Short Summary:
In this Flash editorial, the author begins by referring the provisions of Section 139 & 140 of Companies Act, 2013 relating to ratification of Auditor in every Annual General Meeting & Removal of auditor. The main thrust of the article, however, is upon the "indirectly removal of Auditor through Non Ratification of Auditor1" and most recent case laws decided by the Hyderabad Bench of National Company Law Tribunal in the case of 2SPC & Associates, Chartered Accountants and DVAK & Co.. Questions arise whether principally it is natural justice to remove the statutory auditor during his term by non-ratification in Annual General Meeting.
Introduction:
Hence, three years has passed when various provisions of Companies Act, 2013 came into effect section 139 & 140 are one of them. As per the provisions under Companies Act, 2013 tenure of appointment of auditor shall be 5 years and in every Annual General Meeting shareholders will ratify the continuation of appointment of auditor. Due to implementations of new sections and rules of Companies Act, 2013 if in any AGM auditor is not ratified then it will be consider as removal of auditor.
Statutory Provisions:
As per Section 139(1):
Subject to the provisions of this Chapter, every company shall, at the first annual general meeting, appoint an individual or a firm as an auditor who shall hold office from the conclusion of that meeting till the conclusion of its sixth annual general meeting and thereafter till the conclusion of every sixth meeting and the manner and procedure of selection of auditors by the members of the company at such meeting shall be such as may be prescribed.
Provided that the company shall place the matter relating to such appointment for ratification by members at every annual general meeting. As per Section 140(1) The auditor appointed under section 139 may be removed from his office before the expiry of his term only by a special resolution of the company, after obtaining the previous approval of the Central Government in that behalf in the prescribed manner.
Provided that before taking any action under this sub-section, the auditor concerned shall be given a reasonable opportunity of being heard. Question for discussion in this editorial is "Whether Company simultaneously needs to follow provisions of section 140(1) for removal of auditor in case of non ratification of auditor u/s 139. As the Section 139 exclusively give the power to shareholders for ratification of continuance of auditor so in case shareholders are not contented with the auditor they can pass resolution for non-ratification of auditor and such auditor shall discontinue as auditor of the Company.
RULING BY NCLT:
NCLT, Hyderabad Bench ('the Bench') thereof passed an order on 17th March, 2017 on the question whether "Company could remove its statutory auditor without prior approval from Central Government”. This case involved SPC & Associates, Chartered Accountants & DVAK & Co. Hence, the question was "where NISC Export Services Pvt Ltd (hereafter referred as "Company”) appointed petitioner-CA firm as its Statutory Auditor for period of five years but did not ratify their appointment in its subsequent AGM and appointed another CA firm as its statutory auditor, since company did not obtain prior approval of central Government, removal of petitioner was to be held illegal or not?’ Whether as Principle of natural justice auditor should be provided sufficient opportunity of being heard before his non-ratification or not. Here, after analyzing the provisions of the Companies Act, 2013, the NCLT held:
Principle of Natural Justice:
In The Constitution of India, nowhere the expression Natural Justice is used. However, golden thread of natural justice sagaciously passed through the body of Indian constitution. Preamble of the constitution includes the words, "Justice Social, Economic and political’ liberty of thought, belief, worship... And equality of status and of opportunity, which not only ensures fairness in social and economical activities of the people but also acts as shield to individuals liberty against the arbitrary action which is the base for principles of Natural Justice.
In India, the principles of natural justice are firmly grounded in Article 14 & 21 of the Constitution. With the introduction of concept of substantive and procedural due process in Article 21, all that fairness which is included in the principles of natural justice can be read into Art. 21. The violation of principles of natural justice results in arbitrariness; therefore, violation of natural justice is a violation of Equality clause of Art. 14. In broad-spectrum, The Principles of Natural Justice have come out from the need of man to protect himself from the excesses of organized power man has always appealed to someone beyond his own creation. Such someone is the God and His laws, divine law or natural law, to which all temporal laws and actions must confirm. Natural Law is of the 'higher law of nature' or 'natural law'.
Exp: Natural Law does not mean the law of the nature or jungle where lion eats the lamb and tiger eats the antelope but a law in which the lion and lamb lie down together and the tiger frisks the antelope. Natural Law is another name for common-sense justice. Natural Laws are not codified and are based on natural ideals and values which are universal. In the absence of any other law, the Principles of Natural Justice are followed.
Decision of the NCLT Bench: Upon perusal of all the materials, submissions made by all the parties, The NCLT Bench has held that:
• The Petitioner was not ratified in AGM held on 26.09.2016, as Principles of Natural Justice demands that he should have been provided with sufficient opportunity before his nonratification. Auditor acts as a bridge between management and shareholders of the Company and is an important professional in the whole eco system of the corporate world. Therefore, removal/non-ratification of the Auditor without prior notice/seeking his comments would not be proper.
• The NCLT Bench decide the case with following declarations/ directions:
i. The removal of petitioner firm as the auditor of Company and the appointment of new auditor of Company is improper.
ii. We direct the company to continue the Petitioner firm as the Auditor of Company till the next AGM and subsequently necessary course of action can be taken by Company regarding the continuation of Petitioner firm, in accordance with law
iii. We further direct that Company to take necessary steps to re-appoint the petitioners' firm as Auditor of the Company.
iv. We direct the new auditors firm to submit all the records available in their possession, if any, and to cooperate with the Petitioner firm to conduct the audit of books of account of Company.
Interpretation Note:
The provisions of Companies (Amendment) Bill, 2016 introduced in the Lok Sabha on 15.03.2016 which seeks "to amend Section 139 of the Act to do away with the requirements of the annual ratification by members with respect to appointment of Auditors" The Hon'ble High Court has observed that the provisions of the Companies Act, 1956 underscore that statutory auditor cannot lightly be removed and the statutory procedure has to be followed to the provisions recognized that Auditors are expected to function as independent professionals and not simply toe the line of the management of a company.
The Central government will have to be satisfied that the reasons are genuine keeping in view the best interest of the company and consistent with the need to ensure professional autonomy to its auditors.
The 3 tier statutory protection is given to Auditors. After study the provisions of Companies Amendment Bill, 2016 and the observation of High Court it can be interpreted that auditor is appointed for 5 year under Companies Act, 2013 but the powers are given to shareholder to check yearly whether auditor is qualify to continue or not by ratification in every AGM.
Due to bring to an end exploitation of provision of ratification and safeguarding of the freedom of professional it is recommended in Companies Amendment Bill, 2016 to remove the provisions of ratification of Auditor. Further, Principles of Natural Justice demands that auditor should have been provided with sufficient opportunity of being heard before his non-ratification. Auditor acts as a bridge between management and shareholders of the Company and is an important professional in the whole eco system of the corporate world.
Therefore, removal/non-ratification of the Auditor without prior notice/seeking his comments would not be proper. Further, frequent change of auditor is not advisable for the effective auditing, preparation of financial statement, transparency in audit policies/procedures, etc. Therefore, Companies Act, 2013 added the provisions for tenure of Auditor as 5 years. Conclusion Hence, considering the intention of the statute one can opine that auditor should be given suitable opportunity of being heard as principle of natural justice and company shall follow provisions of the act for prior approval of Central Government for removal of Auditor.
Hence, where company appointed petitioner-CA firm as its Statutory Auditor for period of five years but did not ratify their appointment in its subsequent AGM and appointed another CA firm as its statutory auditor, since company did not obtain prior approval of central Government, removal of petitioner was to be held illegal AGM. Hence one can opine that, Company couldn't remove its statutory auditor without prior approval from Central Government.
1. As per black law dictionary for the definition of Ratification "the formation of a previous act then either by the party himself or another, confirmation of voidable Act"
2. http://nclt.gov.in/Publication/Hyderabad_Bench/2017/Others/DVAK%20&CO.pdf
The new Company act requires auditors to also opine on whether a company has an adequate Internal Financial Control (IFC) system in place and are operating effectively on such controls. This is in addition to the existing audit opinion on financial statements. The concept is new to India which has thrown up many challenges to the members.
The topic that we are going to deliberate upon is internal financial controls and how to drive the real business values from these controls. What all of need to decide whether internal financial controls introduced must be followed as a mere compliance exercise which would be just tick in the box v/s finding something that is going to really try and add to the business.
Firstly, lets discuss the basic elements like what are internal financial controls? and what does it really mean? The Primary Objective behind introducing internal financial controls is to identify opportunities for improvements, and to draw up a benchmark to develop or strengthen the internal control systems and enhance the reliability of their financial statements.
Other benefits of Internal Financial Controls Are:-
Strategic - High-level goals and objectives, aligned with and supporting the mission.
Operational - Effective and efficient use of resources.
Reporting - Integrity and reliability of reporting.
Compliance - Compliance with applicable laws and regulations.
Stewardship - Protection and conservation of assets.
INTERNAL CONTROLS ARE EVERYWHERE:
You exercise internal control principles in your personal life when you: Lock your house when you leave Keep copies of important papers in your safe box. Keep your ATM/debit card PIN number secret To whom does this apply?
The guidance notes clarify that reporting on ICFR by auditors will be applicable to both listed & unlisted companies, including small and one person companies. This is in line with the requirements of section 143(3)(i) of the Companies Act, 2013. Furthermore: it states that auditor will have to report on IFC in respect of both stand alone and consolidated financial statements.
The approach of new Companies Act is of self-governance and in case of non-governance, stringent penalties are provided in the Act. Management should therefore be cautious as the Non-compliance of this may lead to Monetary Penalty of up to 25 Lakhs. Imprisonment up to 3 years and Auditors Quantification New IFC Compliance Requirements - What's changed? If we go back & see what institute's guidance notes says, revised guidance note being issued in September 2015 says that is very categorically re-clarifies the term internal financial controls from internal financial control over financial reporting being used earlier.
While we earlier had clause 49 of the guidance note issued by ICAI already defining the term internal controls over financial reporting as - A process designed to provide reasonable assurance regarding the reliability of financial reporting and preparation of financial statements for external purpose in accordance with generally accepted accounting principles. Now there is a different term which is referred in the company's act which is internal financial controls, to take a little more holistic view & focus more upon the financial aspects of our operating activities, i.e. 10-15% of the key operating controls that are critical to the business growth have to be included in internal financial controls. The other dimensions to this is to be noted is earlier the clause 49 requirements were largely for the CFOs and CEOs to ensure that there is adequate financial control over financial reporting by way of CFO certification.
Now that responsibility has been completely casted to Board of directors. On one side, while the responsibility has been shifted, a lot of accountability that come up to the Board of director level and has been put up as a part of directors' responsibility statement for listed company. And we have seen that the moment responsibility becomes a part of directors' responsibilities statements, the spectrum changes to a whole new level.
We often get to hear about the work 'framework':
Why do we need a framework? Weren't controls enough? Here has to be a benchmark to say whether an entity is working fairly or not that it where the importance of framework comes in. The 2013 framework has a codification of 17 principles that support five components.
The 17 principles are fundamental concepts implicit in 1992 framework. The five components reclassified in the 2013 COSO framework are defined as follows:-
CONTROL ENVIRONMENT
These are the Foundation for all other standards of internal control. And have pervasive influence on all the decisions and activities of an organization. Some of the Effective organizations set a positive 'tone at the top'.
Factors of soft controls are:
Management philosophy, Organizational structure, Communication, Competency of employees
RISK ASSESSMENTS
Risks are internal & external events that threaten the accomplishment of objectives. Risk assessment is the process of identifying, evaluating, and deciding how to manage these events. What is the likelihood of the event occurring? What would be the impact if it were to occur? What can we do to prevent or reduce the risk? Have any of you been through a risk assessment with Internal Audit or an outside party?
CONTROL ACTIVITIES
Control activities are the Tools - policies, procedures, processes - designed and implemented to help ensure that management directives are carried out throughout the organization, at all levels, and in all functions. Includes training, approvals, authorizations, verifications, reconciliations, security of assets, reviews of operating performance, and segregation of duties.
INFORMATION & COMMUNICATIONS, effective information and communication systems enable the organization's people to exchange the information needed to conduct, manage, and control its operations Pertinent information must be captured, identified and communicated on a timely basis.
MONITORING ACTIVITIES Internal control systems must be monitored to assess their effectiveness. Are the controls operating as intended? Ongoing monitoring is necessary to react dynamically to changing conditions- Have controls become outdated, redundant, or obsolete? Periodic testing can be done by the process owner, internal audit and external audit.
The 2013 COSO framework is meant to be applied to all companies. Not that it means that we have to completely borrow what COSO is saying but it is important to draw upon relevant references from its elements. Coming back to my first very point is whether this is something that should really go and add to the business values or is it just a compliance exercise where it just amounts to ticking of the box documentation and its demonstration to statutory auditors.
To achieve business values, following simple illustrative methods can be followed:- Separation of duties Divide responsibilities between different employees such that no one individual has absolute control all aspects of a transaction thus reducing the opportunity for an employee to commit and conceal errors (intentional or unintentional) or perpetrate fraud.
Documentation Maintaining documents & preserve evidence to substantiate each significant transaction. Critical decisions and significant events typically involving the use, commitment, or transfer of resources. This enables a transaction to be traced from its inception to completion since documentation sets forth the fundamental principles and methods that employees rely on to do their jobs.
Authorization & approvals create an organization structure such that each one documents and communicates the activities which require approval, and by whom, based on the level of risk to the organization. Ensure that transactions are approved and executed only by employees acting within the scope of their authority granted by management.
Security of assets
Restrict access to equipment, cash, inventory, confidential information, etc. To reduce the risk of loss or unauthorized use. Perform periodic physical inventories to verify existence, quantities, location, condition, and utilization.
Reconciliation & review Examine transactions, information, and events to verify accuracy, completeness, appropriateness, and compliance. Ensure frequency is adequate enough to detect and act upon questionable activities in a timely manner. Every action is littered with costs and consequences:
Consequences of ineffective IFCs:
If an auditor concludes that internal controls are not effective, following would be the consequences:-
The Auditor report will include a qualified opinion. Not only merely for internal control, but also under section 143(3)(f) of the Act as non-existence of appropriate internal control can also have adverse effect on the functioning of the Company. It can be safely concluded that nonexistence of internal control would imply that existence of Fraud cannot be effectively monitored and the financial statements would lack credibility. Credit rating agencies will take it negatively also it may affect negotiation power of the entity with borrowers.
Here is some illustrative list of operating controls: -
Human resources: Job description should exist, at least for key positions and are understood.
Procurement: There must be a formal process of demand forecasting and supply planning, with clear departmental service levels.
Sales: Sales order are tracked and analysed regularly. Production: Input-output ratios are defined, measured and monitored periodically.
Inventory: Procedure for physical verification at regular interval must be designed and the inventory levels should be fixed.
Conclusion: Beware of the pitfalls - more is not always better, controls must be maintainable Think about the things that worry you in your job and try to think of how internal controls could help elevate your worry. In middle cast, forward thinking companies are already using the framework & internal auditors are using to build awareness around internal control best practices. With this trend, there is no excuse abut not to use it & benefit from it!
Prime Minister of India Mr Narendra Modi in an unscheduled live televised address to the nation at 20:15 Indian time (IST) on 8th November 2016 announced that circulation of all Rs.500 and Rs.1000 bank notes of Mahatma Gandhi series stands invalid and announced the issuance of new Rs.500 and Rs.2000 bank notes of new series. The banknote denominations of Rs 100/-, Rs 50/-, Rs 20/-, Rs 10/- and Rs 5/- of the Mahatma Gandhi series continued to remain as legal tender and were unaffected by the policy. The objective of demonetization is to prevent the funding of terrorism as well as to crack down on black money in the country. Following are the various methods adopted for use of old currency notes and to violate the directives:
a) Gold Purchase: In Gujarat and Delhi, the sale of gold increased to 20% - 30% resulting in the increase in the price of gold to Rs.45000 from the ruling price of Rs.31,900 per 10 gms.
b) Multiple bank transactions: One of the generic method adopted was to make multiple transactions at different bank branches.
c) Railway booking: Booking of tickets in class 1AC or 2AC for the longest distance possible with the objective to cancel the tickets at a later date.
d) Payment of Municipal & Local Taxes: The use of the demonetized notes had been allowed by the government for the payment of municipal and local body taxes. This led to people using the banned Rs 500/- and Rs 1000/- notes to pay large amounts of outstanding taxes, and also advance taxes. As a result, revenue collections of the local authorities have jumped due to the demonetization.
e) Back dated FDs in co-operative banks and credit societies: In most of the co-operative banks and credit societies mostly in the rural areas where most of the bank activities are done manually, people have obtained back dated fixed deposits in the name of villagers by providing the villager some incentives to obtain their bank account details
f) Unsecured loans: Loans were given to the people having minimal bank transactions or minimum amount of bank balance. Specifically those accounts which would not arouse any suspicion.
g) Payment of advance salary: Most of the companies which had earlier paid salaries through cash, have started to pay advance salary in the bank accounts of employees. Old currency notes were deposited in the bank accounts of employees with the threshold limit of Rs.2.5 lakhs.
Role of Auditors
It is important for the auditors to be part of the initiative to curb the black money and help to present a more transparent economy. More transparent economy would take the nation towards the path of growth. The auditors in this present scenario has to change the method of auditing and adopt more aggressive methodology which would help to unearth the above mentioned practices which are generally adopted by people to conceal their income or deposit their undisclosed money.
1. Analytical review: Evaluation of financial information through analysis of plausible relationships among both financial and non-financial data would give us the result in the form of any abnormality between the previous period and the present period. The auditor can arrive at the anticipated result of the entity based on the budgets, forecast or expectation. In case any large deposits are made during the period, the same can be detected by use of analytical procedure. Payment of long pending advances or advances could be given to the employees which may not be general practice or the policy of the company.
2. Review of bank accounts (including dormant account): As a general practice, it is observed that people have started depositing money in various bank accounts. Few of the accounts may have become dormant but money may have deposited after demonetization. The auditors have to check all the bank accounts and verify the pattern of transactions in those bank accounts. High variances or suspicious transactions may be reviewed.
3. Review of fixed assets details: A detailed scrutiny of the fixed assets would help the auditors to identify the abnormal procurement of fixed assets and the source of funding of the assets. The assets could be generally procurement of land, bullions, jewellery etc.
4. Review of transactions in E-Commerce: After the demonetization, since most of the transactions are done through E-Commerce, it is important for the auditors to understand how the transactions are made through E-commerce. Although E-commerce is not much different from any other traditional business other than its close integration with technology, all the e-commerce transactions have distinct characteristics of total involvement of end-user at every stage of the process.
5. Knowledge/training in auditing of financials in integrated systems environment Considering the transactions which will be done through the electronic mode, the auditors should plan the audit accordingly. The audit team members should have knowledge or training in auditing the financial of a highly integrated accounting environment. Because of computerized scenarios, most professional auditors should hold this expertise.
Post Demonetization, many companies are using fraudulent methods to convert the undisclosed income / revenue. It is the duty of auditor to report such fraudulent matters. As per the Companies Act, 2013 if the auditor of a company in the course of performance of his duties as auditor, has reason to believe that an offence of fraud has been made by the officers or employees, he needs to report the same to the audit committee or the Board / or also report to the Central Government. Thus, the responsibility of auditor has increased many folds after the bold step taken by the Government and the audit community has to come forward by performing their duties diligently.
Implementation Guide on Auditor’s Report under Rule 11(d) of Companies (Audit and Auditors) Amendment Rules, 2017 and Amendment to Schedule III to Companies Act, 2013 (Pursuant to Notification No. G. S.R. 307(E) and Notification No. G.S.R. 308(E) dated 30th March, 2017)
The Ministry of Corporate Affairs (Ministry) vide its notifications dated 30th March, 2017 has amended Schedule III to the Companies Act 2013 (the 'Act') and Companies (Audit and Auditors) Rule 2014. The amendment to Schedule III (Division I and Division II) requires every company to disclose the details of Specified Bank Notes (SBN) held and transacted during the period from 8 November 2016 to 30 December 2016 in the specified format. This amendment is effective from the date of its publication in the Official Gazette i.e. 30th March 2017.
As mentioned in the notification,'Specified Bank Notes‘ shall have the same meaning provided in the notification of the Government of India, in the Ministry of Finance, Department of Economic Affairs number S.O. 3407(E), dated the 8th November, 2016.
The said notification, defines the term as "bank notes of denominations of the existing series of the value of five hundred rupees and one thousand rupees". In addition to amendment to Schedule III, Ministry has amended Rule 11 of the Companies (Audit and Auditors) Rule 2014 vide the Companies (Audit and Auditors) Amendment Rules, 2017 by inserting clause (d) which require auditors to report on whether the company had provided requisite disclosures in its financial statements as to holdings as well as dealings in Specified Bank Notes during the period from 8 November 2016 to 30 December 2016 and if so, whether these are in accordance with the books of accounts maintained by the company. These rules are effective from the date of its publication in the Official Gazette.
The Council of ICAI at its 365th meeting held on May 17-19, 2017 considered a matter regarding amendment to paragraph 17 of Revised Guidance Note on Audit of Consolidated Financial Statements issued in October 2016. At the meeting, the Council noted that the members had expressed concerns regarding the 3rd bullet point of Paragraph 17 of Guidance Note (text given below) and requested that the guidance given therein needs to be clarified. “However, while considering the observations (for instance modification and /or emphasis of matter in accordance with SA 705/706) of the component auditor in his report on the standalone financial statements, the concept of materiality would not be considered. Thus, the component auditor's observations, if any, on the component’s financial statements, irrespective of whether the auditors of the component are also the auditors of the CFS or not, are required to be included in the parent auditor's report on the CFS, regardless of materiality. (Refer paragraph 46 of this Guidance Note)”
After detailed deliberations, the Council concluded that the 3rd bullet of Paragraph 17 of the Guidance Note requires to be amended to clarify that the intent of the Guidance Note was also to ensure compliance of SA 600 in such matter. Accordingly, the Council decided to amend the aforesaid 3rd bullet in the following manner: While considering the observations (for instance modification and /or emphasis of matter/other matter in accordance with SA 705/706) of the component auditor in his report on the standalone financial statements, the parent auditor should comply with the requirements of SA 600, “Using the Work of Another Auditor”.
This is for information and compliance to all concerned.
Issued under the authority of the Council of ICAI.
Chairman,
Auditing and Assurance Standard Board
