Expert Advisory Committee

1.3 Query

Whether the statutory auditor of a public company should qualify his audit report

when the provisions of Section 295 of the Companies Act are contravened

1. A closely held public limited company-ABC Limited- carrying on the business of manufacture of woollen goods, has a paid up capital and free reserves amounting to Rs. 3 crores. One of the directors of this company is a share-holder in a private limited company, DEF Pvt. Ltd. Another director of the ABC Limited, is a share-holder in another private limited company-XYZ Private Limited.

2. The ABC Limited, in accounting year ending 30.6.1984, made an advance of Rs. 40 lakhs to DEF Private Limited. ABC Limited, made another advance of Rs. 30 lakhs during the year ending 30.6.1984 to XYZ Private Limited. The total advances at the end of the accounting year of ABC Limited, to the said two companies thus amounted to Rs. 70 lakhs. Special resolutions were passed by the ABC Limited authorizing the directors to make the said advances. However, no prior approval of the Central Government in terms of section 295 of the Companies Act, in respect of these loans was obtained by the ABC Limited. The contraventions of the provisions of Section 295 was brought by the auditors to the notice of the directors of the ABC Limited.

3.After the close of the accounting year, but before the finalization of the audit, the directors of ABC Limited, immediately recalled their loans in full from DEF Private Limited and XYZ Private Limited and the said loans of Rs. 70 lakhs duly credited in the bank account of ABC Limited.

4.The ABC Limited, has made the following disclosure in the final accounts in the annexure on “NOTES ON ACCOUNTS”: -

“Loans and Advances include the following amounts:

(a) Rs. 40 lakhs advanced to DEF Private Limited.

(b) Rs. 30 lakhs advanced to XYZ Private Limited.

There is a contravention of the provisions of Section 295 of the Companies Act. However, the amounts have been received back in full.”

5.The ABC Limited is of view that the statutory auditors in view of the above facts and circumstances should not qualify their report because it would tantamount to duplication of a “Note” either in full or in short. According to the company the balance sheet does disclosed a true and fair view since the balance sheet shows the total loans and advances as on 30.6.1984. They have been realized in full before the finalization of audit. Also, according to the company, the said loans do not affect the profit and loss account and therefore making of loans has no bearing upon the accounts.

6.The company has also relied upon the following para 4.8 of the Institute’s Publication “Statement on Qualifications in Auditor’s Report” (1982 Edition) according to which the auditor should qualify his report:

“When contravention has taken place of the provisions of Companies Act, 1956, having a bearing upon the accounts and transactions of the company e.g. donations to political parties or for political purposes in contravention of section 293A; contributions to charitable or other funds in excess of limitations specified in section 293 (1) (c)”

The company has argued that in the present case, the funds of the company have not gone out irretrievably but funds have been invested, they have been received back and interest has been realized at the market rate, No doubt there is a contravention of Section 295 of the Companies Act, but it does not have any bearing upon the accounts.

7.The querists have indicated the following two contrary views on the matter for the consideration of the Expert Advisory Committee:

(i) According to the first view since the Company has given the relevant details in the “Notes on Accounts” admitting the contravention of Section 295 of the Companies Act, and the amount has been received back, the auditor is not required to look into each and every non compliance of the provisions of the Companies Act. He is not entrusted with the task of reporting breaches of law. His duties are laid down in section 227 of the Act. Primarily, he has to review the balance sheet and the profit and loss account with a view to ascertain whether they reflect a true and fair view of the working results and actual affairs of the company. In the present case the breach of the Act, does not have any impact on the accounts of the company. Compliance of the provisions of the Companies Act, is the responsibility of the directors and the officers of the Company. The amount has not gone from the corpus of the company, irretrievably. In this context the company has also relied upon para 3.14 at page 16 of the Institute’s Publication “Statement on Qualifications in Auditor’s Report” (before modification), where it is mentioned as under: -

“It sometimes happens that the nature of the qualification is such that it is preferable to embody it under a note to the accounts, as it does not really represent a difference of opinion between the management of the company and auditors but represents an item which should be brought to the notice of the share-holders e.g. where remuneration has been paid to the Managing Director of a Public Company in excess of that approved by the Central Government and the Company has approached the Central Government for permission to pay additional remuneration in respect of which application on the date of signing the auditor’s report is pending before the Central Government. A qualification is naturally called for but it is not considered appropriate to include such a qualification in the auditor’s report but it is considered more appropriate to embody it in a note on the accounts.

……………….”

Therefore, in view of these facts and particularly full disclosure having been made in the notes on accounts there should be no further qualification in the auditor’s report.

(ii)According to the other view, the transaction being a material one, the advances having been made, which should not have been made by the company, and the transaction being invalid in law, causing a contravention of section 295 of the Companies Act, and particularly, in view of the Institute’s publications referred to below, the qualification in the auditor’s report must be made.

(a) “Statement on Auditing Practices”, 1977 Edition, Page 75

“Sec. 295. : This section prohibits, except under certain conditions, loans to directors etc. and other persons connected with them. If any loans are given in contravention of this section the auditor should report the matter.”

(b) “A Guide to Company Audit”, 1980 Edition, Page 26,

“(B) Loans and Advances: -

III. Have you ascertained that the provisions of section 295 have been complied with.”

“3.6 (iii) Chapter 3: Whether the matters in question are so material to as affect the presentation of a true and fair view of the whole of affairs of the company, or are of such a nature as to affect only a particular item disclosed in the accounts, and

(iv) Whether the matters constituting qualifications involve a material contravention of any requirements of the Companies Act, 1956, which have a bearing on the accounts.”

8. The querist has sought the opinion of the Expert Advisory Committee on whether in the circumstances of the query, the auditors should qualify their report and, if yes, whether the following qualification in the report in view of the disclosure, in the notes on accounts referred to in para 4 above, be sufficient for the discharge of his duties as statutory auditors.

“Subject to Note No._____________________ on notes to accounts, (Schedule number ___________________) regarding the non-compliance of the provisions of sections 295 of the Companies Act………………..”

Opinion December 31,1985

1The Committee notes that the ‘Statement on Auditing Practices’(1983) issued by the Research Committee of the Institute of Chartered Accountants of India, has stated at page 73 that “If any loans are given in contravention to this section (section 295), the auditor should report the matter”. The Committee is therefore of the view that the auditor should qualify his report in case of contravention of the provisions of section 295 irrespective of the fact that the concerned loans have been repaid after the balance sheet date.

2.With regard to the manner of making qualification in the auditor’s report, the Committee notes that with regard to audit reports signed on or after 1^st April, 1984, the recommendations contained in the 1985 edition of the Statement on Qualifications in Auditor’s Report, issued by the Institute of Chartered Accountants of India, the relevant paragraph of which is reproduced below, would be applicable:

“3.10 All qualifications should be contained in the auditor’s report. The notes to accounts normally represent explanatory statements given by the directors of the company and should not contain the opinion of the auditors. The practice has also grown recently of having a large number of notes to accounts, some of which are subject matter of qualifications in the auditor’s report and some of which are merely clarificatory. It is necessary that the auditors should reproduce* the notes of a qualificatory nature in their report to enable the reader to know the importance of these qualifications. It is also necessary that the auditors should quantify, wherever possible the effect of these qualifications on the financial statements in clear and unambiguous manner if the same is material. In circumstances where it is not possible to quantify the effect of the qualifications accurately, the auditor may do so on the basis of estimates made by the management after carrying out such audit tests as are possible and clearly indicate the fact that the figures are based on management estimates.”

3.On the basis of above, the Committee is of the opinion that:

(i) The auditor should qualify his report in case of contravention of the provisions of section 295 of the Companies Act, 1956. Irrespective of the fact that the loans in question have been repaid.

(ii) The auditor may qualify his report in the following manner:

“Subject to advances of Rs. 40 lakhs and Rs. 30 lakhs made to M/s. DEF Pvt. Ltd., and M/s. XYZ Pvt. Ltd., respectively, included in loans and advances, which are in contravention to the provisions of section 295 of the Companies Act, 1956 (Refer to Note- of Schedule____________). The management, “however, has clarified that these amounts have been repaid in full after the close of the year.”

The above manner of qualification is only illustrative in nature. The auditor may, therefore, modify the same appropriately in the light of the actual circumstances.

____________________________

* For removal of doubts, it is clarified that the use of the word “reproduce” here does not imply a verbatim reproduction. Where notes of a qualificatory nature appear in the accounts, the auditor should state all qualifications independently in his report in an adequate manner so that a reader can assess the significance of these qualifications. For this purpose, where a note is already given in detail by the management, it is not necessary to reproduce verbatim such a note in the audit report and a brief self-explanatory statement may be sufficient.