A company is said to be an artificial person created by law having a separate legal entity distinct from its shareholders. It cannot be directly managed by its owners, i.e. shareholders, because they are very large in number having small holding and also scattered over a wide area. As such, the management and control of the affairs of the company is done by other persons generally known as Directors. Hence, it becomes essential for a company to appoint an independent and qualified person, i.e. an auditor, to verify and certify the truth and fairness of the financial statements.
9.2 PRELIMINARIES BEFORE COMMENCEMENT OF COMPANY AUDIT
Before commencing the actual audit work of a company, the auditor should go through the following preliminaries:
1. Ensuring whether his appointment is in order
Before accepting the offer for appointment as auditor in a company, the auditor should ensure that his appointment is made according to the provisions of Section 224 and Section 225 of the Companies Act and whether all the formalities are being maintained by the company before giving him the appointment as auditor.
The auditor should go through the following:
- He should see whether his appointment has been made according to Section 224 (1B) of the Companies Act. For this purpose he should obtain a copy of resolution adopted at board meeting or the shareholders meeting as the case may be.
- If he is appointed in place of a retiring auditor he should enquire whether due notice was served to the retiring auditor. He should find out from retiring auditor about the circumstances under which he has retired and whether he should accept the appointment. This is a professional requirement as per the Chartered Accountants Act, 1949.
- He should, within thirty days of receipt of appointment letter, inform the Registrar in writing that he has accepted or refused to accept the appointment.
- If he is appointed to fill the casual vacancy caused by the death of the previous auditor, he should get the copy of the minutes of the Board meeting in this regard and also get the confirmation of death of the previous auditor.
- He should see that if the company has failed to appoint or re-appoint any auditor in the annual general meeting, the central government has appointed him to fill the vacancy.
- If he is appointed due to the resignation of the previous auditor he must see that he has been appointed in a general meeting of shareholders. The Board of Directors will have no right to appoint him under such circumstances.
- He should verify whether his remuneration has been fixed according to the provisions of the Companies Act.
- Documents Before the auditor commences the work of audit, he should examine the following documents:
- Memorandum of Association. The auditor must do the following:
- See whether the activities of the company are consistent with the ‘objective clause’
- Check whether the amount of share capital is within the limit of authorised capital
- Observe whether there is any amendment to memorandum and, if so, whether legal formalities have been complied with
- Articles of Association. The auditor must go through the following points:
- The issue of share capital and its subdivisions
- The payment of underwriting commission and brokerage on shares
- The amount of minimum subscription
- Date and amount of call
- Appointments, duties and powers of auditors in addition to statutory powers and duties
- Appointment and remuneration of directors
The above is the list of few examples, which are available in the Articles of Association. The articles may contain several other items and the auditor should go through each item very carefully. If he does not go through the articles and consequently fails to audit properly, he will be held liable as was held in the case of ‘Leeds Estate Building and Investment Society Ltd. vs Shepherd (1887)’.
- Prospectus : In case of newly started company and company gone for public issue the auditor will examine the prospectus to see the matters like whether shares can be issued at a discount, the amount payable on application, allotment and calls, underwriting commission and brokerage etc.
- Certificate of Incorporation and certificate of commencement: These certificates are required to be examined to see whether the company has been duly incorporated and it has started its business, in case of public limited company, after getting commencement of certificate.
- Memorandum of Association. The auditor must do the following:
- Books and registers The following is the list of books and registers required to be maintained by the companies:
- Register of Members (u/s 150)
- Index of Members (u/s 151)
- Register and Index of Debenture-holders (u/s 152)
- Register of Mortgage and Charges (Section 143)
- Register of Investments [Section 49(7)]
- Foreign Register (Section 157 and 158)
- Register of contracts with companies and firms in which the Directors are interested (Section 297, 299 & 301)
- Register of Directors, Managing Director, Manager and Secretary (Section 303)
- Register of Director’s shareholdings (Section 307)
- Register of Loans [Section 370(1C)]
- Minute Books (Section 193)
3. Inspection of contracts
The auditor should inspect and examine the contracts, which have been entered into by a company with others, for example,
- Contracts with the vendors of any property
- Contracts with the brokers and underwriters for their commission
- Contracts with the promoters for the preliminary expenses, etc.
4. Study of previous year’s balance sheet and auditor’s report
The auditor should inspect the previous year’s balance sheet to verify the opening balances of the current year. Moreover, according to the Companies Act, the corresponding figures of the previous year have to be given in the balance sheet of the current year. The auditor should also study the audit report of the previous year/s in order to identify the problem areas of the company.
5. Study of internal control system in operation
The study and evaluation of the internal control system in operation is important, because it serves as a basis for reliance thereon. It helps the auditor in determining the extent of the test to which auditing procedures can be restricted.
9.3 AUDIT OF SHARE CAPITAL TRANSACTIONS
Share capital may be defined as the capital raised by a company by the issue of shares. Section 86 of the Companies Act provides that the share capital of a company limited by shares shall be of two kinds only, namely,
- Preference Share Capital
- Equity Share Capital
The audit of share capital is necessary on incorporation as well as when further shares are issued, and the same is explained in the following part of this section.
9.3.1 Audit of Shares Issued for Cash
While conducting audit of share capital transactions, the auditor has to check the following.
- Ensure that the requirements as laid down in Section 69 and 149, in this connection have been duly complied with.
- See that the issue of shares is properly authorised and that there is no over issue beyond the limit as prescribed in the memorandum.
- See that the provision relating to rights of shareholders are duly complied with.
- Ensure that generally accepted accounting principles are followed while preparing the accounts.
While auditing the amount of share capital, the auditor will have to follow the procedures as stated below:
- Application stage
- He should check the original applications and compare the entries in the application and allotment book with the help of these applications.
- He should compare entries in the application and allotment book with those in the cash book and the bank statement.
- He should ensure that the amount received on application is not less than five percent of the nominal value of shares [Section 69 (3)].
- He should ensure that the application money is 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).
- He should vouch the amount refunded to unsuccessful applications with copies of letters of regret sent to them.
- He should check the totals in the application and allotment book and see that appropriate journal entries have been passed accordingly.
- Allotment stage
- The auditor should examine the Director’s minute book to verify approvals for allotment.
- He should check copies of letters of allotment and letters of regret with entries in the application and allotment book.
- The money received on allotment should be vouched by comparing the entries in the applications and allotment book with the cash book or bank statement.
- He should check the postings in the share register of the amount received on application and allotment with the totals in the application and allotment book.
- He should see that the total of shares issued does not exceed the total authorised capital according to the memorandum.
- He should see that the totals have been correctly made and that proper entry has been passed for this purpose.
- Call stage
- The auditor should examine the Director’s minute book for verifying approval for call money.
- He should check the entries in the calls book from the copies of call letters.
- In order to verify the amount of calls in arrear, he should compare the total amount due on calls as per registers and the actual money received as per cash book or statement of bank account.
- He should also verify the calls in advance received by the company.
- He should check the postings from the calls book and the cash book into the share register.
- He should see that the appropriate entries have been passed in the books accordingly.
- Other aspects
- The auditor should see that the shares issued by the company are within the amount of authorised capital of the company.
- He should see that the allotment of shares has been made in conformity with the conditions as stipulated in the prospectus.
- If the shares are issued through underwriters, the auditor should see the contracts with the underwriters to ascertain whether the terms and conditions have been complied in full by the underwriters. In this respect, he should also see that the commission given to the underwriters does not exceed the statutory limit.
9.3.2 Audit of Shares Issued for Consideration Other Than Cash
Shares may be issued for consideration other than cash under the following circumstances:
- Issue of shares against purchase consideration to the vendor for the business taken over by the company.
- Issue of shares against services rendered to the underwriters, promoters or any other special service rendering agencies by way of payment of their remuneration or for any expenses incurred by them.
- Issue of shares to the existing shareholders as bonus shares.
In order to issue shares for consideration other than cash, the auditor should follow the procedures as explained in the following segment.
1. Issue of shares to vendors/promoters
- Examination of contract The auditor should examine the contract entered into by the company with the vendors/promoters to know the amount of purchase consideration and the mode of payment. For the purchase consideration settlement, the mode of payment would be according to the prospectus. So, the auditor should also examine the prospectus to see the mode of payment.
- Checking of Director’s minute book The decision regarding issue of shares to the vendors/promoters are taken at the Board meeting. The resolution passed by the Directors for allotment of shares to vendors/promoters should be confirmed from the minute book.
- Filing of contracts with the Registrar Such contracts are required to be filed with the registrar of companies within 30 days from the date of allotment.
- Allotment of shares to the nominees If shares have been allotted to the nominees of the vendors/promoters, the auditor should examine the vendor’s/promoter’s authority given to them in their favour.
2. Issue of shares to underwriters
- Examination of the contract The auditor should examine the contract with the underwriters. It is required to know the terms and conditions of the contract between the company and the underwriters.
- Examination of the prospectus The auditor should also examine the prospectus of the company to see the mode of payment. The auditor should verify whether the right for the payment of commission in the form of shares has been mentioned in the prospectus or not.
- Director’s minute book He should examine the resolution of the directors by reference to the Director’s minute book.
- Examination of the articles of association He may confirm the amount of underwriting commission from the Articles of Association. In fact, in the Articles of Association the maximum limit of underwriting commission that can be given to the underwriters and the mode of payment and procedure to be followed are mentioned.
3. Issue of bonus shares
- Examination of the Articles of Association The auditor should examine the Articles of Association to ascertain whether the articles permit capitalisation of profit and also whether the company had a sufficient number of un-issued shares for allotment as bonus shares.
- Assurance about the compliance of SEBI Guidelines The auditor should ensure that SEBI Guidelines (Chapter XV of the SEBI [D & IP] guidelines, 2000) relating to issue of bonus shares have been complied with.
- Checking of allotment book The auditor should trace the allotment of shares as per particulars contained in the allotment book or sheets into the register of members.
- Confirmation about the fulfilment of legal requirements The auditor should confirm that all statutory requirements relevant to the issue of shares have been complied with. The company has to file the particulars of the bonus shares allotted with the Registrar together with a copy of the resolution on the basis of which allotment of bonus shares has been made.
- Inspection of the minute book of shareholders The auditor should inspect the minute book of shareholders for the resolution authorising declaration of the bonus and Director’s minute for the resolution appropriating profits for being applied in payment of shares to be allotted to shareholders as bonus shares.
- Checking of accounting entries The auditor should also check the accounting entries passed for issue of bonus shares and confirm that they are in conformity with the legal requirements and basic accounting principles.
4. Issue of sweat equity shares
As per explanation to Section 79A of the Companies (Amendment) Act, 1999, the term “Sweat Equity Shares” means the equity shares issued by the company to its employees or 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.
The auditor should cover the following aspects while checking the issue of sweat equity share transactions:
- Authorised by a special resolution The issue of sweat equity shares is authorised by a special resolution passed by the company in the general meeting.
- Details about share issues are specified The resolution specifies the number of shares, current market price, consideration, if any, and the class or classes of Directors or employees to whom such equity shares are to be issued.
- Minimum time gap for issue Not less than one year has, at the date of the issue, elapsed since the date on which the company was entitled to commence business.
- SEBI guidelines The sweat equity shares of a company, whose equity shares are listed on a recognised stock exchange, are issued in accordance with the regulations by the SEBI.
- Issue out of already issued share type The sweat equity shares issued by the company should be of a class of shares already issued by the company.
9.3.3 Shares Issued at a Discount
According to Section 79 of the Companies Act, a company can issue shares at a discount subject to the fulfilment of the following conditions:
- The issue should be authorised by an ordinary resolution of the company and sanctioned by the central government.
- No such resolutions shall be sanctioned by the company law board in case the maximum rate for discount exceeds 10% unless the Board is of the opinion that a higher rate of discount is justified by the special circumstances of the case.
- The issue should be made within two months of the sanction by the company law board, but not earlier than one year after the date of commencement of business.
- The shares should be of a class already issued by the company.
- The auditor should confirm that all the conditions of Section 79 have been duly complied with.
- He should also see that the amount of discount, not yet written off, is shown separately in the balance sheet under the head “miscellaneous expenditure”.
- The auditor should check that the appropriate entries have been passed in the books of accounts.
9.3.4 Shares Issued at a Premium
According to Section 78 of the Companies Act, a company can issue shares at a premium subject to the fulfilment of the following conditions:
- Where a company issues shares at a premium, whether for cash or otherwise, a sum equal to the aggregate amount or value of the premium on those shares shall be transferred to an account, to be called the “Securities Premium Account”-Section 78 (1).
- The securities premium account may be applied by the company in the following matters:
- In paying up un-issued shares of the company to be issued to members of the company as fully paid bonus shares
- In writing off the preliminary expenses of the company
- In writing off the expenses of, or the commission paid or discount allowed on any issue of shares or debentures of the company
- In providing for the premium payable on the redemption of any redeemable preference shares or of any debentures of the company-Section 78 (2)
- The auditor should examine the prospectus, the Articles of Association and the minutes book of the Directors to ascertain whether they permit the issue of shares at a premium and, if so, the rate.
- He should check the amount of premium received.
- He should also check that the share premium received has been taken to the ‘Securities Premium Account’ and shown on the liabilities side of the balance sheet under the head “reserves and surplus”.
- He should see that the ‘Securities Premium Account’ if utilised has been utilised for the purposes as specified in Section 78.
9.3.5 Calls in Arrear
Calls in arrear refer to that portion of the share capital, which has been called up, but not yet paid by the shareholders. When a shareholder fails to pay the amount due on allotment and/or calls, the allotment account and/or calls account will show debit balance equal to the total unpaid amount of each instalment. Generally such amount is transferred to a special account called ‘calls in arrear’ Account.
The balance of ‘calls in arrear account’ at the end is shown in the balance sheet as a deduction from respective share capital account.
Interest on calls in arrear may be collected by the directors from the shareholders if the Articles of Association so provide. If the company has adopted ‘Table A’, then it can charge interest @ 5% p.a. from the due date to the actual date of collection of call money.
- The amount due from shareholders in respect of calls in arrears should be verified by reference to the share register.
- If any calls are due from directors, they should be shown separately in the balance sheet.
- Often the articles provide that interest be charged on calls in arrears, the adjustment of interest in such a case should be verified.
- The auditors should also check that the appropriate entries have been passed in the books of accounts and ensure that calls in arrear are properly shown in the balance sheet.
9.3.6 Calls in Advance
A company, if permitted by the articles, may accept from members, either the whole or part of the amount remaining unpaid on any shares held by him as calls in advance. But the amount so received cannot be treated as a part of the capital for the purpose of any voting rights until the same becomes presently payable and duly appropriated (Section 92 of the Companies Act).
A company, if so authorised by the articles, may pay dividend in proportion to the amount paid upon each share, where a larger amount is paid up on some shares than that on other (Section 93 of the Companies Act).
Interest may be paid on calls in advance if Articles of Association so provide. If the company has adopted ‘Table A’, then it is required to pay interest @ 6% p.a. from the date of receipt to the due date (Article 18 of Table A). Such interest is a charge against profit. However, such interest can be paid out of capital, when profits are not available for such payment.
- The auditor should see that the provisions regarding payment of calls in advance exist in the articles.
- He should see that calls in advance have not been treated as part of the share capital and are shown separately in the balance sheet.
- He should ensure that the payment of interest on calls in advance does not exceed the percentage stated in the articles.
- He should vouch the receipt of such amount and the payment of interest thereon by inspecting the relevant entries in the cash book or passbook.
9.3.7 Forfeiture of Shares
If a shareholder fails to pay the calls made on him, the Directors may have the power of forfeiting the shares held by him. The Directors are empowered, subject to the fulfilment of certain conditions, to remove his name from the register of members and to treat the amount already paid by him forfeited to the company.
But it should be noted that shares could be forfeited only if the articles authorise the directors to do so. Forfeiture shall be void, if it is contrary to the provisions of the articles. Forfeiture of shares can ordinarily be made only for non-payment of calls, but the articles may provide for forfeiture on grounds other than non-payment of calls.
Conditions to be fulfilled before forfeiting shares
- Notice to the shareholder Before forfeiting any shares, the defaulting member must be served with a notice requiring him to pay the unpaid amount of call together with interest. The notice must mention the day on or before which the payment is to be made and also mention that in the event of non-payment, the shares will be liable to forfeiture.
- Resolution of the board If the requirements of the above notice are not complied with, the shares may be forfeited by a resolution of the directors.
- The auditor should ascertain that the articles authorise the board of directors to forfeit the shares and that the power has been exercised by the board in the best interest of the company.
- He should verify the amount of call which was outstanding in respect of each of the share forfeited.
- He should also ascertain that the procedure in the articles has been followed, viz. the notice given (14 days, according to Table A) to the defaulting shareholders, warning them that in the event of non-payment by a specified date, the shares shall be forfeited.
- The auditor should verify the entries recorded in the books of account consequent upon forfeiture of shares to confirm that the premium, if any, received on the issue of shares has not been transferred to the forfeited shares account.
9.3.8 Re-issue of Forfeited Shares
A forfeited share is merely a share available to the company for sale and remains vested in the company for that purpose only. Re-issue of forfeited shares is not allotment of shares but only a sale. When shares are re-issued, return of the forfeited shares need not be filed under Section 75(1) of the Companies Act, 1956.
The share, after forfeiture in the hands of the company, is subject to an obligation to dispose it off. In practice, forfeited shares are disposed off by auction. These shares can be re-issued at any price so long as the total amount received for those shares is not less than the amount in arrear on those shares.
- The auditor should ascertain that the Board of Directors has the authority under the articles to re-issue forfeited shares.
- He should refer to the resolution of the Board of Directors when re-allotting forfeited shares.
- He should vouch the amount collected from person to whom the shares have been allotted and also check the entries recorded for this purpose.
- The auditor should see that the total amount received on the shares, including that received prior to forfeiture, is not less than the par value of shares.
- He should also verify that the surplus resulting on the re-issue of shares is credited to the capital reserve account.
9.3.9 Issue of Right Shares
According to Section 81 of the Companies Act, 1956, the new shares that are offered in the first instance to the existing equity shareholders of the company are known as “right shares”, because they are so offered to the existing shareholders as a matter of their right.
Where at any time after the expiry of two years from the formation of a company or at any time after the expiry of one year from the allotment of share of the company made for the first time after its formation, whichever is earlier, the company proposes to issue further shares, then such further shares shall be offered to the existing equity shareholders of the company, in proportions, as nearly as possible to their present holding of shares. The existing shareholders shall have to exercise their right within fifteen days or such further time as may be mentioned. Thereafter they may accept such offer, may decline to accept or may transfer their right to their nominees.
- The auditor should ensure that the provisions of Section 81 have been duly complied with.
- He should satisfy that appropriate resolution was passed either by the Board or the general meeting depending upon the circumstances of the issue.
- He should see that consideration money was duly received.
- He should also check to ensure that the guidelines issued by SEBI have been duly followed.
- He should examine the filing of the return of allotment with the registrar.
- He should satisfy that the allotment was made on pro rata basis.
9.3.10 Buying Back of Equity Shares
The Companies (Amendment) Act, 1999 contains provisions regarding buying back of own securities by a company. The word ‘security’ includes both equity and preference share. But preference share can also be redeemed, perhaps the provision is intended for equity share only.
As per Section 77A of the Companies Act
- A company may purchase its own shares or other specified securities out of
- its free reserves
- the securities premium account, or
- the proceeds of any earlier issue other than from issue of shares made specifying for buy back purposes.
- No company shall purchase its own shares or other specified securities, unless
- the buy-back is authorised by its articles
- a special resolution has been passed in general meeting of the company authorising the buy-back
- the buy-back is less than 25% of the total paid up capital (both equity and preference) and free reserves of the company
- the debt-equity ratio is not more than 2: 1 after buy-back
- all the shares or other specified securities are fully paid up
- the buy-back of the shares or other specified securities listed on any recognised stock exchange is in accordance with the regulations made by SEBI
- the buy back in respect of shares or other specified securities, other than those in point except the last point as above, is in “accordance with the guidelines as may be prescribed.
- Every buy-back shall be completed within 12 months from the date of passing the special resolution or a resolution passed by the board.
- A solvency certificate should be filed before making buy-back.
- The company shall, after completion of the buy-back, file with the registrar and the SEBI, a return containing such particulars relating to the buy-back within 30 days of such completion.
As per Section 77AA of the Companies Act
In case shares are bought back out of free reserves, then a sum equal to the nominal value of shares bought back shall be transferred to a reserve account to be called the “capital redemption reserve account” and details of such transfer shall be disclosed in the balance sheet. This account, as per SEBI guidelines, shall be allowed to be used for issue of fully paid bonus shares.
No company shall, directly or indirectly, purchase its own shares or other specified securities
- through any subsidiary company including its own subsidiary companies
- through any investment company or group of investment companies
- if a default, in repayment of deposit or interest thereon, in redemption of debentures or preference shares or in payment of dividend or repayment of a term loan or interest thereon to any financial institution or bank, is subsisting
- in case it has not complied with provisions of Section 159, Section 207 and Section 211.
- The auditor should ensure that the provisions of Section 77A has been complied with.
- He should vouch that amount of consideration was duly paid.
- He should satisfy that appropriate resolution was passed in general meeting of the company authorising the buying-back option.
- He should also ensure that the guidelines issued by SEBI have been duly followed.
- He should examine the filing of the return after completion of the buy-back with the registrar and the SEBI.
- The auditor should also verify that the proper accounting entries have been passed immediately after the buy-back.
9.3.11 Employees Stock Option Scheme (ESOPS)
‘Employees Stock Option’ means the option given to the whole-time directors, officers and employees of a company to purchase or subscribe at a future date, the securities offered by the company at a pre-determined price. Section 2 (15A) of the Companies Amendment Act, 2000 has allowed the companies to offer stock option scheme to their employees subject to SEBI Guidelines, 2000 in this regard.
SEBI guidelines on ESOPS
- Issue of stock options at a discount to the market price would be regarded as another form of employee compensation and would be treated as such in the financial statement of the company regardless of the quantum of discount.
- The issue of ESOPS would be subject to approval of shareholders through a special resolution.
- In cases of employees being offered more than 1% of shares, a specific disclosure and approval would be necessary in the annual general meeting.
- A minimum period of one year between grant of options and its vesting must be prescribed. After one year, the period during which the option can be exercised would be determined by the company.
- The operation of the ESOP scheme would have to be under the superintendence and direction of a compensation committee of Board of Directors in which there would be a majority of independent directors.
- ESOP would be open to all permanent employees and to the directors of the company but not to the promoters and large shareholders. With the specific approval of the shareholders, the scheme would be allowed to cover the employees of a subsidiary or a holding company.
- Directors report shall contain the following disclosures:
- The total number of shares covered by the ESOP as approved by the shareholders
- The pricing formula
- Options granted, options vested, options exercised, options forfeited, extinguishments or modification of options, money realised by exercise of options, total number of options in force, employee-wise details of options granted to senior managerial personnel and to any other employee who receives a grant in any one year of options amounting to 5% or more of options granted during that year
- Fully diluted earnings per share (EPS) computed in accordance with international accounting standards.
- The auditor will see whether the company has strictly adhered to the above conditions as stipulated in SEBI guidelines in connection with ESOP.
- He will vouch the receipt of cash against issue of shares under option exercised by checking the entries in the cash book and bank statements.
- He will judge the reasonableness of the price at which options were given.
- He will see that paid up capital has not exceeded the authorised capital due to exercise of option.
- He should ensure that discount on issue under option has been treated as employee compensation and has been charged to the profit and loss account.
- The auditor will see that the fact of ESOP has been adequately disclosed in the balance sheet.
9.3.12 Issue and Redemption of Preference Shares
1. Issue of preference shares
A company limited by shares, if authorised by its articles, may issue preference shares, which are liable to be redeemed at the option of the company before or on a predetermined date. However, after the commencement of the Companies (Amendment) Act, 1996 no company limited by shares shall issue any preference share which is irredeemable or is redeemable after the expiry of a period of 20 years from the date of its issue.
- The auditor should see that the issue of redeemable preference shares is properly authorised by the articles.
- He should vouch the issue and check the necessary records made to the books of account in this connection.
- So long as the shares are not redeemed, the terms of redemption, if any, must be stated in the balance sheet along with the earliest date of redemption.
- He should vouch the receipts of issue price from the cash book and the share registers.
2. Redemption of preference shares
Section 80 of the Companies Act describes the conditions to be fulfilled for the purpose of redemption of preference shares:
- The shares to be redeemed are fully paid up.
- The shares are to be redeemed out of profit available for distribution as dividend or out of proceeds of a fresh issue made for the purpose of redemption.
- The premium on redemption, if any, is to be provided for either out of the securities premium account or out of divisible profits of the company.
- If the shares are to be redeemed out of profits, otherwise available for dividend, an amount equal to the nominal amount of shares to be redeemed has to be transferred to the capital redemption reserve account.
- The auditor should see that the redemption of preference shares is in accordance with the provision of Section 80 of the Companies Act.
- In case the shares are redeemed out of fresh issue, the auditor should verify the articles and the minutes of the director’s meeting.
- In case the shares are redeemed out of divisible profits, he should see that the nominal value of shares redeemed has been transferred to the capital redemption reserve account.
- The auditor should also ensure that the capital redemption reserve account is treated as part of capital and not applied except for paying up un-issued share capital of the company to be issued to members as fully paid up bonus shares.
9.3.12 Alteration of Share Capital
A company having a share capital, if so authorised by its articles, may alter its share capital by an ordinary resolution without confirmation of the court, in any of the manners authorised by Section 94. Each alteration made should be noted in every copy of the Memorandum or Articles issued subsequent to the date of alteration (Section 40).
- The auditor should verify that the alteration of capital is authorised by the articles.
- He has to inspect the minutes of the shareholders authorising the alteration.
- He has to see that the procedures prescribed by the articles in this regard has been duly complied with.
- He should verify that the share capital account is correctly presented in the balance sheet.
- He has to inspect the director’s resolution in regard to allotment, consolidation, conversion or sub-division passed pursuant to the resolution of the members.
- He should examine the cancelled share certificates, if any, and match the same with the counterfoils of new certificates issued.
- He should check the required journal entries being incorporated in the accounts to give the effect of alteration to share capital.
- The auditor should see that the necessary intimation to the Registrar contemplated by Section 95 has been sent.
9.3.13 Reduction of Share Capital
The provisions of Section 100 to 105 of the Companies Act, 1956 describes the procedures of reduction of share capital. Reduction of capital may be affected in the following ways:
1. Reduction without the consent of the court
In the following cases, a company need not obtain the confirmation of the court for reducing its share capital:
- Where redeemable preference shares are redeemed in accordance with the provision of Section 80
- When any share is forfeited for non-payment of calls
- Where there is a surrender of shares
- When un-issued shares are cancelled.
2. Reduction with the consent of the court
The Act has neither prescribed the manner in which the reduction of share capital is to be carried out nor has it prohibited any method of affecting the reduction if a companyfulfills the following.
- It is authorised by its Articles.
- It has passed a special resolution for the purpose.
- It has obtained the confirmation of the court.
- It may reduce its share capital in any one of the following ways:
- Reduce or extinguish the liability on any of its shares in respect of share capital not paid up
- Cancel any paid up share capital, which is lost or is not represented by the available assets
- Pay off any paid up share capital which is in excess of the needs of the company.
- The auditor should verify that special resolution for this purpose has been passed in the general meeting of the shareholders and the proposal has been circulated in advance to the members.
- He should confirm that the reduction of capital is authorised by the articles of association.
- He should examine the order of the court confirming the reduction, if the reduction is in accordance with the consent of the court.
- He should also inspect the Registrar’s certificate as regards reduction of capital.
- The auditor should vouch the journal entries passed to record the reduction of share capital.
- He should verify the adjustments made in the member’s accounts in the register of members.
- He should confirm that the words “and reduced”, if required by the order of the court, have been added to the name of the company in the balance sheet.
- The auditor should also verify that the Memorandum of Association of the company has been suitably altered.
9.3.14 Share Transfer
Large-size companies, having numerous shareholders and having their shares quoted in the recognised stock exchanges, often face the problem of frequent and large-scale share transfer. There is a possibility of errors and mistakes or even fraud taking place in the process for which the company may have to pay damages. Therefore, the management often appoints auditors for carrying out this special assignment, though the arrangement for this audit may be concurrent with the ordinary audit.
- The auditor should inspect the articles regarding the prescribed form of transfer and other provisions, particularly the time limits laid down by the articles.
- He should scrutinise transfer forms, noting specially that:
- in every case, the application for transfer was made in the prescribed form and the prescribed authority had stamped the date on which it was presented to it
- each transfer form is properly executed and bears the appropriate stamp duty
- He should vouch the entries in the share transfer journal by reference to the transfer form.
- He should verify postings from the transfer journal to the register of members.
- The auditor should also inspect letters of indemnity for lost certificates and ensure that duplicate certificates have been issued by proper authority.
- Where part of the shares has been transferred, the auditor should verify the issue of balance certificates to the transferors and confirm that the distinctive number of shares has been correctly stated.
- The auditor should verify by reference to the minute’s book that the Board has approved all the transfers recorded in the transfer journal.
- He should reconcile the amount of transfer fees collected with the total number of transfers and verify that the amount of transfer fees have been accounted for.
- He should also reconcile the total number of shares of different classes issued by the company with the total amount of capital issued and its sub - divisions by extracting balances of shares held by different members from the members’ register.
- Finally, the auditor should confirm that the shares transferred by the Directors have been entered in the register of Directors’ share holding.
9.4 AUDIT OF DEBENTURES
Debentures are considered as one of the important sources of external fund to a company. A company may issue debentures to raise funds, provided it is empowered to do so. Memorandum and Articles of Association assigns powers to the company in this regard. Debentures are not considered a part of the capital of the company. Debenture holders are merely the creditors of the company. They have the right to receive interest at a fixed percentage irrespective of the quantum of profit earned by the company in a particular period. The audit procedure of debentures is explained in the following part of this section.
Debentures may be issued at par or at a premium or at a discount. When the debentures are issued at a premium, the amount of premium collected should be credited to premium on debenture account. Subsequently, this balance is transferred to capital reserve account, as it is a capital profit. Where the debentures are issued at a discount, the amount of discount allowed should be debited to discount on issue of debenture account. The balance in this account will appear in the balance sheet until written off.
- The auditor should verify that the prospectus had been duly filed with the registrar before the date of allotment of debentures.
- He should check the allotment of debentures by reference to the director’s minute book.
- He should also check the amount collected in the cash book with the counterfoils of receipts issued to the applicants and also cross check the amount into the application and allotment book.
- The auditor should verify the entries on the counterfoils of debentures issued with the debentures register.
- He should examine the debenture trust deed and note the conditions contained therein as to issue and repayment.
- If the debentures are covered by a mortgage of charge, it should be verified that the charge has been correctly recorded in the register of mortgage and charges and it has also been registered with the registrar of companies.
- Where debentures have been issued as fully paid up to vendors as a part of the purchase consideration, the contract in this regard should be checked.
- Compliance with SEBI guidelines should also be ensured.
9.4.2 Redemption of Debentures
A company can issue redeemable as well as irredeemable debentures. If debentures are redeemable, it can be done in any of the following three ways:
- By way of periodical drawing
- By way of payment on fixed date
- By payment whenever the company desires to do so.
- The auditor should inspect the debentures or the trust deed for the terms and conditions of the redemption of debentures.
- The auditor should also refer to the Article of Association.
- He should see the Directors’ minute book authorising the redemption of debentures.
- He should also vouch the redemption with the help of debenture bonds cancelled and the cash book.
- The auditor should also examine thoroughly the accounting treatment given to the redemption.
9.4.3 Interest on Debentures
A predetermined fixed rate of interest is payable on debentures irrespective of the fact that the company has been able to earn any profit or not. Debenture-holders are the creditors of the company, not the owners. They have no voting rights and cannot influence the management for the affairs of the company, but their claim of interest rank ahead of the claim of the shareholders.
- The repayment of interest should be vouched by the auditor with the acknowledgement of the debenture-holders, endorsed warrants and in case of bearer debentures with the coupons surrendered.
- The auditor should reconcile the total amount paid with the total amount due and payable with the amount of interest outstanding for payment.
- Interest on debentures is payable, whether or not any profit is made. Therefore, a provision should be made that unless it has been specially agreed with the debenture-holders, interest in such a case would be waived by them. The auditor should also consider this aspect.
- The auditor should also consider the disclosure part of the interest on debentures. He should ensure that the interest paid on debenture, like that on other fixed loans, must be disclosed as a separate item in the profit and loss account.
9.4.4 Re-issue of Redeemed Debentures
A company may issue debentures previously redeemed, either by re-issuing the debentures or issuing others in their place. But re-issue is not possible, if the articles or a contract or resolution, recorded at a general meeting, or terms of issue or some other act of the company expressly or impliedly manifest the intention that, on redemption, the debentures shall be cancelled.
However, there are re-issue of redeemed debentures, or the issue of others in their place are treated as a new issue for the purpose of stamp duty and the rights and privileges attaching to the debentures that re-issued shall be the same as if the debentures had never been redeemed.
On these considerations, it is necessary for the auditor to verify the re-issue of debentures in the same manner as those issued for the first time.
The auditor will verify the following:
- Whether the articles permit such re-issue
- Whether the terms and conditions of debenture impose any restriction on re-issue of debentures after they have been redeemed
- Whether the company has passed any resolution in the general meeting for re-issue of redeemed debenture
- Whether Section 121 of the Companies Act, which empowers the holders of re-issued debentures hold same rights and priorities as the original holders, have been complied with
- Whether particulars of re-issued debentures have been clearly shown in the balance sheet
- Whether fresh stamp duty has been paid on re-issued debentures.
9.4.5 Issue of Debentures as Collateral Security
Debentures may be issued to creditors, bankers or any other person, without receiving any cash thereon. It acts as a collateral security and becomes real debentures in the event of the default of the loan. Usually the nominal value of such debentures is more than that of the amount of loan.
- The auditor should see that such debentures do not appear on the liabilities side of the balance sheet, but are shown by way of a note under the heading loan.
- The auditor should ensure that necessary entries made in the register of mortgages and that the necessary papers are filed with the registrar of companies.
- He should also examine the loan agreement and confirm that it has been approved by the board.
- He should also check whether the debentures are automatically cancelled as soon as the loan is repaid.
9.5 AUDIT OF HOLDING COMPANY
A holding company is that company which holds whole or more than half of the equity shares in one or more companies and thus assumes controlling interest in such companies by acquiring majority voting powers in them. The development of holding companies is quite marked in recent years and there are many such business organisations today, even international in character, controlling large number of companies in countries all over the world.
According to Section 4 of the Companies Act, 1956 a holding company is that which fulfills the following requirements.
- Holds more than 50 percent of the nominal value of the equity share capital of another company.
- Controls the composition of the board of directors of the other companies.
- Controls more than half of the total voting power of the other companies.
- Has a subsidiary, which is the subsidiary of the holding company’s subsidiary.
9.5.1 Legal Requirements Regarding Accounts of Holding Companies
The various provisions of the Companies Act related to holding company accounts are given in Sections 212, 213 and 214 and Schedule VI, Part I. These include the following
1. Preparation of balance sheet
The balance sheet of the subsidiary shall be made:
- At the end of the financial year of the subsidiary if it coincides with the financial year of the holding company, or
- At the end of the financial year of the subsidiary last before that of the holding company, in case the financial year of the subsidiary does not coincide with that of the holding company.
2. Disclosure of special items in the balance sheet
The following items should be specifically mentioned in the balance sheet of the holding company related to its subsidiary:
- The aggregate amount of loans and advances to subsidiary company
- The aggregate amount of investment in shares or debentures or bonds in subsidiary company
- Secured loans and advances from subsidiaries
- Unsecured loans and advances from subsidiaries
- The aggregate amount of liabilities due to subsidiary companies.
3. Preparation of profit and loss account
The profit and loss account of the subsidiary must be made out within the period to which the accounts of the holding company relate. But where the financial year of the subsidiary does not coincide with that of the holding company, the financial year of the subsidiary shall not end on a day which precedes the day on which holding company’s financial year ends by more than six months.
4. Statement of profit and loss
A statement should be there specifying how the profits of the subsidiary company or aggregate profits or losses of the subsidiary have been taken into accounts of the holding company. Such statement would also specify how and to what extent, losses, if any, of the subsidiaries have been brought into the accounts of the holding company. Such statement shall be signed by the persons by whom the balance sheet of the holding company is required to be signed.
5. Documents to be attached
The holding company shall at the end of the financial year attach to its balance sheet the following documents in respect of its subsidiary company:
- A copy of the balance sheet of the subsidiary
- A copy of the profit and loss account
- A copy of the report of its board of directors
- A copy of the report of its auditors
- A statement of the holding company’s interest in the subsidiary
- A statement containing any change in the holding company’s interest in the subsidiary or any material change of the subsidiary in its fixed assets, investments, money borrowed etc.
- A report attached to the balance sheet if the board of directors of the holding company is unable to obtain information on any of the specified matters.
The holding company may, by resolution, authorise a particular representative to inspect the books of accounts of any of its subsidiaries during business hours.
The members of the holding company may request the central government to appoint a person to investigate into the affairs of its subsidiaries.
The central government may exempt the holding company from the application of the provision with regard to attachment of various documents to the balance sheet. It is also empowered to extend the financial year so that it may coincide in both the cases.
9.5.2 Consolidation of Accounts
Holding companies attach to their own balance sheet a consolidated balance sheet to give a more detailed and clear picture of their subsidiaries. Such consolidated balance sheet is definitely more useful than the separate balance sheet of each of the subsidiaries. For this purpose, the whole group is regarded as one undertaking and hence the total assets as well as liabilities of all the companies in the group are presented in one balance sheet. The profit and loss account of the whole group is also presented in a similar fashion.
Accounting Standard 21 on ‘Consolidated Financial Statements’ issued by the Institute of Chartered Accountants of India on consolidation of accounts prescribes the accounting principles to be followed by the holding companies in consolidating the balance sheet and profit and loss account with that of the financial statements of the subsidiaries.
The following points should be kept in mind while consolidating the accounts of the holding company:
1. Date of consolidation
The date of the balance sheets of all the companies should be the same. If it is not so, efforts should be made to make adjustments so that the financial position of all the companies should be shown as on a particular date in the consolidated balance sheet.
2. Valuation of assets and liabilities
The basis for the valuation of assets or of bringing liabilities into account should be similar in all cases.
3. Share of subsidiaries
The shares of subsidiaries have to be adjusted by replacing them with the actual assets and liabilities of the subsidiary companies.
4. Minority interest
In case a part of the shares of subsidiary companies is held by persons other than the holding company, their total interest should be shown as liabilities in the consolidated balance sheet.
5. Inter-company loans
The loans taken by the subsidiaries amongst themselves should be shown in the consolidated balance sheet as inter-company debt. However, it has to be set off.
Inter-company profits, if any, should also be adjusted by deducting it from the profit and loss account and the related assets, if they are added therein. Thus, in the consolidated balance sheet, stock and such other type of assets should be combined together at cost.
7. Profits or losses of minorities
The proportion of profits or losses belonging to outside shareholders should be properly adjusted. They should be deducted from the consolidated profit and loss account and at the same time shown as liabilities in the consolidated balance sheet, as they do not belong to the holding company.
The duties of an auditor of a holding company with regard to its subsidiaries have not been extended by the Companies Act, 1956. He has to perform the same type of duties as provided under the Act as in the case of other companies. The additional care which he has to take is to see that the provisions of Sections 212, 213 and 214 as mentioned earlier have been duly complied with.
However, the auditor of a holding company has to see whether the financial statements of the holding company is consolidated with the financial statements of its subsidiaries by following the principles as prescribed in the AS-21 and, if not, he has to report accordingly.
In addition to above, the auditor of a holding company has to pay attention to the following points:
- He should examine the contract of purchase and vouch the purchase consideration, if he finds that during the year under audit, the company has purchased shares in a subsidiary company. He also sees that the shares have been registered in the name of the holding company.
- He should examine and verify the inter-company transactions carefully. He should ascertain that all such transactions have been properly recorded in the books of accounts of the holding company.
- He must verify the valuation of shares in the subsidiary company held by the holding company. Due attention should also be given to any provisions with regard to valuation of shares contained in the memorandum and articles of the company.
- He must vouch the dividends received from the subsidiary companies and see that they have been properly dealt with in the accounts.
- He must examine that the requirements of Schedule VI of the Companies Act with regard to the disclosure of certain items related to the accounts of subsidiary companies separately in the balance sheet of the holding company have been duly complied with.
- He must see that the balance sheet gives a true and fair view of the financial state of affairs of the company.
9.6 AUDIT OF PRE-INCORPORATION PROFIT
In many cases, a new company is formed to acquire exclusively an existing business unit and take it over as a going concern, from a date prior to its own incorporation. In such cases, the business unit is purchased first and the registration of the acquiring company takes place later.
The profit earned during the pre-incorporation period is called ‘pre-incorporation profit (loss)’. Legally, this profit is not available for dividend, since a company cannot earn profit before it comes into existence. Profit earned before incorporation of a company is a capital profit and its accounting treatment is totally different from post-incorporation profit.
Accounting Treatment of Pre-incorporation Profit/Loss
Any profit prior to incorporation may be dealt with as follows:
- Credited to capital reserve account
- Credited to goodwill account to reduce the amount of goodwill arising from acquisition of business
- Utilised to write down the value of fixed assets acquired.
Any loss prior to incorporation may be dealt with as follows:
- Debited to goodwill account
- Debited to capital reserve account arising from acquisition of business
- Debited to a suspense account, which can be written-off later.
- The auditor should examine the methods of calculating such profits and profits subsequent to incorporation.
- He should ensure that such profits are not distributed as dividend to shareholders as these are in the nature of capital profits.
9.7 SPECIFIC PROVISIONS FOR ACCOUNTS IN THE COMPANIES ACT
The provisions in the matter of books of account, which a company is required to maintain, are contained in Section 209 of the Companies Act, 1956. They are briefly summarised as follows:
1. Books to be maintained
Every company shall keep at its registered office proper books of accounts, with respect to the following.
- All sums of money received and expended by the company and the matters in respect of which the receipt and expenditure takes place
- All sales and purchase of goods by the company
- The assets and liabilities of the company, and
- In the case of a company pertaining to any class of companies engaged in production, processing, manufacturing or mining activities, such particulars relating to utilisation of material and labour or to other items of cost as may be prescribed in such class of companies as required by the central government to include such particulars: Section-209 (1).
All the books are usually required to be kept at the registered office in India. All or any of the above stated books of accounts might be kept at such other place instead of registered office in India as the Board of Directors may decide. The company must file with the registrar a notice in writing giving the full address of the other place: Section 209 (1).
3. Books of branch offices
Where a company has a branch office, whether in or outside India, the company shall be deemed to have complied with the aforementioned provisions, if the company maintains proper books of account relating to transactions affected at the branch office and also arranges to obtain from the branch proper summarised returns, at intervals of not more than three months, for being kept at the registered office or the other place: Section 209 (2).
4. Method of accounts
For the purpose of Sub-section (1) and (2), proper books of account shall not be deemed to be kept with respect to the matters specified therein:
- If they 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
- If such books are not kept on accrual basis and according to the double entry system of accounting: Section 209 (3).
5. Inspection of books of accounts
The books of accounts and other books and papers shall be kept open for inspection by any director during business hours: Section 209 (4).
6. Period of preservation
The books of accounts of every company relating to a period of not less than eight years immediately preceding the current year together with vouchers relevant to the entry in such books of accounts shall be preserved in good order. In case of a company incorporated less than eight years before the current year, the books of accounts for the entire period preceding the current year shall be preserved: Section 209 (4A).
If the managing director or manager and, in the absence of any of them, any director of the company fails to take reasonable steps to secure compliance with the requirements of law aforementioned or by a willful act causes any default by the company, he shall be punishable for each offence with imprisonment for a term which may extend to six months or a fine which may extend to Rs. 10,000 or both: Section 209 (5).
9.8 PAYMENT OF INTEREST OUT OF CAPITAL
Under the provisions of Section 208 of the Companies Act, 1956 a company which has raised money by issue of shares to meet the cost of construction of any work or building or provision of any plant which cannot be made profitable for a long time, can pay interest on paid up capital for a period and subject to the conditions specified in Sub-sections (2) to (7) of Section 208.
The interest paid, being a part of the capital expenditure incurred in bringing into existence assets, should be added thereto. Until so added, it must be shown as a separate item in the balance sheet under the head ‘miscellaneous expenditure’.
- The auditor should ascertain that the payment is authorised by the articles or by a special resolution.
- He should verify that the sanction of the central government for making such payment has been obtained.
- He should confirm that the interest has been paid only for such period as has been authorised by the central government and does not extend beyond the next half-year following during which the construction was completed or the plant was provided.
- He should verify that the rate of interest does not exceed 12% or such other rate that the central government has notified in the official gazette.
- The auditor should also check that the amount of interest paid out of capital has been added to the cost of the assets created.
9.9 SPECIAL REQUIREMENTS OF COMPANY AUDIT
The company audit is compulsory in nature and governed basically by the provisions of the Companies Act. While conducting audit in a company form of organisation, the auditor should take into consideration certain requirements of company audit as dictated by the provisions of the companies act.
The special requirements to be kept in mind by the auditor while conducting company audit are described below:
9.9.1 Verification of the Constitution and Power
A company can function within the limits prescribed by the documents on the basis of which it has been registered. It raises its capital from the public on certain conditions. On this account, it is essential that the auditor, prior to starting the audit of a company, shall examine the following:
1. Memorandum of Association
It is a charter containing particulars of business activities that the company can undertake and the powers it can exercise in regard thereto. If a company enters into a transaction, which is ultra-vires, the shareholders may restrain the management from charging the loss, if any, that has been suffered thereon, to the company. If the auditor fails to detect and report the transactions, which are ultra-vires the company, he would be guilty of negligence.
2. Articles of Association
These are rules and regulations for the internal management of the company and they define the rights of different classes of shareholders, conditions under which calls can be made, the maximum and the minimum number of Directors, their qualifications, disqualifications and removal etc. The terms and conditions of these provisions have relevance to the examination of transactions that the auditor is required to carry out. He should, therefore, study the articles and include extracts from them in his permanent audit file. The auditor, who fails to take note of the provisions in the articles in the verification of statements of accounts, would be guilty of professional negligence.
It is a formal document which a public company must issue before it makes the allotment of shares under Section 56. It must contain all the terms and conditions on which subscription to the shares are sought to be obtained from the public. In case the company fails to carry out any of these undertakings, or if any statement made by it ultimately is proved to be false, the shareholder has the right to claim refund of the amount paid by him. The auditor should, therefore, study carefully all the conditions and stipulations made in the prospectus and in case any of them has not been carried out, draw the attention of shareholders thereto.
9.9.2 Knowledge About Authority Structure of the Company
With a view to carry out the audit effectively, it is necessary that the auditor should know the authority structure of the company. Under Section 291 of the Act, the Board of Directors of a company are entitled to exercise all such powers and to do all such acts and things, as the company is authorised to do.
Section 292 specifies five types of decisions that can be taken by the Board of Directors only in Board’s meetings. These include the following:
- Making calls on partly paid shares
- Issue of debentures
- Borrowing money other than on debentures
- Investing the fund of the company and
- Making loans
Apart from the above, the Board also carries out a number of other functions. Such functions include the following:
- Adopting of accounts before the same to be submitted to the auditor for their report—Section 215
- Appointment of the first auditors and filing of casual vacancy-Section 224
- Investment in shares of companies within the limits-Section 372A
- Entering into contracts with persons who are directors of the company or related to or associated with the directors as specified in Section 297 of the Companies Act.
However, the Board shall not exercise any power or do any act or thing which is directed or required by any legislation or by the memorandum or articles of the company, to be exercised or done by the company, in a general meeting.
Following are some of the matters, which only the shareholders can sanction in a general meeting:
- Appointment and fixation of remuneration of auditors in the annual general meeting—Section 224
- Declaration of Dividend—Regulation 85, Table A
- Appointment of relative of directors to an office or place of profit in the company— Section 314
- Sale, lease or disposal of the whole of the company’s undertakings or a substantial part of it and donations above a certain limit—Section 293(1).
Some matters which require the sanction of the central government e.g. for sanctioning loans to directors by a company other than a banking or a finance company, can not be exercised by the board of directors or the shareholders.
9.10 COMPANY AUDITOR
An auditor is a person who is appointed to conduct an independent examination of books, accounts and supporting vouchers to report on the reliability and fairness of profit and loss account and balance sheet. He is a professional man having specialised knowledge and expertise in all branches of accounting.
In order to ensure that the person conducting the audit of accounts of company have sufficient knowledge in accounting, the Companies Act requires him to be a chartered accountant within the meaning of the Chartered Accountants Act, 1949. Apart from being well versed in accounting, the auditor should be honest, tactful, methodological, cautious and careful. Lord Justice Lindley in his famous case London and General Bank (1895) held that “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”. Learned Judge Lopes in Kingston Cotton Mill case remarked, “an auditor need not be overcautious or always suspicious. He is a watchdog but not a bloodhound. He is justified in believing the tried servants of the company and entitled to rely upon their representation provided he takes reasonable care.”
9.10.1 Appointment of Auditors
The provisions regarding appointment of the auditors are contained in Section 224 of the Companies Act.
1. First auditor
Section 224(5) provides for the appointment of first auditors, by the Board of Directors within one month of the date of registration of the company. The auditor or auditors so appointed shall hold office till the conclusion of the first annual general meeting.
But the company may at a general meeting remove such an auditor and appoint another in his place, on a nomination being made by any member of the company, notice being given to the members of the company, not less than 14 days before the date of the meeting.
If the first auditor is not appointed by the directors, within one month of registration, the company in general meeting may appoint the first auditor. The auditor of a company is normally appointed by the shareholders by passing a resolution at the annual general meeting. Once appointed, he holds office from the conclusion of that meeting to the conclusion of the next annual general meeting.
An auditor once appointed may be reappointed in the next annual general meeting or a new auditor may be appointed in his place. It is obligatory on the part of a company to annually make such an appointment, as well as to give, within seven days of the appointment, intimation to every auditor so appointed or reappointed.
Subsequent auditors of a company are appointed every year by the shareholders in annual general meeting by passing an ordinary resolution. According to Section 224(1), “Every company shall, at each annual general meeting, appoint an auditor to hold office.” Section 224 (1A) requires the auditor so appointed to communicate his acceptance or refusal to the registrar within the period of 30 days of the receipt from the company intimating his appointment.
If the auditor so appointed does not accept the appointment, the vacancy can neither be treated as casual vacancy nor a vacancy by resignation. The research committee of the Institute of Chartered Accountants of India has clearly expressed this opinion on the strength of the provisions of the Companies Act which vest the general power with shareholders and the delegation of powers to the board of directors is not permitted. Therefore, another general meeting has to be convened to appoint new auditor.
3. Appointment by central government
According to Section 224(3), where at an annual general meeting, no auditors are appointed or re-appointed, the central government may appoint a person to fill the vacancy. Within seven days of the power of the central government becoming exercisable, the company shall give notice of that fact to the central government. Failure to give such notice will make the company in default with a fine, which may extend to Rs. 5,000.
4. Appointment against a casual vacancy
If due to death, insanity or insolvency etc, a casual vacancy of the auditor arises, the board of directors can fill the same u/s 224(6). The auditor appointed against such a vacancy will hold office till the conclusion of the next annual general meeting.
5. Appointment by special resolution
The Companies (Amendment) Act, 1974 introduced Section 224A, which provides that in the case of a company in which 25%, or more, of the subscribed share capital is held, whether individually or collectively by
- a public financial institution or a government company or any state government or
- 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
- a nationalised bank or an insurance company carrying on general insurance business the appointment of the auditor shall be made by a special resolution.
If the company fails to pass a special resolution, it shall be deemed that no auditor has been appointed by the company at its annual general meeting and the central government will be empowered to make an appointment.
6. Appointment of auditors of government or certain other companies
Section 619 provides that the auditor of a government company shall be appointed or reappointed by the central government on the advice of the comptroller and auditor general of India.
The amendment act also introduced another section, i.e. Section 619B which extends the provision of Section 619 to a company in which the central government or state government or any government company or any government corporation hold either singly or jointly not less than 51% of the paid up share capital.
A person should keep these provisions in mind while accepting an appointment as the auditor of a company since the onus of complying with the provisions of section 619B lies with the concerned companies. All the same it would be necessary on the part of the auditors appointed or re-appointed under Section 224 of the Act to ensure, before accepting the appointment/ re-appointment that the company concerned is in fact outside the ambit of Section 619B of the Act.
9.10.2 Tenure of Appointment
Section 224 (1) of the Companies Act provides that an auditor is appointed from the conclusion of one annual general meeting until the conclusion of next annual general meeting. But, if the annual general meeting is not held within the period prescribed by Section 166, the auditor will continue in office till the annual general meeting is actually held and concluded. So, if an annual general meeting is adjourned, his tenure will extend till the conclusion of the adjourned meeting.
9.10.3 Re-appointment of Retiring Auditor
According to the provisions of Section 224(2), retiring auditor, by whatsoever authority appointed, shall be automatically re-appointed by passing an ordinary resolution except in the following circumstances:
- Where he is not qualified for re-appointment
- Where he has given to the company a notice in writing of his unwillingness to be re-appointed
- Where a resolution has been passed at the meeting, appointing somebody else instead of him or providing expressly that he shall not be re-appointed
- Where a notice has been given of an intended resolution to appoint some person in the place of retiring auditor, and by reason of death, incapacity or disqualification of that person, the resolution can not be proceeded with.
The re-appointment will not be automatic. Also, the non-reappointment of the retiring auditor in the annual general meeting is not removal of the auditor. It will be considered simply as retirement.
The auditor will also not be re-appointed in the following two special cases:
- Where he holds the audit of specified number of companies or more than that on the day of appointment in terms of Section 224 (1B) of the Companies Act.
- Where 25%, or more, of the subscribed capital of the company is held by public financial institution(s), government companies etc. or a combination of them, unless the retiring auditor is appointed by a special resolution.
The rights of retiring auditor are as follows:
- He has the right to receive the notice of the resolution.
- He has the right to make a written presentation to the company and request its notification to members of the company.
- The auditor has the right to get his representation circulated among the members.
- He has the right to get his representation read out at the meeting, if it has not been sent to the members because of delay or default on the part of the company.
The Companies (Amendment) Act, 1974 added two new sub-sections 224(1B) and 224(1C) on ceiling on number of audits. The objective of these sections is to prevent concentration of audits in few hands. These sections were further amended in 1988 and finally revised in the year 2000.
According to Section 224(1B), an individual cannot be the auditor of more than 20 companies at a time. Further, out of these 20 companies not more than 10 should be companies having a paid up share capital of Rs. 25 lakhs or more. In case of a partnership firm of auditors, the ceiling is 20 companies per partner of the firm and if a partner is also a partner in any other firm, the overall ceiling in relation to such a partner will be 20.
In a firm of chartered accountants, say, there are three partners— X, Y and Z. The overall ceiling of the firm will be 3 x 20 = 60 company audit, out of which not more than 3 x 10 = 30 companies may have paid up share capital of Rs. 25 lakhs or more.
Again, say X is also a partner of another firm of chartered accountants. In that case, in these two firms, total number of company audit he can undertake as a partner of the firms is limited to 20 only subject to the ceiling of 10 large company audits i.e. companies having a paid up share capital of Rs. 25 lakhs or more. It is his affair that how he will allocate these 20 company audits between these two firms.
Section 224(1C) has been amended by the Companies (Amendment) Act, 1988 to disallow the appointment of person, who are in full time employment elsewhere, as company auditor. Even in case of partnership, such a partner shall be excluded from counting the number of audits per partner.
According to the recent amendments in the Companies Act in the year 2000, the above provisions are applicable in case of public limited companies only. So, private limited companies are excluded in computing the ceiling of number of audits.
However, the Institute of Chartered Accountants of India has issued a notification [No. 1-CA (7)/53/2001] in the gazette of India dated 19th May 2001 to include private companies also within the ceiling of 20 companies. According to the notification, “a member of the Institute in practice shall be deemed to be guilty of professional misconduct, if he holds at any time appointment of more than specified number of audit assignment of the companies including private companies.”
9.10.5 Remuneration of Auditor
- In case of an auditor appointed by the Board of Directors or the central government, his remuneration may be fixed by the Board of Directors or the central government as the case may be.
- In all other respect, it must be fixed by the company in general meeting or in such manner as the company in general meeting may determine.
‘Remuneration’ includes any sum paid by the company in respect of the auditor’s expenses in carrying out his duties. Obviously, the general meeting can disperse without deciding the amount of the remuneration of the auditor. However, it must provide the manner in which the remuneration can be determined.
If an auditor renders services other than the audit work, he will be entitled to get additional remuneration for such work. A special disclosure of all amount paid to the auditor in whatever capacity is required to be made in the profit and loss account as any of the following
- As auditor
- As adviser, or in any other capacity, in respect of
- taxation matters,
- company law matters,
- management services, and
- In any other manner.
The aforesaid manner of disclosure is required by Part II of Schedule VI to the Act.
Where the auditor is re-appointed in the next annual general meeting, the amount fixed for the previous year continues to be the remuneration of the auditor, unless specific changes are made.
9.10.6 Qualification of an Auditor
Section 226 of the Companies Act prescribes the qualification and disqualification of Company Auditors. According to Section 226(1), “a person shall not be qualified as auditor of a company unless he is a chartered accountant within the meaning of the Chartered Accountants Act, 1949.”
It further provides that a firm whereof all the partners practicing in India are qualified for appointment as auditors may be appointed by firm’s name to be the auditor of the company. In this connection, it may be noted that under the Chartered Accountants Act, 1949 only a chartered accountant having a certificate of practice can be engaged in the public practice of the profession of accountancy. Therefore, only a practicing chartered accountant can be appointed as an auditor of a company.
In addition to above, a person, holding a certificate under the law in force in the whole or any portion of a Part B State immediately before the commencement of the Part B States (Laws) Act, 1953 or of the Jammu and Kashmir (Extension of Laws) Act, 1956 as the case may be, entitling him to act as an auditor of the companies in the territories which, immediately before 1st November, 1956 were comprised in that state or any portion thereof, shall also be entitled to be appointed to act as an auditor of companies registered anywhere in India.
Thus, the auditor of a company must either be (1) a practising chartered accountant, or (2) the holder of a certificate in erstwhile Part B States entitling him to act as an auditor of companies.
9.10.7 Disqualification of an Auditor
Section 226(3) provides the disqualification of auditors. According to it, none of the following shall be qualified for appointment as an auditor of a company:
- A body corporate
- An officer or employee of the company
- A partner or an employee of an officer or employee of the company
- A person who is indebted to the company for an amount exceeding Rs. 1,000 or who has given any guarantee or provided any security in connection with the indebtness of any third person
- A person holding any security of the audit company when such security carries voting right.
A person shall not be qualified for appointment as an auditor of a company if he is, by virtue of Section 226(3), disqualified for appointment as an auditor of any other company which is that company’s subsidiary or holding company or a subsidiary of that company’s holding company.
Disqualification may come to an auditor if he ceases to be a member of the Institute of Chartered Accountants of India or adjudged as having unsound mind or is an undischarged insolvent.
If after his appointment, an auditor becomes disqualified subject to any of the points listed above, he shall be deemed to have vacated his office as such.
9.10.8 Removal of Auditors
An appointed auditor may be removed from his office either in accordance with the provisions of the Companies Act or as per restrictions imposed by the Chartered Accountants Act.
Removal as per the Companies Act
The removal of the auditor in accordance with the provisions of the Companies Act depends upon the option of the concerned company. He may be removed before the expiry of his term or after the expiry of his term. The service of the first auditor appointed by the board and supposed to hold office till the conclusion of the first annual general meeting can be terminated beforehand by way of passing a resolution in a general meeting. However, the removal of any subsequent auditor before the expiry of his term is difficult in the sense that it requires the approval of the central government as per Section 227 (7). So, the central government has to be convinced about the unsuitability of the existing auditor to continue as auditor.
The Companies Act lays down clear procedures about the removal of auditors in Section 224 and Section 225.
- Removal before the expiry of the term
- Under Section 224(5)(a), it is provided that the company can remove in a general meeting the first auditor appointed by the board of directors.
- Under Section 224(7), it is provided that except the first auditor, auditors appointed u/s 224 could be removed before the expiry of the term in a general meeting, only after obtaining previous approval of the central government.
- Removal after the expiry of the term
The auditor can be removed after the expiry of his term of office, as per the procedures laid down in Section 225.
According to the Section, for removal of a retiring auditor or appointing another auditor in his place, the following procedures must be observed:
- Special notice must be given by a member of the intended resolution to be passed at an annual general meeting
- On receipt of such a notice, the company shall forward a copy thereof to the retiring auditor
- The retiring auditor then may make written representation to the company not exceeding a reasonable length and request their notification to the members of the company.
The company shall, unless the representations received by it are too late to do so,
- state the fact of the representation in any notice of the resolution given to members of the company and
- send a copy of the representation to every member of the company to whom notice of the meeting is sent.
If a copy of the representation is not sent as aforesaid, because they are received too late or because of the company’s default, the auditor may require that the representation shall be read out at the meeting. However, these are not required, if it is established that the above rights are abused by the auditor.
Removal as per Chartered Accountants Act
An auditor may also be removed from his office due to his professional misconduct. Following are some of the important clauses of the Chartered Accountants Act, 1949, which mention the professional misconduct for which a chartered accountant may be removed from his office:
- If a Chartered Accountant accepts the position as an auditor previously held by another chartered accountant without first communicating to him in writing
- If a chartered accountant is grossly negligent in the conduct of his professional duties
- If a chartered accountant is engaged in any business or occupation other than the profession of accountancy unless permitted by the council of the Institute
- If a chartered accountant contravenes any of the provisions of the act and regulation made thereunder etc.
9.10.9 Status of the Company Auditor
The auditor of a company can be considered a servant of the company, an agent of the shareholders as well as an officer of the company.
1. A servant of the company
Like any other employee or director of a company, an auditor also renders his services to the company. The employees get remuneration from the company for their services. The auditor is receiving remuneration from the company, (not termed as audit fees) for the services rendered by him for the company. Hence, like employees of the company, the auditor may also be considered as a servant of the company.
But if payment to auditor by the company makes him a servant of the company, it will create a lot of confusion. Then the doctor who is paid by the patient is to be treated as servant of the client. So, it would not be logical to treat the auditor as servant of the company.
2. An agent of the company
Except in certain special situations where an auditor is appointed by the Directors or the central government, an auditor is normally appointed by the shareholders. Not only that, the auditor checks the accounts on behalf of the shareholders and he has to submit his report to the shareholders. It therefore appears that an auditor is an agent of the shareholders.
Lord Cranworth in the course of his judgment in the case Spackman vs Evans also said, “The auditor may be the agent of the shareholders, so far as it relates to the audit of the accounts. For the purpose of the audit, the auditors will bind the shareholders”.
However, according to the Law of Agency, “he who does through another does by himself”. It means that any act of the agent will be purported to be the act of the principal. But this relationship does not exist between the shareholders and the auditors. Again, under the same law, the knowledge of an agent regarding a matter is also taken as the knowledge of the principal. So far as company auditor is concerned, he is not supposed to intimate the shareholders any information other than the actual results and financial position through financial statements.
Therefore, a company auditor cannot be treated as an agent of the shareholders. He can best be described as the representative of the shareholders under certain circumstances.
3. An officer of the company
An auditor is an officer of the company under Section 2(30) of the Companies Act for the purpose of the following sections:
- Section 477: Powers to summon persons suspected of having property of the company.
- Section 478: Power to order public examination of promoters, directors, officers etc.
- Section 539: Penalty for falsification of books
- Section 543: Power of the court to assess damages against delinquent directors, officers etc. in course of winding up procedure
- Section 545: Prosecution of delinquent officers and members of the company
- Section 621: Offences against act to be cognizable only on complaint by registrar, shareholder or government
- Section 625: Payment of compensation in cases of frivolous or vexatious prosecution
- Section 633: Power of the court to grant relief in certain cases
Except for the above sections, an auditor shall not be considered as an officer under the Companies Act, 1956.
In addition to that there are many legal decisions where a company auditor has been termed as an officer of the company. In London and General Bank case, it was held by Justice Lindley that it seems impossible to deny that for some purposes and to some extent, an auditor is an officer of the company. It was also held in the famous Kingston Cotton Mills Co. Ltd. case that the auditors are officers of the company.
But an officer is bound by the service rules of the company and is required to work as per the directions given to him. But independence in the work of an auditor is a well-established principle. He needs to be independent of management in order to make his report reliable to the shareholders and other interested parties like bankers, creditors etc. There fore, the auditor must work according to his own judgment and independent thought even though that may not suit the desire of management. So, to treat the auditor as an officer of the company is contrary to the basic philosophy of audit.
The position of an auditor is, therefore, a bit controversial. Sometimes he may appear to be an agent of the shareholders and sometimes he may be considered an officer of the company. But an auditor is an independent person rendering professional services to the company in return of fees. He can neither be an agent of the shareholders nor be an officer of the company, nor is he a servant of the company.
9.10.10 Auditor’s Rights, Duties and Liabilities
The auditor of a company has statutory rights, duties and liabilities under the Companies Act.
Rights of a company auditor
An auditor of a company is required to report on the truth and fairness of the financial statement of the company. To perform his duties effectively, he requires some rights and powers. In case of sole-proprietor or partnership firm, the rights and duties of an auditor are determined by the agreement entered into by him with the sole proprietor or the partnership firm as the case may be. But the Companies Act, 1956, has specifically laid down the rights and duties of a statutory auditor of a joint stock company. These rights and duties are absolute and cannot be curtailed in any way. Any resolution or provision in the articles in this regard will be null and void. It was held in the case of Newton vs Birmingham Small Arms Co. Ltd. that any resolution precluding the auditor from of any information to which he is entitled to as per Companies Act is inconsistent with the Act.
The Companies Act provides the following rights to the auditor to enable him to discharge his duties properly:
- Right of access to books and vouchers Section 227(1) of the Companies Act, 1956 provides that the auditor of a company shall have the right of access, at all times, to the books and vouchers of the company whether kept at the head office or elsewhere. This right of the auditor is the fundamental basis on which the auditor can proceed to examine and inspect the records of the company for the purpose of making his report.
- Right to obtain information and explanations Section 227(1) also entitles the auditor to require from the officer of the company such information and explanations as the auditor may think necessary for the performance of his duties. Corresponding to the right to ask for information and explanations, Section 221 of the Act also makes it obligatory for the concerned officers of the company to furnish without delay the relevant information to the auditor.
- Right to visit branch offices and access to branch accounts Section 228(2) of the Companies Act gives specific rights to the company auditor where the accounts of any branch office are audited by another person. The company auditor has the right to visit branch office, if he deems it necessary to do so for the performance of his duties and has the right of access to books and accounts along with vouchers maintained by the branch office.
- Right to receive branch audit reports The company auditor has also the right to receive the audit report from the branch auditor for his consideration and deal with it in such a way, as he considers necessary while preparing his audit report on the accounts of the company.
- Right to receive notices and to attend general meeting Section 231 of the Companies Act entitles the auditors of a company to attend any general meeting of the company and to be heard on any part of the business, which concerns him as the auditor. He is also entitled to receive all notices and communications relating to any general meeting of the company.
- Right to make representation Pursuant to Section 225, the retiring auditor is entitled to receive a copy of the special notice intending to remove him or proposing to appoint any other person as auditor. The retiring auditor sought to be removed has a right to make his representation in writing and request that the same be circulated amongst the members of the company. In case, the same could not be circulated, the auditor may require that the representation shall be read out at the general meeting.
- Right to sign audit report According to Section 229 of the Companies Act, only the person appointed as auditor of the company, or where a firm is so appointed only a partner in the firm practising in India, may sign the auditor’s report.
- Right to seek legal and technical advice The auditor of a company is entitled to take legal and technical advice, which may be required in the performance of conduct of audit or discharge of his duties (London and General Bank Case).
- Right to be indemnified For different purposes, an auditor is considered to be an officer of the company. As an officer, he has the right to be indemnified out of assets of the company against any liability incurred by him in defending himself against any civil or criminal proceedings by the company, if he is not held guilty by the law.
- Right to receive remuneration On completion of his work, an auditor is entitled to receive his remuneration. The rights of the auditor cannot be limited by any resolution of the members passed in the general meeting (Homer vs Quitler).
Right of lien of company auditor
The right of ‘lien’ means right of one person to retain the property of another person who owes money to the former. The right of lien of an auditor of a limited company indicates his right to retain documents and records of the company for his unpaid fees. The Companies Act is silent about the right of lien of auditors on clients’ documents and records. Also there are many conflicting legal judgments regarding this issue. The Institute of Chartered Accountants of England and Wales has issued a guideline in this regard.
Based on that guideline, the auditor’s lien can be discussed under the following heads:
- Lien on books of accounts In the case Herbert Alfred Burliegh vs Ingram Clark Ltd. (1901), it was held that while an auditor acts as an accountant preparing books of accounts, he should have lien on such books of accounts for unpaid fees. But if he merely audits the books of accounts, he will not enjoy any right of lien on them.
But allowing auditor to enjoy right of lien on books of accounts prepared by him will conflict Section 209 of the Companies Act which make it mandatory for every company to keep its books of accounts at its registered office or at such other place in India as the directors think fit. So, the auditor’s lien would not be upheld on books of accounts, which the company has to keep in its possession as per the provisions of the Companies Act.
- Lien on working papers Audit working papers are those documents and records, which the auditors prepare in connection with his audit work. In fact, this question of ownership in respect to the working papers arose in the case of Sockockingky vs Bright Graham & Co. (1938) in England. The question was whether the auditor had a right to retain the working papers as if it were their own property even after the payment of the audit fees. The court gave judgment in favour of the auditors on the ground that they were independent contractors and not agents of the client.
- Lien on communication documents An auditor may communicate with third parties either as an agent on behalf of the client or independently in connection with his work. In this case, the communication documents will belong to the client. However, if the auditor makes correspondence with third parties not as an agent, but as a professional man for discharging his duties, the correspondence with the third parties will be his property.
- Lien on client’s money The auditor should not have any lien on client’s money, which may be kept with him. This is simply because he does not work on the money. He may be required to keep the money as a trustee only. So, if the auditor appropriates client’s money towards his outstanding fees, he will be held liable.
- General or special lien An auditor has only lien on the particular document in respect of which he has rendered his professional service, but he has not yet been paid. He cannot have general lien, i.e. he cannot retain other documents with which he has not been concerned.
Duties of a company auditor
The duties of a company auditor can be described by classifying it in the following categories:
- Statutory duties
- Duty to report: According to Section 227 of the Companies Act, 1956, it is the duty of the company auditor to make a report to the members of the company on the accounts examined by him and on balance sheet and profit and loss account laid before the company in its general meeting.
- Duty to enquire: Sub-section (1A) of Section 227 of the Companies Act specifies six matters, which are required to be looked into by a company auditor. The statement on qualifications in the auditor’s report issued by the ICAI clarifies that the auditor is not required to report on the matters specified in Sub-section (1 A), unless he has any special comments to make on any of the items referred to therein.
- Duty to follow CARO: Under Section 227(4A) of the Companies Act, the central government has the power to direct by a general or special order that in the case of specified companies, the auditor’s report shall include a statement on such matters as may be specified in its order. In accordance with the provision, the central government issued revised order in 2003, namely Companies (Auditor’s Report) Order. The auditor has the duty to follow the order.
- Other duties under the Companies Act: The auditor has the following other duties under the Companies Act:
- Duty of the auditor or a partner of a firm of chartered accountants practising in India to sign audit report (Section 229)
- Duty of the auditor to report on prospectus on the accounting part (Section 56)
- Duty to assist the inspector appointed by the central government to investigate the affairs of the company (Section 240)
- Duty to report on profit and loss account for the period from the last closing date to the date of declaration of insolvency by the directors and also on balance sheet (Section 488)
- Duty to certify the statutory report of the company in respect of shares allotted, cash received in respect of such shares and the receipts and payments of the company [Section 165(4)]
- Contractual duties A professional accountant may be hired by a company for purposes other than the statutory audit. In all such cases, the duty of the auditor will depend upon the terms and conditions of his appointment.
- Duty to have reasonable care and skill An auditor of a company must be honest and must exercise reasonable care and skill to perform his audit work, otherwise he may be sued for damages. It was observed in Kingston Cotton Mills Case (1896) that the auditor should perform his audit work with such care, skill and caution that a reasonably competent, careful and cautious auditor will use.
- Duty ofan auditor regarding mandatory accounting standards According to the decision of the Council of the Institute of Chartered Accountants of India, it has been resolved that while discharging their functions, it is the duty of the members of the Institute, to ensure that the mandatory accounting standards are followed in the presentation of the financial statements covered by their audit report. In the event of any deviation from the standards, it is also the duty of the auditor to makes adequate disclosure in their reports so that the users of such statements may be aware of such deviations.
Section 227 (3) (d) of the Companies Act also states that the auditor’s report shall state whether the company’s balance sheet and profit and loss account comply with the accounting standards referred to in Section 211 (3C).
- Duty to the profession itself Every profession has its own code of conduct and professional ethics. The Institute of Chartered Accountants of India has also issued the required code of conduct and professional ethics, which has to be maintained by the members of the Institute. So, it is the duty of the company auditor to follow code of conduct and his professional ethics.
Liabilities of company auditor
The auditor holds a position of great responsibility and has to perform certain duties, statutory or otherwise, assigned to him. In performing his duties, he has to exercise reasonable care and skill. His client expects him to follow the generally accepted auditing standards and he may be held liable in case he does not act with reasonable care and skill required from him in a particular situation.
Liabilities on the basis of legal implications On the basis of legal implication, liabilities may be divided into three categories, namely,
- Liabilities under the Companies Act: Under the Companies Act, the liability of an auditor may arise in the following cases:
- Misappropriation and retention of client’s money: If an auditor has misappropriated or retained or become liable or accountable for any money or property of the company, or has been guilty of any misfeasance or breach of trust in relation to the company, the court may compel him to repay or to restore the money or property of or any part thereof with interest at certain rate or to contribute such sum to the assets of the company by way of compensation (Section 543).
- Mis-statements in the prospectus: He shall be liable with regard to mis-statements in the prospectus of the company under Section 62. The auditor is liable to pay compensation to every person who subscribes for any shares or debentures on the faith of the prospectus issued by the company for any loss or damage he may have sustained.
- False statement in returns, reports etc.: He shall be liable if he makes a false statement with material particulars in returns, reports or other statements knowing it to be false or omits any material fact knowing it to be material (Section 628),
- Intentional false evidence: He shall be liable if he gives false evidence intentionally upon any examination upon oath or solemn affirmations, authorised under this Act or in any affidavit, deposition or solemn affirmations, in or about the winding up of any company under this act (Section 629).
- Liability for delinquency: The liquidators may prosecute an auditor as an officer of the company during the course of winding up of the company for delinquency (Section 545).
- Wilful default in report making: He will be held liable if he wilfully makes a default in making his report to the shareholders according to the provisions of Sections 227 and 229 (Section 233).
- Destruction, alteration of books etc.: If he is found guilty of destruction, mutilation, alteration, falsification or hiding of any books, papers or securities or if he makes any false or fraudulent entry in any register, books of accounts or documents of the company, he may be held liable (Section 539).
- Authorising false statement in the prospectus: If he authorises the issue of the prospectus of a company containing a false and untrue statement, he will be held liable (Section 63).
- Party to the issue of prospectus: He may be held liable if he is party to the issue of prospectus including statement purporting to be made by him as an expert, unless he is not interested in the formation or promotion or in the management of the company (Sections 57, 58 and 59).
- Inducing fraudulently to invest money: He will be liable if he induces a person fraudulently to invest money by knowingly or recklessly making a statement or promise which is false or misleading, or if he dishonestly conceals the material fact (Section 68).
- Liabilities under the Chartered Accountants Act: Liability of chartered accountant, acting as an auditor, may be in the form of disciplinary proceedings under the Chartered Accountants Act, 1949. It may arise on account of professional misconduct on the part of the auditor.
There are separate provisions for professional misconduct in relation to (a) chartered accountants in practice (b) members of the institute in service and (c) members of the institute in general.
The Council, under Section 21, refers the case of professional misconduct on the part of the members to the disciplinary committee. The latter holds the enquiry and reports its findings to the council. In case the council finds, on the basis of its report that the member is guilty of professional misconduct, it gives chance to the member to explain his conduct. On the basis of hearing, the council takes necessary actions. But if the misconduct on the part of the member is other than that specified in the first schedule of the Chartered Accountants Act, 1949 the council has to refer the case to the High Court with its recommendations thereon.
- Liabilities under any special act: In addition to the Companies Act and the Chartered Accountants Act, the auditors are also held liable under different special acts, which are stated below:
- Under Banking Regulation Act, 1940:
- Under Section 46 of the Banking Regulations Act, 1940, if an auditor in any return, balance sheet or other document, wilfully makes a statement, which is false in any material particulars, knowing it to be false, or wilfully omits to make a material statement, he will be held responsible.
- Under Section 45G, an auditor of a banking company may be publicly examined in the winding up proceedings. On such examination, the high court may make an order, if he is not found fit to act as an auditor, that he will not act as auditor of any company for such period not exceeding five years as may be specified in the order.
- Under the Life Insurance Corporation Act: Under Section 104 of the Life Insurance Corporation Act, 1956 an auditor may be sentenced to imprisonment or fine, or both, if he gives a false statement knowingly in any return, report or other such forms to be issued under the act.
- Under the Indian Penal Code: Under Section 197 of the Indian Penal Code, if any person including auditor issues or signs a certificate required by law to be given or signed, or relating to any fact of which such certificate is by law admissible in evidence, knowing or believing that such certificate is false in any material point, he shall be punishable in the same manner as if he gave false evidence.
- Under the Income Tax Act: Under Section 278 of the Income Tax Act, 1961, if any person including an auditor abets or induces in any manner another person to make and deliver an account, statement or declaration relating to any income chargeable to tax which is false and which he either knows to be false or does not believe to be true, he shall be punishable.
- Under Banking Regulation Act, 1940:
Liabilities on the basis of nature of liability On the basis of nature of liability, it can be divided into two groups:
- Civil liability: The civil liability of an auditor can be for (a) negligence or (b) misfeasance. In these cases, he may be called upon to pay damages as decided by the court.
- Liability for negligence: An auditor is appointed to perform certain duties. To the extent of his duties as an auditor, he acts as an agent of his client. In this capacity, he must exercise reasonable care and skill to perform his duties for which he is employed. If he acts negligently on account of which the client has to suffer loss, the auditor may be held liable and may be called upon to make good the damages, which the client suffered due to his negligence.
It should be noted that if an auditor fails to discover frauds, he might not be failing in his duty. In fact, fraud and other irregularities may not be disclosed by an annual audit and even a detailed audit may not discover certain types of fraud. Under such circumstances, whether the auditor will be held responsible that depends on the fact that whether the auditor should have been able to discover that fraud if he applies reasonable care and skill. If he could, he will be held responsible, otherwise not.
- Liability for misfeasance: The term ‘misfeasance’ implies breach of trust or breach of duty. An auditor has to perform certain duties, which may arise out of a contract with the client as in the case of sole-proprietor or partnership or it may be statutory as laid down under various statutes. The duties of a company auditor have been statutorily laid down in the Companies Act, 1956. If the auditor does not perform his duties properly and as a result his client suffers, he may be held liable for misfeasance.
It should be noted that according to Section 543, the court might assess damages against delinquent Director or other officers of the company, including an auditor for misfeasance or breach of trust. In the case of an auditor, who also comes within the definition of officer in Section 2(30) for the purpose of this section, if he is guilty of neglect of duty or misfeasance, so as to cause loss to the company in any way, proceedings may be taken under this section against him either independently or other officers or jointly with them.
- Liability for negligence: An auditor is appointed to perform certain duties. To the extent of his duties as an auditor, he acts as an agent of his client. In this capacity, he must exercise reasonable care and skill to perform his duties for which he is employed. If he acts negligently on account of which the client has to suffer loss, the auditor may be held liable and may be called upon to make good the damages, which the client suffered due to his negligence.
- Criminal liability: An auditor of a company can be held guilty of criminal offences, if he wilfully makes a false statement in any report, return, certificate or balance sheet.
Under Section 628 of the Companies Act, “if an auditor in any report, certificate, balance sheet, prospectus, statement or other document required by or for the purpose of any of these acts, makes a statement (a) which is false in any material particular, knowing it to be false or (b) omits any material fact, knowing it to be material, he will be held liable on criminal offence.
Again, Section 197 of the Indian Penal Code provides that whoever issues or signs any certificate required by law to be given or signed or relating to any fact which such certificate is by law admissible in evidence, knowing or believing that such certificate is false in any material point, shall be punishable in the same manner as he gave false evidence.
Other liabilities The other liabilities of an auditor may include the following:
- Liability to third parties: There are several persons who completely rely upon the financial statements entitled by the auditor and enter into transactions with the company without any further enquiry. These parties may include creditors, the bankers, the tax authorities, the prospective investors etc.
In general, the auditor is not liable to third parties since no contractual obligation exists between the auditor and the third parties. Since they do not appoint him, he owes no duty to them and hence there is no question of any liability to them. He cannot be held liable unless he owes any duty to the persons, who hold him able for damages caused.
The third parties, however, can hold him liable, if there has been any fraud on the part of the auditor. Even if there is no contractual obligation between the auditor and the third parties, the latter can sue the auditor if the report of the auditor is of such a nature as amounts to fraud.
- Liability for unlawful act of the client: An auditor may obtain knowledge about the unlawful acts or defaults committed by his client during the course of his audit. The question arises whether he should inform the proper authorities about it and whether he can be held liable if he does not do so. It is a difficult question indeed since it involves breach of confidence placed on him by his client.
Under such circumstances, he must act very carefully. He must not act in such a way, which unnecessarily injures the confidence of his client on him. If required, he should terminate his association with the client rather than open himself to such liability.
- Liability to article clerks: The auditor may be held liable to his article clerks in the following circumstances:
- If he does not act honestly with his article clerk
If he removes any of his article clerks without any prior notice
If he does not pay the required amount of monthly stipend to the article clerks
- If he gives a false certificate of payment of stipend to his article clerks.
The auditor, however, cannot be held liable to his article clerks to pay compensation to them in case their services are terminated by the auditor. The question of payment of compensation to a retrenched or dismissed worker arises under the Industrial Dispute Act, 1956 only, which is not applicable to article clerks.
- If he does not act honestly with his article clerk
Power has been given to the central government under Section 233A of the Companies Act, 1956, to direct a special audit, where the government is of the opinion that:
- the affairs of any company are not being managed in accordance with sound business principles or prudent commercial practices, or
- any company is being managed in a manner likely to cause serious injury or damage to the interest of the trade, industry or business to which it pertains or
- the financial position of any company is such as to endanger its solvency.
The central government may, at any time, direct that a special audit of the company’s account for such period or periods as may be specified, be carried out.
A chartered accountant as defined in Clause (b) of Sub-section (1) of Section 2 of the Chartered Accountants Act, 1949, whether such accountant is in practice or not, or the company’s auditor himself may be appointed to conduct such special audit. This appointment is made by the central government.
3. Rights, powers and duties of special auditor
The special auditor shall have the same rights, powers and duties in relation to the special audit as an auditor of a company has under Section 227 of the Companies Act.
However, instead of making his report to the members of the company, the special auditor must submit his report to the central government. The report of the special auditor shall, as far as may be, include all the matters required to be included in an auditor’s report, under Section 227 and if the central government so directs, shall also include a statement on any other matter which may be referred to him by the government.
4. Remuneration of special auditor
The remuneration of special auditor is fixed by the government, but is payable by the company. If the company fails to pay the remuneration, it can be recovered in the same way as land revenue.
9.12 BRANCH AUDITOR
Section 228 of the Companies Act governs the audit of branch offices. Where a company has a branch office in India, the accounts of that office shall be audited by the company’s auditors or by a person qualified under Section 226.
If the branch is situated outside India, audit can be conducted, in addition to persons mentioned above, by an accountant duly qualified to act as an auditor in accordance with the laws of the country in which the branch office is situated.
If it is decided in the general meeting of the company to have the accounts of a branch audited by auditor other than the auditor of the company, Section 228(3) requires that the meeting should appoint any qualified person as auditor of the branch or authorise the board of directors to appoint a qualified person as auditor for the branch in consultation with the main auditor of the company.
The branch auditor shall have the same rights, powers and duties in relation to the branch audit as an auditor of a company has under Section 227 of the Companies Act (Section 228(3)(b)).
The branch auditor shall prepare a report on the accounts of the branch office examined by him and forward the same to the auditor of the company, who shall, in preparing the audit report, deal with the same in such manner as he considers necessary (Section 228 (3)(c)).
4. Remuneration of the branch auditor
The branch auditor shall receive such remuneration and 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 Directors if so authorised by the company in general meeting (Section 228 (3)(d)).
5. Exemptions from branch audit
Under Section 228(4) of the Companies Act, the central government is empowered to give exemptions from branch audit. The central government is also empowered to withdraw these exemptions.
9.13 JOINT AUDITOR
Sometimes, two or more firms are appointed to conduct the audit of a company. This is the usual case with large companies like insurance and banking companies having a wide geographical network. In such a situation, the following matters assume importance:
- The audit work has to be shared by the joint auditor
- There should be proper co-ordination of work of the joint auditors
- Proper attempt should be made to resolve the differences of opinion among the joint auditors
The Companies Act, 1956 does not contain any specific provisions regarding joint audit. However, the Institute of Chartered Accountants of india has issued AAS-12 on the ‘responsibility of joint auditors’. According to this statement, the functions and duties of joint auditors can be stated as follows:
1. Division of work
Where joint auditors are appointed, they should, by mutual discussion, divide the audit work among themselves. In some cases due to the nature of the business of the entity under audit, such a division of work may not be possible. In such situation, the division of work may be with reference to items of assets and liabilities or income and expenditure or with reference to periods of time. The division of work among joint auditors as well as the areas of work to be covered by all of them should be adequately documented and preferably communicated to the entity.
Where, in the course of his work, a joint auditor comes across matters, which are relevant, to the areas of responsibility of other joint auditors, and which deserve their attention, he should communicate the same to all the other joint auditors in writing.
3. Responsibility of joint auditor
In respect of audit work divided among the joint auditors, each joint auditor is responsible only for the work allocated to him.
Each auditor should bring to the attention of the other joint auditors matters requiring discussion, disclosure or application of judgment, by submitting a report or a note prior to the finalisation of audit. If any such matter were brought to the attention of the other joint auditors by an auditor after the audit report has been submitted, the other joint auditors would not be responsible in respect of those matters.
It is the responsibility of each joint auditor to determine the nature, timing and extent of audit procedures to be applied in relation to the area of work allocated to him.
4. Audit report
Normally, the joint auditors are able to arrive at an agreed report. However, where the joint auditors are in disagreement with regard to any matters to be covered by the report, each one of them should express their own opinion through a specific report. A joint auditor is not bound by the views of the majority of the joint auditors regarding matters to be covered in the report and should express his opinion in a separate report in case of disagreement.
9.14 LEGAL VIEWS ON AUDITOR’S LIABILITY
The legal views as discussed in different cases so far taken to courts of law can be summarised as follows:
Case: Leeds Estate Building and Investment Co. vs Shepherd (1887)
Fact of the case: In this case, the auditor had not discovered that certain payments relating to dividends, directors fees and bonus were irregular. This was because he had not concerned himself with the company’s articles. He was held liable for damages.
Legal view: This case had established that it is not sufficient for an auditor to concern himself with the arithmetical accuracy of the books and accounts. He has a duty to ensure that the transactions are in order. When an auditor takes over a company audit, one of his first actions is to obtain a copy of the memorandum and articles and note important points therein affecting the account.
Fact of the case: The company, in this case, had not made adequate provision for bad debts. The auditor had discovered that the debts were doubtful and had clearly reported the situation to the directors, but, when the directors failed to make provisions, instead of reporting the facts equally clearly to the shareholders, he simply made the statement that “the value of the assets is dependent upon realisation”. It was held that the auditor had failed in his duty to convey information clearly in his report, and he was made liable for certain dividends improperly paid.
Legal view: This case is important because it was stated unequivocally that an auditor has a duty to convey facts clearly to shareholders. “A person whose duty is to convey information to others does not discharge that duty by simply giving them so much information as is calculated to induce them, or some of them, to ask for more.” This case established the fact that an auditor who shrinks from fully and clearly disclosing all the material facts known to him is putting himself at risk. The court also discussed the basic duty of an auditor. It was laid down that he must exercise reasonable care and skill, but that he is in no way acts as an insurer and does not guarantee the accounts.
Case: Kingston Cotton Mill Co. Ltd. (1896)
Fact of the Case: In this case, the accounts had been manipulated by the over-valuation of stock by the managing director, who had certified the stock valuation to the auditor. It was held in the Court of Appeal that it was not the duty of the auditor to take stock, and that in the absence of suspicious circumstances he was not guilty of negligence in accepting the certificate of a responsible official with regard to the value of stock.
Legal view: As far as the main question is involved, whether the auditor could place total reliance on the stock certificate of a responsible official with regard to the value of stock in the absence of suspicious circumstances, this case is now of historical interest only. The Companies Act also requires that the auditors should state whether the accounts show a true and fair view. The professional accountancy bodies have issued statements regarding detailed audit work to be carried out in relation to stock verification and valuation and attendance by the auditor at stock taking. It does not seem that the auditor could now simply accept a stock certificate from a responsible official where stock was a material item and then plead this case in justification when defending the inevitable action for misfeasance or negligence.
Case: Irish Wollen Co. Ltd. vs Tyson (1900)
Fact of the case: The auditor was found to have been negligent in that he had failed to discover that the company’s liabilities were understated due to the suppression of creditor’s invoices. This fraud would have been discovered if the auditor had either checked the ledger balances against the creditor’s statements or scrutinised the dates entered in the first few weeks of the next period.
Legal view: This case again shows the courts refusing to accept that an auditor had discharged his duties by checking the arithmetical accuracy of the entries in the books. He must exercise due skill and care in checking the validity of these entries. Auditors would now always carry out the tests omitted in this case, checking balances against creditors’ statements and testing the correctness of the “cut-off” procedure carefully.
Fact of the case: This was another case where the auditors had concerned themselves only with the entries in the books, and not with verification procedure. The balance sheet showed cash balances of almost £ 800, which agreed with the books, but the actual balance was only £ 30, the difference having been misappropriated. The auditor was held to have been negligent in not verifying the balance. However, damages of only five guineas were awarded against the auditor because the court held that the director responsible for supervising the fraudulent employee was the person primarily responsible for the loss.
Legal view: There are two important aspects to this case. The first is that the court again held that auditors have a duty to verify assets and not merely to check bookkeeping entries. The second, and very important, or aspect is that auditors are responsible for the loss resulting directly from their negligence and thus are not responsible where the loss has resulted from other causes.
Case: Arthur E. Green & Co. vs the Central Advance & Discount Corporation Ltd. (1920)
Fact of the case: The case concerned the failure of the company to make adequate provision for bad debts. The auditors relied upon the bad debt provisions made by the managers, despite the fact that many debts not provided for were old and some were even statue-barred. The auditors were found to have been negligent.
Legal view: The decision indicates that the auditors must exercise proper skill and care in carrying out their own tests to establish the value of material assets. They are not adequately performing their duties by relying on a certificate provided by a responsible official.
Case: The City Equitable Fire Insurance Co. Ltd. (1924)
Fact of the case: This case concerned various alleged frauds in relation to the accounts of the company. The most important of these with regard to auditing principles was that securities owned by the company were deposited with its stock brokers. The auditor accepted a certificate from the stock brokers in respect of such securities for a very material amount. Had they insisted on inspecting the securities, these could not have been produced as they had been pledged by the stock brokers. An additional complication was that the chairman of the company was also a partner in the firm of stock-brokers.
The auditors escaped liability because the company had a clause in its articles, which provided that the directors, auditors and officers of the company should be indemnified by the company except in the case of willful default.
Legal view: The importance of this case was that it demonstrated the importance of auditors’ actually inspecting documents of title held by third parties. Only where such documents are held by one of the major banks or are not very substantial and are held in the ordinary course of a business by another independent third party should the auditor accept a certificate. Moreover, if the auditor entertains the slightest doubt of the desirability of accepting a certificate, it would always be wise to insist on actual inspection.
Fact of the case: This case concerned misfeasance by the auditor of a company, which had subsequently gone into liquidation. The auditor was held to have been negligent for failing to detect the omission of liabilities from the balance sheet in circumstances where their omission should have been apparent, and for failing to detect the over-valuation of work-in-progress in circumstances where there was available evidence to have enabled him to do so.
Legal view: This case again underlined the need for sound verification procedures and, with regard to the work-in-progress, underlined the need for the auditor to make use of all available records and information.
Case: S. P. Catterson and Sons Ltd. (1937)
Fact of the case: In this case, the company had a poor system of dealing with sales in that the same invoice book was used for both cash sales and credit sales, this led to defalcations. The auditors had drawn the attention of the directors to the shortcomings of the system, but no action had been taken. The auditor was acquitted of negligence on the grounds that the primary responsibility for exercising control vested with the directors.
Legal view: The auditors had reported about the weaknesses in the system rightly to the directors. This should now be done formally in internal control letters (letters of weaknesses). So, the auditor was not held liable.
Case: Thomas Gerrand & Sons Ltd. (1967)
Fact of the case: The accounts of this company had allegedly been manipulated in the following ways:
- The stock figures were inflated.
- Purchases relating to the current period were charged in the succeeding period.
- Sales made after the accounting date were credited in the earlier period. The auditors were found liable for misfeasance in respect of dividends paid by the company where, had the accounts not been manipulated, no profits would have been available. The auditors’ negligence arose primarily from their failure to follow up the alternations of the purchase invoices. They had discovered the alterations, but accepted explanations too easily.
Legal view: Two main conclusions can be drawn from this case: firstly, the need for sound audit tests on the year end cut-off procedures and secondly, the fact that once auditors have discovered suspicious circumstances. In this case the alteration of the dates on the invoices they have a duty to probe the matter thoroughly, and must not be easily satisfied by explanations provided by Directors or officers.
- As in case of a company, the ownership is separated from management it becomes essential for a company to appoint an independent and qualified auditor to verify and certify the truth and fairness of the financial statements.
- Before commencing the actual audit work of a company, the auditor should go through certain preliminaries, which include ensuring whether his appointment is in order or not, inspecting the statutory books and documents, inspecting contracts with third parties, studying previous year’s balance sheet and audit report and studying of internal control system of the company.
- While conducting audit of share capital transactions, the auditor has to ensure that the legal requirements have been duly complied with, to see that the issue of share is properly authorised and that there is no overissue beyond the prescribed limit, to check that the rights of the shareholders are duly protected and to ensure that the generally accepted accounting principles are followed while recording the transactions relating to issue.
- Shares can be issued on consideration other than cash as issue of shares to the vendors or promoters or issue of shares to underwriters, issue of sweat equity shares etc.
- Shares can be issued at par or at a discount or at a premium. There can be calls in arrear or calls in advance in case of issue of shares. Shares can be forfeited for non-payment of share call and forfeited shares can also be reissued.
- Shares can be issued to the existing shareholders as right shares, to the employees under employees stock option scheme or even shares can be bought back form the shareholders.
- A company limited by shares may issue preference shares, which are liable to be redeemed at the option of the company on a predetermined date. At present, no company limited by shares shall issue any preference shares, which are irredeemable or is redeemable after the expiry of a period of 20 years from the date of its issue.
- A company having a share capital may alter its share capital and each alteration made should be noted in the memorandum and articles issued subsequent to the date of alteration.
- A company can reduce its share also in a number of ways, which include reduction without the consent of the court and with the consent of the court.
- Large-size companies often face the problem of frequent and large scale share transfer and there is every possibility of errors and mistakes taking place in the process for which the company appoints auditors for carrying out this special assignment.
- In addition to shares, a company can issue debentures for procuring fund. Debentures can be issued at par, at a premium or at a discount. The debentures are redeemable after a certain period of time. A predetermined fixed rate of interest is payable on debentures irrespective of the fact that the company has been able to earn any profit or not.
- Debentures may be issued to creditors, bankers or any other person, without receiving any cash thereon. It acts as a collateral security and becomes real debentures in the event of the default of the loan.
- Accounting Standard 21 on ‘consolidated financial statements’ issued by the ICAI prescribes the principles to be followed by the holding companies in consolidating the balance sheet and profit and loss account with that of the financial statements of the subsidiaries. The auditor of a holding company has to see whether the financial statements of the holding company is consolidated with the financial statements of its subsidiaries by following the principles as prescribed in AS-21.
- The profit earned during the pre-incorporation period is called ‘pre-incorporation profit’. Legally, this profit is not available for dividend, since a company cannot earn profit before it comes into existence.
- Every company shall keep at its registered office proper books of accounts as prescribed in Section 209 of the Companies Act. The books are usually to be kept at the registered office for at least last eight years.
- The special requirements of company audit include the verification of the constitution and power of the company and knowledge about the authority structure of the company.
- The provisions regarding the appointment of the auditors are contained in Section 224 of the Companies Act. The first auditors are usually appointed by the Board of Directors and subsequent auditors are appointed by the shareholders in the annual general meeting. In some cases, auditors are appointed by the central government or by passing a special resolution.
- Usually a retiring auditor shall be automatically reappointed by passing an ordinary resolution. An individual auditor cannot be the auditor of more than 20 companies at a time. The remuneration of the auditors is fixed by the appointing authority.
- The auditor of a company must be either a practicing chartered accountant or the holder of a certificate in erstwhile Part B States entitling him to act as an auditor of companies.
- An appointed auditor may be removed from his office either in accordance with the provisions of the Companies Act or as per restrictions imposed by the Chartered Accountants Act.
- The auditor of a company can be considered a servant of the company, an agent of the shareholders as well as an officer of the company.
- Rights of the company auditor includes right of access to books and vouchers, right to obtain information and explanations, right to visit branch offices and to receive branch audit report, right to receive notices to attend general meeting, right to sign audit report and right to receive remuneration.
- Duties of a company auditor include statutory duties, contractual duties, duty to have reasonable care and skill, duty regarding accounting standards and duty to the profession itself.
- The auditor is liable under the Companies Act, under the Chartered Accountants Act and under other special acts. He has civil liabilities as well as criminal liabilities. He is liable to third parties and to the article clerks.
- Write short notes on:
- Issue of shares at premium
- Payment of interest out of capital
- Reduction of share capital
- What are the points you will consider at the time of examining the issue of right shares?
- State how an auditor should outline the programme suitable for a share transfer audit.
- How will you examine the following items while auditing the accounts of a limited company?
- Re-issue of forfeited shares
- Profit prior to incorporation
- How are the first auditors of a limited company appointed?
- Explain in brief the legal provisions as well as the Schedule VI requirements regarding auditors’ remuneration.
- Describe the qualifications of an auditor according to the Chartered Accountants Act, 1949.
- Discuss the status of an auditor in the company.
- How will you examine the following items while auditing the accounts of a limited company?
- Redemption of preference shares
- Forfeiture of shares
- State the circumstances when a person will be disqualified for being appointed as company auditor.
- How is the auditor of a government company appointed?
- Discuss the auditors’ liability to third party?
- What are the steps to be taken by a statutory auditor before commencement of an audit of a company?
- Mention important items for which auditor would refer to each of the following:
- Board’s meeting minutes book
- Shareholders’ meeting minutes book
- What are the points to which you would direct your attention, while accepting an appointment as an auditor of a company? State under what circumstances, an appointed auditor can be removed from his office?
- State clearly the rights and duties of an auditor.
- Under the Companies Act, an auditor may be held liable both for negligence and misfeasance. Do you agree? Give reasons for your answer.
- Under what circumstances, an auditor can be appointed by the following:
- The Board of Directors
- The shareholders
- The central government
- Discuss the circumstances in which bonus shares can be issued by a company.
- Enumerate the procedures to be followed
- Explain the duties of the auditor in relation to the above
- State the procedures an auditor should follow to verify the issue of share capital for the following.
- Consideration other than cash
- Employees as ‘sweat equity share’
- Explain the statements:
- Information and means of information are by no means equivalent terms.
- An auditor is liable for any damages sustained by a company by reason of falsification, which might have been discovered by exercise of reasonable care and skill in the performance of audit.
- Discuss the rights of lien of an auditor of a limited company.
Schedule VI to the Companies Act, 1956
PART I—FORM OF BALANCE SHEET
General Instructions for Preparation of Balance Sheet
- The information required to be given under any of the items or sub-items in this form, if it cannot be conveniently included in the balance sheet itself, shall be furnished in a separate Schedule or Schedules to be annexed to and to form part of the balance sheet. This is recommended when items are numerous.
- Naye Paise can also be given in addition to Rupees, if desired.
- In the case of subsidiary companies the number of shares held by the holding company as well as by the ultimate holding company and its subsidiaries must be separately stated.
The auditor is not required to certify the corrections of such shareholdings as certified by the management
- The item “Share Premium Account” shall include details of its utilisation in the manner provided in section 78 in the year of utilisation.
- Short-term loans will include those which are due for not more than one year as at the date of the balance sheet.
- Depreciation written off or provided shall be allocated under the different asset heads and deducted in arriving at the value of fixed assets.
- Dividends declared by subsidiary companies after the date of the balance sheet should not be included unless they are in respect of period which closed on or before the date of the balance sheet.
- Any reference to benefits expected from contracts to the extent shall not be made in the balance sheet but shall be made in the Board’s report.
- The debit balance in the profit and loss account shall be shown as a deduction from the uncommitted reserves, if any.
- As regards Loans and Advances, amounts due by the managing agents or secretaries and treasurers, either severally or jointly with any other persons, to be separately stated; the amounts due from other companies under the same management within the meaning of sub-section (1B) of section 370 should also be given with the names of the companies; the maximum amount due from every one of these at any time during the year must be shown.
- Particulars of any redeemed debentures which the company has power to issue should be given.
- Where any of the company’s debentures are held by nominee or a trustee for the company, the nominal amount of the debentures and the amount at which they are stated in the books of the company shall be stated.
- A statement of investments (whether shown under “Investment” or under “Current Assets” as stockin trade) separately classifying trade investments and other investments should be annexed to the balance sheet showing the names of the bodies corporate (including separately the names of the bodies corporate under the same management) in whose shares or debentures, investments have been made (including all investments, whether existing or not, made subsequent to the date as at which the previous balance sheet was made out) and the nature and extent of the investment so made in each such body corporate; provided that in the case of an investment company, that is to say, a company whose principal business is the acquisition of shares, stock, debentures or other securities, it shall be sufficient if the statement shows only the investments existing on the date as at which the balance sheet has been made out. In regard to the investments in the capital of partnership firms, the names of the firms (with the names of all their partners, total capital and the shares of each partner), shall be given in the statement.
- If, in the opinion of the Board, any of the current assests, loans and advances have not a value on realisation in the ordinary course of business at least equal to the amount at which they are stated, the fact that the Board is of that opinion shall be stated.
- Except in the case of the first balance sheet laid before the company after the commencement of the Act, the corresponding amounts for the immediately preceding financial year for all items shown in the balance sheet shall be also given in the balance sheet. The requirement in this behalf shall, in the case of companies preparing quarterly or half-yearly accounts, etc. relate to the balance sheet for the corresponding date in the previous year.
- The amounts to be shown under sundry debtors shall include the amounts due in respect of goods sold or services rendered or in respect of other contractual obligations but shall not include the amounts which are in the nature of loans or advances.
- Current accounts with directors, managing agents, secretaries and treasurers and manager, whether they are in credit, or debit, shall be shown separately.
- A small-scale industrial undertaking has the same meaning as assigned to it under clause (j) of Section 3 of the Industries (Development and Regulation) Act, 1951.
- Details under each of the above items shall be given in separate Schedules. The Schedules shall incorporate all the information required to be given under A—Horizontal Form read with notes containing general instruction for preparation of balance sheet.
- The Schedules, referred to above, accounting policies and explanatory notes that may be attached shall form an integral part of the balance sheet.
- The figures in the balance sheet may be rounded off as under:—
Where the turnover of the company
Round off permissible
in any financial year is:
(i) less than one hundred crore rupees
to the nearest hundreds or thousands, or decimals thereof.
(ii) one hundred crore rupees or more but less than five hundred crore rupees
to the nearest hundreds or thousands, lakhs or million, or decimals thereo.
- A footnote to the balance sheet may be added to show separately contingent liabilities.
Requirements as to Profit and Loss Account
- The provisions of this Part shall apply to the income and expenditure account referred to in Subsection (2) of Section 210 of the Act, in like manner as they apply to a profit and loss account, but subject to the modification of references as specified in that sub-section.
- The profit and loss account-
- shall be so made out as clearly to disclose the result of the working of the company during the period covered by the account; and
- shall disclose every feature, incuding credits or, receipts and debits or expenses in respect of nonrecurring transactions or transactions of an exceptional nature.
- The profit and loss account shall set out the various items relating to the income and expenditure of the company arranged under the most convenient heads and in particular, shall disclose the following information in respect of the period covered by the account:—
- The turnover, that is, the aggregate amount for which sales are effected by the company, giving the amount of sales in respect of each class of goods dealt with by the company and indicating the quantities of such sales for each class separately.
- Commission paid to sole selling agents within the meaning of Section 294 of the act.
- Commission paid to other selling agents.
- Brokerage and discount on sales, other than the usual trade discount.
- In the case of manufacturing companies—
- The value of the raw materials consumed, giving item-wise break-up and indicating the quantities thereof. In this break-up, as far as possible, all important basic raw materials shall be shown as separate items. The intermediates or components procured from other manufacturers may, if their list is too large to be included in the break-up, be grouped under suitable headings without mentioning the quantities, provided all those items which in value individually account for 10 per cent or more of the total value of the raw material consumed shall be shown as separate and distinct items with quantities thereof in the break-up.
- The opening and closing stocks of goods produced, giving break-up in respect of each class of goods and indicating the quantities thereof.
- In the case of trading companies, the purchases made and the opening and closing stocks, giving break-up in respect of each class of goods traded in by the company and indicating the quantities thereof.
- In the case of companies rendering or supplying services, the gross income derived from services rendered or supplied.
- In the case of a company, which falls under more than one of the categories mentioned in (a), (b) and (c) above, it shall be sufficient compliance with the requirements herein if the total amounts are shown in respect of the opening and closing stocks, purchases, sales and consumption of raw material with value and quantitative break-up and the gross income from services rendered is shown.
- In the case of other companies, the gross income derived under different heads.
Note 1—The quantities of raw materials, purchases, stocks and the turnover, shall be expressed in quantitative denomination in which these are normally purchased or sold in the market.
Note 2—For the purpose of items (ii)(a), (ii)(b), and (ii)(d), the items for which the company is holding separate industrial licences, shall be treated as separate classes of goods, but where a company has more than one industrial licence for production of the same item at different places or for expansion of the licensed capacity, the item covered by all such licences shall be treated as one class. In the case of trading companies, the imported items shall be classified in accordance with the classification adopted by the Chief Controller of Imports and Exports in granting the import licences.
Note 3—In giving the break-up of purchases, stocks and turnover, items like spare parts and accessories, the list of which is too large to be included in the break-up, may be grouped under suitable headings without quantities, provided all those items, which in value individually account for 10 per cent or more or the total value of the purchases, stocks, or turnover, as the case may be, are shown as separate and distinct items with quantities thereof in the break-up.
- In the case of manufacturing companies—
- In the case of all concerns having works-in-progress, the amounts for which such have been completed at the commencement and at the end of the accounting period.
- The amount provided for depreciation, renewals or diminution in value of fixed assets.
If such provision is not made by means of a depreciation charge, the method adopted for making such provision.
If no provision is made for depreciation, the fact that no provision has been made shall be stated and the quantum of arrears of depreciation computed in accordance with Section 205(2) of the Act shall be disclosed by way of a note.
- The amount of interest on the company’s debentures and other fixed loans, that is to say, loans for fixed periods, stating separately the amount of interest, if any, paid or payable to the managing director, the managing agent, the secretaries and treasurers and the manager, if any.
- The amount of charge for Indian incom-tax and other Indian taxation on profits, including, where practicable, with Indian income-tax any taxation imposed elsewhere to the extent of the relief, if any, from Indian income-tax and distinguishing, where practicable, between income-tax and other taxation.
- The amounts reserved for—
- repayment of share capital and
- repayment of loans.
- The aggregate, if material, of any amounts set aside or proposed to be set aside, to reserves, but not including provisions made to meet any specific liability, contingency or commitment known to exist at the date as at which the balance sheet is made up.
- The aggregate, if material, of any amounts withdrawn from such reserves.
- The aggregate, if material, of the amounts set aside to provisions made for meeting specific liabilities, contingencies or commitments.
- The aggregate, if material, of the amounts withdrawn from such provisions, as no longer required.
- Expenditure incurred on each of the following items, separately for each item—
- Consumption of stores and spare parts.
- Power and fuel.
- Repairs to buildings.
- Repairs to machinery.
- Salaries, wages and bonus
- Contribution to provident and other funds.
- Workmen and staff welfare expenses to the extent not adjusted from any previous provision or reserve.
Note Information in respect of this item should also be given in the balance sheet under the relevant provision or reserve account.
- Rates and taxes, excluding taxes on income.
- Miscellaneous expenses.
Provided that any item under which the expenses exceed 1 per cent of the total revenue of the company or Rs. 5,000, whichever is higher, shall be shown as a separate and distinct item against an account head in the profit and loss account and shall not be combined with any other item to be shown under ‘Miscellaneous expenses’.
- The amount of income from investments, distinguishing between trade investments and other investments.
- Other income by way of interest, specifying the nature of the income.
- The amount of income-tax deducted if the gross income is stated under sub-paragraphs (a) and (b) above.
- Profits or losses on investments showing distinctly the extent of the profits or losses earned or incurred on account of membership of a partnership firm to the extent not adjusted from any previous provision or reserve.
Note—Information in respect of this item should also be given in the balance sheet under the relevant provision or reserve account.
- Profits or losses in respect of transactions of a kind, not usually undertaken by the company or undertaken in circumstances of an exceptional or non-recurring nature, if material in amount.
- Miscellaneous income.
- Profits or losses on investments showing distinctly the extent of the profits or losses earned or incurred on account of membership of a partnership firm to the extent not adjusted from any previous provision or reserve.
- Dividends from subsdiary companies.
- Provisions for losses of subsidiary companies.
- The aggregate amount of the dividends paid, and proposed and stating whether such amounts are subject to deduction of income-tax or not.
- Amount, if material, by which any items shown in the profits and loss account are affected by any change in the basis of accounting.
- The profit and loss account shall also contain or give by way of a note detailed information, showing seperately the following payments provided or made during the financial year to the directors (including managing directors), the managing agents, secretaries and treasurers or manager, if any, by the company, the subsidiaries of the company and any other person—
- managerial remuneration under Section 198 of the Act paid or payable during the financial year to the directors (including managing directors), the managing agent, secretaries and treasurers or manager, if any;
- expenses reimbursed to the managing agent under Section 354;
- commission or other remuneration payable separately to a managing agent or his associate under Section 356, 357 and 358;
- commission received or receivable under Section 359 of the Act by the managing agent or his associate as selling or buying agent of other concerns in respect of contracts entered into by such concerns with the company;
- the money value of the contracts for the sale or purchase of goods and materials or supply of services, entered into by the company with the managing agent or his associate under Section 360 during the financial year;
- other allowances and commission including guarantee commission (details to be given);
- any other perquisites or benefits in cash or in kind (stating approximate money value where practicable;
- pensions, etc.—
- payments from provident funds, in excess of own subscriptions and interest thereon.
- compensation for loss of office.
- consideration in connection with retirement from office.
- The profit and loss account shall contain or give by way of a note a statement showing the computation of net profits in accordance with Section 349 of the Act with relevant details of the calculation of the commissions payable by way of percentage of such profits to the directors (including managing directors), the managing agents, secretaries and treasurers or manager (if any).
- The profit and loss account shall further contain or give by way of a note detailed information in regard to amounts paid to the author, whether as fees, expenses or otherwise for services rendered—
- as auditor;
- as adviser, or in any other capacity, in respect of:
- taxation matters;
- company law matters;
- management services; and
- in any other manner.
- In the case of manufacturing companies, the profit and loss account shall also contain, by way of a note in respect of each class of goods manufactured, detailed quantitative information in regard to the following, namely
- the licensed capacity (where licence is in force);
- the installed capacity and
- the actual production.
Note 1—The licensed capacity and installed capacity of the company as on the last date of the year to which the profit and loss account relates, shall be mentioned against items (a) and (b) above, respectively.
Note 2—Against item (c), the actual production in respect of the finished products meant for sale shall be mentioned. In cases where semi-processed products are also sold by the company, separate details thereof shall be given.
Note 3—For the purposes of this paragraph, the items for which the company is holding separate industrial licences shall be treated as separate classes of goods but where a company has more than one industrial licence for production of the same item at different places or for expansion of the licensed capacity, the item covered by all such licences shall be treated as one class.
- The profit and loss account shall also contain by way of a note the following information, namely—
- value of imports calculated on CIF basis by the company during the financial year in respect of (i) raw materials; (ii) components and spare parts; (iii) capital goods;
- expenditure in foreign currency during the financial year on account of royalty, know-how, professional consultation fees, interest, and other matters;
- value of all imported raw materials, spare parts and components consumed during the financial year and the value of all indigenous raw materials, spare parts and components similarly consumed and the percentage of each to the total consumption;
- the amount remitted during the year in foreign currencies on account of dividends with a specific mention of the number of non-resident shareholders, the number of shares held by them on which the dividends were due and the year of which the dividends related;
- earnings in foreign exchange classified under the following heads, namely:
- export of goods calculated on FOB basis;
- royalty, know-how, professional and consultation fees;
- interest and dividend;
- other income, indicating the nature thereof.
- The central government may direct that a company shall not be obliged to show the amount set aside to provisions other than those relating to depreciation, renewal or diminution in value of assets, if the central government is satisfied that the information should not be disclosed in the public interest and would prejudice the company, but subject to the condition that in any heading stating an amount arrived at after taking into account the amount set aside as such, the provision shall be so framed or marked as to indicate that fact.
- Except in the case of the first profit and loss account laid before the company after the commencement of the act, the corresponding amounts for the immediately preceding financial year for all items shown in the profit and loss account shall also be given in the profit and loss account.
- The requirement in sub-clause (1) shall, in the case of companies preparing quarterly or half-yearly accounts, relate to the profit and loss account for the period which entered on the corresponding date of the previous year.
7.(1) For the purposes of Parts I and II of this Schedule, unless the context otherwise requires:
- the expression “provision” shall, subject to Sub-clause (2) of this clause, mean any amount written off or retained by way of providing for depreciation, renewals or diminution in value of assets, or retained by way of providing for any known liability of which the amount cannot be determined with substantial accuracy;
- the expression “reserve” shall not, subject as aforesaid, include any amount written off or retained by way of providing for depreciation, renewals or diminution in value of assets or retained by way of providing for any known liability;
- the expression “capital reserve” shall not include any amount regarded as free for distribution through the profit and loss account; and the expression “revenue reserve” shall mean any reserve other than a capital reserve;
and in this sub-clause the expression “liability” shall include all liabilities in respect of expenditure contracted for and all disputed or contingent liabilities.
- any amount written off or retained by way of providing for depreciation, renewals or diminution in value of assets, not being an amount written off in relation to fixed assets before the commencement of this Act; or
- any amount retained by way of providing for any known liability;
is in excess of the amount which in the opinion of the directors is reasonably necessary for the purpose, the excess shall be treated for the purposes of this Schedule as a reserve and not as a provision.
8. For the purposes aforesaid, the expression “quoted investment” means an investment in respect which there has been granted a quotation or permission to deal on a recognised stock exchange and of the expression “unquoted investment” shall be construed accordingly.
Balance Sheet Abstract and Company’s General Business Profile
- Registration Details
- Capital Raised During the Year (Amount in Rs. Thousands)
- Position of Mobilisation and Deployment of Funds (Amount in Rs Thousands)
- Performance of Company (Amount in Rs Thousands)
- General Names of Three Principal Products.Services of Company (as per monetary terms)
Item Code No. (ITC Code)
Item Code No. (ITC Code)
Note: For ITC Code of Products please refer to the publication Indian Trade Classfication based on harmonised commodity description and coding system by Ministry of Commerce, Directorate General of Commercial Integence & Statistics, Calcutta-700 001.