized and wastes

avoided. Thus, he is not required to point out the changes and improvements in the system of

running the business which may produce better results in future. He has no legal right to do

all this.

It is very often argued that the internal auditor is bestowed with the task stated above.

But in practice he is confined only to the financial aspect for the prevention and detection of

errors and fraud, or misappropriations and manipulations. Undoubtedly, all the activities, and

operations major or minor in nature, of the business have financial implications. For this, the

financial auditing cannot serve the purpose. It cannot cover the management auditing as the

management audit can prevent financial loss before it occurs, whilst the financial audit can

only establish the fact that a loss has been made.1

Today, the business has becomes so large and complicated that most of the unhealthy

situations are attributable to the basic defects of the organizational structure and ineffective

and inefficient type of the organization. The firms of professional accountants are being

called upon to render management consultancy services. The object of management

consultancy services is to improve the operations of an organization. The presence of

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management service amounts to a practical guarantee that the l T. G. Rose. The Management

Audit, p. 39. work will be satisfactory. It has to offer recommendations and its job is over.

Thus, management audit is a new concept and goes beyond the conventional audit. It

is actually a comprehensive and a critical review of all aspects of Management. It is

concerned with the appraisal of the efficiency of Management. It can be said to be an

expansion of internal audit and the idea has developed recently.

Definition of Management Audit

1. T. G. Tokhe : "The Management Audit has been defined as a comprehensive critical

review of all aspects of process of Management."

2. William P. Leonard: "A comprehensive and constructive examination of an

organizational structure of a company, institution or branch of Government, or of any

component thereof, such as a division or department, and its plans and objectives, its means

of operations and its use of human and physical facilities."

These definitions have pointed out that the management audit deals with the

management process as a whole. It facilitates the most effective relationship with the outside

world and the internal efficiency of the business.

A long, but a comprehensive definition has been given by L. R. Howard as given

below :

3. Leslie R. Howard : "Management audit is an investigation of a business from the

highest level downwards in order to ascertain whether sound management prevails

throughout, thus facilitating the most effective relationship with the outside world and the

most efficient organization and smooth running internally."

4. Taylor and Perry : "Management auditing is a method to evaluate the efficiency of

management at all levels throughout the organization, or more specifically, it comprises the

investigation of a business by an independent body from the highest executive level

downwards, in order to ascertain whether sound management prevails throughout and to

report as to its efficiency or otherwise with recommendations to ensure its effectiveness

where such is not the case."

From the above definitions, it would be evident that the management audit is an

examination, scrutiny and appraisal of the plans, policies, objectives, means of operation and

the use of physical facilities. This reviews the policies and actions of the management in turn.

It will normally be so revealing as to encourage action of a perspective nature that will put

into effect the objects for which it was originally demanded.

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Objectives of Management Audit

(1) To reveal defects or weaknesses in any of the elements examined by the

management auditor and to suggest improvements to obtain the best possible results of the

operations of the concern.

(2) To ensure the most efficient administration of the operations essential for smooth

running of a business.

(3) To obtain the efficiency and effectiveness of the management.

(4) To suggest ways and means and for the achievement of objectives and targets set

forth by the management.

(5) To assist at all levels of management in the effective discharge of their duties and

responsibilities.

(6) To facilitate the most effective relationship with the outside world and the most

efficient organization and smooth running internally.

(7) To evaluate performance by relating inputs (human and physical both) with

outputs.

(8) To assist the management to establish good relationship with the staff to enable it

to elaborate the duties, rights and liabilities of the entire personnel.

Distinction between the Statutory Audit and Management Audit

As has been emphasized earlier, the management audit is concerned with the appraisal

of the operations of a business while the statutory audit is to examine the accounts in a way as

has been laid down by the statute. The distinction between the two has been given hereunder :

Statutory Audit Management Audit

1. It is concerned with the examination of

past records, mainly the financial records. It

is virtually a financial audit.

2. The statutory auditor is expected to report

on the financial position of the organization

as to whether the financial statements

exhibit a true and fair view of the state of

affairs of the company.

3. The statutory audit has nothing to do with

the performance of the management. It has

no concern with the activities of the

The mam concern of the management

audit is to review and appraise the policies

and actions of the management Le., to

appraise the performance of the executive.

It is virtually an operational audit. The

management auditor submits a report on

the performance of the management

during a particular period and suggests

methods for achieving the objectives in

future.

The management audit is concerned with

330

management.

4. Its scope is to check the financial records.

5. It ends with reporting on the financial

records.

6. It is concerned with the financial aspects

of the organization.

making the activities of the management

more effective and efficient.

Its scope comprises the operating areas.

The Management auditor's work begins

where the work of a statutory auditor ends.

It involves an analytical examination of

the objectives, plans and policies,

production and distribution planning and

schedule and lastly the overall efficiency

as a result thereof.

Management Audit and Cost Audit

The cost audit is a regular feature in the lives of the financial audit. Both the ffnancial

audit and cost audit are governed by the State regulation in some way or the other. The cost

audit is concerned with the cost aspects of the working of a business. With the analysis of

cost records, a guideline is sought out to go ahead and to affect economy and avoid wastages,

if possible. The management auditing is concerned mainly with the evaluation of the

objectives and policies in relation to the activities of the management.

The following may be the points of distinction between cost audit and management

audit :

Cost Audit

1. Cost audit is a verification of cost records to measure the internal efficiency of a

business.

2., The cost auditor checks the cost accounting records.

3. The cost auditor should be a person with the requisite qualifications to conduct the

cost audit.

4. The cost audit is made compulsory and statutory.

5. It is a programme of one year and the report is to be submitted every year.

6. Only independent chartered accountant or cost accountant can perform the work of

cost audit.

7. To submit a report under cost audit, the time limit is fixed by the statute under

which it is conducted.

Management Audit

331

Management audit is intended to develop the relationships with the outside world and

internal efficiency of a business.

The management auditor investigates objectives and actions of the management.

The management auditor may be a person having good knowledge of the management

control, production planning and control etc. The management audit is not a statutory

obligation for a concern. It covers a very wide area having its scope of all the management

activities.

It can be conducted by any independent person.

No time limit can be fixed for submission of the report under management audit.

Management Auditor

Appointment. It is to be noted that the management audit is not prescribed by law and

hence, a company is free to take its own decision in regard to the appointment and selection

of Management Auditor. The Board of Directors or the shareholders of a company can

appoint a firm of practising Chartered Accountants to undertake the management audit. Such

a decision will, of course, depend upon the circumstances of a particular case.

It is argued that the internal auditor is fit enough to conduct management audit and he

is familiar enough with the procedures and performances of the management. Further, it is

also suggested that the work of management audit should be entrusted to the O & M

(Organization and Methods Study) personnel who have an analytical bent of mind in regard

to the organizational structure and the methods of operations. Much will depend upon the

circumstances of each particular case but a note should be made of the technical efficiency

needed for conducting the management audit.

Qualities of Management Auditor

No specific qualities can be narrated for a management auditor but as his task is

related to investigate and to appraise the objectives of a business in relation to the activities of

the management, he must be capable enough to put all his professional skills in the task of

evaluating and advising the Board members on the various aspects of organizational

operations.

Some of the qualities of a Management Auditor can be given as under:

1. He should have the ability to understand the purposes and problems of the

organization.

2. He should have a good understanding of the nature and objects of the organization

and also of its area of operation.

3. He should be competent enough to assess the progress of the organization.

332

4. He should be well familiar with the principles of delegation of authority,

management by objectives, management by exception, framing management planning and

control and preparation of different types of statements, financial and others, and also of the

budgets of different types.

5. He should have a thorough knowledge of different internal control devices and

modern techniques of job analysis.

6. He should know the techniques and devices of making an effective and efficient

use of modern office equipments including flow charts, work schedules, use of computer, etc.

7. He should see that the plans as prepared by the management are suitable and

practicable to achieve the objectives set forth by the management.

8. He should be conversant with the nature of production activities in the

organization.

9. He should have the ability to assess the adequacy and efficacy of controls in use in

the organization.

10. He should be well familiar with the personnel procedures and the personnel

development programmes so as to ensure whether or not proper allocation of duties has been

made to the staff according to their qualifications, experience and aptitudes.

11. He should be humble, pleasing and cooperative in nature.

12. He should be conversant with different types of laws relevant with the functioning

of a business concern.

13. He should be expert in drafting various reports to be presented to the management.

Functions of Management Auditor

The functions or duties of Management Auditor can be explained in brief as given below :

1. The management auditor helps the management in the preparation and execution of

plans and policies. His job is not that of fault-finding of the management but he should point

out the weaknesses and defects with the sole objectives of making the management more

dynamic in future.

2. He assists the management in taking the best decisions which are very vital for

smooth running of a business. Wrong and faulty decisions amount to a great loss to the

business and sometimes jeopardise the basis on which the business functions.

3. He helps the top management in designing the authority and delegating the

responsibilities to every core of the managerial cadre in the organization. The defects in the

channels of communication can be removed and friction avoided if the responsibility area is

well defined. The management auditing can ensure it.

333

4. The management auditor can assist in strengthening the business communication

system inside and outside the business. He can recommend and advise the most suitable

system of flow of information internally and externally.

5. He can recommend to the management the best measures and devices for.

evaluating the performance of the business. As a result, its operations can be improved and

the profits maximized.

6. He can help the management in the preparation of tax plans and budgetary policies.

He appraises the lightness of different information and data and thus, helps the management

in the preparing sales budget, purchase budget, cash and capital budget, etc.

Operational Aspects of Management Audit

1. Objects and Aims of the Organization. The management auditor should study the

aims and objects of the business. Business organizations are formed with the object of

fulfilling certain needs besides having the aim of earning profits. The original aims may be

varied and expanded. A good business has failed to meet its objectives owing to change in

policy without adequate long-range planning and organization.

2. Financial Plans and Policies. It is to be ensured by the management auditor

whether the decisions in regard to financial plans and policies have been implemented at

opportune times, leading to advantageous results or else whether these have only been made

after a period of stagnation or depression.

3. Production. Beyond the area of financial accounting, the management auditor

should have a thorough knowledge of production techniques and various plans and systems

like costing systems. He should see that production policies have been implemented in

practice and are in right perspective. The aim should be their effective and efficient

implementation.

4. Safes and Distribution. The auditor is concerned with the basic requirements of

selling section. In a business, information must be obtained as to sales on the market as a

whole and the effect of changes in price, style or manufacture over a period of time. Market

research system is relevant for this task.

5. Organizational Control. The management auditor will be concerned to see that the

overall planning and organization are most suitable for the business concerned. He should be

capable enough to take an independent view so as to enable him to recommend the overall

adjustment to more economic and effective methods of operation over the whole of the

business.

334

6. Operations. He should ascertain whether there are defects or loopholes in the

working of the organization in regard to the manufacturing process and how the system can

be improved to ensure maximum production. He can suggest ways and means to overcome

the difficulties and drawbacks.

7. Layout and Physical Equipments. The present position of layout and physical

equipments can be examined by the auditor and in order to make it more effective,

recommendations for better and greater use can be made by him.

8. Personnel Development. The management auditor can suggest ways and means for

the effective utilisation of the manpower in order to increase productivity. He is to give

suggestions for improved relationship between management and labour.

9. Regulations. It is to be ascertained by him that the rules and regulations of the

relevant statute under which a business has been set-up are being followed in toto. The

lacuna, if any, can be brought to the notice of the management.

Main Steps in Management Audit

The process of Management Audit can involve the following main steps:

1. To identify the objectives of the organization. To start with, it would be a very

important step to perceive clearly and identify exactly the objectives of the organization.

2. To break down the objectives into detailed targets and plans for various activities of

the organization.

3. To assess the adaptability of the organizational structure to achieve effectively the

targets. After all, it is the organizational structure to attain goals and to implement plans of an

enterprise.

4. To evaluate the performance of the functional areas. Above all, each functional area

is expected to contribute its maximum for the attainment of targets.

5. To suggest a more concrete and realistic course of action. This is the main purpose

of management audit to ensure that the managemer. operates effectively and efficiently by

suitably adjusting its operations wit:, the pre-determined objectives.

Management Audit Report

The report of the management auditor should be correct, concise clear-cut and

comprehensive. The report should be courteously worde and the criticism made therein about

the functioning of the managemer. should be constructive and healthy, Le., without bias on

his part.

335

The auditor while suggesting reorganization of the business, must b sufficiently

confident of his own ability to have assessed the situation th he can make adequate proposals

which will lead to improvement a; increased profitability.

336

DIFFERENT AUDITS

1. BANKING COMPANIES

Banking Companies are governed by the Banking Regulation Act. 1949, as well as by

the relevant provisions of the Companies Act, 1956. which apply to the Banking Regulation

Act except in so far as the said provisions are inconsistent with the provisions of the Banking

Regulation Act, 1949.

Section 5(b) of the Banking Regulation Act, 1949, has defined the term banking as

given below :

'The accepting, for the purpose of lending or investment, of deposits of money from

the public repayable on demand or otherwise, and withdrawable by cheque, draft, order or

otherwise."

Meaning of Banking Company

Section 5(c) of the Act provides that any company which transacts the bank business

in India is said to be banking company. The foreign companies which transact the banking

business in India come within the purview of the definition of banking company. The Act

also provides that the companies engaged in manufacture of goods and accept deposit from

the public for the financing of the business are not considered banking companies.

Restrictions on Business

1. A banking company cannot carry on any business except those business which are

mentioned in Sec. 6(i) of the Act.

2. Under Sec. 8, a bank is prohibited from carrying on directly or indirectly any

trading business such as buying and selling of goods.

3. Under Sec. 19, specific restrictions are placed on the nature of business of

subsidiary companies which can be formed for purpose-specified therein or for such purposes

as are incidental to the business i : banking.

4. A banking company is not allowed to hold shares (whether as pledgee, mortgagee

or absolute owner) of other companies exceeding 3( per cent of its own paid-up capital and

reserves or 30 per cent capital i : such companies, whichever is less.

5. A banking company is not allowed to make loans or advances on the security of its

own shares or grant unsecured loans or advances to anjy of its Directors or to firms or private

companies in which it is directly or indirectly interested.

337

6. It cannot hold any immovable property for a period exceeding seven years except

for its own use. Any land or building received by it in satisfaction of a claim or debt must be

disposed of within seven years or such a time as extended by the Reserve Bank of India. .

It is needless to emphasize that the auditor of a banking company should be well

familiar with the important provisions of the Banking Regulations Act, especially those

relating to accounts. Though it would not be possible to quote here each and every such

provision, yet some very important points are given below.

1. Management

The restrictions imposed are briefly put hereunder :

(i) A banking company cannot employ or be managed by a Managing Agent.

(ii) It cannot pay to its employees remuneration or a part of remuneration :

(a) which takes the form of commission or of a share in the profits of the company

except bonus, or

(b) a remuneration which is, in the opinion of the Reserve Bank, excessive.

(iii) All appointments or re-appointments of Managing Directors (not liable to retire

by rotation), managers or chief executive officers must be made with the previous approval of

the Reserve Bank. Such appointments shall not be effective unless approved by the Reserve

Bank.

(iv) No banking company incorporated in India shall have as a Director any person

who is a Director of any other banking company or who is a Director of other companies

which among themselves are entitled to exercise voting rights in excess of 20 per cent of the

total voting rights of all the shareholders of the banking company.

(v) The Chairman, Director, Auditors, etc., of a banking company are deemed to be

public servants for the purposes of the Indian Penal Code

2. Capital and Reserves (a) Capital

(i) Under Sec. 11, no banking company can commence or carry on business in India

unless the requirements in respect of minimum paid-up capital and reserves as mentioned

therein are duly complied with.

(ii) In case of a banking company incorporated outside India, a minimum prescribed

(i.e., the value of its paid-up capital and reserves shall not be less than fifteen lakhs of rupees,

and if it has a place of business in Mumbai or Kolkata or both, twenty lakhs of rupees) shall

be kept deposited with the Reserve Bank of India in the form of cash or unencumbered

approved Securities or partly in cash or partly in Securities.

338

(iii) Under Sec. 12, the authorized capital of a banking company cannot be less than

one-half of its subscribed capital and the paid-up capital not be less than one-half of the

subscribed capital.

(iv) A banking company cannot create any charge on unpaid capital and any such

charge is invalid.

(v) Under Sec. 13, a banking company cannot pay, directly or indirectly, by way of

commission, brokerage, discount, remuneration in any form in respect of any shares issued by

it, more than 2V2% of the paid-up value of the shares.

(b) Reserves

(i) Under Sec. 17, every banking company incorporated in India shall maintain a

Reserve Fund and shall, out of the net profits of each year and before declaring any dividend,

transfer 20% of the profits to the Reserve Fund irrespective of the fact that the amount of the

Reserve Fund is equal to the paid-up capital. Banking companies incorporated outside India

(and operating in this country) have to maintain a reserve of 20% of their net profit earned in

India. This amount shall have to be deposited with the Reserve Bank in addition to the

amount deposited under Sec. 11 of the Banking Regulations Act.

(The net profits are to be calculated as under Sec. 349 of the Companies Act, 1956.)

(ii) If any sum has been appropriated from the Reserve Fund or the Share Premium

Account, it should be reported to the Reserve Bank within 21 days of such appropriation.

(c) Cash Reserves

(i) Under Sec. 18, every banking company not being a Scheduled Bank shall maintain

a Cash Reserve with itself or with the Reserve Bank or the State Bank of India or any other

bank notified by the Central Government in this behalf a sum equal to at least 3% of the total

of its time and demand liabilities in India and shall submit to the Reserve Bank before the

fifteenth day of every month a return showing the amount so held on Friday of each week of

the preceding month with particulars of its time and demand liabilities in India on each such

Friday.

(ii) Under Sec. 42 of the Reserve Bank Act, every Scheduled Bank is required to

maintain Cash Reserve of some fixed amount as specified therein [Le., an average daily

balance, the amount of which shall not be less than 3 per cent of the time and demand

liabilities), however, thi-amount may be raised up to 15 per cent of the total time and demand

liabilities (Sec. 18). The Reserves Bank can ask any Scheduled Bank t deposit with it an

additional amount which should not exceed fifteen per cent of its time and demand liabilities.

339

Besides the above requirements, a banking company is required t maintain in India Cash,

Gold and unencumbered Securities amounting I not less than twenty-five per cent of its total

time and demand liabilitit s Assets in India of every banking company should not be less than

seventy-five per cent of its time and demand liabilities in India at the clos of last Friday of

every quarter. 3. Dividend

For the purpose of dividend, Sec. 15 may be reproduced hereunder : (1) No banking

company shall pay any dividend on its shares until a its capitalized expenses (including

preliminary expenses, organization expenses, share-selling commission, brokerage, amounts

of losses incum and any other item of expenditure not represented by tangible assets) ha\ -

been completely written-off.

(2) Notwithstanding anything to the contrary contained in Sub-Sec. (1) or in the

Companies Act, 1956, a banking company may pay dividends on its shares without writing

off :

(i) The depreciation, if any, in the value of its investments in approved Securities in

any case where such depreciation has not actually been capitalized or otherwise accounted for

as a loss;

(ii) The depreciation, if any, in the value of its investments in Shares, Debentures or

Bonds (other than approved Securities) in any case where adequate provision for such

depreciation has been made to the satisfaction of the auditor of the banking company.

(iii) The bad debts, if any, in any case where adequate provision for such debts has

been made to the satisfaction of the auditor of the banking company.

As stated earlier, a Statutory Reserve Fund is required to be created out of the profits

before the declaration of any dividend. These provisions are also applicable to nationaksed

banks and regional rural banks. [Sec. 17)

4. Annual Accounts

According to Sec. 29, a banking company incorporated in India is required to prepare

at the end of each Calendar Year a Balance Sheet and Profit and Loss Account as on the last

working day of the year in respect of all business transacted by it (every banking company

incorporated outside India, in respect of all its business transacted in India) in the forms as

prescribed in the Third Schedule of the Act or as near thereto as circumstances permit.

Provided that in the case of a banking company incorporated outside India, the profit

and loss account may be prepared as on a date not earlier than two months before the last

working day of the year.

340

The Balance Sheet and Profit and Loss Account in case of a banking company

incorporated in India must be signed by the Manager or the Principal Officer of the company

and when there are more than three Directors of the company, by at least three of those

Directors or by all the Directors if there are not more than three Directors, and in case of a

banking company incorporated outside India, by the Manager or Agent or the Principal

Officer of the company in India.

(A proforma of the Balance Sheet and the Profit and Loss Account as under the

Banking Companies Act, is given in Appendix 1.)

5. Audit

Section 30 of the Act is reproduced hereunder:

(1) The Balance Sheet and Profit and Loss Account prepared in accordance with Sec.

29 shall be audited :

(a) in the case of a bankfng company incorporated in India, by a person duly qualified

under any law for the time being in force to be an audftor of companies.

(b) fn the case of a banking company incorporated outside India, either by such an

auditor as aforesaid, or by a person duly qualified to be an audftor under the law of the

country in which the company is incorporated.

(1-A) Notwithstandfng anything contained in any law for the time being in force or in

any contract to the contrary every banking company shall, before appointing or re-appointing

or removing any auditor obtain the previous approval of the Reserve Bank.

(1-B) Without prejudice to anything contained in the Companies Act, 1956, or any

other law for the time being in force, where the Reserve Bank is of the opinion that it is

necessary in the public interest or in the interests of the banking company to audit the

accounts of the banking company in relation to any transaction or class of transactions

specified in the order and the auditor shall comply with such directors and make a report of

such audit to the Reserve Bank and forward a copy thereof to the company

(1-C) The expenses, or incidental to, the audit of the transactions or class of

transactions specified in the order made by the Reserve Bank shall be borne by banking

company.

(2) The auditor shall have the powers of, exercise the functions vested in and

discharge the duties and be subject to the liabilities and penalties imposed on, auditors of

companies by Sec. 227 of Companies Act, 1956.

6. Branch Office Audit

341

Under Sec. 5(cc) of the Banking Regulation Act, 1949, 'Branch' or 'Branch Office' in

relation to a banking company means any Branch or Branch Office, whether called a Pay

Office or Sub-pay Office or by any other name, at which deposits are received, cheques

cashed or money lent, and for the purposes of Sec. 35, includes any place of business where

any othe; form of business referred to in Sub-Sec. (1) of Sec. 6 is transacted.

Appointment of Branch Auditor

The following can be appointed as Branch Auditor to audit the accounts of a branch

of a bank :

(i) The Statutory Auditor of the Bank;

(ii) Any person who is qualified to be appointed as auditor of the Bank:

(iii) In the case of a Branch in the Foreign Country :

(a) Any person as in (i) and (ii) above, or

(b) Any person who is qualified for appointment as an auditor o: a bank according to

the laws of that country.

If it is decided by the company to appoint any person other than the company's auditor

to audit the accounts of the Branch Office, the appointment shall be made at the General

Meeting of the Shareholders However, the meeting may authorize the Board of Directors to

make the appointment. In both the cases, the person so appointed should be a qualified

auditor. Even if the Board makes the appointment, it shall be made in consultation with the

company's auditor.

Rights and Duties of Branch Auditor

The Branch Auditor shall have the same rights and duties as th< Statutory Auditor of

the bank.

The report shall be prepared on the same lines as laid down in Sec 227 of the

Companies Act and Sec. 30 of the Banking Regulations Act 1949. The Branch Auditor shall

send his report to the Statutory Auditor the bank and not to the shareholders.

Auditor's Duty

The following important points should be noted by the auditor in the audit of accounts

of a banking company. General

He should, first of all, confirm that his appointment is in order. He should see that

Annual Accounts of the banking company have been prepared in proper form.

He should examine the system of internal check and control and ascertain whether

such a system is adequate or not. Generally, banks have a separate audit department for the

examination of day-to-day transactions. The efficacy of such a system should be examined.

342

He should visit the bank on the last working day of the year to count the cash himself.

If the money has been kept with the Reserve Bank of India or any other bank, he should

obtain a certificate confirming the deposit.

He should specially check the receipt of drafts, cheques, etc., on the last working day

which has not been entered in the books.

He should verify investments and incomes therefrom. It should be seen that such

investments have been properly valued. He should vouch the interest on loans and advances

and ensure that irrecoverable interest is adequately provided for. He should verify bills

discounted and also discount received in respect of such bills. It is to be ascertained that the

rebate on bills discounted and unmatured bills has been carried forward. Sometimes, a

banking company gets a commission from its customers for services rendered to them. If so,

such a commission received should be vouched by proper vouchers. He should verify the

Securities deposited with bank for safe custody purposes and see that income in respect

thereof has been properly accounted for. Expenditure

11. He should see that capital expenditure has been properly dealt with in the books

and proper distinction has been made between capital and revenue.

12. He should check the balance of Current Account, Fixed Deposit and Savings Bank

Ledgers with the schedules obtained from the client and ascertain that all interest outstanding

on deposits has been provided for.

Miscellaneous

13. All assets and liabilities should be verified and it should be seen that adequate

provision has been made for doubtful and bad debts. He should specially check the

overdrafts, etc.

14. He should examine the Branch Returns and ensure that they are being properly

incorporated in the Head Office books.

15. He should go through the details of Secret Reserves, if any, maintained and see

that their purpose is genuine.

16. He should ascertain the adequacy of Securities in respect of loans and advances in

both cases, fully secured and partly secured.

17. He should ensure that 20% of profits before paying dividend is transferred to the

Reserve Fund as required under the Act.

18. He should see that the provisions of Sec. 11-20 (stated earlier) of the Banking

Regulation Act have been fully complied with.

343

Specimen of Auditor's Report

We have audited the attached Balance Sheet of the Central Bank Executor and

Trustee Company, Limited, as at 31st December, 2001, and also the Profit and Loss Account

for the year ended upon that date annexed thereto and report that :

(a) We have obtained all the information and explanations which to the best of our

knowledge and belief were necessary for the purposes of our audit:

(b) In our opinion, proper books of accounts as required by law have been kept by the

Company so far as appears from our examination of the books;

(c) The Balance Sheet and Profit and Loss Account under report are in agreement

with the books of account;

(d) In our opinion and to the best of our information and according to the explanations

given to us, the said accounts with the note thereon give the information required by the

Companies Act, 1956. in the manner so required and give a true and fair view :

(i) In the case of the Balance Sheet, of the State of the company's affairs as at 31 st

December, 2001, and

(ii) In the case of Profit and Loss Account, of the profit for the year ended on that

date. Mumbai, ..................... 24th March, 2002 Chartered Accountants

Audit of Nationalised Banks

The nationalised banks are governed by the provisions of the Bankn._ Companies

(Acquisition and Transfer of Undertakings) Act, 1970 which provided for the nationalisation

of fourteen major banking companies. A similar Act was passed in 1980 which provided for

the nationalisation c another six banking companies. Many provisions of the Bankin,

Regulations Act also apply to the nationalised banks.

Some of the important provisions of 1970 Act are given hereunder :

(1) Section 3(4) of the Banking Companies (Acquisition and Transfer Undertakings),

Act, 1970 provides that each nationalised bank shall be body corporate with perpetual

succession and a common seal and shal sue and be sued in its name. It is also provided that

each such bank shal carry on and transact the business of banking as defined in section 5(b) c:

the Banking Regulation Act and may engage in one or more forms business specified of

section 6(1) of the Act.

(2) According to section 10 of the Banking Companies (Acquisition ar. Transfer of

Undertakings) Act, each nationalised bank is required to clo-its books of accounts on

December 31 each year with the previous approv of the Reserve Bank. The auditor of the

bank shall be appointed by the Board of Directors with the prior approval of the Reserve

344

Bank of India. The remuneration of such auditor will be fixed by the Reserve Bank of India

in consultation with the Central Government.

(3) Under Section 10(3) of the 1970 Act, every auditor should be supplied with a copy

of the annual balance sheet and profit and loss account and a list of all books kept by the

nationalised bank. The auditor should examine the financial statements with the accounts and

vouchers relating thereto. In the performance of his duties, an auditor will have all those

powers and rights which are laid down in this regard in the Companies Act, 1956. He shall

have, at all reasonable times, access to the books, accounts and other documents of the

nationalised bank, and may, at the expense of the nationalised bank, employ accountants or

other persons to assist him in investigating such accounts and examine any officer of the

nationalised bank.

According to Sec. 10(1) of the Banking Companies (Acquisition and Transfer of

Undertaking) Act, 1970, the audit of banks would be conducted in the manner given, in short,

below :

1. The appointment of an auditor would be made with the prior approval of the Reserve

Bank of India.

2. The remuneration of an auditor would be determined by the Reserve Bank with the

advice of the Central Government.

3. The qualifications of such an auditor would be the same as have been laid down in

Sec. 226 of the Companies Act, 1956.

4.. Such an auditor would have the following rights :

(i) to appoint accountants for his help at the expense of the bank;

(ii) to examine all the books, accounts and other documents of the bank; and

(iii) to examine custodians, officials or employees of the bank in the matter of

accounts.

5. The auditor would submit his report to the Central Government and send one copy

each to the Reserve Bank and the bank. The report would cover the following points :

(i) In his opinion, the Balance Sheet of the bank is full and fair and gives a true and

fair view of the state of the bank's affairs;

(ii) He has obtained all the information and explanations necessary for his work and

they are satisfactory;

(iii) The transactions affected by the bank are within its powers;

(iv) The Returns received from the branches of the bank are adequate for the audit

work;

345

(v) The Profit and Loss Account exhibits a correct balance of profit or loss; and

(vi) Any other important matter which the auditor wants to bring to the knowledge of

the Central Government.

The Central Government shall cause every auditor's report and report on the working

and activities of such bank to be laid for not less than 30 days before each House of

Parliament as soon as may be after each such report is received by the Central Government.

2. EDUCATIONAL INSTITUTIONS (Schools, Colleges or Universities)

General

1. The Charters, Trust Deeds, University Act, etc., containing Rules and Regulations

should be examined and those Rules which relate to accounts in particular should be

taken note of in detail.

2. The auditor should inspect the Minutes of the Board of Management to ascertain from

them any resolution specially passed in respect of accounts. He should confirm how

far such resolutions have been complied with.

3. He should examine the internal check system and ensure how far it is satisfactory.

Income

The sources of income of an educational institution are fees from students, grants

from the Government or the local authorities, subscriptions and donations, income

from investments, etc. The auditor should note the following points :

4. He should check the cash receipts on account^of fees by reference to the counterfoils

of the Fee Receipt Books used and, if necessary, the Students' Register should also be

inspected. For free studentship, he should see that it is duly authorized by a

responsible officer.

5. Admission Fee or Examination Fee received ordinarily once a year should be vouched

by reference to the proper documentary evidence. He should ensure that all such fees

have been properly recorded in the relevant books and registers.

6. If there is a part of fees which is totally recoverable, he should see that it is written-off

by the person duly authorized for it. If he comes across something unfair, he should

make the fact known to the Committee of Management.

7. He should see that the fees unpaid for a part of the academic year but exempted to that

extent have been properly accounted for or adjusted.

8 It should be seen that the fees paid in advance have been duly carried forward and

adjusted in the accounts subsequently.

346

9. He should vouch the Grant received from the Government or a local body with the

help of correspondence or any other documentary evidence.

10. Receipts from donations and subscriptions, etc., should be verified with the

Statements in the Annual Report. Such receipts should be checked with the

counterfoils of receipts issued in this respect. The Cash Book should also be checked.

The auditor should ascertain that such receipts are being utilized for purposes for

which they have actually been received.

11. If the institution has some landed property, endowments and securities, etc., the

income therefrom should be verified by reference to proper vouchers. Investments

may be vouched by reference to the Bank's Certificate.

12. Any other income should similarly be vouched with the help of proper vouchers.

Expenditure

13. The auditor should vouch all items of capital expenditure and ensure that such an

expenditure is duly sanctioned. In case of some abnormal expenditure, its checking

should be done very carefully. He should confirm that distinction between capital and

revenue has been clearly made.

14. Sanction of increases in the salary of the staff should be checked by reference to the

Minutes of the Committee of Management.

15. He should examine the internal check system with regard to the purchases of

materials, etc., for the boarders, proper control has to be exercised on the purchase,

issue and preservation of such provisions.

16. He should verify the stock of provisions, furniture, stationery, etc., and see that it is

properly preserved.

17. He should confirm that an adequate reserve is being maintained for contingencies.

18. He should ascertain that all outstanding assets and liabilities have been taken into

account.

Miscellaneous

19. He should further see that the provident fund money of the staff is being regularly

invested outside in proper securities. Such fund is to appear separately on the

liabilities side and investment on the assets side of the Balance Sheet.

20. He should see that all taxes which are deducted at source are properly refunded.

Educational institutions are not subject to Income-tax payment.

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3. EMPLOYEES' PROVIDENT FUND

The Provident Fund is a matter of concern for all employees engaged in different

capacities and in different enterprises. Some relevant points in regard to audit of Employees'

Provident Fund are given below : General

1. The auditor should first of all examine the Provident Fund Rules to ensure that the

transactions regarding Fund have been within the powers of the trustees and

accordingly, accounts have been prepared.

2. It should be seen that monthly deductions in regard to wages and salaries have been

made correctly and as per rules in force in the unit from time to time. The amounts so

deducted have been deposited in the Scheduled Bank pending investment.

3. The employees' contribution and also the contribution of the unit or company have

been credited to their accounts properly.

4. If the employees have taken loans from their Provident Fund Accounts, it is to be

ensured that such loans have been repaid within the time-limit fixed and loans of

retiring employees have been deducted before the amount of Fund has been paid to

them.

5. It should be seen that each year a statement is invariably prepared and sent to every

member of the Fund showing the contribution made by the employee, the contribution

of the employer, the interest credited and the balance standing to his credit at the end

of the year. Such a balance should be confirmed by the members and in case of

dispute, proper investigations should be made into the reasons therefor.

6. The auditor should examine the minutes of the meetings of the

Governing/Management bodies and check that the decisions are in accordance with

rules and are also put into effect properly.

Regarding Investment

7. The auditor should vouch the purchase of investments which should always be in

approved securities.

8. If some of such investments have been sold to meet the large claims, their sale should

be vouched with reference to the authority for sale and the broker's sold notes. It is to

be seen that the profit or loss on such sales is correctly arrived at and treated as such

in the books of account.

9. The interest on investments should be properly accounted for proper adjustment

should also be made for the outstanding interest or investments correctly.

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10. It should be ensured that the amount of interest has been properly credited to the

members' accounts and such amounts have been actually earned.

Miscellaneous

11. If necessary, the personal files of employees should be referred to and matters under

doubt be made to explain by the authorities.

12. The lapses and forfeiture on account of resignations or dismissals of employees

should be verified by the auditor and it should be ensured that their amounts have

been correctly settled according to rules.

13. There should be a proper reconciliation of the total of the balances of members' ledger

with the control account which is maintained in general ledger.

14. The auditor should vouch the payment of the amount of the Fund to the retired

employees and ensure that such payments have been in time and are correct and

admissible under the Rules.

4. CO-OPERATIVE SOCIETIES

A co-operative society is framed under the provisions of the Co-operative Societies

Act, 1912, and hence, its accounts are prepared under the Rules and Regulations laid down

for the purpose. The auditor of such a society is appointed by the Registrar of Co-operative

Societies. He conducts the audit on behalf of the Registrar and also submits his report to the

Registrar. The fees of the auditor are paid by the society as per the status of the society.

Sometimes the fees are determined on the basis of the turnover or business which the society

transacts.

Formerly, books and records were maintained by a society as prescribed by the

Central Co-operative Societies Act of 1922 but now they are governed by the State Co-

operative Societies Act, 1912 and State Legislations have provided for the maintenance of

books and accounts as on the lines stipulated under section 209 of the Companies Act, 1956.

However, much depends upon the size, nature and business transacted by a particular society

in this regard. No specific formula can be laid down in this respect. It is also laid down that a

member cannot hold more than 10 per cent of the share capital of the Society.

The following points may be noted in the audit of the Co-operative Society : General

1. The auditor should go through the rules and regulations of the Society and see how far

they are being followed by it.

2. He should examine the capital structure of the Society and find out the number of its

members and also their shareholdings. He should inspect the Minutes of the Members.

3. He should also examine the internal check system in operation in the society.

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Income

4. He should vouch the receipt of cash on account of share capital with the Register of

the Shareholders and also on account of deposits with the Cash Book and counterfoils

of receipts issued. If it is a Consumers' Society, its sales should be vouched with the

summaries and Sales Account.

5. He should vouch the receipt of interest and return of loans from the borrowers. Proper

records must always be maintained for this purpose. Expenditure

6. He should vouch the loans granted to the borrowers by reference to the agreements.

7. Other management and establishment expenses should also be checked by him.

Miscellaneous

8. A Co-operative Society pays dividend to its members as per the rules and regulations.

It should be ascertained as to how such a dividend is calculated and is recorded in the

books. The rate should not exceed 6V2%.

9. He should verify the assets and see that the stock is properly valued.

10. He should specially verify the cash in hand and investments of such a society.

11. He should note that 25 per cent of the profit is transferred to the Reserve Fund and 10

per cent is carried to Welfare Fund.

12. He should ensure that the accounts of such a society are prepared in accordance with

the provisions of the Co-operative Societies Act, 1912.

350

INVESTIGATION

Meaning

Investigation is an examination of accounts and records of a business concern with

some special purpose in view. In most of the cases the purpose of such an enquiry is to know

as actually as possible the financial position of the concern so that an opinion can be formed

and action taken accordingly. Thus, it is a sort of special audit with a particular object in

view. It is actually conducted in addition to the regular audit of accounts and is, thus, a

scrutiny of accounts pertaining to several years whereas an audit relates only to a particular

period, more specially a financial year. This is the major point of difference between the

two.1 But it has to be remembered that the investigation of accounts of a joint-stock company

is not legally compulsory as is the case with audit.

Thus, there is another major point of difference between the two. An auditor performs

audit as a matter of routine at some regular interval but an investigator has to be more

searching and inquisitive in his enquiry, even though there are no suspicious circumstances

during the course of his work. Nevertheless, the objects are different in each case.

Taylor and Perry have rightly defined investigation as given below :

"Investigation involves inquiry into facts behind the books and accounts, into the

technical, financial and economic position of the business or organisation."

Essentials for Investigation

An investigator should keep the following points in view during the course of

investigation:

1. He should keep himself free from the influence of Directors and Managers of the

business.

2. He should familiarise himself with all the important details about a business before

the commencement of his work.

3. If necessary, he should seek the assistance of technical experts during the course of

his enquiry.

4. He should confine to himself the purpose of investigation and keep details in regard

thereto quite secret.

l Difference between 'Investigation' and Auditing' has been given in Chapter 1 of this

book.

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Scope of Investigation

The scope of investigation is quite different from that of audit. Much depends upon

the terms of investigation. Thus, its scope may be more extensive or limited depending upon

the circumstances of the case. The enquiry under investigation may go beyond the books of

accounts of a business concern. It may cover matters of technical and financial nature. An

auditor through investigation tries to establish a relationship between the causes and the

findings. Thus, investigation means an enquiry into the details so that actual facts can be

analysed with causes.

When an investigator is appointed by his client, he should obtain in writing all the

necessary instructions from him so as to decide for himself the scope of work to be performed

in pursuance of a special object. If any limitations are placed on his work, he should obtain

them in writing so that he may exactly determine the scope and nature of his duties.

Objects of Investigation

Investigation of accounts of a business will be advisable under the following

circumstances :

1. When a person intends to purchase a business.

2. When a new company wishes to purchase a running business or firm.

3. When a person desires to enter into a partnership firm as a new partner.

4. When a person wishes to lend money to a business and wants to know its financial

position.

5. When a person seeks avenues of investments.

6. When a person wishes to make a valuation of shares of a limited company.

7. When the proprietor of a business suspects fraud.

8. When it is suspected that the affairs of the company are not being properly managed

[le., Statutory Investigation).

1. When a Person intends to Purchase Business

A person, when he intends to purchase a business, wants to know whether the

business is worth buying or not. If so, he has to ascertain whether the amount of purchase

consideration payable is just and proper. For this, the investigator should go through the

Balance Sheets and the Profit and Loss Accounts for several years and make a searching

enquiry to confirm that the results disclosed by these accounts are genuine and fair. Actually,

he is interested in ascertaining whether the proposal in hand will yield expected results in the

352

form of profits in the years to come. An investigator should note the following points

carefully :

(a) Earning Capacity. The investigator in such a situation should try to assess the

financial position and ensure the position of assets and liabilities as shown in the Balance

Sheet. The earning capacity of a business can exactly be located by going deeply into the

results disclosed by the Profit and Loss Account.

The trend of profits earned during the past years should be enquired into. He should

calculate the percentage of gross profits and other expenses to turnover and redraft the Profit

and Loss Account in a tabular form. If there are any new changes, he should note them

carefully. It has to be seen that an appreciation of profits is not the result of a sort of window-

dressing but it is actual. Profit can be inflated as a result of inflation of sales, suppression of

purchases, omission of expenses or capitalization of revenue expenditure, less or no provision

for depreciation or bad debts, etc., over-valuation of stock or addition of fictitious items of

income. He should carefully go through all these details and ensure that capital profits are

distinctly dealt with and are not mixed with the revenue profits. Such a procedure can bring

to light the real earning capacity of the business which is being purchased.

(b) Financial Stability. Next, he should go through the details about assets and

liabilities as shown in the Balance Sheet. He should ascertain that the assets have been

properly valued and depreciation has been adequately provided for. Similarly, the liabilities,

position is also real and not artificial. These are the simple things which an investigator

should keep in mind.

He should confirm that the working capital is adequate. It is to be ensured that there is

not much gap between the paid-up capital and Block Account. The position of availability of

working capital has to be thoroughly enquired into.

(c) Goodwill. He should enquire into the method of valuation of goodwill. The bases

of valuation of goodwill may be either past profits or turnover. The price demanded by the

vendor for goodwill should be verified with reference to the trend of past profits and other

factors, e.g., its dependence upon the personality and relations of the proprietor, etc. It has to

be remembered that if the basis of calculation is the past profit, necessary adjustments for

extraordinary profits or losses, capital profits or losses and similar items will have to be

made. If, on the other hand, the goodwill is calculated on the basis of turnover, it should be

carefully scrutinized. If goodwill is attached to a particular place where the business is being

carried on, it should be seen how far the change in proprietorship will affect it favourably or

adversely.

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(d) General Considerations. The investigator should also pay attention to the

following factors :

(i) It should be enquired into whether the business enjoys State protection. If so, how

long will it continue? This is important as the expansion and further improvement in the

affairs of a business depend to a large extent on the protection granted by the Government.

(ii) Another point to be considered is the term of credit given and received. It is true

that the term of credit affects the volume of working capital and also the amount of goodwill.

(iii) It is to be seen how far the success of the business is dependent upon the qualities

and character of the vendor. It is to be confirmed whether the business will enjoy similar

benefits or extra gain under the new proprietorship.

(iv) Next, he should examine the possibilities of competition. This may be ascertained

by reference to the terms of sale imposing any restrictions on the vendor to start another

business in competition.

(v) He should also enquire into the nature of customers. It should be seen if change in

the proprietorship is to affect adversely their attitude.

(vi) The attitude of employees is another important factor to be taken into account.

The investigator should ensure whether they would like to continue in employment when

there is change in the ownership.

(vii) The closing stock should be properly verified. This is an important item to be

judiciously examined.

The investigator should submit his report to the client in clear terms indicating therein

the period covered. It is expected from him that he will disclose all matters which are likely

to affect the future of the business to be purchased.

2. When a New Company wishes to Purchase a Running Business Concern

A newly incorporated company, wishing to purchase a running firm, intends to get its

accounts investigated because it desires to appraise the prospective shareholders of its real

position. An investigator so appointed should take into account the following points:

(i) The Profit and Loss Account pertaining to previous years should be redrafted in a

tabular form and each item therein should be compared on the basis of the calculated

percentage. He should ensure that the profits have not been inflated as a result of some

manipulation in the accounting records.

(ii) He should throw light on all the matters about the business which may influence

the earning capacity of the business in future.

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(iii) Correct profits should be arrived at. Even if correct profits are calculated, it

would be necessary to make certain adjustments in their figure in order to arrive at the profits

which the purchaser will be in a position to earn after the business has been actually

purchased.

(i) Items to be Added to the Profits of the Vendors

1. Interest on Partners' Capital and Current Accounts;

2. Capital Losses;

3. Rent of the land not owned by the vendor for which he was paying rent regularly;

4. Interest on loans, bank overdrafts, etc.;

5. Capital expenditure treated as revenue expenditure;

6. Excessive provision for depreciation or reserve for bad debts;

7. Exceptional losses;

8. Discount on purchases, etc.

(ii) Items to be Deducted from the Profits

1. Capital Profit;

2. Profits not earned in the ordinary course of business;

3. Expenditure, if any, to be incurred after the purchase;

4. Interest from investments not to be taken over by the purchasing company;

5. Exceptional profits;

6. Interest on Partners' drawings credited to the Profit and Loss Account by the Vendor,

etc. The investigator should submit his report in clear and unambiguous terms so that

it may reveal the true picture of the business purchased. He should be very careful in

this matter. Nevertheless, he must not express any opinion about the future earning

capacity of the business.

3. When a Person Desires to Enter into a Partnership Firm as a New Partner

The Investigator will, first of all, like to know in detail the true state of affairs of the

firm and the prospects for profits in future. He should proceed in a manner similar to that

which he could have adopted if his client would have been an intending purchaser. He should

take the following points into consideration :

1. He should enquire about the reasons as to why a new Partner is being taken in by the

existing Partner.

2. If the New Partner is taking the place of a deceased or retiring Partner, he should

ascertain whether the firm will be put to some loss by the absence of such a Partner. It

355

should also be seen if the loss so caused will be made good by the availability of skill

and experience of the new Partner.

3. He should locate the use to which the capital to be introduced by the new Partner will

be put. Such a capital may be utilized for paying off any liability or paying back the

capital balance of the retiring or deceased partner or for providing additional working

capital. In the latter case, it should be .seen whether this amount of capital will be

sufficient for the purposeful expansion of the business.

4. He should compare the capital of different Partners with their proportion of shares in

the profit or loss of the firm.

5. He should have a thorough peep into the financial position of the business. If it is

under heavy financial strain, it should be carefully diagnosed whether such a situation

will adversely affect the interests of the new partner.

6. He should study the Balance Sheet to ensure that assets and liabilities have been

correctly shown therein.

7. He should make a careful scrutiny of the Partnership Deed, specially the clauses

which are connected with the entry of the new partner.

8. He should carefully enquire whether the amount of goodwill to be paid by his client is

a reasonable one. Ordinarily, a new partner is asked to bring in a specific amount of

goodwill. It has to be seen as to how this amount is to be shared by the existing

partners.

9. He should pay special attention to the earning capacity of the business so that he may

be in a position to make an idea of the future prospects of the business.

10. He should enquire whether any specialized technical knowledge is necessary for the

successful conduct of the business, and, if so, how far the new partner will be in a

position to fill up the gap.

He should submit his report to his client and deal with all these matters freely and

clearly in his report.

4. When a Person Wishes to Lend Money to Business

When a banker is approached by its customer to advance a sum of money as loan, it is

quite natural that he should familiarize himself with the trend of the business. The attention of

the investigator should be directed towards the following points in such a case :

1. He should know about the nature and circumstances of the business to which the

money is to be lent and specially enquire about the skill, qualification and experience

of the managing personnel who are responsible for its management.

356

2. He should make a survey of the earning capacity and for this, he should redraft the

Profit and Loss Accounts of previous years in a tabular form.

3. He should go through the Balance Sheet of the business and study its financial

position. It should be seen whether adequate security can be made available if loan is

advanced to the business.

4. He should compare the amount of current liabilities with the liquid resources of the

business and specially note down the ratio between the two.

5. He should estimate the security and note if it has already a prior charge. If so, what is

the value of the charge?

6. It should be seen whether the liabilities are being paid off regularly and in time.

7. He should study the purpose of loan. If it is meant for expanding the business, he

should examine thoroughly the possibilities of expansion of the business.

8. He should enquire into the nature of the product manufactured by the business and

also the position of the stock of raw materials.

9. He should examine the investments of the business and ascertain income received

therefrom.

10. He should check the bills receivable and bills payable.

11. It should be enquired whether the loan has been sought from any other source and if

so, why has it been refused?

He should submit his report to his client giving therein all the details as stated above.

5. When a Person Seeks Avenues of Investments

The major point to be considered by the investigator is to know exactly the nature of

business in which he has to invest his money so that he may ascertain whether the investment

will be profitable or not. He should keep the following points in view:

1. If the investment is proposed to be made in a private concern or in a partnership firm,

the investigator should go through the terms of investment to ensure whether they are

favourable or not.

2. If he finds that some of the terms of investments are against hi? interest, he should

make a report to that effect to his client.

3. If the investment is proposed to be made by way of purchase o: shares or debentures

in a joint-stock company, he should examine the Memorandum and Articles of

Association with the object of determining the rights and liabilities of various classes

of shareholders.

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4. He should thoroughly examfne the Balance Sheets and Profit and Loss Accounts of

past years so as to be familfar wfth the earning capacity and financial position of the

business in which the investment fs proposed to be made.

5. He should try to determine the effective capital employed in the business and for this

purpose, he should ascertain the correctness of the valuation of assets after deducting

therefrom the existing liabflitfes.

6. Lastly, he should think of the proposed investment to be safe with the business and

report to his client accordingly.

6. When a Person Wishes to make a Valuation of Shares of a Limited Company

There are two bases of valuation of shares of a company :

(i) 'Assets' basis method, Le., the extent to which the share capital of a company is

represented by its tangible assets.

(ii) 'Yield' basis method, Le., the yield or return on capital in the form of dividends paid

by the company during the past years. Such a return can well be compared with the

return available on similar investments in the market.

Under the 'Assets' basis method, the total value of liabilities (including the prior

claims of other classes of shareholders) is deducted out of the total value of assets (including

goodwill). The net amount so derived is divided by the number of shares and the value of

each share can thus be ascertained.

Under the Yield' basis method, the valuation of each share is made on the basis of

returns avaflable for it in the company. The following example will make it clear :

Suppose, a company has : (i) 1,00,000 Equity Shares of Rs. 100 each, and (fi)

2,00,000, 3% Preference Shares of Rs. 100 each. If the average annual profits of the company

are Rs. 19,00,000, then the profits available for Equity Shareholders would be :

Rs. 19,00,000 10,00,000

Average Profit Less : Dividend payable to Preference Shareholders 9,00,000

If the average income from investments in other companies of similar nature is 6 per

cent according to the market quotations, the capftalized value of the Equity Shares at the rate

of 6 per cent will be : 9,00,000 x 100

The value of each share will be

1,50,00,000

= Rs. 1,50,00,000

or Rs. 150.

1,00,000 The investigator should then see :

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(1) The profit-earning capacity of the business during the past years and the change, if

any, to be affected in the future years (2) Dividend payable on preference shares.

(3) Reserves made for bad debts, discount, etc.

(4) Prospects of trade and trend of the money market.

He should proceed in the same way in which he has investigated the accounts on

behalf of a lender and submit his report accordingly to his

7. When the Proprietor of a Business Suspects Fraud

When a proprietor of a business suspects fraud, an investigator is appointed to

investigate into it. The investigator so appointed should go through the duties of the persons

suspected of fraud and the books of accounts dealt with by them.

The investigator should know at the very outset whether the fraud involves

misappropriation of cash or goods. Ordinarily, the defalcation of goods is the result of

collusion between two or more persons. He should examine the system of supplying and

receiving goods and check the sales thoroughly. He should also scrutinize the system of

purchases returns and sales returns. Besides, he should check the Debtors' Accounts, doubtful

debts, etc., very carefully.

If cash has been misappropriated, the investigator should note the following :

1. He should be familiar with the nature of business and of the fraud suspected.

2. He should check the Cash Book thoroughly. In doing so, he should take the following

steps :

(i) He should check up the balances and totals of the Cash Book carefully.

(ii) The balances of Cash Book should well be compared with those of the Bank Pass

Book.

(iii) The counterfoils of Pay-in-Slip Book should be compared with the Schedules

received from the Bank.

(iv) Cash sales should be checked by reference to the original contracts and documents.

(v) Items of expenditure should be verified.

(vi) Discount received or allowed should be vouched.

3. He should carefully examine the Purchases Book and Sales Book.

4. He should examine the Petty Cash Book.

After taking the steps stated above, he should submit the report to his client.

8. When it is Suspected that the Affairs of the Company are not being Properly

Managed (Le., Statutory Investigation)

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There is a provision for investigation in sections 235-251 of the Companies Act,

1956.

Under Section 235(1) and (2), the Central Government may, where a report has been

made by the Registrar under sub-section (6) of section 234. or under sub-section (7) of that

section, read with sub-section (6) thereof, appoint one or more competent persons as

inspectors to investigate the affairs of a company and to report thereon in such manner as the

Central Government may direct.

Where—(a) in the case of a company having a share capital, an application has been

received from not less than two hundred members or from members holding not less than

one-tenth of the total voting power therein, and (b) in the case of a company having no share

capital, an application has been received from not less than one-fifth of the persons on the

company's register of members.

The Company Law Board may, after giving the parties an opportunity of being heard,

by order declare that the affairs of the company ought to be investigated by an inspector or

inspectors, and on such a declaration being made, the Central Government shall appoint one

or more competent persons as inspectors to investigate the affairs of the company and to

report thereon in such manner as the Central Government may direct.

Under section 236, an application by members of a company under sub-section (2) of

section 235 shall be supported by such evidence as the Company Law Board may require for

the purpose of showing that the applicants have good reason for requiring the investigation;

and the Central Government may, before appointing an Inspector, require the applicants to

give security, for such amount not exceeding one thousand rupees as it may thing fit, for

payment of the costs of the investigation.

Under section 237, there is provision for investigation of a company's affairs in other

cases. The Central Government:

(a) shall appoint one or more persons as Inspectors to investigate the affairs of a company

and to report thereon in such a manner as the Central Governrnent may direct, if:

(i) the company, by special resolution, or

(ii) the Court, by order, declares that the affairs of the company ought to be investigated

by an Inspector appointed by the Central Government; and

(b) may do so, if, in the opinion of the Company Law Board, there are circumstances

suggesting :

(i) that the business of the company is being conducted with intent to defraud its

creditors, members or any other persons, or otherwise in a manner oppressive to any

360

of its members, or that the company was formed for any fraudulent or unlawful

purpose;

(ii) that persons concerned in the formation of the company or the management of the

affairs have in connection therewith been guilty of fraud, misfeasance or other

misconduct towards the company or towards any of the members; or

(iii) that the members of the company have not been given all the information with respect

to its affairs which they might reasonably expect, including information relating to the

calculation of the commission payable to a Managing or other Director, or the

Manager of the company.

It is provided in section 238 that no firm, body corporate or other association shall be

appointed as an Inspector under sections 236 or 237.

If an Inspector is appointed to investigate into the affairs of a company, he has powers

to carry Investigation into affairs of related companies etc., under section 239.

Under section 240, it shall be the duty of all officers and other employees and agents

of the company to preserve and to produce to an Inspector or any person authorised by him in

this behalf with the previous approval of the Central Government, all books and papers of, or

relating to, the company or, as the case may be, of or relating to the other body corporate,

which are in their custody or power and otherwise to give to the Inspector all assistance in

connection with the investigation which they are reasonably able to give.

Under section 241, the Inspector may, and, if so desired by the Central Government,

shall make interim reports to that Government and on the conclusion of the investigation,

shall make a final report to Central Government.

Any such report shall be written or printed, as the Central Government may direct.

The investigator in such a case should take note of the following points:

(i) It should be confirmed that the books of the company have been kept in accordance

with the provisions of the Companies Act, 1956.

(ii) It should be ascertained that the directors of the company are not making improper

use of the company's money directly or indirectly.

(iii) He should compare the profits of the company with those actually distributed amongst

shareholders by way of dividends.

(iv) He should examine carefully the share capital, investment, debentures, etc., and verify

the income received from the investments.

(v) He should ensure that the authorities of the company are not misusing or abusing the

powers conferred upon them by the company.

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(vi) He should compare and contrast the reserve fund with similar funds for the past years.

If secret reserve is created, its genuineness should be thoroughly enquired into.

(vii) He should specially check the capital and revenue expenditure and ensure that proper

allocation has been made between the two.

After making an exhaustive enquiry into the company's affairs, the investigator should

make a report to the Central Government with all the material facts at his disposal.

The Central Government shall forward a copy of the report other than an interim

report to the company at its registered office and to any other body corporate dealt with in the

report. The Central Government may furnish the copy on request and on payment of

prescribed fees to any person :

(a) who is a member of the company or other body corporate dealt with in the report, or

(b) whose interests as a creditor of the company or other body corporate appear to the

Central Government to be affected.

(c) shall, where the inspectors are appointed in pursuance of the provisions of sub-section

(2) of section 235, furnish, at the request of the applicants for the investigation, a copy

of the report to them.

(d) shall, where inspectors are appointed under section 237 in pursuance of an order of

the court, furnish a copy of the report to the Court;

(dd) shall, where the inspectors are appointed in pursuance of the provision of sub-section

(2) of section 235, furnish a copy of the report to the Company Law Board; and

(e) may also cause the report to be published.

Position of Investigator

The position of an investigating auditor has been made clear by the Court of Law in

the decisions given from time to time in various cases. Some of such cases have been quoted

below :

1. Colmer vs. Merrett, Son & Street (1914)

The case was decided by Mr. Justice Lush and a special Jury in the rung's Bench

Division on 15th January, 1914. The investigating accountant failed to discover the errors in

the books of account. As the stock statements were not correct, the investor suffered loss.

Brief Facts of the Case. The plaintiff, Engineer Colmer, asked the auditor, the

defendant to prepare the accounts of the company for the further period so that he could

ascertain the position of the company before making the investment. The auditor was given

only three days' time to prepare the accounts. The auditor did not undertake the complete

audit as they agreed that "an approximate statement of affairs would do." The statement so

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prepared revealed that the profit was made but afterwards, it was found that in both these

periods profit was not made at all.

Decision. "It was very unfortunate case from several point of view.

Negligence....meant in law breach of duty which one person owed to another who paid him to

render certain services by not bringing to bear that reasonable skill and care which a

professional man impliedly undertook that he would use.....It was very unfortunate that a

gentlemen who was going to invest a considerable sum in a business should have been

content with having the result of two or three days' work from the auditor authorized to

accept from Bradley his own view of what the stock was worth instead of having done with

full case."

A verdict was returned by the Jury in favour of plaintiff and damage for £ 250 was

assessed.

2. Short & Crompton vs. Brackett (1904)

In this case it was held by His Hon'ble Judge Tindal Atkinson on 6th May, 1904 that

the investigating accountant while making an investigation of accounts for incoming partner

is entitled to assume that the figures appearing in the books of the firm were correct.

Brief Facts of the Case. The plaintiff sent for the fees for having investigated the

books of the defendant firm in respect of the proposed admission of partner in the defendant

firm. It was later discovered that an employee of the firm defrauded the company or firm by

defalcation of wage sheets. It is noteworthy that a part of the fraud was made by an employee

during the period of investigation.

Decision. It was held that "having regard to the object for which they were employed,

the accountants were entitled to assume that the figures, appearing in the defendant's books as

having been paid out in wages, were correct, and in view of the fact that there was no

suspicion of anything wrong, the accountants could not be held negligent."

3. Regina vs. Wake & Stone (1954)

In this case, the auditor of the company was fined for carelessly inducing a person to

invest.

Brief Facts of the Case. The prospectus of the defendant company, Wake and Stone,

contained the figures for stock and work-in-progress which was duly certified by the auditor

of the company which was proved to be false, deceptive and misleading. The auditor

accepted the explanation of the managing director without further enquiry or investigation.

It was pleaded on behalf of the auditor that he relied on the statement given by the

managing director.

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Decision. It was held that both the managing director and auditor were guilty. The

managing director was sentenced to imprisonment and the auditor was asked to pay a fine of

£ 200 or in the alternative six months' imprisonment for having signed the report recklessly.

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TAX AUDIT

The financial statement prepared by a business enterprise are very useful for owners

of the organization. Besides them, there are other interested parties such as investors, bank

authority, creditors or suppliers, tax authority and labour representatives. It is, however, to be

noted that these statements may not fulfil the requirements of all the parties alike. As such,

the organisations are advised to prepare a special statement of accounts giving relevant

information and such a statement should be duly audited by professional accountants.

The Income Tax Act, 1961 for the purpose has made certain specific provisions under

sections 12A, 35D, 44AB, 80HH, 80HHA, 80HHB, 801, 142(2A) etc. and all these

provisions have become compulsorily applicable in our country since the assessment year

1985-86.

Tax Audit Defined

In every business enterprise, final accounts are prepared at the close of the financial

year for submission to the owners of the business. These final accounts exhibit a true and fair

view of the financial affairs of the business. Such accounts are audited by a professional

accountant who duly certifies them and submits them to the owners of business. But how to

determine tax payable is not possible unless the auditor examines them and submits to the

Income Tax authorities. Hence, it is established that in accordance with the provisions of the

Income Tax Act, 1961, the accounts are required to be audited by an auditor for

determination of tax payable by an individual assessee or organization. The process as such is

called tax audit.

Compulsory Tax Audit (Section 44AB)

Every person :

(a) carrying on business shall, if his total sales, turnover or gross receipts, as the case may

be, in business exceed or exceeds forty lakh rupees in any previous year, or

(b) carrying on profession shall, if his gross receipts in profession exceed ten lakh rupees

in any previous year, or

(c) carrying on the business shall, if the profits and gains from the business are deemed to

be the profits and gains of such person under section 44AD or section 44AE or

section 44AF, as the case may be, and he has claimed his income to be lower than the

profits or gains so deemed to be the profits and gains of his business, as the case may

be, in any previous year, get his accounts of such previous year audited by an

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accountant before the specific date and furnish by that date the report of such audit in

the prescribed form duly signed and verified by such accountant and setting forth such

particulars as may be prescribed.

Provided that this section shall not apply to the person, who derives income of the

nature referred to section 44B or section 44BB or section 44BBA or section 44BBB on and

from the 1st day of April, 1985 or, as the case may be, the date on which the relevant section

came into force, whichever is later.

Provided further that in a case where such person is required by or under any other

law to get his accounts audited, it shall be sufficient compliance with the provisions of this

section if such person gets the accounts of such business or profession audited under such law

before the specified date and furnishes by that date the report of the audit as required under

such other law and a further report by an accountant in the form prescribed under this section.

Explanation : For the purpose of this section :

(i) "accountant" shall have the same meaning as in the explanation below sub-section (2)

of section 288.

(ii) Specified Date : Specified date in relation to the accounts of the assessee of the

previous year relevant to an assessment year, means :

(a) where the assessee is a company, the 30th day of November of the assessment year;

(b) in any other case, the 31st day of October of the assessment year. Accountant

An accountant for the purpose of section 44AB as also for audit of specified

statements under sections 12A, 35D, 35E, 80HHB, 80HHC, 80HHD, 80HHE, 801, 80-IA,

80-IB and 142(2A) means a chartered accountant within the meaning of the Chartered

Accountants Act, 1949 and includes in relation to any state, any person who by virtue of the

provisions of sub-section (2) of Section 226 of the Companies Act, 1956 is entitled to be

appointed to act as an auditor of companies registered in that state.

Appointment of Tax Auditor

While a chartered accountant is covered by the definition, only a practising chartered

accountant can perform tax audit as required under section 7 of the Chartered Accountants

Act, 1949. But before accepting the assignment, the chartered accountant may communicate

with the auditor of the previous year as he has done similar work earlier.

For the purpose of tax audit and audit of statements for the purposes of reliefs and

deductions under the Income Tax Act, an accountant may be appointed by the management

of the organization or by the assessee himself. For a company, the Board of Directors or the

Chief Executive on behalf of the Board can appoint the tax auditor. Similarly, the owner of a

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sole trader or partners in a partnership firm or any person authorized by them can appoint the

auditor.

Definition of 'Business' and 'Profession'

According to section 2{13) of the Income Tax Act, a 'business' includes any trade,

commerce or manufacture or any adventure or concern in the nature of trade, commerce or

manufacture. Under Section 44AA (1) of the Income-tax Act, every person carrying on legal,

medical, engineering or architectural profession or the profession of accountancy or technical

consultancy or interior decoration or any other profession as is notified by the Board in the

official gazette shall keep and maintain such books of account and other documents as may

enable the Assessing Officer to compute his total income in accordance with the provisions of

this Act.

Under section 44AA(2), every person carrying on business or profession (not having a

profession referred to in sub-section (1) above], shall :

(i) if his income from business or profession exceeds one lakh twenty thousand rupees or

his total sales, turnover or gross receipts, as the case may be, in business or profession

exceed or exceeds ten lakh rupees in any one of the three years immediately preceding

the previous year; or

(ii) where the business or profession is newly set up in any previous year, if his income

from business or profession is likely to exceed one lakh twenty thousand rupees or his

total sales, turnover or gross receipts, as the case may be, in business or profession are

or is likely to exceed ten lakh rupees during such previous year; or

(iii) where the profits and gains from the business are deemed to be profits and gains of

the assessee under section 44AD or section 44AE or section 44AF, as the case may

be, and the assessee has claimed his income to be lower than the profits or gains so

deemed to be the profits and gains of his business as the case may be, during such

previous year; keep and maintain such books of account and other documents as may

enable the Assessing Officer to compute his total income in accordance with the

provisions of this Act.

Penalty

Under section 27 IB of the Income Tax Act, 1961, if any person fails to get his

accounts audited in respect of any previous year or years relevant to an assessment year or

furnish a report of such audit as required under section 44AB, the Assessing Officer may

direct that such person shall pay, by way of penalty, a sum equal to one-half per cent of the

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total sales, turnover or gross receipts, as the case may be, in business or of the gross receipts

in profession, in such previous year or years or a sum of Rs. 1,00,000, whichever is less.

Limits (Ceiling) on Acceptance of Tax Audits

The Institute of Chartered Accountants of India has prescribed the number of tax

audits which a chartered accountant can accept in a financial year. For an individual chartered

accountant, the number of tax audits that he can accept is thirty while a firm of chartered

accountants, such limit of 30 will be applicable per individual partner. For a partner in one

firm, if he is a partner in another such firm, the number of tax audits to be accepted by him

will not exceed thirty.

The assessee can be corporate or non-corporate. Besides this, the tax audit of the head

office and its branch or branches will be counted as one tax audit. If a tax audit is conducted

jointly by 2 or more firms, it will be counted as one tax audit in the case of such firm.

Tax Audit Report

According to Rule 6G of the Income Tax Rules, the report of audit of the accounts of

a person under section 44AB will be submitted in the proforma given at the end.

TAX AUDIT IN OTHER CASES

(1) Audit of Public Trusts

Section 12A of the Income-Tax Act, 1961 provides for tax audit of the accounts of

public trusts. Under sections 11 and 12 of the Act, certain items of income of public trust

have been exempted from calculating of taxable income of public trust. As per the provisions

of section 12A(b), if the total income of the trust or institution as computed under this Act

without giving effect to the provisions of section 11 and section 12 exceeds Rs. 50,000 in any

previous year, the accounts of trust or institution for that year should be audited by an

accountant and report be made in the prescribed form, duly signed and verified by him.

Under Rule 17B of the Income Tax Rules, 1962, the audit report is to be prepared in Form

No. 10B and a statement of particulars is to be annexed therewith.

(2) Audit for Claiming Deduction under Sections 35D and 35E

Section 35D of the Income-Tax Act, 1961 has provided for the conditions under

which some preliminary' expenditure was incurred for extension of an industrial undertaking

or in connection with the setting up of a new industrial unit. The assessee shall be allowed, in

connection with and subject to the provisions of this section, a deduction of an amount equal

to one-tenth of such expenditure for each of the ten successive previous years beginning with

the previous year in which the business commenced or, as the case may be, the previous year

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in which the extension of the industrial undertaking is completed or the new industrial unit

commenced production or operations.

Section 35E of this said act has stated the manner in which deductions will be allowed

for expenditure on any operations regarding prospecting for, or extraction or production of

any mineral or group of associated minerals listed in the seventh schedule of the Income Tax

Act.

The above two sections have prescribed that in case of assessees other than a

company or a cooperative society, the deductions are admissible only when the accounts are

audited by an accountant and the audit report is made in Form No. 3B according to Rule 6AB

and a statement of particulars annexed therewith.

(3) Deductions for Setting up Industries in Backward Areas

Under section 80HH of the Income Tax Act, a deduction is allowed to the assessee

from his total income, of a sum equal to 20% of the profits or gains derived from a new

industrial undertaking or hotel set up an run in a backward area. For the assessees other than

companies and cooperative societies, this deduction will be allowed only when accounts for

the previous year have been audited by an accountant and report of such audit is furnished by

the assessee.

Under Rule 18B of Income Tax Rules, the audit report shall be made in Form No.

IOC.

(4) Deduction being Claimed under Section 80HHB

As per section 80HHB of the Income Tax Act, 1961, if an Indian company or any

person resident in India derives profits and gains from projects outside India, a part of the

income is deductible from such profits and gains of an amount equal to :

(i) 40% thereof for an assessment year beginning on the 1st day of April, 2001;

(ii) 30% thereof for an assessment year beginning on the 1st day of April, 2002;

(iii) 20% thereof for an assessment year beginning on the 1st day of April, 2003.

(iv) 10% thereof for an assessment year beginning on the 1st day of April, 2004.

and no deduction will be allowed for an assessment year beginning on the 1st day of April,

2005 and any subsequent year. (The Finance Act, 2000 w.e.f. from 1-4-2000)

The certain conditions have been prescribed and are to be fulfilled for such a

deduction from the total income of the assessee.

As per rule 18BBA of the Income Tax Rules, the audit report after the accounts are

checked by an accountant, is to be made in Form No. 10CCA.

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The condition as to such audit will not apply in the case of a company or a

cooperative society because it is statutorily required to have its accounts audited otherwise.

(5) Audit under Section 80-1

As per provisions of section 80-1 of the Income Tax Act : Where the gross total

income of an assessee includes any profits and gains derived from an industrial undertaking

or a ship or the business of a hotel or the business of repairs to ocean-going vessels or other

powered craft to which this section applies, there shall in accordance with and subject to the

provisions of this section, be allowed in computing the total income of the assessee, a

deduction from such profits and gains of an amount equal to twenty per cent thereof.

Provided that in the case of an assessee, being a company, the provisions of this sub-

section shall have effect in relation to profits and gains derived from an industrial undertaking

or a ship or the business of a hotel as if for the words "twenty per cent", the words "twenty-

five per cent" had been substituted.

This exemption is allowed only when the accounts of the assessee for the previous

year have been audited by an accountant and report of such audit is furnished by the assessee.

The audit report, as per Rule 18BBB of the Income Tax Rules, should be prepared in Form

No. 10CCB.

(6) Audit under Section 80-IA

Deduction under section 80-IA is allowed to an assessee who derives profits and gains

from an eligible business Le. an industrial enterprise, cold storage, operation of a ship or

business of a hotel, and the business starts functioning after 31st March, 1991.

The deductions are :

(i) for an industrial undertaking—25% of the profits.

(ii) If undertaking is owned by a company, the rate is—30% of the profits.

The period is 10 years for availability of deductions.

For a cooperative society—the period is 12 years beginning from the previous year in

which the business starts functioning.

Besides this, a relevant condition for allowing deduction is that the accounts of such

undertaking should be audited by an "accountant" and the report be submitted in Form No.

10CCB as per Rule 18BBB.

(7) Selective Tax Audit [Sec. 142{2A)]

The provisions of 4 sub-sections Le. 2A, 2B, 2C and 2D of section 142 of the Income

Tax Act have been given hereunder :

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(2A) If, at any stage of the proceedings before him, the Assessment Officer, having

regard to the nature and complexity of the accounts of the assessee and the interests of the

revenue, is of the opinion that it is necessary so to do, he may, with the previous approval of

the Chief Commissioner or Commissioner direct the assessee to get the accounts audited by

an accountant, as defined in the Explanation below sub-section (2) of section 288, nominated

by the Chief Commissioner or Commissioner in this behalf and to furnish a report of such

audit in the prescribed form duly signed and verified by such accountant and setting forth

such particulars as may be prescribed and such other particulars as the assessment officer

may require.

(2B) The provisions of sub-section (2A) shall have effect notwithstanding that the

accounts of the assessee have been audited under any other law for the time being in force or

otherwise.

(2C) Every report under sub-section (2A) shall be furnished by the assessee to the

Assessing Officer within such period as may be specified by the Assessing Officer. Provided

that the Assessing Officer may, on an application made in this behalf by the assessee and for

any good and sufficient reason, extend the said period by such further period or periods as he

thinks fit, so, however, that the aggregate of the period originally fixed and the period or

periods so extended shall not, in any case, exceed one hundred and eighty days from the date

on which the direction under sub-section (2A) is received by the assessee.

(2D) The expenses of, and incidental to, any audit under sub-section (2A) (including

the remuneration of the accountant), shall be determined by the Chief Commissioner or

Commissioner which determination shall be final and paid by the assessee and in default of

such payments, shall be recoverable from the assessee in the manner provided in Chapter

XVII-D for the recovery of arrears of tax.

Then, what is the necessity of tax audit? It may be said that the audited financial

accounts may be of use and importance to many people outside the concern as well as to the

concern itself. It is true that Income-tax Authorities have to depend upon these audited

accounts to assess the amount of tax payable. But just to acquire the necessary information

relating to income-tax, such audited financial accounts will not serve the purpose. Hence, in

order to collect the information and justify its authenticity and to determine the amount of tax

payable by the assessee. the importance of re-examining the accounts already audited cannot

be denied.

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DEPRECIATION AND RESERVES

DEPRECIATION

"Depreciation may be defined as the measure of the exhaustion of the effective life of

an asset from any cause during a given period." —Spicer and Pegler

'Depreciation may be defined as a gradual deterioration in value due to use." —R. G.

Williams

"It is a matter of common knowledge that all fixed assets such as plant, machinery,

tools, buildings, leaseholds, furniture, etc., gradually diminish in value as they get older and

becomes worn out by constant use in the business." —J. R. Batliboi

"Depreciation represents the loss in value of the capital sunk in buildings, plant,

machinery and other equipments due to normal inevitable deterioration during the life of

these assets." —Harold J. Wheldon

"In practice, the term 'depreciation' is commonly used in a very wide sense, covering

diminution in the value of assets caused by outside fluctuations in realizable and replacement

value, and also the amortization in the cost of an asset over the period of its use." —De

Paula

"Depreciation is a reasonable allowance for the exhaustion, wear and tear of the

property used in the trade or business, including a reasonable allowance for obsolescence."

—U. S. Treasury Department, Bureau of Internal Revenue

Meaning of Depreciation

From the above definitions, it is evident that depreciation is the permanent and

continuous decrease in the value of an asset from any cause. It differs from fluctuation which

is a temporary increase or decrease in value. When a fixed asset is acquired for use in the

business, its working capacity or its earning is gradually reduced. It is a fall in the value of

the fixed asset. In other words, it is the estimated cost of the expired usefulness of the fixed

asset. It is, thus, a capital loss and must be provided for out of profits before they are actually

distributed. If this is not done the Profit and Loss Account and the Balance Sheet will reveal

misleading and incorrect results.

Causes of Depreciation

The causes of depreciation may normally be two : (1) Internal Causes, and (2)

External Causes.

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(1) Internal Causes. Those cause which relate to the nature of the asset itself may be

placed under this head. They are the following :

(i) Wear and Tear. Some assets, such as building, plant, machinery, motor, etc., decrease

in value by constant use to which they are put. Although they are kept in order by

providing for their repairs, the time comes when they are totally of no value.

(ii) Exhaustion. Assets like plantations, animals, etc., lose their value gradually with the

passage of time. They have their definite age, and exhaust in value and become

useless after the expiry of a certain fixed period.

(iii) Depletion. There are oil-wells, mines, etc., which lose their value if the oil or mineral

is extracted out of them. This is termed as 'Depreciation by Depletion'.

(iv) Deterioration. Normally, depreciation by deterioration is in case of those assets, e.g.,

food articles, etc., which have temporary or short life. Repairs make up the loss

caused by deterioration.

(2) External Causes. Those factors which arise from causes outside the assets are external

causes. They are the following:

(i) Effluxion of Time. Decrease in the value of assets, such as patents, leasehold property,

etc., is caused by the effluxion of time. An asset acquired on lease becomes valueless

after the expiry of the period of lease.

(ii) Obsolescence. Obsolescence is the loss in the value of an asset which arises out of

new inventions which can now produce goods better and cheaper. Since old machines

becomes out-of-date due to discovery of new machines and change of fashion, a

businessman has to purchase the latest models and sell the old ones and thus, suffer a

loss. Hence, obsolescence is totally an external factor which has no definite time of its

occurrence.

(iii) Accident. Some assets, such as works, machines, motors, furniture, etc., become

valueless due to an accident, like fire, flood or similar other havocs. These are

examples of depreciation by accident.

(iv) Permanent fall in the Market Value. Assets like investments lose their value by a

permanent fall in their market value. Actually, this is an example of permanent or

temporary loss in value due to market fluctuations.

Necessity of Depreciation

(1) Every asset is purchased in a business for use and its constant use causes depreciation

or decrease in its earning capacity. Such a decrease in value is like any other business

expense which must be debited to Profit and Loss Account. If it is not done, correct

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profits cannot be calculated and, secondly, when the asset will become a mere scrap,

it would be a heavy charge on the Profit and Loss Account if the whole of the loss,

Le., the entire cost of the asset is charged to the Profit and Loss Account of that year.

This is totally unfair, unjustified and against business principles.

(2) If provision is not made for depreciation for a particular asset, it will appear in the

Balance Sheet at an overhead figure, i.e., at a higher value than its real value. Thus,

the Balance Sheet will not exhibit the true and fair view of the state of affairs of the

business.

(3) The real motive pf providing for depreciation on a particular asset is to keep the

capital intact and show the correct value of the asset in the Balance Sheet. Hence, the

entire loss is distributed over a number of years for which the asset remains in use.

Example. Suppose, the expenses of the goods manufactured are: Rs.

1. Raw Materials used 500

2. Wages 100

3. Indirect Expenses 50

Cost Rs. 650

Also, suppose machinery worth Rs. 1,000 has been acquired to manufacture those

goods which are consumed in the process of manufacture and scrap value is Rs. 200

only. Thus, the net cost of the machinery, le., Rs. 1,000 - 200 = Rs. 800 will also be

included in the cost of goods manufactured which will now be Rs. 1,450 and not Rs.

650 only.

(4) Another purpose behind providing for depreciation for an asset is to make a certain

sum available at a time when that asset becomes totally valueless for its replacement.

(5) If depreciation is not provided for, the asset will be shown at an over-valued figure

and profits would be higher than the actual ones. If so, dividend will be paid out of

capital and thus, a part of the capital will be returned to the shareholders.

Bases of Depreciation

There are some reasonable, accurate and widely accepted principles on the basis of

which the amount of depreciation should be charged to the Profit and Loss Account every

year. They are as given below :

(1) Original Cost of the Asset. The books of accounts can reveal facts about the original

cost of the asset. If the business has been purchased from the vendors, the price at

which it has been acquired should be enquired into. This is a simple affair to know

about its cost.

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(2) Estimated Working Life. It is rather a technical question to estimate the working life

of an asset. The assets differ in their nature and character and the exhaustion in their

value also depends upon their use in business. Some businesses employ experts to

assess the probable life for which an asset will remain in use and in proper working

order. However, much will depend upon the conditions under which an asset

maintained and preserved. Thus, the working life of an asset is carefully to be

considered.

(3) Provision for Repairs and Renewals. As already stated, proper provision for repairs

will help in maintaining an asset in good order. Given proper attention, as asset can

work well for the stipulated period otherwise it will become useless after a few years.

This has to be considered before depreciation is provided for.

(4) Capital Expenditure. This is another vital issue to be considered. Throughout the life

of an asset, additions and extensions are made whenever necessary and thus

improvements are affected in a way that the asset maintains its earning capacity as

normal as it could be. Such an expenditure is of capital nature and if it is incurred in

large amounts, the working life can be extended and accordingly, depreciation will

have to be provided for.

(5) Loss of Interest on Capital Investment. This is another consideration. The capital

involved in purchasing an asset would have been invested elsewhere and interest

could be earned. Since a part of capital is blocked in a particular asset, the loss of

interest on that account must be taken into account before depreciation is provided

for.

(6) Residual or Scrap Value. The value which an asset will bring when it is sold as scrap

should also be considered before making provision for depreciation.

(7) Depreciation in Case of Obsolescence. This is yet another factor to be considered. If

an asset is likely to be of no value due to some new inventions, more amount of

depreciation should be provided for. The possibility of new developments and

inventions is a factor which should be given due weight before making provision for

depreciation. New inventions make assets valueless.

(8) Provision for Depreciation in Previous Years. If excessive provision has been made

for depreciation in previous years, a business may not provide a huge amount for

depreciation during the current year. This is also to be considered.

(9) Legal Provision or any Change therein. If there is some legal provision for providing

depreciation on assets or there has been some amendment to change in the existing

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law in this regard, the effect of such an arrangement should be fully considered. It

should be seen whether the legal provisions have been complied with. The provisions

of the Companies Act in regard to depreciation, etc., have been discussed in a separate

chapter of this book.

Methods of Providing for Depreciation

Different methods may be adopted and applied to provide for depreciation of different

types of assets but it is to be remembered that once a method has been finally decided and

adopted, it must be followed from year to year. The following are some of the important

methods of providing for depreciation :

1. Fixed Instalment Method.

2. Diminishing Balance or Reducing Instalment Method.

3. Annuity Method.

4. Depreciation Fund Method.

5. Insurance Policy Method.

6. Revaluation Method.

7. Compound Interest Method.

8. Depletion Unit Method.

9. Use of Kilometre (Mileage) Method.

10. Efficiency Hour Method.

11. Single Charge Method.

12. Global Method.

1. Fixed Instalment Method. The first method is also called 'Fixed Percentage Method',

'Straight Line Method' or 'Original Cost Method'. Under this method, a fixed percentage of

the original cost of the asset is written-off each year till the asset is ultimately reduced to nil

or its break-up value. Thus, the entire cost less the scrap value is written-off during the

estimated working life after which the asset becomes valueless.

This method is simple in calculation and also in such a case, the charge to the Profit

and Loss Account is uniform every year. But with the passage of time, the charge of repairs

increases and hence, the effects on net profits are not steady every year. In case of additions

made to the asset, a lot of calculations are involved.

2. Diminishing Balance Method. This method is also known as 'Dirninishing Value

Method' or 'Written-Down Value Method' or 'Decline Balance Method'. Under this method, a

fixed percentage is written-off every year on the reduced balance of the asset. Thus, the

percentage of depreciation is not applied to the original cost but only to the balance which

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remains after charging depreciation in the beginning of a year. The percentage of depreciation

remains fixed for all the years of the working life of an asset but the actual amount of

depreciation written-off every year goes on decreasing with the reduction in the value of the

asset till after the expiry of the working life, the value of the asset is brought down to its scrap

value by and by.

It is a useful method in the case of assets which have fairly long life and which

require plenty of repairs, e.g., plant and machinery. For assets having short life for which

depreciation has to be charged at a uniform rate, it is not of much use.

3. Annuity Method. Under the annuity method of charging depreciation, the asset is

treated just like an interest bearing investment, i.e., the money invested in the asset is retained

in the business and is expected to earn interest at a fixed rate. Thus, an amount equivalent to

the estimated loss of interest is written-off in the Profit and Loss Account throughout the

useful life of the asset, and a certain fixed amount of depreciation as shown by the annuity

table is provided for every year. The asset account is debited with interest at a fixed rate and

also a fixed sum is written-off the asset account so that the value of the asset plus interest

comes to nil at the end of its working life.

The Annuity Method is applied in case of assets which have a definite span of life,

e.g., lease, etc. It is not of much value for assets to which additions are made every year. This

is why, this method is not much popular in use.

4. Depreciation Fund Method. This is also known as 'Sinking Fund Method' or

'Reduction Fund Method' or Amortizatfon Fund Method'. According to thfs method a

depreciation fund is created every year and credited with the amount charged to the Profit and

Loss Account and simultaneously, an equivalent sum is invested outside the business to bring

interest every year while the asset remains as its original cost fn the books of accounts. The

instalments are fixed in such a way that the whole investment will accumulate at the

compound interest and provide a sum equivalent to the replacement cost of the asset at the

end of its working life. This is the usual practice followed under this method.

Thus, the asset will be written-off entirely after a fixed interval of time and the money

would be available to replace it at the end of its useful life. The cash is usually invested in

gilt-edged securities. This is a good method of charging depreciation under which no in-

convenience is caused to the business and money becomes available from outside to replace

the asset after the expiry of its working life.

5. Insurance Policy Method. Under this method, the fund instead of being invested in

gilt-edged securities is applied in taking out an Insurance Policy so that after the expiry of the

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working life of the asset, the insurance company will pay the sum assured by which the asset

can be replaced.

The superiority of this method over the Depreciation Fund Method is that under it,

there are little chances of loss on realization, but at the same time, it is more expensive and is

not applicable to assets the life of which cannot be calculated and determined precisely.

6. Revaluation Method. This is a simple method under which the asset is required to

be valued at the end of each year when the Balance Sheet has to be prepared and the fall in its

value is charged as depreciation. Occasions are rare in which there are profits on revaluation.

Assets are usually revalued by technical experts and their value is determined as the value to

the business as a going concern. This method is applicable in case of assets such as loose

tools, horses, patterns, models, designs, bottles, trade-marks, etc.

This method may be said to be the most scientific method of calculating depreciation.

However, it is costly in the sense that competent men are needed to revalue the assets.

7. Compound Interest Method. This method is usually adopted for charging

depreciation on fixed assets of the electric supply undertakings. It is just like the Depreciation

Fund Method with the only difference that investments are not made outside the business and

the interest is also calculated on the increasing balance of depreciation each year. The

depreciation provided for each year is so adjusted that it becomes equivalent to 90% of the

value of the asset accumulated at the rate of 4% per annum compound interest.

This method enables to retain enough of the working capital in the business and

involves no risk of loss on realization as in the case of the Depreciation Fund Method.

8. Depletion Unit Method. This is also known as the 'Production Unit Method'. This

method is used in case of wasting assets such as mines, quarries, etc. To find out the amount

of depreciation, the value of the mine is reduced to the extent to which the output is obtained

from it. It is, thus, based on factual data and not so much on calculations. For example, if the

estimated output of a mine is 5,000 tonnes of coal and the total cost is Rs. 2,500, the

depreciation will be 50 paise per tonne. If the coal drawn out is 100 tonnes, depreciation will

be Rs. 50.

The method provides that the amount of depreciation should be written-off to the

account according to the amount of output raised.

9. Use or Kilometre [Mileage) Method. This method is adopted in case of those

assets, the use of which can be measured in terms of kilometres, e.g., cars, buses, motor-

cycles, etc. If a car costing Rs. 40,000 is estimated to run for about 1,60,000 kilometres and

on an average, it runs for about 16,000 kilometres each year, it will be valueless after the

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expiry of 10 years. But if it runs 32,000 kilometres in the first year, 24,000 kilometres in the

second year, 28,000 kilometres in the third year and so on, the depreciation charged will be

Rs. 8,000, Rs. 6,000 and Rs. 7,000 respectively (calculated at the rate of 25 paise per

kilometre).

This method is simple in nature but difficult for adoption in practice.

10. Efficiency Hour Method. This method is also known as 'Machine Hour Method' or

'Unit of Production Method' or 'Hours of Service Method'. It is just like the Kilometre

Method with the only difference that the working life of the asset is calculated in terms of

hours instead of calculating it in terms of kilometres. This is applied in case of machines, the

working life of which can be measured in terms of hours. This is used for costly machines.

11. Single Charge Method. Under this method, a fixed sum of money equivalent to

the amount of depreciation and repairs over the working life of the asset is charged to the

debit of the Profit and Loss Account and credited to a depreciation and Repairs Reserve

Account. Repairs affected in following years are charged to this account.

12. Global Method. Under this method, a flat rate of depreciation is charged every

year on all the assets taken together. This method is practically not much in use. The use of

this method is not permissible under the Companies Act as the fixed assets have to be

distinguished from one another for this purpose.

Auditor's Duty as regards Depreciation1

It has already been made clear that the auditor is not a valuer. It is as such difficult for

him to estimate the amount of depreciation in case of each individual asset. It is actually for

competent men and technical experts in the line to ascertain exactly the amount of

depreciation for different types of assets. The auditor should, however, see that :

(i) adequate provision has been made for depreciation every year;

(ii) relevant principles of accountancy have been followed in making provision for

depreciation;

(iii) the officers of the business have sincerely and honestly made provision for

depreciation;

(iv) the principles followed from year to year for providing depreciation are more or less

the same;

(v) the capital employed in the assets is being kept intact;

(vi) the business traditions and rules have been fully considered; and

(vii) the provisions of Companies Act as regards depreciation have been complied with.

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l The provisions of the Companies Act as regards depreciation are given in Chapter on

'Divisible Profits and Dividends'.

But if he finds that-:

(i) the depreciation has not been dealt with honestly by the management;

(ii) competent persons have not been employed, and if employed they have not carefully

examined the issue;

(iii) the provision for depreciation is not adequate; and

(iv) the principles of accountancy have not been followed by the management in making

the charge for depreciation; the auditor should draw the attention of the owners of the

business towards the issue and mention the fact in his report. If there is any change in

the method of providing for depreciation, it must be disclosed in the Profit and Loss

Account along with its effect on the profit or loss for the year. This is all what he can

do in this matter.

The Income-tax Act and the rules laid down under it have specified the rate of

depreciation on different types of assets in a company before arriving at its assessable

income. Thus, an auditor has been relieved of his burdensome responsibility regarding the

provision for depreciation. The Electricity (Supply) Act, 1948, has laid down the provisions

for working out the working life of the different classes of assets and rates for charging

depreciation, Sections 205 and 350 of the Companies Act are quite important in this regard

and have been discussed in detail in the Chapter of this book on 'Divisible Profits and

Dividends'.

Some Arguments as regards Depreciation

The Directors of a company have made no provision for depreciation and for this,

they have advanced the following arguments :

(1) The market value of the fixed asset has improved and is much in excess to its present

book value.

(2) The repairs and renewals have fully maintained the asset and hence, it is as good as

new.

(3) The current year's profits are not sufficient to provide for further depreciation.

(4) The amount of depreciation already written-off during previous years has been quite

excessive. Hence, there is no necessity of providing for depreciation.

Answer

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(1) A fixed asset is not acquired for resale but for the purpose of earning profits. Its

depreciation is a necessary business charge against the profits, not an appropriation of

profits. Hence, the market price should not be taken into account in calculating

depreciation and the loss in value sustained by its use must be brought into account.

(2) This argument is again invalid. It is to be remembered that no amount of repairs and

renewals can protect a fixed asset from being depreciated, though, of course, it can

maintain it for a longer time in proper working order. Depreciation represents loss in

the value of the asset caused by its constant use. Hence, depreciation must be

provided for.

(3) It is also wrong to think that since current year's profits are not sufficient, depreciation

should not be provided on the assets. Depreciation is a charge against Profit and Loss

Account and not an appropriation of profits. Hence, profits may be sufficient or

insufficient, or dividend may be paid or not, or the shareholders may be satisfied or

not, but depreciation must be provided for. Even in a year of loss, depreciation has to

be charged against the Profit and Loss Account.

(4) The excessive depreciation provided for in the past years is not a sound argument to

contend that no provision should be made. Depreciation being an actual loss arising

out of the use of a fixed asset during the current year must be provided for before the

calculation of net profits. Only then, the Balance Sheet can reveal the true and correct

view of the financial affairs of a business.

If excessive depreciation is provided for in the previous years, it may be transferred to

Reserve Account. The provision for depreciation should be made out of the profits of a year

in which the assets have been used and hence, it must be so provided at all costs.

RESERVES

Reserve is an appropriation of profits and it denotes that amount which is kept aside

for emergency likely to arise in the future. Any contingency, known or unknown, can be met

out of reserve so created. A reserve is, thus, a part of the profits set aside for some general

contingencies or for some specific purposes and is the undistributed portion of the profits.

Classification of Reserves

Reserves are of the following types :

1. General Reserve,

2. Specific Reserve,

3. Capital Reserve,

4. Reserve Fund,

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5. Secret Reserve.

1. General Reserve

The purpose of creating a general reserve is to provide additional working capital or

to strengthen the financial position of a business. Such a reserve is available to meet any

unknown contingency or for expansion of business, etc. The purpose behind its creation is

usually general.

Aims—(1) A general reserve is often created to strengthen the liquid resources of a

business. It is an appropriation of profits. It increases the reputation of a business in the

market.

(2) It is also aimed at making additional working capital available. Borrowing money

from outside for providing working capital is not a healthy practice and hence, general

reserve is created to provide additional working capital.

(3) It is also designed to meet any known liability, contingency or similar other

commitments. In the absence of general reserve, the business has to face a lot of difficulties.

(4) In the absence of adequate profits during a particular year, general reserve can also

be utilised for equalizing the rates of dividend.

(5) It is also thought useful to create a general reserve in some particular

circumstances to conceal the actual profits which are excessive in a particular year.

Progressive institutions usually adopt this practice.

Auditor's Duty. The question of creating a general reserve depends absolutely upon

the management and the policy of a business concern. The auditor can neither make

recommendations in this connection nor can place any restrictions on this account. He should

merely see that a general reserve is created in the interests of the business and shown properly

in the Balance Sheet. He should keep the following points in view :

(1) He should examine carefully the rules of the business, e.g.. Articles of Association

in case of a company.

(2) If some definite rate of creating a general reserve is prescribed, he should see that

it is created on the basis of this rate of percentage.

(3) He should also scrutinize the provisions made for grantfng deprecfation, provfding

for doubtful debts, etc. Ordinarily, a general reserve is equivalent to net assets (Le., Assets-

Liabilities).

If the auditor finds something objectionable in the accounts in this regard, he may

mention the fact in his report. However, he can advise his client on the issue of adequacy or

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otherwise of the general reserve, if he is asked to do so. He should not insist upon its creation

if the profits are not adequate.

2. Specific Reserve

A specific reserve is created for some specific purpose and is meant to meet some

certain but unestimated liabilities. It is a charge on profits and not an appropriation of profits.

Some of the examples of such reserve are:

(1) To meet out some future expected loss, such as depreciation, repairs and renewals,

etc.

(2) To meet an outstanding liability for expenses, e.g., salary, wages, income-tax, rent,

etc.

(3) To provide for an expected contingency, e.g., doubtful debt, discount on debtors, a

disputed claim, equalization of dividends, etc.

Hence, it is evident that a specific reserve has to be made irrespective of the fact that

there is profit or not. It is not surplus but purely a charge against profits. It is a prior provision

to meet out some future liability.

DIFFERENCE BETWEEN GENERAL RESERVE AND SPECIFIC RESERVE

General Reserve Specific Reserve

1. It is for some general purpose.

2. Its creation depends upon adequacy or

inadequacy of profits.

3. It is shown on the liabilities side of the

Balance Sheet separately.

4. It is created to strengthen the liquid

resources of a business.

5. It is a portion of the part of undistributed

profits and hence, can be distributed if there

is need for doing so.

It is created for a specific purpose.

It is compulsorily to be made

whether there is profit or loss.

It is usually shown along with the

item with which it is connected.

Its purpose is to provide for the loss

for which it is created.

It is not distributable but can be

used for the purpose for which it is

created.

Auditor's Duty. The auditor should be alert as to the adequacy of the same. He has no

doubt a great responsibility in regard to the creation of a specific reserve. How much specific

reserve is adequate will depend upon the nature and the objectives of a business.

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3. Capital Reserve

Capital reserve is created out of capital profits or gains of capital nature. They arise

out of :

(1) Premium on issue of Shares or Debentures;

(2) Sale of fixed assets at a profit;

(3) Amount in the credit of the Forfeited Shares Account;

(4) Profit prior to incorporation;

(5) Profit (Le., as a result of appreciation) on revaluation of assets or liabilities;

(6) Profit on taking over a business from the vendor;

(7) Profit on redemption of debentures.

Capital is, as a general rule, not distributable among the shareholders, though, of

course, it can be so distributed under certain specific conditions. It can, however, be utilized

for meeting out capital losses or writing-off abnormal losses.

Auditor's Duty. 1. The auditor should see that a capital reserve is created out of capital

gains.

2. He should ensure that capital reserve is utilized for meeting losses of capital nature.

3. If capital reserve is utilized for distribution among the shareholders by way of

dividend, he should study the rules in this regard, i.e., the provisions of Articles and

Law.

(The details about capital reserve are explained in the Chapter on 'Divisible Profits

and Dividends'.)

4. Capital reserve has to be shown separately and distinctly in the Balance Sheet and

must be distinguished from the revenue or general reserve.

4. Reserve Fund

Reserve Fund and general reserve have more or less the same object. The term

Reserve Fund1 is often used by some accountants when the money so reserved is invested

outside the business in Securities which are readily and easily realizable.

Hence, Reserve Fund is not a new concept. It is only a means of setting aside a sum of

money so as to strengthen the financial position of a business. To invest such a Reserve Fund

outside the business, a Reserve Fund Investment Account is opened and when a Reserve

Fund is invested, it is debited and such account is credited.

Auditor's Duty. The auditor should see that the Reserve Fund has been distinctly

shown in the Balance Sheet. It is also to be mentioned that the fund is a reserve or is a special

provision for specific purpose.

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i "The term 'Reserve Fund' should not be used where a reserve Is specially represented

by readily realizable and earmarked assets." —The Institute of Chartered Accountants of

England.

5. Sinking Fund

Sinking Fund1 is a type of specific reserve created with one of the following objects in

view :

(i) Replacement of a liability, e.g., loans, debentures, etc., or

(ii) Redemption of a Wasting Asset, e.g., a mine, etc., or

(iii) Replacement of an asset of depreciable nature, or

(iv) Renewal of a lease.

Thus, a Sinking Fund is created by means of a sum set aside periodically out of the

profits every year with the purpose of investing it outside the business so that by a specific

date, a certain sum may be accumulated to meet out a liability or to replace a wasting asset.

The procedure is simple. The Sinking Fund is created by setting aside a portion of

profits. But there is a difference between Sinking Fund and Reserve Fund. A Sinking Fund is

always for a specific purpose while a Reserve Fund is usually created for general

contingencies. A Sinking Fund is invested outside the business as a matter of rule while a

Reserve Fund may or may not be so invested. Two things are still more important :

(1) In the case of Sinking Fund created for the replacement of an asset, it is a charge

against profits and the object is to provide against a loss which is likely to fall on

revenue. Depreciation on Sinking Fund is a good example of this type of Sinking

Fund and to create it, the Profit and Loss Account is debited every year with a certain

sum of money.

(2) The creation of a Sinking Fund for redemption or reduction of a liability is usually an

appropriation of profits and in such a case, the Profit and Loss Appropriation Account

is debited with a certain sum of money every year. Debenture Redemption Fund is an

example of this type.

Whatever the purpose behind the creation of a Sinking Fund, a certain sum of money

is invested outside the business in such a way that a fixed amount accumulated with

compound interest may be made available at a future date to meet out a liability or loss or to

replace an asset.

There is another point of difference. In the case of Sinking Fund, created to repay a

liability, the accumulated profits remain unused at the end of the period and the liability is

paid out of the cash raised from the sale of investments. The Sinking Fund Account is closed

385

by transferring the balance to General Reserve Account. In the case of Sinking Fund for the

replacement of an asset, the old asset is closed by transferring to the Sinking Fund Account,

and new asset is purchased out of the sale of investments. If any loss is incurred in the

process, it is transferred to the debit of the Profit and Loss Account.

Auditor's Duty. (1) The auditor should see that a Sinking Fund is created according to

the provisions of the Articles of Association, the Debenture Trust Deed, etc. It is to be

ensured that the provisions have been duly complied with.

(2) He should also see that the provisions made in this regard every year are adequate.

This is a necessary part of his duty.

l "Any fund which is created by the regular investment of such an amount as, with

compound interest earned thereon, will accumulate to a given sum at the end of a stated

period." —Lancaster

(3) Proper records are being maintained in regard to the creation of a Sinking Fund

and investing it outside the business. He should vouch such records and see that the

investments made in this respect are distinctly earmarked on the Balance Sheet.

6. Secret Reserve

This is often called 'Hidden Reserve' or 'Internal Reserve' or 'Inner Reserve'. A secret

reserve is not disclosed on the face of the Balance Sheet. However, if a close and intelligent

scrutiny is made into the accounts of a business, the existence of a secret reserve may be

established. It is, of course, true that if a secret reserve exists, the Balance Sheet of a business

cannot reveal the correct picture of the financial affairs of the business.

Methods of Creating Secret Reserve

There are a variety of ways of creating secret reserve as given below :

(1) Undervaluing investments, stock-in-trade, plant and machinery, etc., and showing

them much below their cost or market value.

(2) Not recording the permanent appreciation or rise in the value of a fixed asset.

(3) Providing excessive depreciation on fixed assets.

(4) Overprovision for bad and doubtful debts.

(5) Under-estimating Goodwill.

(6) Omitting some of the assets totally from the Balance Sheet.

(7) Charging capital expenditure to revenue or crediting revenue receipts to an asset.

(8) Overvaluing a liability.

(9) Inclusion of fictitious liabilities.

(10) Showing contingent liabilities as real liabilities.

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(11) Grouping items of dissimilar nature on the liabilities side of the Balance Sheet.

Objects of Creating Secret Reserve

There are various objects of creating a secret reserve. They may or may not be always

in the interest of the business. Some of such objects are the following:

In the Interest of a Business

(1) The reserve may be utilized to meet out an unforeseen loss without making the fact

known to the owners or outsiders.

(2) The existence of secret reserve can help in avoiding undue competition by concealing

the high amount of profits from the rivals.

(3) A secret reserve enables the company to regulate a normal rate of Dividend, le., by

creating reserve when there are abnormal profits and distributing the same in a lean

year.

(4) A secret reserve increases the working capital and, thus, strengthens the financial

position of a business.

(5) The management may have an opportunity to hide a portion of the profits by creating

a secret reserve which it does not want to distribute to the advantage of the business as

a whole.

Against the Interests of a Business

(1) By creating a secret reserve, the Balance Sheet gives a false and inaccurate picture of

the affairs of a business. Thus, the true position is concealed and value of the shares

goes down in the market as the position of the concern is. not shown better than what

it actually is.

(2) The directors favour the creation of a secret reserve as in the case, they get an

opportunity of misappropriating the funds of the business.

(3) The actual profits are not made known to the owners of the business and hence, by

creating a secret reserve, the directors indulge in malpractices and speculations in the

shares of the company which go against the interests of the concern.

Other Objections to Create Secret Reserve

(1) The Balance Sheet does not present a true picture of the financial affairs of a concern.

(2) The owners or the shareholders of a company do not get their due share in the profits

of the business and as such, they are deprived of their legitimate right in the share of

profits.

(3) Value of shares goes down in the market.

(4) The concern loses its reputation in the market.

387

(5) Secret reserve may be a measure of concealing the ineffi-ciency and other defects.

Losses arising out from the careless and negligent management are concealed by the

management against a secret reserve.

(6) If fixed assets are undervalued to create a secret reserve, claims may be made with the

insurance company in case of a break of fire on the basis of the valuation shown in the

Balance Sheet. It goes against the interests of the business.

(7) Directors find an opportunity to misuse funds out of a secret reserve.

(8) If an asset is altogether omitted from the Balance Sheet to create a secret reserve, the

auditor may omit to verify the existence of an asset which can be misappropriated

easily.

(9) According to the Companies Act, 1956, the creation of secret reserve is now

prohibited except in the case of companies governed by special Act such as Banking,

Insurance and Electric Supply Companies. The following are the reasons:

(i) It requires full disclosure in the actual accounts of the transactions relating to reserves

and provisions.

(ii) It is also required under the Act that the Profit and Loss Account and the Balance

Sheet must show a true and fair view of its profit or loss and of financial position. P'or

this, the accounts must not be misleading, Le., there should neither be overstatement

of the assets nor understatement of the liabilities.

Thus, the building up and utilization of undisclosed reserves is now prohibited under

the provisions of the Companies Act except in the case of Banking, Insurance and Electricity

Supply Companies.

Auditor's Duty. It is now clear that no secret reserve can be created by public

companies other than Banking, Insurance, Electricity Supply

Companies and the position of the auditor is quite safe. If he finds that something

contrary to this has been done, he may disclose the fact in his report. He should never certify

as correct the Profit and Loss Account and the Balance Sheet under such circumstances :

(1) He should, first of all, enquire into the necessity of creating a secret reserve.

(2) He should study thoroughly the Articles of Association and examine the legality or

otherwise of creating a secret reserve. He should ensure that the intentions of

Directors in this regard are quite honest.

(3) He should try to collect every minute information about the creation of a secret

reserve. He should satisfy himself about the method and the procedure of creating

such a reserve.

388

(4) If a secret reserve is created by overvaluing liabilities or undervaluing assets, he

should discuss the issue with the management and go deep into the policy and

practices behind it.

(5) He should ensure that unless it is felt absolutely necessary to create a secret reserve,

he should not accept the creation of a secret reserves as valid and ask the management

to prepare the revised annual accounts.

But if the management is not prepared to accept his arguments, he should mention the

fact in his report. Hence, if the creation of a secret reserve is absolutely necessary, proper and

within rules, he should not object to such a creation, otherwise he should disclose the fact in

his report.

LEGAL DECISIONS Newton vs. Birmingham Small Arms Co. Ltd. (1906)

Brief Facts of the Case—The Articles of Association of the Company were altered by

special resolution to give Directors the powers to build up secret reserve without showing it

on the face of the Balance Sheet. The special resolution also gave powers to the auditors to

verify the transactions relating to the creation of secret reserve and to see that this reserve was

properly utilized. The special resolution also provided that the matter of secret reserve would

not be brought to the notice of the shareholders by the auditors through their report.

Decision—A special resolution to insert an article which deprives the auditor of statutory

power is ultra vires, le., against the accepted Canons of Law.

Royal Mail Steam Packet Ltd. (1931)

Brief Facts—For several years, this company had been running at a loss but their

accounts showed considerable profits available for being distributed as dividend. This

manipulation in the accounts was made possible through the utilization of special credits in

connection with the excess profits, duty recoveries and taxation reserves created in excess out

of the past profits while on the face of the final accounts, there was no indication of any

secret reserve and the shareholders were totally in the dark about the real trading position.

Decision—The keeping of secret reserve by a company is a very

disputed point......The auditors should not as a rule be liberal in the matter of allowing

undisclosed reserves to be utilized for inflating the profits with the resultant dividend

payment..... The auditor should without any hesitation mention in his report the presence of

secret reserve. Shamdasani vs. Pochkhanwala (1927)

It was held in this case that if any part of secret reserve is availed of to meet bad and

doubtful book debts, it must be revealed in the Balance Sheet and not concealed.

Provision

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When some loss is anticipated but its exact amount cannot be ascertained, a provision

is made. Such provisions may be made either (i) to provide for losses which may arise on the

realization of certain assets, or (ii) on accruing liabilities. The exact amount cannot readily be

made known for the present in such cases, e.g., provision for bad debts, provision for

discount, provision for taxation, etc. The following are some of the points of distinction

between a reserve and a provision :

Reserve (An Appropriation of Profits)

1. A reserve is a sum for an unknown liability.

2. Its purpose is to strengthen the financial position of a business.

3. It is a question of financial policy of a concern.

4. It adds to the amount of working capital.

5. The amount of a reserve depends upon the policy and discretion of the management.

6. It is available for distribution as dividend.

7. Lastly, it is an appropriation of profits. If there are profits, reserve will be created,

otherwise no reserve need be created.

Provision (A Charge against Profits)

A provision is a sum for a known liability.

Its purpose is to meet out a specific loss on realization of his asset or an accruing

liability.

It is a question of financial urgency to make a provision Le., a loss has to be provided

for. It is a 'must'.

It is for meeting out an anticipated loss or liability.

The amount of a provision cannot be ascertained accurately at the date of the Balance

Sheet, though the liability is known.

It is not so available.

It is a charge against profits. It means that if there is a loss in a company, provision is

a 'must' and has to be made.

Auditor's Duty. The auditor should thoroughly check the sums allocated as provisions

against specific loss or liability. He should examine all facts and figures and go through all

the relevant documents to ensure that all known losses, liabilities and contingencies have

been duly provided for. For this, he should examine the Articles of Association and the

Directors' Minute Book to ensure whether there is any resolution in respect of provisions

contained therein. He should ensure that provisions have been adequately made and he can

point out the valid arguments in favour of making provisions, if he is so asked by his client. If

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he feels that the losses are considerable and due provisions have not been made, he should

refer to the issue in his report. This is all what he can do in this regard.

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CAPITAL AND REVENUE

Business transactions may be put into two categories, viz., capital and revenue, a brief

description of which will not be out of place here. It is very essential to know exactly the

nature of a transaction so that it may be recorded accordingly in the financial books. If correct

allocation is not made between capital and revenue, the Profit and Loss Account will reveal a

misleading figure of profits or losses and the Balance Sheet will not exhibit a true and fair

picture of the financial affairs of a business. A variety of errors may arise in the books of

accounts if transactions are distinguished as capital and revenue carelessly.

After all, the auditors has to report :

"In our opinion and to the best of our information and according to the explanations

given to us, the annual accounts give the information required by the Companies Act, 1956,

in the manner so required, and give a true and fair view :

(i) in the case of Balance Sheet, of the state of affairs of the company as at the close of

the year, and

(ii) in the case of Profit and Loss Account, of the profit (or loss) for the year ended on

that date."

For this purpose, a clear-cut distinction has to be made between capital and revenue.

But what are capital and revenue items? It is very difficult to discriminate the two types and

there are no hard and fast rules in this connection. It is just possible to distinguish items as

capital and revenue as a matter of principle, but in practice, it is rather difficult to fully abide

by the principles. Whether a particular item of profit or loss would be treated as capital or

revenue depends upon the nature of source from which it has been derived.

Classification

All capital and revenue items may be put into different categories as stated below :

(1) Capital Income and Revenue Income.

(2) Capital Expenditure and Revenue Expenditure.

(3) Capital Receipt and Revenue Receipt.

(4) Capital Payment and Revenue Payment.

(5) Capital Profit and Revenue Profit.

(6) Capital Loss and Revenue Loss.

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With this classification we may now proceed to examine the various principles which

govern the distinction between capital and revenue. In brief, it may be laid down that all

expenditure which is incurred in the acquisition of assets of permanent nature which are

meant for the continual use in business for the purpose of earning revenue is capital

expenditure.

Besides this, if some amount is so expended from time to time to extend or improve

existing assets that it results in increasing the revenue-earning capacity, it may also be treated

as capital expenditure.

All expenditure incurred in the conduct and administration of the business is revenue

expenditure. Besides this, all expenses incurred in connection with repairs, renewals and

replacements are kept in this category. Such expenses do not in any way increase the earning

capacity but maintain the asset in its original position and in working order.

Whether an expenditure should be charged to reserve or to capital depends mainly

upon the following factors :

(1) The nature of business and also the nature of transaction in relation to the business;

(2) Whether such an expenditure has resulted in increasing earning capacity of efficiency;

and

(3) Financial policy and exigencies, if there are doubts.

Items Chargeable to Capital

1. Cost of land, buildings, plant and machinery, motor-lorries, tools, lease acquired,

furniture & fixtures, goodwill, trade-marks, patents and copyright, patterns and

designs or cost of any other asset acquired by way of equipment.

2. Expenses on erection of plant and machinery.

3. Actual additions and extensions to existing assets.

4. Structural improvements resulting in enhancing the revenue- earning capacity.

5. Administrative expenses incurred during the period of construction and equipment.

Items Chargeable to Revenue

1. All expenses incurred in connection with the conduct and administration of the

business, e.g., salaries, wages, rents and taxes, printing, stationery and advertising,

travelling expenses, etc.

2. Expenses incurred for repairs, renewals and replacement for the purpose of

maintaining the existing fixed assets in proper working order.

3. Cost of goods meant for resale, e.g., raw materials, stores, etc.

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4. All other expenses incurred in the manufacturing and distribution of the products, e.g.,

advertising expenses, commission paid to agents, etc.

5. Maintenance Expenses.

6. Loss arising from sale of fixed assets or from wear and tear and obsolescence of

assets utilized in business.

How to Allocate?

This is a big question but is quite significant. There are a variety of expenses which,

by nature, seem to be revenue but are treated as capital. These all depends upon the peculiar

circumstances and purposes for which they are actually incurred. For example, legal

expenses, carriage, stamp duty, brokerage, wages, repair, etc., are rightly the items of revenue

expenditure. But when they are incurred in connection with the acquisition and development

of fixed assets, they are treated as capital expenditure. The factor to be considered is that if an

expenditure relates to some improvements in the earning capacity of an asset, it is a capital

item but if it is incurred simply to maintain it in an efficient working order, it is a revenue

expenditure. Ordinary repairs are treated as of revenue nature, but if an old property has been

acquired in a dilapidated state and an expenditure is incurred to bring it into a tenantable

condition, it will form part of the cost and will be capitalized as such. Similarly, changes

made in the furniture held by a cinema-house for making improvement so as to attract more

customers will be a capital expenditure as it will help in enhancing the revenue of the cinema-

house.

Sometimes, there are expenses which can neither be treated as capital nor as revenue.

For example, a building is reconstructed after dismantling it, its book value plus the

expenditure incurred in its dismantling, less its residual value will be a revenue loss. The cost

of new construction will be a capital expenditure. Thus, it can be put like this :

(i) the entire cost of new construction is capitalized, and

(ii) the book value of the asset + the cost of dismantling-proceeds from the sale of old

materials and also the value of the old material utilized in new construction is charged

to revenue.

A Few Rules

1. The entire capital expenditure is represented by an asset or some improvements in it

so as to enhance its profit-earning capacity. A revenue expenditure is incurred simply

to maintain it.

2. An expenditure not representing an asset should not be capitalized permanently.

3. Only actual cost of additions or extensions should be capitalized.

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4. An abnormal loss arising from obsolescence should not be charged to revenue in the

year in which it has taken place but should be spread over a reasonable number of

years.

5. Heavy revenue expenditure may be capitalized temporarily and be carried forward in

the Balance Sheet. Thus, a firm may prepare its advertising campaign of new season

goods in advance of the accounting year and the cost thereof may be carried forward.

It is treated as Deferred Revenue Expenditure.

Other Items

So far as other items classified as capital receipts and payments, revenue receipts and

payments, etc., are concerned, it is quite simple to distinguish. The receipt of capital from the

owner of a business is a capital receipt and the income from sale of goods will be a revenue

receipt.

Premium received on issue of shares and debentures is a capital profit while profit

earned from sale of products is a revenue profit. These are the various examples found in

daily business and need no further elaboration.

Capital or revenue payment is always made in connection with an expenditure of

capital or revenue nature respectively. If, for example, furniture is acquired for Rs. 5,000 and

payment made is Rs. 2,000; Rs. 5,000 is a capital expenditure and Rs. 2,000 is a capital

payment. Similarly, revenue items can be illustrated with similar examples. Auditor's Duty

(1) The auditor should fully acquaint himself with the nature and working of the business

so that he can check easily the allocations of items treated as Revenue and Capital,

e.g., Purchase of Machinery for a manufacturer is a capital expenditure but for a

dealer in purchase and sale of machinery, its purchase is not capital expenditure but a

revenue one. Similarly furniture is a floating asset and its purchase is revenue item for

a dealer in furniture while it is a capital expenditure for manufacturers or industrial

concerns.

(2) He should also know the circumstances in which an item of expenditure has been

classified as Revenue or Capital, e.g., legal charges paid for acquiring some property

of a permanent nature or for preparation of legal documents such as Memorandum of

Association and Articles of Association or some Deed is a capital expenditure while

legal charges paid in the ordinary course of business is a revenue expenditure.

(3) He should see that Principles of Accountancy have been fully observed in making this

distinction, e.g., all the expenses directly attributable to the construction of an asset

such as cost of materials and stores issued for construction of a building, wages paid

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in this connection, etc., should be capitalized. Similarly, in the case of purchase of an

asset, the purchase price, transportation costs and expenditure incurred on its

installation should be capitalized.

(4) If there are some controversial items, he should enquire about them from responsible

officers of the business and take decisions very cerefully.

To sum up. it can be submitted that this part of an auditor's duty is very significant as

only on this very basis, he has to certify the accounts as correct and report that the Profit and

Loss Account and the Balance Sheet exhibit a true and fair view of the state of financial

affairs of business in hand. The correct allocation of expenditure as capital and revenue is

most vital from both accountancy and auditing point of view.

Deferred Revenue Expenditure

This is a clear example of a revenue expenditure. But if a heavy expenditure is

incurred, it should be extended beyond the year in which it has taken place. Hence, as a

matter of practice, it is quite legitimate to capitalize it temporarily and should be spread over

the number of years for which the benefits are to be enjoyed by the business. The treatment is

quite justifiable as the full benefits of an expenditure have not yet expired.

The heavy expenditure incurred by a firm in connection with the advertising

campaign of new products is another example of Deferred Revenue Expenditure, Le., an

amount of Rs. 10,000 incurred in connection with the advertising campaign may well be

spread over, say, 10 years and thus, Rs. 1,000 may be charged to the Profit and Loss Account.

Thus, a Deferred Revenue Expenditure involves some considerable exceptional expenditure

and should be treated as such. Examples

1. Preliminary expenses, brokerage on shares.

2. Cost of issue of Debentures or discount on issue of Debentures.

3. Cost of removal of business to a more convenient place.

4. Cost of removal of works, and incidental expesnes which are incurred in connection

with the dismantling, removing and re-erection of plant and machinery.

5. Exceptional repairs to any particular asset. Auditor's Duty

The auditor should call for the detailed computation of the amount carried forward

and see that the charge made to the Revenue Account is quite reasonable. A proper

distinction has to be made between the normal and exceptional expenditure and also between

the normal trading and the incremental trading resulting from the exceptional expenditure. He

should examine the bases on which the estimates have been made and ensured that they are

reasonable.

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Exceptional losses have to be spread over a number of years. They have to be

distinguished from Deferred Revenue Expenditure and treated accordingly.

The auditor cannot have any objection to the treatment of an expenditure as Deferred

Revenue Expenditure as it will all depend upon the nature and circumstances of a particular

business.

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QUESTIONS

Auditing & Corporate Governance

1. Define Auditing. Explain its objects and advantages.

2. “An auditor is a watchdog and not a bloodhound” Explain.

3. “Accountancy begins where bookkeeping ends; auditing begins where accountancy

ends.” Illustrate.

4. “Accountancy is a necessary while auditing is a luxury.” Do you agree? Examine

critically the role of auditing.

5. State briefly the essential qualities of successful auditor.

6. What is meant by continuous audit and to what class of business is it especially

applicable? State briefly the advantages and disadvantages of such audit.

7. What do you understand by annual audit? What are its advantages and disadvantages?

8. What is audit programme and how should it be prepared? Give its advantages and

disadvantages?

9. What is test checking in auditing? State what precautions should be taken in this

connection?

10. What is routine checking? What are its objects? Describe the advantages and

disadvantages of routine checking?

11. What is meant by internal check? Explain its objects and advantages?

12. Describe a system of internal check in respect of wage payments suitable for a large

manufacturing concern.

13. Suggest a system of internal check on purchase of a large manufacturing concern.

14. How would you device on internal check with regard to cash sale of a large retail

establishment?

15. “Vouching is the backbone of auditing.” Discuss.

16. “In vouching payment, the auditor does not merely seek proof that money has been

paid away.” Discuss.

17. What is vouching? How would you vouch the cash book? How far is the auditor

responsible as regard the verification of following assets: a) Goodwill, b) Household

Property, c) Motor Vehicle, d) Patents, e) Plant and Machinery?

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18. “An Auditor is not a valuer and yet he is intimately concerned with proper

valuation of assets and Liabilities.” Discuss the above statement quoting some

legal decisions.

19. Explain the different methods of charging depreciation. Discus the duties of the

auditor in this regard.

20. What is Secret Reserve? How is it created? What is the auditor’s duty in this regard?

21. Write short Note on any two:

1. Interim Audit & Internal Audit

2. Audit Note Book

3. Audit working Papers

4. Routine Checking

5. Test Checking

6. Valuation of Stock

7. Sinking Fund

8. Reserve Fund