Some of the most frequently asked exam questions on investigation and audit of a limited company are as follows:
Q.1. Enumerate the circumstances under which the Central Govt. may order ‘investigation’ of a limited company.
Ans. The Companies Act., 1956, under its Section 237, states the specific circumstances when the Central Government may order for investigation into the affairs of the limited companies.
These are as follows:
1. When the shareholders numbering not less than two hundred or the members holding not less than one-tenth of the total voting power of the company submit an application for the purpose, in the case of a company having a share capital.
2. When the members not less than one-fifth of the persons on the company’s register of members submit an application for the purpose, in the case of a company not having a share capital.
3. When the Register of companies submits a report for the purpose.
4. When a court declares by its order as such.
5. When a company adopts a special resolution for the purpose.
6. When the business of the company is being conducted with an intention to defraud its creditors, members or any other persons, or otherwise for a fraudulent or unlawful purpose, or in a manner oppressive to any of its members, or that the company was formed for any fraudulent or unlawful purpose.
7. When persons concerned with the formation of the company or the management of its affairs have in connection therewith been guilty of fraud, misfeasance or other misconduct towards the company or towards the members.
8. When members of the company have not been given all the information with respect to its affairs which they might reasonably expect, including information relating to the calculation of the commission payable to a managing director, director, or manager of the company. It is to be noted that the order of the Central Government is not necessary when the investigation is carried out by the company itself or under the court’s order.
Q.2. Briefly indicate the points to which you would give attention when carrying out an investigation on behalf of a client with respect to: (A) Purchase of a running business, (B) Admission of a partner, (c) Loan to a company, (D) Valuation of ‘goodwill’, (E) Valuation of ‘shares’, and (F) Suspicion of ‘fraud’.
Ans. (A) Purchase of a running business:
The following points should be looked into:
1. Nature of business:
A limited company or a trading concern or a partnership business.
2. Status of business:
Recently incorporated or an old one having an image in the market. Whether the shares are quoted in the Stock Exchanges.
3. Accounting aspects:
The position of assets and liabilities, existence of various fixed assets and their values, existence of raw-materials and stores and finished goods and their values, value of investments, trend of sales and profits, age schedule of debtors, nature and types of contingent liabilities, contracts and agreements with the parties, etc. The study of important accounting ratios, such as Gross profit ratio, Net profit ratio, Return on Capital employed.
Earnings per share, Dividend per share, Current ratio, Liquidity ratio, Stock turnover ratio, Cost ratios, Debtors/Creditors ratios, etc. for three to five years would also give indications as to the past performances for meaningful comparisons with those of other similar businesses in the same industry.
4. Capital and organisation aspects:
The present structure (viz., authorised, issued, called- up and paid-up capital) and the reserve capital, if any; the rights of shareholders; accumulated reserves; rates of dividend declared for the past 3 to 5 years, etc.
(B) Admission of a Partner:
The need for an investigation may arise both from (i) an incoming partner and (ii) existing partners.
The following points should be investigated:
On behalf of an incoming partner:
1. Review of the existing partnership deed to ascertain as to the clause that may be unsuitable to a new partner.
2. The accounting aspects [as enumerated against A (3)].
3. The amount of goodwill to be brought in by a new partner and the basis of goodwill calculation. If the amount proposed by the existing partners is lump sum, then a comparison should be made with the amounts calculated on the basis of super-profits, or certain year’s purchase of average net or gross profits. In the latter case, the profit figure should be checked from all aspects to ensure that it is not inflated.
4. Ascertaining as to whether goodwill will be retained in the partnership business, or utilised in paying off debts, or invested in other business, or taken away by the existing partners.
5. Review of the proposed profit sharing scheme with reference to the capital of other partners and also the future prospects of the business.
6. Ascertaining the role of the new partner if admitted, and examining the conditions as to salary, commission, etc.
On behalf of existing partners:
The investigation should be conducted more or less on the lines indicated above. But the investigating auditor should carry on his investigation to ascertain the extent of additional benefits that are likely to arise to the business and other partners on the admission of a new partner.
He should, therefore, consider the following points:
1. The specific criteria and objectives for admission of a new partner; that is, whether for additional capital, new lines of business activities, special skill and knowledge of the new partner, excessive work load with the existing business, etc.
2. The probable impact on the affairs of the management, if a new partner is admitted.
3. The amount of goodwill that should be charged from the new partner and its uses.
4. The scheme of profit sharing among the partners.
(C) Loan to a company:
Such loan to a company may be given by a bank or other parties.
The investigating auditor on behalf of a client (bank or party) should consider the following points, among others:
1. The purposes for which a company requires the loan.
2. The terms of repayment of the loan, and the capacity of the company to fulfill them.
3. The nature and kind of securities pledged by the company for such loan and their status.
4. The nature and kind of assets including stores proposed to be hypothecated for such loan.
5. The borrowing powers of the company and the authorisation thereof in the articles and in the board’s resolution of the company.
6. The financial position, the trend of operational activities in the recent past, the future projection of activities, the debtors/creditors position, the status of current liabilities and contingent liabilities, etc. of the company.
7. The information about the other loans, if any, taken by the company and the extent of arrears of repayment, if any.
8. The details of insurance policies and the risks covered and the present position regarding the payment of premiums.
9. The present position with respect to the payment of various taxes to the Government and the adequacy of the provision for taxation.
10. The position of the cash flow vis-a-vis the funds flow broken into several periods for the current year as well as for the next few years duly projected on the basis of action plans and programmes of the company.
(D) Valuation of Goodwill:
The investigator should keep in mind that the following circumstances or events necessitate the valuation of goodwill:
(a) When a new partner is admitted.
(b) When a partner retires or dies.
(c) When the firm is sold to or amalgamated with another firm.
(d) When there is a change in the profit sharing ratio among the partners existing.
The investigating auditor should consider the following factors:
1. Nature of industry its past performance with respect to profits and dividends and its future prospects.
2. The basis of valuation of assets and their values.
3. The general reputation of the company and its products and/or services.
4. The nature of management and the composition of the partners or directors, their integrity and skill.
5. The capital structure, the incidence of taxation, and the state of commercial and technical advantages possessed by the firm over others in the similar industry.
6. The method adopted for valuing goodwill. While checking the valuation methods, it is necessary to examine the following ;
(a) Simple profit method i.e., valuation based on certain number of years’ purchase of the average profits of the past few years.
(b) Super profit method i.e., valuation based on the difference between future maintainable operating profit and normal profit.
(a) Whether the following adjustments have been made while calculating average profits:
(1) All actual expenses and losses not likely to occur in the future are added back to profits;
(2) All profits likely to come in future are added;
(3) Actual profits not likely to recur are deducted;
(4) Expenses and losses expected to be borne in future are deducted.
(b)(1) Choice of normal rate of return for representative firms in the industry and de- termination of the amount of capital employed.
(2) Whether the following adjustments have been made to arrive at the future maintainable profits:
(i) calculation of past average taxed earnings,
(ii) projection of future maintainable taxed profits and
(iii) preferential rights, and the manner in which these are determined.
(E) Valuation of Shares:
The first and foremost thing for the investigating auditor should be to ascertain which of the following circumstances necessitate the valuation of shares:
(a) Assessments under the Estate duty, Gift tax or Wealth tax Acts;
(b) Conversion of share (i.e., preference to equity, etc.);
(c) Purchase of shares;
(d) Formulation of amalgamation or absorption schemes;
(e) Compensation to the shareholders on the acquisition of shares by the Government;
(f) Proposal to sanction on the security of shares;
(g) Acquisition of shares under the reconstruction scheme, etc.
He should also consider the following points:
1. Whether the shares are quoted or unquoted.
2. Whether the shares relate to a private limited company.
3. Whether there is a direction from the court.
4. Whether a large block of shares is under transfer.
5. Whether the articles of association of a company so provide.
6. Whether the method adopted for valuation has taken into account the pertinent factors, like earning capacity, value of assets employed value of goodwill, the trends of profits and dividends, etc., and whether the data on them have been considered with reference to the audited accounts.
(F) Suspicion of Fraud:
Broadly, there are three types of fraud misappropriation of cash, misappropriation of goods; and manipulation of accounts. Because of the variety of items, the investigator should be aware that the procedure of investigation would vary in content and depth.
Misappropriation of Cash:
The investigating auditor, when entrusted with this task, should bear in mind that this type of fraud generally involves either or all of the cases, such as cash received but not recorded or recorded for a shorter amount, cash paid against false bills or vouchers, fictitious entries in records etc.
He should, therefore, consider the following points:
1. The systems of cash receipts and disbursements, and cash sales and purchases, and the existence of internal checks at various stages.
2. The separation of duties and incompatible functions, e.g., an employee who receives and deposits cash and cheque should not prepare sales invoices or reconcile bank accounts; an authorised cheque- signer should not approve vouchers for payment.
3. Testing cash transactions with a ‘block reconciliation’ for a selected period to obtain the proof of cash.
‘Block reconciliation’ involves the steps like:
(a) Confirm with bank and trace to ending balance on previous month bank statement and beginning balance on current month bank statement,
(b) Trace to current month bank statement and authenticated deposit slip,
(c) Obtain or prepare a list of outstanding cheques: determine whether each cheque on list:
(i) cleared with current month bank statement (by examination of cancelled cheque) or
(ii) was listed as outstanding at the end of the current month,
(d) Compare with general ledger or cash book,
(e) Prepare a list of deposit from bank statement and note the date of each deposit,
(f) Prepare a list of deposits from cash book and note the date of each deposit,
(g) Compare these two lists between (e) and (f) and investigate any significant delays between dates,
(h) Trace to cut-off bank statement and authenticated deposit slip,
(i) Prepare and total a list of cancelled cheques included in the bank statement.
(j) Perform bank reconciliation,
(k) Prepare and total a list of disbursements from cash book and
(l) Confirm with bank and trace to ending balance on current month bank statement and beginning balance on cut-off bank statement.
4. The systems of maintaining petty cash.
5. The systems of authorisation with respect to withdrawals (by partners); advances paid and adjustments; payments of commission, discounts, ‘duplicate’ bills, ‘proforma’ invoices, donations and charities, etc.
Misappropriation of Goods:
The investigating auditor should consider the following points in particular:
1. The systems of internal accounting and administrative control with regard to the production and/ or receipts and dispatches of goods.
2. The systems of record keeping and its adequacy.
3. The systems of authorisation with respect to receipts, issues, transfers and returns of all goods including the internal check and control of all relevant documents.
4. The procedures adopted for the issue of free samples to customers and of goods for internal use and captive consumption in the manufacture of other goods or in the assembly of other final products.
Manipulation of Accounts:
The following points should be looked into by an investigating auditor:
1. The stock-in-trade and the valuation thereof. Whether the methods of valuation are proper and consistent from period to period.
2. The internal accounting controls associated with administrative routines with respect to purchases, sales, disposals and transfers of various goods and the payment of wages to a large number of workmen.
3. The rates and amounts of depreciation charged in the accounts. Whether the method is followed consistently from period to period, and in accordance with the applicable laws.
4. The appropriateness of the allocation of capital and revenue expenditure in the accounts, and whether the accounting policy in this regard is consistently followed.
5. The valuation of all assets and liabilities and their consistent application, and the criteria chosen for revaluation of assets as a matter of policy.
6. Inter-company transactions and the transactions relating to the personal expenses of the directors or other officers with a view to checking their admissibility or otherwise.