Investigation of frauds by using unconventional techniques

Use of techniques which would not ordinarily in an audit 
Each investigation is unique. Techniques fit the circumstances. The investigator may have to employ techniques which he would not ordinarily use in an audit situation. 

• “Investigator’s Bluff”-For example, decoy customers may be used. Audit personnel of CA firm posing as customers purchase from the shop of the client and observe whether receipt/cash memo is issued etc.
• Dimensional Analysis-When investigating  for an insurance company a claim for loss of stocks, it may be useful to ask a question like “How many TV sets can be stored in this godown even if all TV sets stored are of the smallest model?”

Case study illustrating the use of Investigator’s bluff

Facts of the case-A trading concern, dealing in chocolates and sweets and having a chain of retail outlets in all the metro cities announced an incentive scheme to induce shoppers to visit its shops again. The scheme provided that if a shopper made a purchase of more than Rs. 1,000, he would be  entitled to  a 10% discount coupon for his next visit. The guidelines framed by management required the  prominent display of  a placard at each of the shops to advertise the discount scheme. Appropriate internal controls in the form of pre-numbered receipt books and discount coupons were also introduced. As a result of  the scheme, sales of all the metros increased  as expected, except in one city. In that city,  even after the introduction of the discount scheme, the sales had not increased, though large values of discounts had been availed of. The management was intrigued by this and appointed an investigator to look into the matter.

Investigator’s routine examination-use of audit procedures-The investigator’s routine examination of Sales, purchases, cash and bank transactions, salaries, journal entries, other  books of account did not reveal anything untoward. The serial numbers controls, cash totals and cash registers appeared to be satisfactory. So, the investigator decided to personally visit the shop.

Investigator’s personal visit to the shop-On  personal visit, the first thing he noticed was that the placard regarding the scheme was not displayed. Therefore, shoppers would not  know that the discount  scheme was in force unless the cashier was, as a matter of routine, informed shoppers purchasing chocolates worth Rs. 1,000 or more, of the discount entitlement and furnishing discount coupons. He went through all the past discount coupons encashed by customers. The investigator observed the unusual trend that  a lot of shoppers had visited the shop again on the same or the very next day to purchase chocolates. This led the investigator to believe that the discounts claimed were not genuine. However, since the names and addresses of the shoppers were not available, it was not possible to confirm directly with the shoppers and  proving any foul play was difficult.

Use of Investigator’s bluff-The investigator adopted the  “Investigator’s bluff’ technique. He  sent  a decoy customer who purchased chocolates worth Rs. 2,500. As expected, the customer did not get the discount coupon. He was given a receipt of Rs. 2,500, numbered 20026. The spaces relating to information of discount coupon as well as the net payment amount were left blank in the receipt. At the end of the day, the cashier reported his total cash sales for the day and a statement of account coupons issued, which showed that discount coupon number 2113 had been issued against the receipt 20026. The investigator confronted the cashier about the discount coupon, who confessed that he had fraudulently retained the discount coupon himself.

Investigator’s findings-The cashier explained how he went about encashing such discount coupons, as follows:

Step 1: Receipt say 2XX1 was issued to ABC for Rs. 2,000/-

Step 2: Daily Cash Receipt and Discount Coupons Statement would disclose: A discount coupon say 2XX1 issued to the shopper ABC against Receipt 2XX1, though the discount coupon 2XX1 was actually in possession of the cashier himself.

Step 3: When another customer making a purchase of Rs. 1,200/- did not ask for a cash receipt, the cashier would make out a receipt for Rs. 1,200/ with Rs. 120/- entered in the discount column, and attach coupon 2XX1 to that receipt as if that customer was ABC who had returned to purchase chocolates again with the discount receipt 2XX1.

Step 4: The cashier would pocket Rs. 120/- and put Rs. 1,080/- In the cash box.

In this manner, he had siphoned off an average of almost Rs. 20,000 per week. Thus, the discount scheme, in fact, had never been in operation at all. This explained why the sales at the concerned metro had not increased even after the introduction of the scheme.

Lessons to be learnt-Very often the conventional procedures(routine audit tests)  do disclose weaknesses in controls and anomalies in findings. However, these procedures may, at times, fail to discover or bring to light the actual damage done and the nature of deceit or trickery. It is, therefore, essential for an investigator to adopt effective fact-finding techniques to determine whether all policies and control procedures are being implemented or not. That is also why personal inspection, visits and ‘walk-through tests’ are very meaningful, and where situation so demands, an “investigator’s bluff”, as shown above, can be used.

Investigation on behalf of an incoming partner

Nature of investigation
An incoming partner of a firm/ Limited Liability Partnership (LLP) may approach a CA to investigate the books of the firm/LLP.

Purpose of investigation

The purpose of such investigation is that the  incoming partner would be interested to know:

• whether the terms offered to him are reasonable having regard to 
• the nature of the business, 
• profit records, 
• capital distribution, 
• personal capability of the existing partners, 
• socio-economic setting, etc., and
• whether he would be capable of deriving continuing benefit in the shape of return on capital to be contributed and remuneration for services to be rendered .
• whether the capital to be contributed by him would be safe and applied usefully. 

Understanding between incoming partner and firm/LLP 

In this investigation, the problem is that the CA would investigate the books and records of a firm/LLP. However, he is appointed not by the firm/LLP but by a third party(a person who has been offered partnership by the firm/LLP). Therefore, it would be very useful if the firm/LLP and the incoming partner have a clear understanding that the CA appointed by the latter would be extended full co-operation and assistance by the firm/LLP in terms of access to records, personnel etc.

Steps involved in the investigation

Broadly, the steps involved in the investigation are:

(a)Ascertain the history of the inception and growth of the firm/LLP

(b)Study the provisions of the deed of partnership/LLP agreement , particularly for composition of partners, their capital contribution, drawing rights, retirement benefits, job allocation, financial management, goodwill, etc

(c)Scrutinise the record of profitability of the firm’s business over a suitable number of years, with usual adjustments that are necessary in ascertaining the true record of business profits. 

Pay particular attention to the nature of partners’ remuneration, which may be excessive or inadequate in relation to the nature and profitability of the business, qualification and expertise of the partners and such other factors as may be relevant.

(d)Examine  the asset and liability position to determine the tangible asset backing for the partner’s investment, appraisal of the value of intangibles like goodwill, know how, patents, etc. impending liabilities including contingent liabilities and those for pending tax assessment. In case of firms rendering services, the question of tangible asset backing usually is not important, provided the firm’s profit record, business coverage and standing of the partners are of the acceptable order.

(e)Examine position of orders at hand and the range and quality of clientele which the firm is presently operating.

(f)Carefully scrutinise position and terms of loan finance to assess its usefulness and implication for the overall financial position; reason for its absence should be studied.

(g)Study the composition and quality of key personnel employed by the firm/LLP and any likelihood of their leaving the organisation in the near future by retirement etc.

(h)Ascertain various important contractual and legal obligations and study their nature.It may be the case that the firm/LLP has standing agreement with the employees as regards salary and wages, bonus, gratuity and other incidental benefits. Full import of such standing agreements would be gauged before a final decision is reached.

(i)Ascertain Reasons for the offer of admission to a new partner.Determine whether the same synchronises with the retirement of any senior partner whose association may have had considerable bearing on the firm’s/LLP’s success.

(j)Appraisal of the record of capital employed and the rate of return. It is necessary to have a comparison with alternative business avenues for investments and evaluation of possible results on a changed capital and organisation structure, if any, envisaged along with the admission of the partner.

(k)Manner of computation of goodwill on admission as also on retirement, if any, should be ascertained

(l)Whether any special clause exists in the deed of partnership/LLP agreement to allow admission in future of a new partner, who may be specified, on concessional terms

(m)Whether the incomplete contracts which will be transferred to the reconstituted firm will be a liability or a loss.

Can bonus shares be issued by capitalising revaluation reserves?

Position under the Companies Act,1956-Unlisted company could issue bonus shares by capitalising revaluation reserve in view of SC's ruling in Bhagwati Developers case
The proviso to sub-section (3) of section 205 of the 1956 Act permitted capitalization of profits or reserve of a company for the purpose of issuing fully paid up bonus shares or paying up any amount for the time being unpaid on any shares held by the members of the company. Thus, the 1956 Act specifically permitted utilization of reserve arising from revaluation of assets for purpose of issuing fully paid up bonus shares. In view of the aforesaid proviso, a company can issue bonus shares by capitalization of revaluation reserve if the Articles of Association of the company so permits.-Bhagwati Developers v. Peerless General Finance & Investment Co. [2005] 62 SCL 574 (SC). In the above case, Supreme Court was concerned with an
unlisted company. In case of listed companies, the SEBI (ICDR) Regulations, 2009 prohibits issue of bonus shares by capitalization of revaluation reserves. The SEBI (ICDR) Regulations is not applicable
to unlisted companies. Thus, under the 1956 Act, an unlisted company could use revaluation reserve for issuing bonus shares.

Section 63 of the Companies Act,2013 bars all companies from capitalising revaluation reserve to issue bonus shares
In order to overcome Supreme Court’s decision in Bhagwati Developers (supra), proviso to section 63(1) of the Companies Act,2013 provides that no issue of bonus shares shall be made by capitalizing reserves created by the revaluation of assets. This bar on issuing bonus shares out of revaluation reserves applies to all companies whether listed or unlisted.

The provisions of section 63 have been enforced with effect from 01-04-2014. Therefore, with effect from 01-04-2014, no company whether listed or unlisted can issue bonus shares by capitalising revaluation reserves

Duty of auditor where bonus shares issued by capitalising revaluation reserve

Apart from proviso to section 63(1) of the 2013 Act forbidding issue of bonus shares by capitalising revaluation reserves, ICAI's Guidance Note on Availability of Revaluation  Reserve for Issue of Bonus Shares also recommends against the same. According to the Guidance Note, revaluation reserve does not represent a realized gain. It is created as a result of a book adjustment only. It does not result from an arm’s length transaction. Since revaluation reserve does not represent a realized gain, it cannot be used for issue of bonus shares/to increase amount paid-up on equity shares. If company uses revaluation reserve for issue of bonus shares/to increase amount paid-up on equity shares , auditor will have to qualify its report. 

The statutory auditor should qualify his audit report if company issues bonus shares on or after 01-04-2014 capitalising its revaluation reserves in contravention of section 63 of the 2013 Act. An illustrative qualification is as under:

Basis for qualified opinionThe company has issued bonus shares for Rs…………(……equity shares of Rs……….each)by capitalizing its revaluation reserve. Accordingly, the Paid-Up Equity Share Capital of the company stands increased by Rs…….. and the revaluation reserve stands reduced by that amount. The issue of bonus shares as aforesaid is contrary to provisions of section 63 of the Companies Act,2013 and the recommendations of the Institute of Chartered Accountants of India. Had the company not issued bonus shares by capitalising its revaluation reserves, its paid-up equity share capital would have been lower by Rs...... and its revaluation reserves would have been higher by Rs......OpinionIn our opinion and to the best of our information and according to the explanations given to us, except for the effects of the matter described in the Basis for Qualified Opinion paragraph, the financial statements give the information required by the Act in the manner so required and give a true and fair view in conformity with the accounting principles generally accepted in India:
(a)in the case of the Balance Sheet, of the state of affairs of the Company as at March 31, 20XX;
(b)in the case of the Profit and Loss Account, of the profit/ loss for the year ended on that date;  and
(c)in the case of the Cash Flow Statement, of the cash flows for the year ended on that date.

The above is in accordance with Standard of Auditing SA 705 Modifications to the Opinion in the Independent Auditor’s Report and ICAI's Guidance Note on Availability of Revaluation  Reserve for Issue of Bonus Shares

 

Interim Dividend

'Dividend' includes interim dividend
According to section 2(35)of the Companies Act,2013 ('the 2013 Act'), “dividend” includes any interim dividend. This means that whatever provisions apply to declaration of final dividend shall also apply to interim dividend subject, of course, to the provisions of section 123(3) and the proviso to section 123(3).

Sources from which interim dividend can be declared and paid
Section 123(3) of the Companies Act,2013  provides that the Board of Directors of a company may declare interim dividend during any financial year out of:

• the surplus in the Profit and Loss account as well as
• the profits for the financial year in which the interim dividend is sought to be declared. 

Contrast section 123(3) with section 205(1A) of the Companies Act,1956 which provided that
"The Board of Directors may declare interim dividend and the amount of dividend including interim dividend shall be deposited in a separate bank account  within five days from the date of declaration of such dividend"

It can be seen that section 205(1A) of the 1956 Act did not specify the sources from which interim dividend can be declared. Section 123(3) specifies sources from which interim dividend can be declared. It appears that, under the 2013 Act, interim dividend can be paid only from 'surplus in the Profit and Loss Account' and profits of the current financial year. It seems that past profits lying in Reserves cant be used for Interim Dividend. MCA or ICAI needs to clarify this.

Article II(81) of Table F of Schedule I to the 2013 Act provides that subject to the provisions of section 123, the Board may from time to time pay to the members such interim dividends as appear to it to be
justified by the profits of the company.

Maximum rate of interim dividend that can be declared if company has incurred loss during the current financial year up to the end of the immediately preceding quarter
In case the company has incurred loss during the current financial year up to the end of the quarter immediately preceding the date of declaration of interim dividend, such interim dividend shall not be declared at a rate higher than the average dividends declared by the company during the immediately preceding three financial years. [ Proviso Section 123(3)]

Declaration and Payment of Dividend-II

Sources out of which dividend may be declared
No dividend shall be declared or paid by a company for any financial year except out of—

• profits of the company for that year arrived at after providing for depreciation (current profits),or
• profits of the company for any previous financial year or years arrived at after providing for depreciation and remaining undistributed (past profits remaining undistributed), or 
• both (current profits and past profits remaining undistributed), or 
• money provided by the Central Government or a State Government for the payment of dividend in pursuance of a guarantee given by that Government.

Depreciation has to be provided in accordance with Schedule-II to the Companies Act,2013
Entire past unabsorbed losses need to be set off before dividend is declared

The Companies Act,1956 Act  required that the company shall not declare dividend unless it has provided, in respect of each previous financial year, the loss for that year (after providing for depreciation) or the amount of depreciation provided, whichever is lower.

Example

Year	Profit/(loss) before depreciation (Rs)	Depreciation (Rs)	Profit/(loss) after depreciation (Rs)
2011-12	(100)	25	(125)
2012-13	5	25	(20)
2013-14	28	30	(2)
2014-15	200	30	170

In terms of the provisions of the 1956 Act, the company can declare dividend for 2014-15 only after setting off for each past year amount of loss or depreciation whichever is less. Thus, the following amounts are to be set-off.

Year	Amount to be set-off before declaring dividends(Rs)	Remarks
2011-12	25	Depreciation is lower than the amount of loss.
2012-13	20	Loss is lower than depreciation
2013-14	2	Loss is lower than depreciation
Total	47

Thus, under the 1956 Act, the company needed to set off only Rs 47 out of the Rs147 unabsorbed losses and depreciation from its profit of 2014-15( Rs170) before declaring dividend and company’s divisible profits would be Rs 23. This is against the concept of prudence which demands that the entire unabsorbed loss and depreciation of past years of  Rs 147 be set off against profits of 2014-15 before a dividend is declared and accordingly divisible profits should be only Rs.23. There is no reason why the unabsorbed losses should be set off only to the extent of the unabsorbed depreciation and rest of the unabsorbed losses should not be set off.

The 2013 Act is silent on this issue. Section 123 of the 2013 Act does not contain provisions along the lines of clause (b) of the first proviso to section 205(1) of the 1956 Act. However, Rule 3(5) of the Companies (Declaration and Payment of Dividend) Rules, 2014 notified under the 2013 Act seeks to remedy the situation. Accordingly Rule 3(5) provides that no company shall declare dividend unless carried over previous losses and depreciation not provided in previous year or years are set off against the profit of the company for the current year. In the above example, under the 2013 Act, entire Rs 147(unabsorbed losses) will have to be set off and divisible profits will be only Rs.23.  The 2013 Act is stricter in this regard. It requires setting off of the entire amount of arrears of unabsorbed depreciation and losses (and rightly so) and not merely the lower of the loss after depreciation and depreciation


Only free reserves to be used for declaring dividends
No dividend shall be declared or paid by company from its reserves other than free reserves [Third proviso to section 123(1)].

Definition of free reserves
Section 2(43) of the 2013 Act defines ‘free reserves’ to mean such reserves which, as per the latest audited balance sheet of a company, are available for distribution as dividend.

The following shall not be regarded as free reserves and shall not be available for distribution as dividend :

• unrealized gains, whether shown as reserve or otherwise 
• notional gains, whether shown as a reserve or otherwise 
• amount representing revaluation of assets, whether shown as reserve or otherwise.
• any change in carrying amount of an asset or liability recognized in equity, including surplus in P&L account on measurement of assets or liability at fair value.

Transfer of amounts to reserves is optional [First Proviso to section 123(1)]
The first proviso to section 123(1) provides that a company may, before the declaration of any dividend in any financial year, transfer such percentage of its profits for that financial year as it may consider appropriate to the reserves of the company. There is no requirement along the lines of the 1956 Act to transfer specified percentage of profits before declaring dividend if dividend rate exceeds a specified percentage. The 956 Act which provided for compulsory transfer of prescribed percentage of profits to reserves before declaring dividends at a rate exceeding 10% of paid-up capital.

Declaration of dividends out of accumulated past profits transferred to reserves [Second proviso to section 123(1)].
Where, owing to inadequacy or absence of profits in any financial year, any company proposes to declare dividend out of the accumulated profits earned by it in previous years and transferred by the company to the
reserves, such declaration of dividend shall not be made except in accordance with such rules as may be prescribed in this behalf. [Second proviso to section 123(1)].
Rule 3 of the Companies (Declaration and Payment of Dividend) Rules, 2014 titled ‘Declaration of dividend out of reserves’ provides that in the event of inadequacy or absence of profits in any year, a company may
declare dividend out of free reserves subject to the fulfillment of the following conditions, namely:—

• The rate of dividend declared shall not exceed the average of the rates at which dividend was declared by it in the three years immediately preceding that year. (The above limit on rate of dividend shall not apply to a company, which has not declared any dividend in each of the three preceding financial years).
• The total amount to be drawn from such accumulated profits shall not exceed one-tenth of the sum of its paid-up share capital and free reserves as appearing in the latest audited financial statement.
• The amount so drawn shall first be utilised to set off the losses incurred in the financial year in which dividend is declared before any dividend in respect of equity shares is declared. 
• The balance of reserves after such withdrawal shall not fall below fifteen per cent of its paid up share capital as appearing in the latest audited financial statement. 
• No company shall declare dividend unless carried over previous losses and depreciation not provided in previous year or years are set off against profit of the company of the current year.

Declaration and Payment of Dividend-I

Chapter VIII of the Companies Act,2013 titled 'Declaration and Payment of Dividend' comprises sections 123 to 127(both inclusive)as under :

• Section 123 : Declaration of dividend
• Section 124 : Unpaid dividend account(not yet made applicable)
• Section 125 : Investor Education and Protection Fund(not yet made applicable)
• Section 126 : Right to dividend, rights shares and bonus shares to be held in abeyance pending registration of transfer of shares 
• Section 127 : Punishment for failure to distribute dividends

Comparison of the Companies Act,2013 vis a vis the Companies Act,1956
Various changes made by section 123 of the 2013 Act as regards declaration and payment of dividend are as under:

• Transfer of profits to reserves made optional. Unlike the 1956 Act, it is not necessary to transfer specified percentage of profits to reserves where company intends to declare dividend above a specified percentage.  
• Company will have to provide entire unabsorbed losses and depreciation of earlier years before declaring dividend. Unlike the 1956 Act, it is not sufficient to provide merely lower of loss after depreciation and depreciation.
• Section 123 clearly provides that dividends shall not be declared out of reserves other than free reserves. Since revaluation reserves are excluded from definition of free reserves by section 2(43), declaration of dividends out of revaluation reserves is barred. There was no such express bar in the 1956 Act.
• If company has incurred loss during the current financial year up to the end of the quarter immediately preceding the date of declaration of interim dividend, such interim dividend shall not be declared at a rate higher than the average dividends declared by the company during the immediately preceding three financial years. Such restriction was not there in the 1956 Act.
• Sub-section (6) of section 123 provides that a company which fails to comply with sections 73 and 74 of the 2013 Act (relating to acceptance of deposits from public/members/repayment of deposits accepted before commencement of the Act) shall not, so long as such failure continues, declare any dividend on its equity shares. There was no such express bar in the 1956 Act

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Duty of confidentiality of CA under Code of Ethics

Ingredients of professional misconduct under clause (1) of Part I to the Second Schedule to the Chartered Accountants Act,1949

(i)A CA in practice discloses information acquired in the course of his professional engagement.  
(ii)Such disclosure is to any person other than his client so engaging him.  
(iii)Such disclosure is otherwise than as required by any law for the time being in force. 
(iv)Such disclosure is without the client’s consent. 

If all the above conditions (i) to (iv) are satisfied, disclosure of information by a CA in practice tantamount to professional misconduct. It does not matter whether disclosure is deliberate or unintentional. Also, it does not matter whether client’s interest is actually harmed or not.

One can see that duty of confidentiality is not an absolute on but a qualified one. If disclosure is "as required by any law for the time being in force", the CA cant be held guilty under Clause (1). So legal requirement to disclose(for example section 143(12) of the Companies Act,2013 is good defence in professional misconduct proceedings under clause (1)  especially when the legal requirement overrides the duty of confidentiality(eg section 143(13) of the Companies Act,2013)

Sub-sections (12) of section 143 casts a duty on auditor to report fraud  to the Central Govt if:

• in the course of the performance of his duties as auditor, 
• the auditor has reason to believe that an offence involving fraud is being or has been committed
• the fraud is against the company by officers or employees of the company 

Sub-sections (13) of section 143 provide as under:

• No duty to which an auditor of a company may be subject to (e.g. duty of confidentiality under the Chartered Accountants Act,1949) shall be regarded as having been contravened by reason of his reporting the matter as above if it is done in good faith. [Section 143(13)]

So if auditor reports fraud to Central Government in confirmity with Section 143(12) in good faith, he gets the benefit of protection of section 143(13) and cannot be held guilty of violating duty of confidentiality under clause (1) of Part I to the Second Schedule to the Chartered Accountants Act,1949

Auditor to attend Annual General Meeting

Under the 1956 Act, it was entirely up to the auditor whether to attend any general meeting of the company or not and whether or whom to depute as his representative at such meetings. Section 146 of the 2013 Act brings a sea change in this. Now, auditor shall, unless otherwise exempted by the company, attend any general meeting : (i) by himself or (ii) through his authorised representative who is qualified to be an auditor.

Section 146 deals with:

• Duty of company to forward notices of general meetings to auditors 
• Auditor’s duty to attend general meeting and right to be heard at general meeting

  

Notices of general meetings to be forwarded to the auditor of the company

The first limb of section 146 provides that all notices of, and other communications relating to, any general meeting shall be forwarded to the auditor of the company. The forwarding of notices and other communications is required irrespective of whether the agenda for the meeting contains any item related to accounts or audit or auditors.

Auditor’s duty to attend general meeting and right to be heard at general meeting

The second limb of section 146 deals with auditor’s attendance at general meetings and auditor’s right to be heard at general meetings. The second limb of section 146 provides as under:

(A)he auditor shall, unless otherwise exempted by the company, attend any general meeting

(i)by himself, or

(ii)through his authorised representative who is qualified to be an auditor.

(B)The auditor shall have right to be heard at such meeting on any part of the business which concerns him as the auditor.

The following points are noteworthy:

• Section 146 makes auditor’s attendance at general meetings compulsory either by himself or authorized representative qualified to be an auditor. 
• Such attendance is compulsory whether or not any matter related to accounts or audit or auditors is scheduled in the agenda of the general meeting. 

'Quarantining’ audit from other serivces

Quarantining’ audit from other services - Services which auditor should not provide to the auditee-company-Section 144 of the Companies Act,2013

Section 144 stipulates what the Cadbury Report termed as ‘quarantining audit from other services’ but recommended against the same. Section 144 of the Act provides that an auditor appointed under this Act shall not directly or indirectly  provide any of the following “other services” (i.e. services other than statutory audit under the 2013 Act) to auditee-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.

Services other than the above may be provided by the auditor to the company only if the services are approved by the Board of directors or the audit committee, as the case may be.

Transitional provisions

An auditor or audit firm who or which has been performing any non-audit services on or before the commencement of this section shall comply with this section before the closure of the first financial year after the date of such commencement.

“Directly or indirectly”

The Explanation to section 144 defines the expression “directly or indirectly” as under :

(A) In case auditor being an individual

(B) In case of auditor being a firm (including LLP incorporated under the LLP Act)

The term “directly or indirectly” shall include rendering of services : either by himself or  through his relative  or  through any other person connected or associated with himself  through any other entity, whatsoever, in which such individual has significant influence or  through any other entity, whatsoever, in which such individual has control or  through any other entity whose name or trade mark or brand is used by such individual.

The term “directly or indirectly” shall include rendering of services: either by itself or  through any of its partners or  through its parent or  through its subsidiary or  through its associate entity or  through any other entity in which the firm has significant influence or  through any other entity in which the firm has control or  through any other entity whose name or trade mark or brand is used by the firm  through any other entity in which any partner of the firm has significant influence  through any other entity in which any partner of the firm has control  through any other entity whose name or trade mark or brand is used by any of its partners.

It may be noted that the expressions, ‘associate entity’, ‘associated person’, ‘connected person’ are used in the Explanation to section 144 but are not defined in the Act.

Compulsory Rotation of auditors

Concept of mandatory audit firm rotation

Mandatory audit firm rotation is defined in the Sarbanes-Oxley (SOX) Act as the imposition of a limit on the period of years during which an accounting firm may be the auditor.

Rationale of mandatory rotation of auditors - To enhance audit quality

The idea behind mandatory rotation of auditors is to enhance audit quality. Quality of an audit is a function of (1) the competence of the audit firm (i.e., the auditor’s ability to detect material omissions or mis-statements in the client’s financial statements), and (2) the level of actual threats to auditor independence (i.e., the probability the auditor will reveal material errors). The US Supreme Court has emphasized the importance of the connection between investor confidence and the appearance of independence of auditor “….Public faith in the reliability of a corporation’s financial statements depends upon the public perception of the outside auditor as an independent professional. If investors were to view the auditor as an advocate for the corporate client, the value of the audit function itself might well be lost.” [United States v. Arthur Young & Co. 465 U.S. 805, 819 n.15 (1984)].

Companies to which provisions for compulsory rotation of auditor’s apply [Section 139(2)]

Provisions for compulsory rotation of auditors in section 139(2) shall apply to :

• listed companies
• a company belonging to such class or classes of companies as may be prescribed

Rule 5 of the Companies (Audit and Auditors) Rules, 2014 provides that for the purposes of sub-section (2) of section 139, the class of companies shall mean the following classes of companies excluding one person companies and small companies:—

(a)all unlisted public companies having paid up share capital  of rupees ten crore or more;

(b)all private limited companies having paid up share capital  of rupees twenty crore or more;

(c)all companies having paid up share capital of below threshold limit mentioned in (a) and (b) above, but having public borrowings from financial institutions, banks or public deposits of rupees fifty crores or more

The provisions of section 139(5)/139(7) dealing with Government Companies and companies owned or controlled directly or indirectly by Government override only section 139(1) but not section 139(2). Therefore, provisions of section 139(2) shall also apply to Government companies and companies owned or controlled directly or indirectly by Government if such companies are listed companies or fall in prescribed class or classes of companies i.e. covered by Rule 5 above.

Provisions as to compulsory rotation of auditors

The following provisions may be noted:

No listed company or a company belonging to such class or classes of companies as may be prescribed, shall appoint or re-appoint—

(a) an individual as auditor for more than one term of 5 consecutive years; and

(b) an audit firm (including LLP) as auditor for more than two terms of 5 consecutive years.

Cooling off period

The cooling off period is the minimum gap between expiry of maximum tenure and appointing the auditor again which is stipulated by law. The provisions in this regard are as under:

• An individual auditor who has completed his term as per (a) above shall not be eligible for re-appointment as auditor in the same company for 5 years from the completion of his term; 
• An audit firm (including LLP) which has completed its term under (b) above, shall not be eligible for re-appointment as auditor in the same company for 5 years from the completion of such term.

Provisions cannot be circumvented by appointing partner of audit firm whose tenure is over - On the date of appointment no audit firm having a common partner or partners to the other 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 5 years. The words ‘same company’ in section 139(2) of the 2013 Act are significant. It appears that there is no bar on appointing the rotated auditor (auditor/audit firm who has completed term) as auditor of holding company/subsidiary/co-subsidiary/associate of the company in question during the cooling-off period.

Every company, existing on or before the commencement of this Act which is required to comply with provisions of this sub-section, shall comply with the requirements of this sub-section within three yearsfrom the date of commencement of this Act.

The above provisions shall not prejudice the right of the company to remove an auditor or the right of the auditor to resign from such office of the company. [Section 139(2)]

The Central Government may, by rules, prescribe the manner in which the companies shall rotate their auditors. [Section 139(4)]

Manner in which the companies to rotate their auditors on the expiry of term

Rule 6 of the Companies (Audit and Auditors) Rules, 2014 provides as under :

• The Audit Committee shall recommend to the Board, the name of an individual auditor or of an audit firm who may replace the incumbent auditor on expiry of the term of such incumbent. 
• Where a company is required to constitute an Audit Committee, the Board shall consider the recommendation of such committee, and in other cases, the Board shall itself consider the matter of rotation of auditors and make its recommendation for appointment of the next auditor by the members in annual general meeting. 
• For the purpose of the rotation of auditors—(i) in case of an auditor (whether an individual or audit firm), the period for which the individual or the firm has held office as  auditor prior to the commencement of the Act shall be taken into account for calculating the period of five consecutive years or ten consecutive years, as the case may be;(ii)the incoming auditor or audit firm shall not be eligible if such auditor or audit firm is associated with the outgoing auditor or audit firm under the same network of audit firms. 
• The term “same network” includes the firms operating or functioning, hitherto or in future, under the same brand name, trade name or common control. 
• For the purpose of rotation of auditors,—(a) a break in the term for a continuous period of five years shall be considered as fulfilling the requirement of rotation;(b) if a partner, who is in charge of an audit firm and also certifies the financial statements of the company, retires from the said firm and joins another firm of chartered accountants, such other firm shall also be ineligible to be appointed for a period of five years.

Illustration explaining rotation in case of individual auditor

Number of consecutive years for which an audit firm has been functioning as auditor in the same company [in the first AGM held after the commencement of provisions of section 139(2)]	Maximum number of  consecutive years for which the firm may be appointed in the same company (including transitional period)	Aggregate period which the firm would complete in the same company in view of columns I and II
I	II	III
5 years	3 years	8 years or more
4 years	3 years	7 years
3 years	3 years	6 years
2 years	3 years	5 years
1 year	4 years	5 years

Note: 1. Individual auditor shall include other individuals or firms whose name or trade mark or brand is used by such individual, if any.

2. Consecutive years shall mean all the preceding financial years for which the individual auditor has been the auditor until there has been a break by five years or more.

Illustration explaining rotation in case of audit firm

Illustration 2:—

Number of consecutive years for which an audit firm has been functioning as auditor in the same company [in the first AGM held after the commencement of provisions of section 139(2)]	Maximum number of  consecutive years for which the firm may be appointed in the same company (including transitional period)	Aggregate period which the firm would complete in the same company in view of columns I and II
I	II	III
10 years (or more than 10 years)	3 years	13 years or more
9 years	3 years	12 years
8 years	3 years	11 years
7 years	3 years	10 years
6 years	4 years	10 years
5 years	5 years	10 years
4 years	6 years	10 years
3 years	7 years	10 years
2 years	8 years	10 years
1 year	9 years	10 years

Note : 1. Audit Firm shall include other firms whose name or trade mark or brand is used by the firm or any of its partners.

2. Consecutive years shall mean all the preceding financial years for which the firm has been the auditor until there has been a break by five years or more.

Rotation of auditors to be factored in while appointing joint auditors

Rule 6(4) of the Companies (Audit and Auditors) Rules, 2014 provides that  where a company has appointed two or more individuals or firms or a combination thereof as joint auditors, the company may follow the rotation of auditors in such a manner that both or all of the joint auditors, as the case may be, do not complete their term in the same year.

Enabling provision for rotation of audit partners

Rotation of auditor/audit firm is not to be confused with rotation of audit partner/team. The former is mandatory. The latter is optional. Moreover, rotation of auditor applies to auditor irrespective of whether auditor is individual/audit firm. Rotation of audit partner applies only when auditor is audit firm.

Subject to the provisions of this Act, members of a company may resolve to provide that in the audit firm appointed by it, the auditing partner and his team shall be rotated at such intervals as may be resolved by members [section 139(3)(a)]