Expert Advisory Committee

1.8 Query

(1) Expression of negative opinion in the auditors’ report

(2) Provision for shortfall in the value of investments

(3) Treatment of profit realised on the sale of trade investments

1. A Government company changed the method of valuation of its work-in-progress and finished goods. The earlier method and the new method of valuation of finished goods were not in accordance with the accepted method of valuation. However, with regard to work-in-progress the new method was not in accordance with the accepted principles. The closing stock was therefore over-valued to the extent of Rs. 22.31 lacs. The effect of change in the method of valuation, after valuing the opening inventory on the same basis as that of closing stock, was that the profit for the year was overstated to the extent of Rs. 12.05 lacs. The auditors of the company made this observation while auditing the accounts of the company.

2. The auditors made some other observation, the cumulative effect of which was that profit for the year was overstated to the extent of Rs. 22.27 lacs. Overall, the profit for the year was overstated to the extent of Rs. 34.32 lacs. The reported profit for the year amounted to Rs. 91.51 lacs.

3. The auditors were of the opinion that the over-statement of the profit was material. They accordingly reported that profit and loss account did not reflect a true and fair view of the profit for the year. Since the over-statement of various assets qualified in the report amounted to only 4% of the total assets, the auditors reported that subject to their observations on the over-statement of assets, the balance sheet reflected a true and far view of the state of affairs of the company as at the date of balance sheet.

4. The auditors also observed that the company had sold it shares which were held as investments and realised a profit of Rs. 38.60 lacs. The shares were purchased on the directions of the Government and they were classified as trade investments. The company treated the sum of Rs 38.60 lacs as revenue profit for the year. It may be noted that the company did not revalue its other assets and liabilities.

5. The value of investments held as on the date of balance sheet had fallen by Rs. 26 lacs vis-à-vis the cost. As the market value was considerably less than cost during the last five years, the auditors were of the opinion that the fall in the value must be provided for in the accounts. The company however did not agree to this. The auditors qualified their report accordingly.

6. The opinion of the Expert Advisory Committee has been sought on the following issues arising from the above:

(a) Whether the manner of reporting by the auditors specified in para 3 above is correct.

(b) Whether the profit realised on sale of trade investments can be treated as revenue profit for the year or it should be treated as a capital reserve?

Opinion May 15, 1987

1. The Committee notes that para 3.7 of the “Statement on Qualifications in Auditor’s Report” issued by the Institute of Chartered Accountants of India, sates as below:

“In a majority of cases, items which are the subject matter of qualification are not so material as to affect the truth and fairness of the whole of the accounts but merely create uncertainty about a particular item. In such case, it is possible for the auditors to report that in their opinion but subject to the specific qualifications mentioned, the accounts present a true and fair view. Sometimes, however, the items which are the subject matter of qualifications are so material that it would be meaningless to state, that subject to the qualification, the accounts disclose a true and fair view. An extreme example would be where the auditors were not able to examine a substantial part of the books of accounts, e.g., they were in police custody. In such a case it would not be proper to express an opinion on the truth and fairness of the accounts after merely stating that the books of account were not examined. In such cases the auditors must report that either:

(i) they are unable to state whether the accounts present a true and fair view; or

(ii) make a categorical statement that in their opinion the accounts do not present a true and fair view.

Which of the above two alternatives should be followed would depend upon the facts of each case. An Example of a situation referred to in paragraph 3.7 (ii) is as follows:

(a) The Company has adopted the method of taking entire profits on construction contracts to the Profit and Loss Account on entering into the contract. This has resulted in anticipating the profit in cases where contracts have not even been commenced or where only a very minor part of the expenditure on the contract has been incurred. We are of the opinion that this method of accounting is contrary to accounting principles and methods;

(b) In view of para (a) above, we are of the opinion that the said accounts do not give a true and fair view:

(i) in the case of the Balance Sheet, of the state of affairs of the Company as at 31^st March, 1980;and

(ii) in the case of the Profit and Loss Account, of the profit of this year ended on that date.”

2. Regarding manner of making qualification in the auditor’s report, the Committee notes that para 3.10 of the above Statement, recommends as below:

“All qualification should be contained in the auditors’ 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 auditors’ report and some 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 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 the above, the opinion on various issues raised by the querist is as follows:

(a) In case the auditors are satisfied about the materiality of the subject-matters stated in paras 1 and 2 of the query, keeping in view the relevant facts and circumstances, the auditors can report that the profit and loss account does not give a true and fair view of the profit of the year, and in the case of the balance sheet, make a qualification in accordance with the recommendations of the “Statement of Qualifications in Auditor’s Report” particularly paras 3.7 and 3.10 thereof reproduce above.

(b) (i) The Committee is of the view that profit on sale of ‘trade investments’ should be considered as a capital profit.

(ii) The Committee notes that there is no direct reference to the distribution of capital profits as distinguished from capital reserves in the Companies Act, 1956. Therefore, a view on the matter can be taken on the basis of application of accounting principles and sound and prudent financial policies. The Committee also notes that two foreign cases, viz., Lubbock Vs. The British Bank of South America Ltd. and Foster Vs. The New Trinided Lake Asphalte Co. Ltd. lay down the following wholesome principles in this regard which the Committee supports:

(a) The Articles of Association permit such a distribution.

(b) The surplus is realised.

(iii) On the basis of the above, the Committee is of the opinion that the company can distribute profit on sale of trade investments provided (i) the articles of association of the company permit such a distribution and (ii) surplus remains after taking into account the shortfall of Rs. 26 lakh in the value of investments and proper valuation of the other assets has been fairly taken.

(c) (i) The Committee notes that Part II of Schedule VI to the Companies Act, 1956, contains instructions for the preparation of balance sheet of a company. The relevant instruction regarding ‘Investments’ states that “Aggregate amount of company’s quoted investments and also the market value thereof shall be shown”.

(ii) On the basis of above, the Committee is of the opinion that strictly from the legal point of view, it is not necessary to provide for the short-fall in the value of investments in the balance sheet. However, from the accounting point of view it would be prudent to provide for the shortfall in the value of investments, particularly, in case the fall in the market value thereof is permanent in nature.

* 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 sate 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.