CA Inter FM + SM

(a) General Considerations in Framing a System of Internal Check

Internal check is defined as the arrangement of duties of members of staff so that the work performed by one person is automatically and independently checked by another in the ordinary course of business. The primary objective is to detect and prevent errors and frauds. The following are the general considerations that must be kept in mind while framing an effective system of internal check:

1. No Single Person Should Control an Entire Transaction: The work relating to any transaction must be so divided that no single employee has exclusive control from beginning to end. Each transaction must pass through at least two or more hands, so that the work of one acts as a check on the other.

2. Proper Allocation and Definition of Duties: The duties of every employee must be clearly defined and allocated in writing. There should be no ambiguity or overlapping. Each employee should know exactly what he is responsible for and what falls outside his purview.

3. Rotation of Duties: Employees performing sensitive jobs should be periodically rotated so that no one person remains permanently in the same position. This prevents collusion and ensures that irregularities, if any, do not remain concealed for long.

4. Compulsory Leave: Every employee, particularly those handling cash or securities, should be required to take compulsory leave at regular intervals. During his absence, another employee takes over, which often brings irregularities to light.

5. Separation of Custody and Accounting Functions: The person who physically handles assets (cash, inventory, securities) must not be the same person who maintains the accounting records for those assets. This separation is a cornerstone of internal check.

6. Cross-Checking and Independent Verification: All postings and summaries must be independently cross-checked. For instance, the total of the purchase day book should be independently verified against creditors' ledger balances.

7. Use of Mechanical and Electronic Devices: Use of cash registers, accounting software, electronic access controls, and other devices reduces the possibility of manipulation and provides an automatic trail of transactions.

8. Proper Authorisation System: Every transaction must be authorized by an appropriate level of management before it is processed. No payment should be made, no purchase should be sanctioned, and no adjustment should be passed without proper written authority.

9. Physical Safeguards: Assets like cash, securities, and inventory must be physically safeguarded through locks, vaults, access restrictions, and periodic physical verification. This prevents misappropriation.

10. Periodic Reconciliation and Surprise Checks: Reconciliation of subsidiary records with control accounts (e.g., debtors control account with individual ledger balances), and surprise verification of cash and stock, act as a powerful deterrent against fraud.

11. The System Must Be Cost-Effective: The cost of maintaining internal check must not exceed the benefits derived. The system should be practical, workable, and proportionate to the size and nature of the business.

12. Review and Updation: The system of internal check must be periodically reviewed and updated to address new risks, changes in business operations, and technology advancements. A static system becomes ineffective over time.

A well-designed internal check system, while not a substitute for internal audit, significantly reduces the risk of undetected errors and frauds and strengthens the overall internal control environment of the organisation.

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(b) Audit Procedure for Verification of Payment of Dividends

Dividend is a distribution of profits by a company to its shareholders. The auditor must verify that dividends have been declared and paid in accordance with the provisions of the Companies Act 2013 and the company's Articles of Association. The following audit procedures should be adopted:

1. Verify Board and Shareholder Resolutions: For interim dividend, check the Board of Directors' resolution authorizing its declaration. For final dividend, verify the resolution passed at the Annual General Meeting (AGM) by the shareholders. The amount of dividend declared must not exceed the amount recommended by the Board (Section 123 of the Companies Act 2013).

2. Verify Compliance with Section 123 – Declaration out of Profits: Ensure that dividend has been declared only out of current year's profits or past accumulated profits (free reserves). Dividend cannot be declared out of capital. Verify that any transfer to reserves required by Rules has been complied with before declaration.

3. Verify the Register of Members / Dividend List: Reconcile the list of shareholders entitled to dividend with the Register of Members as on the record date or book closure date. The total number of shares and class of shares (equity/preference) should be verified.

4. Verify the Rate and Amount of Dividend: Calculate the total dividend payable independently by multiplying the paid-up share capital by the rate of dividend declared, and reconcile this with the total amount credited to the Dividend Pay-out Account.

5. Verify Dividend Warrants / Payment Records: Examine dividend warrants or payment advices issued to shareholders. In case of electronic payment (NEFT/RTGS), verify bank advice and payment records. Confirm that payments were made only to registered shareholders or their mandatees.

6. Verify Unpaid Dividend — Section 124: Any dividend remaining unpaid or unclaimed within 30 days of its declaration must be transferred to a separate Unpaid Dividend Account with a scheduled bank. Verify that this transfer has been made and the account is properly maintained.

7. Verify Transfer to IEPF — Section 125: Amounts remaining unclaimed in the Unpaid Dividend Account for 7 years must be transferred to the Investor Education and Protection Fund (IEPF). The auditor should verify compliance with this provision.

8. Verify TDS Deduction — Section 194 of the Income Tax Act 1961: Since Finance Act 2020, dividends are taxable in the hands of shareholders and companies are required to deduct TDS under Section 194 at the applicable rate before payment. Verify TDS deductions, Form 26Q filings, and TDS payment challans.

9. Verify Preference Dividend: If the company has issued preference shares, check that preference dividend (cumulative or non-cumulative) has been dealt with correctly. Verify arrears of cumulative preference dividend, if any, have been disclosed.

10. Verify Disclosure in Financial Statements: Confirm that the dividend declared after the balance sheet date but before the approval of financial statements is not recognised as a liability (as per AS 4 – Contingencies and Events Occurring After the Balance Sheet Date), but is disclosed as a note. Dividend declared before the balance sheet date must be shown as a liability.

Conclusion: The auditor should obtain a management representation letter confirming that all dividends have been paid in compliance with the Companies Act 2013 and other applicable laws, and that there are no outstanding disputes related to dividend payments.

Part (a): Verification/Vouching of Retirement Gratuity to Employees

Retirement gratuity is a significant liability and its audit requires careful verification of both the amount paid and the underlying entitlement. The following procedures should be adopted:

1. Review of Gratuity Policy and Legal Compliance: The auditor should examine the company's gratuity policy and verify compliance with the Payment of Gratuity Act, 1972. Under Section 4 of the Act, gratuity is payable to an employee who has rendered continuous service of not less than five years, at the rate of 15 days' wages for every completed year of service.

2. Verification of Employee Records: Obtain the personnel file of each employee for whom gratuity has been paid. Verify the date of joining and date of retirement/resignation/death to confirm eligibility and compute the qualifying period of service accurately.

3. Calculation Verification: Cross-check the gratuity calculation using the formula: Gratuity = (Last drawn salary × 15/26 × Number of completed years of service). For employees not covered under the Act, verify the formula used as per the company's own scheme. Ensure the maximum ceiling of ₹20,00,000 (as amended) is applied where applicable under Section 4(3) of the Payment of Gratuity Act, 1972.

4. Authorisation: Verify that the gratuity payment has been properly authorised by a competent authority — HR department approval, management sanction, and, where applicable, the Board's approval for large amounts. Check that the payment voucher bears appropriate signatures.

5. Actuarial Valuation and Provision: As per AS 15 (Revised) — Employee Benefits, gratuity being a defined benefit obligation must be measured using the Projected Unit Credit Method through an actuarial valuation. Verify that the actuary's report is obtained, the assumptions (discount rate, salary escalation, mortality) are reasonable, and the provision in the accounts agrees with the actuarial valuation report.

6. Payment Verification: Examine the payment vouchers, bank transfer records or cheque counterfoils, and confirm that payment has been made to the correct retired employee. Obtain acknowledgement/receipt from the employee. If payment is made through a Gratuity Trust (LIC Group Gratuity Scheme), verify the trust deed, contributions made, and claims settled.

7. Tax Deduction at Source: Verify whether TDS has been deducted on gratuity in excess of the exemption limit under Section 10(10) of the Income Tax Act, 1961, and that Form 16 has been issued accordingly.

8. Disclosure: Ensure proper disclosure of gratuity liability, expense for the year, actuarial gains/losses, and fund assets (if any) as required by AS 15 (Revised) in the financial statements.

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Part (b): Appointment of Auditor by Special Resolution

Under the Companies Act, 2013, the general rule is that an auditor is appointed by an ordinary resolution at the Annual General Meeting. However, certain situations mandate appointment by a special resolution.

Section 139(1) provides for appointment of the first auditor and subsequent auditors by the company at the AGM. Normally, this is by ordinary resolution.

Situations requiring Special Resolution for Auditor Appointment:

1. Re-appointment beyond two terms (Section 139(2)): Listed companies and certain other prescribed classes of companies are subject to mandatory rotation of auditors. An individual auditor can be appointed for one term of five consecutive years, and an audit firm for two terms of five consecutive years. After completing the maximum term, a cooling-off period applies. Re-appointment of an audit firm for a second consecutive term of five years requires a special resolution.

2. Section 140(4) — Filling a casual vacancy caused by resignation: Where an auditor who has resigned is to be replaced, and the vacancy falls within a rotation scenario, a special resolution may be required by the Board/shareholders as per the circumstances.

3. Removal of Auditor (Section 140(1)): Although this is removal, it is relevant contextually — removal before expiry of term requires prior approval of the Central Government and passing of a special resolution by the company. This allows shareholders to replace the auditor mid-term only with special resolution protection.

Procedure: A special resolution requires at least three-fourths majority of votes cast by members present and voting at the general meeting. Prior notice of the resolution must be given to members along with the notice of the meeting. The auditor being considered must have given written consent and confirmed that the appointment, if made, will be in accordance with conditions prescribed under Section 141 of the Companies Act, 2013.

Rationale: The requirement of special resolution in the context of rotation and removal provides a higher threshold of shareholder protection, preventing hasty replacement or continuation beyond prescribed limits without broad shareholder consensus.

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Part (c): Matters that Only Shareholders Can Sanction at a General Meeting

Certain matters are so fundamental to the company's constitution or involve significant interests of shareholders that the Companies Act, 2013 reserves them exclusively for shareholder approval at a General Meeting. The Board of Directors has no power to sanction these independently.

Key matters requiring shareholder sanction at General Meeting:

1. Alteration of Memorandum of Association — Change in name, registered office (state-to-state), objects clause, or capital clause (Section 13).

2. Alteration of Articles of Association — Any change in the internal regulations of the company (Section 14), requiring a special resolution.

3. Increase, reduction or reorganisation of share capital — Reduction of share capital requires a special resolution and confirmation by National Company Law Tribunal (NCLT) under Section 66.

4. Appointment and remuneration of Auditors — As discussed, certain auditor appointments require shareholder approval (Section 139).

5. Declaration of Dividend — The final dividend is declared by shareholders at the AGM on the recommendation of the Board (Section 123). Shareholders cannot declare a dividend higher than recommended by the Board.

6. Appointment of Directors — Appointment of directors is generally subject to shareholder approval at the AGM (Section 152).

7. Winding up of the Company — Voluntary winding up by members requires a special resolution (Section 59 of Insolvency and Bankruptcy Code, 2016).

8. Approval of Related Party Transactions beyond specified thresholds — Certain related party transactions require prior approval of shareholders by ordinary/special resolution (Section 188).

9. Buy-back of Shares beyond Board's limit — Buy-back exceeding 10% of paid-up capital requires a special resolution (Section 68).

10. Conversion of company — Conversion from public to private company or vice versa requires shareholder approval (Section 14/18).

Note: Write short notes on any four of the following topics:

Preliminary Expenses: Preliminary expenses are costs incurred before the business commences commercial operations, such as legal fees, incorporation costs, underwriting fees, and advertising for the new business. Per Ind AS 38 (Intangible Assets), preliminary expenses do not meet the definition of an intangible asset as they lack future economic benefits in the traditional sense. However, they are often capitalized as a deferred revenue expenditure. The auditor should verify: (1) that expenses genuinely relate to pre-operative period, (2) that they are not revenue in nature, (3) that amounts are not inflated, and (4) that these are properly amortized over 5 years as permitted under Section 35 of the Income Tax Act, 1961. Disclosure of capitalized preliminary expenses should be clear in the balance sheet notes.

Initial Engagements: When accepting a new client engagement, per SA 210 (Agreeing Terms of Audit Engagements), the auditor must establish the engagement scope, responsibilities, and limitations in writing. Key procedures include: (1) obtaining consent from the entity, (2) communicating with the predecessor auditor (if any), (3) reviewing available information about the client's business, regulatory environment, and previous audit findings, (4) assessing management integrity and governance quality, (5) evaluating whether the engagement team possesses requisite knowledge and independence, (6) determining whether the auditor can complete the engagement, and (7) obtaining representation letters from management on key audit matters. This groundwork is essential to minimize engagement risk and establish clear understanding.

Disadvantages of Audit Programme: While audit programmes provide structure and ensure comprehensive coverage, they have significant limitations: (1) Mechanical application — auditors may follow procedures without professional judgment, reducing skepticism; (2) Inflexibility — the programme may not adapt to changed circumstances discovered during the audit; (3) Incomplete risk coverage — emerging risks not anticipated during planning may be missed; (4) Time consumption — detailed programmes can be time-consuming to prepare and may not provide proportionate value; (5) Outdated rapidly — in dynamic industries, programmes become obsolete quickly; (6) Over-reliance — may create false confidence that all relevant matters are covered; (7) Customization burden — programmes must be heavily tailored to each engagement, limiting reusability.

Audit Techniques: These are specific methods employed during audit execution. Inspection involves examining documents, records, and tangible assets. Observation means watching processes and controls in operation to verify their actual functioning. Inquiry involves asking questions of management, staff, and third parties. Confirmation is direct written communication with external parties (debtors, creditors, banks). Recalculation and reperformance test the accuracy of calculations and the operation of controls. Analytical procedures examine relationships and trends in financial data to identify anomalies. Sampling examines a subset rather than the entire population. Use of specialists involves engaging experts for complex or technical areas like valuation, tax, or IT. The auditor selects techniques based on audit risk, materiality, and nature of assertion being tested.

Simple Random Sampling: This is a probability sampling method where every item in the population has an equal and known chance of being selected. Selection is achieved through random number tables or computer-generated random selection. Key characteristics: (1) Absence of bias — no conscious or unconscious bias in selection, (2) Representativeness — the sample is likely to reflect population characteristics, (3) Statistical validity — provides a mathematical basis for extending results to the population, (4) Suitability — most appropriate when the population is homogeneous and of manageable size, (5) Implementation — requires clear definition of population, sample size determination using statistical formulas, and random selection method. The auditor must document the method and population definition to justify statistical inferences.