Audit of Limited Companies | Auditing

Some of the frequently asked exam questions on audit of limited companies are as follows: 

Q.1. Indicate the Important points to be considered if you are appointed:

(a) As the First Auditor,

(b) as the Auditor in place of the Retiring Auditor, and

(c) as the Auditor through an order of the Government.

Ans. (a) As the First Auditor:

The following points are necessarily to be considered:

1. To see that the appointment has been duly con­firmed by the Board of Directors at the com­pany meeting held within one month of the date of incorporation of the company;

2. To check-up that the letter of auditor’s appoint­ment along with a copy of the board’s resolution have been sent to the auditor;

3. To verify that the audit assignment is within the terms of Section 224 of the Companies Act;

4. To ensure that the acceptance of audit work is informed to the Registrar of Companies within one month of the receipt of appointment.

(b) As an Auditor in place of Retiring Auditor:

1. To ensure that the formalities of the Company Law in this regard are really complied with;

2. To clearly communicate the Retiring Auditor in writing about the appointment before accept­ance so that he is not held guilty of professional misconduct;

3. To scrutinize the minutes of the Board meeting or general meeting about the appointment and the remuneration determined, before the con­firmation as to acceptance is sent to the Regis­trar of Companies.

(c) As an Auditor under the Government’s Order:

1. To go through the terms and conditions of the order received directly from the Government, and to see the original order copy received by the company in this respect;

2. To confirm his acceptance in writing to the Cen­tral Government.

Q.2. What is capital reserve? How is it created?

Ans. This refers to a reserve created out of the profits of capital nature. The company law has not specifically defined this term, but state that it should not include any amount regarded as free for distribution through the Profit and Loss Account among the shareholders.

Capital Reserve is created by transferring the amounts from one or all the following sources to this account:

(a) Profits prior to the incorporation of a company;

(b) Profits on the redemption of debentures at a discount;

(c) Premium receipts on the issue of shares and debentures;

(d) Credit balance against Forfeited Shares Account after re-issue of such forfeited shares;

(e) Differential amount when the value of the net assets acquired on purchase of a business exceeds the original purchase price;

(f) Profits on the sale of fixed assets;

(g) Profits earmarked for non-distribution among shareholders in terms of a provision in the Articles of Association;

(h) Appre­ciation amount as a result of revaluation of assets; and

(i) Certain capital gains earned but not distributed.

Q.3. Why is a revenue reserve created?

Ans. It is created to:

(1) Meet any unknown contingency;

(2) Strengthen financial solvency;

(3) Provide additional working capital; and

(4) Pay dividends in the years of inadequate profit.

Q.4. What are the duties of an auditor in relation to capital reserve and revenue reserve?

Ans. In relation to a Capital Reserve, the auditor should:

(1) Review the Articles of Association for the relevant clause and the purposes for which utilisation of this reserve are admissible;

(2) Verify the transfers of all (completeness test) capital profits;

(3) Review the Director’s minute book for transfer and utilisation of capital profits, including investments, if any;

(4) Examine the balance sheet for separate disclosure of this reserve including the additions and withdrawals; and

(5) Ensure the fulfilment of the conditions as to the distribution as dividends among the shareholders, such as Board’s resolution recommending the dividend, Articles permitting the distribution and existence of realisable surplus after an appropriate revaluation of all the fixed assets.

In relation to the Revenue Reserve, the auditor should:

(1) Review the Articles of Association for the relevant clauses which authorize creation of this reserve;

(2) Review the Directors’ Minute Book for the amount set aside for the various reserves and for authorisation of withdrawals;

(3) Examine the mode of creation of this reserve out of the profits, and other reserves such as development rebate reserve, investment allowance, etc., which are charged against the profit ;

(4) Verify the adequacy of this reserve under the Companies (Transfers of Profits to Reserves) Rules, 1975, in case of recommendation of dividend by the directors; and

(5) Ensure appropriate disclosures in the company’s annual accounts.

Q.5. Give three examples of capital reserve and revenue reserve.

Ans. Capital Reserve: Share Premium Account, Capital Redemption Reserve, Development Rebate Reserve, Fixed Assets Revaluation Reserve, etc.

Revenue Reserve: General Reserve, Dividend Equalisation Reserve. Deferred Taxation Reserve, Contingencies Reserve, Staff Gratuity Reserve, etc.

Q.7. What is a secret reserve? How and why is it created?

Ans. It refers to a reserve which is not disclosed in the balance sheet.

According to E.L. Kohler (in his ‘Dictionary for Accounts), a secret reserve represents “the amount by which the net worth has been deliberately understated a hidden reserve.” “Such a condition exists where they are omitted or where liabilities are overstated. The term does not represent any account actually bearing that name.”

A variety of methods are usually adopted, such as:

(1) Overvaluation of liabilities;

(2) Undervaluation of assets like investments, stocks, WIP, etc.;

(3) Excess provision of depreciation, doubtful debts, discount on debtors;

(4) Fictitious liabilities;

(5) Capital expenditure treated as revenue expenditure;

(6) Deferred revenue expenditure charged in the current year, etc.

Secret reserve is created due to the following important reasons:

(1) Pay lower rates of taxes;

(2) Declare lower dividends;

(3) Conceal abnormal profits;

(4) Meet losses owing to bad debts;

(5) Keep the confidentiality of the earning capacity;

(6) Equalize the dividends in the years of inadequate profits thereby maintaining the corporate image before the investors and public.

Q.6. Can a public limited company create secret reserve now? Quote legal decisions, if any, and give reasons for your answer. Explain the position of an auditor in this regard.

Ans. With the introduction of the Companies Act, 1956, a public limited company is not allowed to create a secret reserve. The creation of a secret reserve will amount to a contravention of the company law, as the balance sheet will not reflect the true and fair view of the state, of affairs of the company and the Profit and Loss Account will not show the true and fair view of the profit or loss for the year.

Legal decisions:

1. In Shamdasani vs. Poch Khandelwala, it was held that if a part of secret reserve was utilised to meet bad and doubtful debts it must be revalued in the balance sheet of a company. It must not be concealed in any way.

2. In Rex Vs. Kylsant & other, it was observed that a secret reserve was an intolerable abuse as it may lead to cover up the management’s negligence and irregularities and inefficiencies. It is almost a breach of faith if a large portion of the company’s assets is left in the secret disposition of the managing authority to whom the investors and shareholders entrust their moneys faithfully.

3. In Royal Mail case, the auditor was warned to report the fact of utilizing the secret reserve for the payment of dividends in the years of losses.

Auditor’s position:

The auditor should always endeavour to unearth a secret reserve (if any), as because he remains responsible to submit a report as to: whether the balance sheet gives a true and fair view of the state of affairs of a company, and whether Profit and Loss Account shows the true arid fair view of the profit or loss for the financial year.

Thus, he should:

1. Review critically the reserve clauses in the Articles of Association;

2. Examine thoroughly the books of accounts and records to see that the bad debts written off have been disclosed in the annual accounts;

3. Check up the valuation of the closing stocks, work-in-progress, and assets, and the correctness of the values of liabilities;

4. Guard against the inclusion of contingent liabilities as current liabilities;

5. Study and evaluate the internal accounts and administrative controls established and operated in the company;

6. Examine whether there has been any change in the method of accounting or the basis of valuation of the stocks, and also recomputed the information to ascertain its impact on the profit for the year.