Accounts of Companies, Audit and Auditors — Practice

Question 1

A company is registered on 1 April. The Board takes no action on appointing an auditor. Advise on the position, the deadlines, and how long the auditor so appointed will hold office. How would the answer differ for a government company?

Accepted Answer

The first auditor of a company, other than a government company, must be appointed by the Board of Directors within thirty days from the date of registration of the company, so here by 30 April. Where the Board fails to appoint within that period, it must inform the members of the company, who must appoint the first auditor within ninety days at an extraordinary general meeting. That ninety-day period runs from the expiry of the Board's thirty days. The auditor so appointed, whether by the Board or by the members, holds office until the conclusion of the first annual general meeting, and not for any longer term; the misconception that a first auditor holds a five-year term is among the commonest errors in this chapter. At the first annual general meeting the company appoints an auditor who then holds office from the conclusion of that meeting till the conclusion of its sixth annual general meeting. For a government company, or a company owned or controlled directly or indirectly by the Central Government or by any State Government or Governments or partly by both, the first auditor is appointed by the Comptroller and Auditor-General of India within sixty days from the date of registration; if the CAG does not appoint within that period, the Board appoints within the next thirty days, and failing that the members appoint within sixty days at an extraordinary general meeting.

Question 2

A company's auditor resigns on 10 May. Separately, another company's auditor dies in office. State how each vacancy is filled and the approvals required.

Accepted Answer

Both are casual vacancies in the office of auditor, but the approval required differs according to the cause, and that difference is the point of the question. The general rule is that any casual vacancy in the office of an auditor shall be filled by the Board of Directors within thirty days. Where the vacancy arises from the death of the auditor, that is the whole of the requirement, and the auditor appointed by the Board holds office till the conclusion of the next annual general meeting. Where the casual vacancy is the result of the resignation of an auditor, an additional step is required: the appointment must also be approved by the company at a general meeting convened within three months of the recommendation of the Board, and the auditor so appointed holds office till the conclusion of the next annual general meeting. The reason for the distinction is that a resignation may signal a disagreement between the auditor and the management, and requiring the members to approve the replacement prevents the Board from quietly installing a more compliant auditor. The resigning auditor is separately obliged to file a statement in the prescribed form with the company and the Registrar within thirty days of resignation, indicating the reasons and other facts relevant to the resignation, and in the case of a government company also with the Comptroller and Auditor-General.

Question 3

An unlisted public company with paid-up capital of ₹15 crore has had the same audit firm for ten consecutive years. It proposes to appoint a different firm that shares two partners with the outgoing firm. Advise fully.

Accepted Answer

Rotation applies to this company. The requirement covers every listed company and prescribed classes, which include every unlisted public company having paid-up share capital of rupees ten crore or more, every private limited company having paid-up share capital of rupees fifty crore or more, and every company having public borrowings from financial institutions, banks or public deposits of rupees fifty crore or more. With paid-up capital of 15 crore this unlisted public company falls squarely within the first class. An audit firm may not be appointed as auditor for more than two terms of five consecutive years, so ten years exhausts the permitted tenure and the incumbent firm cannot be reappointed. It is further not eligible for reappointment in the same company for five years from the completion of its term. The proposed replacement also fails. As on the date of appointment, no audit firm having a common partner or partners to the outgoing audit firm, whose tenure has expired in a company immediately preceding the financial year, shall be appointed as auditor of the same company for a period of five years. The proposed firm shares two partners with the outgoing firm and is therefore barred for five years. The company must appoint a firm with no common partners. The purpose of the common partner restriction is to prevent rotation being defeated in substance by moving the same engagement partners into a differently named entity.

Question 4

The Board of a company is dissatisfied with its auditor's qualifications on the accounts and proposes to remove him by ordinary resolution at the next general meeting. Advise, and explain the policy behind the procedure. What is the position where the company simply does not reappoint him?

Accepted Answer

The proposal is unlawful in two respects. The auditor may be removed from his office before the expiry of his term only by a special resolution of the company, and only after obtaining the previous approval of the Central Government in the prescribed manner; an ordinary resolution is insufficient and the Government's approval must precede the resolution. In addition, before taking any action for removal, the auditor concerned must be given a reasonable opportunity of being heard. The policy behind this triple protection is direct: an auditor whose function is to report independently on the accounts prepared by the directors cannot perform it if those directors can dismiss him at will, and the qualifications the Board objects to are precisely the circumstance in which the protection matters most. Requiring approval from outside the company, from the Central Government, is what makes the protection real, since a controlling shareholder could otherwise muster a special resolution. Not reappointing an auditor at the end of his term is a different matter but is also regulated. Special notice is required for a resolution at an annual general meeting appointing as auditor a person other than a retiring auditor, or providing expressly that a retiring auditor shall not be reappointed. On receipt of such notice the company must send a copy to the retiring auditor, who is entitled to make a representation in writing and to require it to be notified to the members of the company.

Question 5

Assess the eligibility of each to be appointed auditor of Alpha Ltd: (a) a chartered accountant whose wife holds shares of face value ₹800 in Alpha; (b) a CA whose brother is a director of Alpha; (c) a CA who is already auditor of 19 companies; (d) a private limited company of chartered accountants; (e) a CA who provides internal audit services to Alpha's subsidiary.

Accepted Answer

Candidate (a) is eligible. A person is disqualified where he, or his relative or partner, is holding any security of or interest in the company, but a proviso permits a relative to hold security or interest in the company of face value not exceeding one thousand rupees or such sum as may be prescribed; 800 rupees is within that. Candidate (b) is not eligible: a person whose relative is a director or is in the employment of the company as a director or key managerial personnel is disqualified, and a brother is a relative. Candidate (c) is eligible on the numbers, since the disqualification bites on a person or a partner of a firm holding appointment as auditor of more than twenty companies, and nineteen is within the ceiling; accepting Alpha would take the total to twenty, still within it. Candidate (d) is not eligible: a body corporate other than a limited liability partnership registered under the Limited Liability Partnership Act, 2008 cannot be appointed, so a private limited company of chartered accountants is barred while an LLP of them is not. Candidate (e) is not eligible: section 144 prohibits an auditor from rendering internal audit services directly or indirectly to the company or its holding or subsidiary company, and any person whose subsidiary or associate company or other entity is engaged as on the date of appointment in such specialised services is disqualified under section 141.

Question 6

List the services an auditor may not render under section 144 and explain the two distinct threats to independence the prohibition addresses.

Accepted Answer

An auditor appointed under the Act shall provide to the company only such other services as are approved by the Board of Directors or the audit committee, but which shall not include any of the following services, whether rendered directly or indirectly to the company or its holding company or subsidiary company: accounting and book keeping services; internal audit; design and implementation of any financial information system; actuarial services; investment advisory services; investment banking services; rendering of outsourced financial services; management services; and any other kind of services as may be prescribed. The prohibition addresses two distinct threats. The first is self-review: where the auditor has prepared the books, designed the financial information system or performed the internal audit, the audit becomes an examination of the auditor's own work, and no professional can be expected to identify and report his own errors with the detachment the role requires. Accounting and book keeping, internal audit and financial system design fall into this group. The second is advocacy: where the auditor advises on investments, acts as investment banker or provides management services, he becomes identified with the company's commercial interests and its management's decisions, and the appearance and reality of an independent opinion are both compromised. Actuarial, investment advisory, investment banking and management services fall into this group.

Question 7

During an audit the auditor forms a reasonable belief that officers have committed a fraud of ₹2 crore, and separately that an employee has committed a fraud of ₹3 lakh. State the auditor's duties in each case and the protection available to him.

Accepted Answer

The duty is two-tiered by amount, and the tiers have different recipients. If an auditor of a company, in the course of the performance of his duties as auditor, has reason to believe that an offence of fraud involving such amount as may be prescribed is being or has been committed in the company by its officers or employees, he must report the matter to the Central Government within such time and in such manner as may be prescribed. The 2 crore fraud, being above the prescribed threshold, falls into this tier and must be reported to the Central Government. In the case of a fraud involving an amount less than the prescribed threshold, the auditor must report the matter to the audit committee constituted under section 177 or to the Board in other cases, within such time and in such manner as may be prescribed, and the company must disclose the details of that fraud in the Board's report in the prescribed manner. The 3 lakh fraud falls into this second tier. The protection is express and important: no duty to which an auditor of a company may be subject shall be regarded as having been contravened by reason of his reporting any matter in good faith. That provision relieves the auditor of the concern that reporting would breach his duty of confidentiality to the client, without which the reporting obligation could not work in practice. The same reporting duty extends to cost auditors and company secretaries in practice.

Question 8

State the auditor's right of access, his rights in relation to general meetings, and the treatment of a branch audit report.

Accepted Answer

Every auditor of a company has a right of access at all times to the books of account and vouchers of the company, whether kept at the registered office of the company or at any other place, and is entitled to require from the officers of the company such information and explanation as he may consider necessary for the performance of his duties as auditor. The words at all times matter: the right is not confined to a scheduled audit period. The auditor of a holding company also has a right of access to the records of all its subsidiaries and associate companies, in so far as it relates to the consolidation of financial statements. On general meetings, the auditor is entitled to receive all notices of and other communications relating to any general meeting, to attend the meeting either himself or through his authorised representative who must also be qualified to be an auditor, and to be heard at the meeting on any part of the business which concerns him as auditor. Attendance is a right and, where required by the company, an obligation. On branch audit, the accounts of a branch office may be audited by the company's auditor, by any other person qualified for appointment as auditor, or where the branch is outside India by an accountant or other person duly qualified under the laws of that country. The branch auditor prepares a report on the accounts of the branch examined by him and sends it to the auditor of the company, who deals with it in his report in such manner as he considers necessary.

Question 9

A company had net worth ₹300 crore, turnover ₹700 crore and net profit ₹6 crore in the immediately preceding financial year. Its net profits over the three preceding years were ₹4 crore, ₹5 crore and ₹6 crore. Advise on CSR applicability, the amount, and the committee requirement.

Accepted Answer

CSR applies. Every company having, during the immediately preceding financial year, a net worth of rupees five hundred crore or more, or a turnover of rupees one thousand crore or more, or a net profit of rupees five crore or more, must comply. The three tests are alternatives, not cumulative, which is the point the figures are designed to test: net worth of 300 crore is below the threshold and turnover of 700 crore is below the threshold, but net profit of 6 crore exceeds 5 crore, and that alone brings the company within the provision. On amount, the Board must ensure that the company spends, in every financial year, at least two per cent of the average net profits of the company made during the three immediately preceding financial years, in pursuance of its corporate social responsibility policy. The average of 4, 5 and 6 crore is 5 crore, so the obligation is 2 per cent of 5 crore, that is 10 lakh. Note that the base is the three-year average and not the current or immediately preceding year's profit, which is a common computational error. On the committee, the general rule is that such a company must constitute a Corporate Social Responsibility Committee of the Board consisting of three or more directors of whom at least one shall be an independent director. But where the amount to be spent does not exceed fifty lakh rupees, the requirement to constitute a CSR Committee is not applicable and the functions are discharged by the Board itself; the obligation here is 10 lakh, so no committee is needed.

Question 10

A company was required to spend ₹80 lakh on CSR but spent only ₹50 lakh. Of the shortfall, ₹20 lakh relates to an ongoing project and ₹10 lakh does not. State the treatment of each, and the position where a company spends more than required.

Accepted Answer

The Board must specify the reasons for not spending the required amount in its report, and the unspent amount is then dealt with according to whether it relates to an ongoing project. The 10 lakh that does not relate to an ongoing project must be transferred within a period of six months of the expiry of the financial year to a Fund specified in Schedule VII, such as the Prime Minister's National Relief Fund or another fund set up by the Central Government for socio-economic development. The 20 lakh that relates to an ongoing project must be transferred within a period of thirty days from the end of the financial year to a special account opened by the company in a scheduled bank called the Unspent Corporate Social Responsibility Account, and must be spent by the company in pursuance of its obligation towards the CSR policy within a period of three financial years from the date of that transfer, failing which it must be transferred to a Fund specified in Schedule VII within thirty days from the date of completion of the third financial year. The distinction reflects that a multi-year project cannot sensibly be funded within a single year, whereas an unexplained shortfall should leave the company's control. Where a company spends an amount in excess of the requirement, the excess may be set off against the requirement to spend for up to the immediately succeeding three financial years, subject to prescribed conditions. Administrative overheads must not exceed five per cent of total CSR expenditure for the financial year.

Question 11

State where books of account must be kept and for how long, the procedure for keeping them elsewhere, and who may inspect them. What is the position for a subsidiary's financial statements?

Accepted Answer

Every company must prepare and keep at its registered office books of account and other relevant books and papers and financial statements for every financial year, which give a true and fair view of the state of its affairs including that of any branch office, which explain the transactions effected both at the registered office and at its branches, and which are kept on an accrual basis and according to the double entry system. The Board may decide to keep all or any of the books at any other place in India, and where it does so the company must file with the Registrar a notice in writing giving the full address of that other place within seven days of the Board's decision. Books may be kept in electronic mode in the prescribed manner. On preservation, the books of account together with the vouchers relevant to any entry must be kept in good order for not less than eight financial years immediately preceding a financial year, or where the company had been in existence for a period less than eight years, in respect of all the preceding years; where an investigation has been ordered, the Central Government may direct that the books be kept for a longer period. On inspection, the books and other books and papers are open to inspection at the registered office by any director during business hours. In the case of the financial statements of a subsidiary, however, inspection may be done only by a person authorised in that behalf by a resolution of the Board of Directors.

Question 12

State what a financial statement includes, who is exempt from the cash flow statement, and who must sign. When must consolidated financial statements be prepared?

Accepted Answer

A financial statement in relation to a company includes a balance sheet as at the end of the financial year; a profit and loss account, or in the case of a company carrying on any activity not for profit, an income and expenditure account for the financial year; a cash flow statement for the financial year; a statement of changes in equity, if applicable; and any explanatory note annexed to, or forming part of, any of these documents. Four categories need not include the cash flow statement: a One Person Company, a small company, a dormant company, and a private company which is a start-up. On signing, the financial statement including the consolidated financial statement is approved by the Board of Directors before it is signed on behalf of the Board at least by the chairperson of the company where he is authorised by the Board, or by two directors out of which one shall be the managing director, and the chief executive officer if he is a director in the company, the chief financial officer and the company secretary of the company wherever they are appointed; in the case of a One Person Company, by only one director. On consolidation, where a company has one or more subsidiaries, or one or more associate companies, it must in addition to its own financial statements prepare a consolidated financial statement of the company and of all the subsidiaries and associate companies in the same form and manner as that of its own, and lay it before the annual general meeting along with its own financial statement.

Question 13

Distinguish reopening of accounts from voluntary revision. State who may apply, what must be shown, and the limits on each.

Accepted Answer

The two provisions serve different situations and neither permits a company to reopen its accounts of its own motion. Reopening of accounts is available only on an order of a court of competent jurisdiction or the Tribunal, and only on an application made by the Central Government, the Income-tax authorities, the Securities and Exchange Board of India, any other statutory regulatory body or authority, or any person concerned. The order can be made only to the effect that the relevant earlier accounts were prepared in a fraudulent manner, or that the affairs of the company were mismanaged during the relevant period casting a doubt on the reliability of the financial statements. The court or Tribunal must give notice to the applicant authorities and consider their representations before passing the order, and accounts so revised or recast are final. Voluntary revision is different in initiative and in scope. If it appears to the directors of a company that the financial statement of the company or the report of the Board do not comply with the requirements of section 129 or section 134, they may prepare a revised financial statement or a revised report in respect of any of the three preceding financial years, after obtaining the approval of the Tribunal on an application made by the company. Two limits apply: the Tribunal must give notice to the Central Government and the Income-tax authorities and consider their representations, and such revised financial statement or report shall not be prepared or filed more than once in a financial year.

Question 14

Set out the contents of the directors' responsibility statement and identify which item applies only to listed companies.

Accepted Answer

The directors' responsibility statement is included in the Board's report and states six things. That in the preparation of the annual accounts, the applicable accounting standards had been followed along with proper explanation relating to material departures. That the directors had selected such accounting policies and applied them consistently and made judgements and estimates that are reasonable and prudent so as to give a true and fair view of the state of affairs of the company at the end of the financial year and of the profit and loss of the company for that period. That the directors had taken proper and sufficient care for the maintenance of adequate accounting records in accordance with the provisions of the Act for safeguarding the assets of the company and for preventing and detecting fraud and other irregularities. That the directors had prepared the annual accounts on a going concern basis. That the directors, in the case of a listed company, had laid down internal financial controls to be followed by the company and that such internal financial controls are adequate and were operating effectively. And that the directors had devised proper systems to ensure compliance with the provisions of all applicable laws and that such systems were adequate and operating effectively. The internal financial controls item is the one confined to listed companies, and the explanation attached to it defines internal financial controls as the policies and procedures adopted by the company for ensuring the orderly and efficient conduct of its business, including adherence to company's policies, safeguarding of its assets, prevention and detection of frauds and errors, accuracy and completeness of the accounting records, and timely preparation of reliable financial information.

Question 15

The Central Government applies to the Tribunal alleging that a company's auditor colluded in a fraud. State the Tribunal's powers, the timeline, and the consequences for the auditor.

Accepted Answer

Where the Tribunal is satisfied, either suo motu or on an application made to it by the Central Government or by any person concerned, that the auditor of a company has, whether directly or indirectly, acted in a fraudulent manner or abetted or colluded in any fraud by, or in relation to, the company or its directors or officers, it may by order direct the company to change its auditors. Where the application is made by the Central Government and the Tribunal is satisfied that any change of the auditor is required, it shall within fifteen days of receipt of such application make an order that the auditor shall not function as an auditor and the Central Government may appoint another auditor in his place. The consequences for the auditor are severe and extend well beyond the engagement in question. An auditor, whether individual or firm, against whom a final order has been passed by the Tribunal is not eligible to be appointed as an auditor of any company for a period of five years from the date of passing of the order, and is liable for action under section 447, which is the fraud provision carrying imprisonment and fine. Where the auditor is a firm, the liability, whether civil or criminal, for the fraudulent act is of the partner or partners concerned and of the firm jointly and severally, but only that partner or partners who acted in a fraudulent manner or abetted or colluded in any fraud are criminally liable.

Practice — Accounts of Companies, Audit and Auditors

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