Auditor's Liability

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Table of Contents………………………………………………………………………………. 1
INTRODUCTION…………………………………………………………………………………………. 3
Importance of Audit…………………………………………………………………………………. 4
Objects of an Audit………………………………………………………………………………….. 4
Auditors Distinguished from Other White-collar Professionals………… 5
Problem Areas in Auditing………………………………………………………………………. 5
Research Methodology:………………………………………………………………….. 7
Appointment, Removal, Resignation and Remuneration of Auditors 8
Appointment of Auditors…………………………………………………………………………. 8
Indian Law………………………………………………………………………………………………. 8
english law…………………………………………………………………………………………….. 12
Removal or Resignation of Auditors…………………………………………………….. 14
Indian Law…………………………………………………………………………………………….. 14
English Law…………………………………………………………………………………………… 14
Qualifications and Disqualifications of Auditors……………………………….. 16
Indian law……………………………………………………………………………………………… 16
English law…………………………………………………………………………………………….. 18
Remuneration of Auditors…………………………………………………………………….. 19
Indian Law…………………………………………………………………………………………….. 19
English Law…………………………………………………………………………………………… 19
Duties and Responsibilities of Auditors…………………………………. 20
Position of the Auditors………………………………………………………………………… 20
Auditor as a Watchdog………………………………………………………………………….. 21
Duties of Auditors…………………………………………………………………………….. 23
GENERAL DUTIES IN CARRYING OUT AUDIT……………………………………. 24
DUTY OF CARE………………………………………………………………………………………… 24
Standard of Care……………………………………………………………………………………. 26
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Auditor’s Liability file:///F:/08. Downloads/Documents/auditor-e2-80-99s-liability.html
AUDITORS REPORT…………………………………………………………………………………. 27
Legal Requirement…………………………………………………………………………………. 27
Qualifications in auditor’s report………………………………………………………… 30
Accounts of branch office…………………………………………………………………….. 32
Auditors Liability…………………………………………………………………………….. 34
Negligence……………………………………………………………………………………………… 34
Nature of negligence liability…………………………………………………………………….. 34
Rights of Auditors…………………………………………………………………………………. 38
Right to call for information and explanations………………………………….. 38
Right to have access to books of accounts……………………………………………. 38
Right to notices and to attend meetings……………………………………………….. 39
Lien:………………………………………………………………………………………………………… 40
Audit and Accounting Standards……………………………………………… 41
Financial Indicators:……………………………………………………………………………….. 42
Operating Indicators:………………………………………………………………………………. 42
Other Indicators……………………………………………………………………………………… 43
Four Stages on scale of assessment……………………………………………………….. 43
1. Going concern status being appropriate…………………………………………………. 44
2. Going concern status being QUESTIONABLE AND resolved by management explanations. 44
3. Going concern status being questionable and managements explanations being inadequate.
44
4. Going concern status being inappropriate………………………………………………. 44
Audit Committee………………………………………………………………………………… 45
Independence of Auditors…………………………………………………………….. 53
The Rise and fall of Enron Corp: Lessons for Auditing…… 57
Auditing Issues Relating to Enron………………………………………………………… 58
Independence of Auditors…………………………………………………………………………. 58
Reliability of Accounting Standards…………………………………………………………… 59
Independent Authority to Oversee the Auditing……………………………………………. 60
Is the Audit Committee Enough?……………………………………………………………….. 61
Transactions with Related Parties……………………………………………………………… 61
Conclusion……………………………………………………………………………………………. 62
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The Audit operation refers to an examination of auditing records undertaken with a view to
establishing the correctness or otherwise of the transactions reflected therein. It involves an intelligent
scrutiny of the books of account of a company, with reference to documents, vouchers and other
relevant records to ensure that the entries made therein give a true picture of the business conducted
during that period, that every transaction has been properly authorised by the appropriate authority
and that the effect of all the entries in the books of account has been reflected in the final accounts.[1]
Thus, the role of audit is to provide a moral check on those who are entrusted with the task of running
the business and keeping and maintaining books of account of the company. Auditors are also
regarded as the agents of the members appointed to carry on certain duties as laid down in the
statute and the articles for the purposes of the audit.
Of late, the role of the auditor has gained tremendous importance. The role of regulators and
inspectors such as auditors has been brought into prominence with the sweeping changes that
liberalization has brought in, along with recent instances of embezzlement, which have shaken
investor confidence.
Audit plays a pivotal role in keeping proper legal check on those who carry on the business in a
fiduciary capacity. Shareholders not being legal experts, the auditor acts as a link between the
shareholders and the management.
Statutory auditing, mandatory for all companies, is one of the regulatory mechanism designed to
check abuses and irregularities in the financial aspects of the companies. There are numerous
provisions incorporated in the Companies Act, 1956 stipulating the norms and rules to be followed in
maintaining the accounts of the company.[2]
All companies are statutorily required to prepare and maintain accounts which are then scrutinised by
the auditor who certify their correctness. For company accounts to be credible they must be true and
fair and this is more likely to happen if someone competent and independent of the company has
vetted the accounts.
An auditor has a fiduciary relationship with the company. The statutory auditors are often described
as the watchdogs of the company.[3] They have access to the book of accounts, vouchers and
documents, which no member of the company has. At the same time a number of duties and
responsibilities are cast upon them.
While describing the position of the auditor Ramaswamy J. has opined:[4]
“An audit is intended for the protection of the shareholders and the auditor is expected to examine
the accounts maintained by the directors with a view to inform the shareholders of the true financial
position of the company. The directors occupy a fiduciary position in relation to the shareholders and
in auditing the accounts maintained by the directors the auditor acts in the interest of the
shareholders who are in the position of beneficiaries. Thus, the auditor is like a trustee for the
shareholders.”
The auditor may be an individual or a firm of many individuals wherein each one is qualified to be an
“auditor” individually also.
The Companies Act, 1956 envisages independence in the office of the auditor and therefore,
elaborate provisions have been incorporated in the Companies Act to ensure the same. Sections 224
to 226 of the Companies Act, 1956 provides for the appointment, qualifications, disqualifications and
payment of remuneration to the statutory auditors.
The present structure of a modern company has the shareholder as the focal point of the legal system
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governing them. This is evident in not only the present structures available but also the concerns for
the future. The single largest concern at the moment seems to be corporate governance. The image of
the Company is of great concern to the company.
Transparency in accounts and an audit that will enforce the financial discipline is the most crucial
aspect of maintaining this public image.[5] Audit is the examination of the financial accounts of the
company. There is a belief that the presence of independent, competent and vigilant authority
exercising strict audit control, ensuring that all the required disclosures have been made by the
directors from time to time, and the funds of the company have not been siphoned off for extraneous
purposes and so on. The aim is to get the company to present a true and fair view of the financial
position.[6] Thus, the Companies Act, 1956 has provided for appointment, remuneration, removal,
etc of the Auditors. Also the listing agreements of various Stock Exchanges have made provisions to
ensure independent auditing.
The annual audit is one of the cornerstones of corporate governance. Given the separation of
ownership from management, the directors are required to report on their stewardship by means of
the annual report and financial statements sent to the shareholders. The audit provides an external
and objective check on the way in which the financial statements have been prepared and presented,
and it is an essential part of the checks and balances required. The question is not whether there
should be an audit, but how to ensure its objectivity and effectiveness.[7]
Audits are a reassurance to everybody who has a financial interest in companies, quite apart from
their value to boards of directors. The most direct method of ensuring that companies are
accountable for their actions is through open disclosure by boards and through audits carried out
against strict accounting standards.[8]
The main objects of an audit are:
Verification of the book of account and financial statements

Detection of errors and frauds.
Prevention of the occurrence of errors and frauds.
The primary object of an audit is to establish by an examination of books, accounts and vouchers that
the balance sheet at a given point of time is properly drawn up and reflects the true and fair view of
the financial status of the company.
Another effect of auditing is the moral effect it has on employees, frequently deterring those, so
inclined, from committing defalcations or embezzlements. There is distinct possibility that the audit
may uncover a fraud or errors in the records, however that is not the main purpose of the audit.
The audit is also expected to bring to light how effective and efficient the system of accounting being
followed by the company is. In the course of audit, the strengths, weaknesses and faults in the system
will be exposed. Based on this input, the Board can ensure that these weaknesses and faults are taken
care of.
The role of the auditor is to report whether the financial statements of the company give a true and
fair view. An audit is designed to provide a reasonable assurance that the financial statements are free
of material misstatements. The auditors role is neither (to cite a few of the misunderstandings) to
prepare the financial statements, nor to provide absolute assurance that the figures in the financial
statements are correct, nor to provide a guarantee that the company will continue in existence.
It is a common practice of companies to appoint the same entities as the Auditors as well as the
accountants for the company. This causes conflicts of interests and the independent nature of the
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audit is open to serious questioning.[9]
The auditor occupies a unique place among white-collar professionals.[10] Although selected and
compensated by client, the duties of an auditor very often extend beyond the client to certain third
parties and public investors.[11] While attorneys and physicians act as advocates, advisors, and
confidants, an auditor must remain a disinterested and independent party and may be engaged to
protect and promote interests other than those of the client. An understanding of the auditor’s public
responsibility and the auditor-client relationship is essential to distinguish auditors from other white-
collar professionals.
In partial recognition of the auditor’s unique role, courts have struggled with the issue of whether they
should be treated differently than other professionals when malpractice litigation arises. This is a
consideration which ought to be kept in mind while examining the auditor’s unique position.
The framework within which auditors operate, however, is not well designed in certain respects to
provide the objectivity which shareholders and the public expect of them in carrying out their
function. The main reasons for this are as follows:[12]
Accounting standards and practice sometimes allow the boards too much scope for presenting facts
and the figures derived from them in a variety of ways. Auditors cannot stand firm against a particular
accounting treatment if it is permitted within the standards.
Although the shareholders formally appoint the auditors, and the audit is carried out in their interests,
the shareholders have no effective say in the audit negotiation and have no direct link with the
auditors. Auditors do, however, have to work closely with those in management who have prepared
the financial statements which they are auditing in order to carry out their task, and audit firms, like
any other business, will wish to have a constructive relationship with their clients.
Audit firms are in competition with each other for business. They wish to maximise their business
with companies, of which auditing may only be a part. To the extent that they compete on the basis of
their professional reputation, this will act as an incentive to maintain high standards. So will the
ethical guidance of the profession, and the threat of litigation. To the extent however that audit firms
compete on price and on meeting the needs of their clients (the companies they audit), this may be at
the expense of meeting the needs of the shareholders.
Companies too are subject to competitive pressures. They will wish to minimise their audit costs and
they are likely to have a clear view as to the figures they wish to see published, in order to meet the
expectations of their shareholders.
Furthermore, another important problem is with regard to conflict of interest on account of the other
services that the auditing firm provides to the company. Auditing firms may avoid giving adverse
reports so as not to lose out on the income from the other services that they provide to the company
which often exceeds the income they get for the audit services provided. This could result in loss of
auditor independence.
These are some of the issues discussed in detail in this research paper. In this research paper, the
researchers seek to highlight the various issues which arise under company law with regard to the role
and responsibility of the auditors and provide solutions for the same.
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This research paper aims to examine the role, responsibilities and liabilities of auditors. The
objective if this research paper is to examine the position regarding the same in the Indian context in
detail taking lessons from the experiences in other jurisdictions. The attempt is to elucidate the
reasons for having auditors and to examine the protection they afford to the various stakeholders in a
Company. This research paper seeks to also examine the recommendations of the various
Committees with regard to the role and responsibilities of auditors in the context of corporate
governance. This project-report also aims to scrutinise the role, responsibility and liabilities of the
auditors in the context of Enron.
The research questions addressed in this project report include:
The chapterisation of this research paper is as follows: This research paper is divided into four
parts. The first part deals with the appointment, re-appointment, remuneration, resignation and
removal of auditors under both Indian and English law. The second part of the research paper deals
with rights, duties, responsibilities and liabilities of auditors not only in the Indian context but also in
other jurisdictions. Further, this part also deals with the importance of auditor independence. The
third part of the research paper deals with role of the audit committee in the context of corporate
governance. The fourth part of this research paper deals with a case study of Arthur Anderson in the
context of the Enron debacle.
The sources of data relied on include both primary and secondary sources. The materials used for
this research paper include articles, case law and books. The research-methodology adopted is
mainly analytical and descriptive.
The mode of citation adopted is uniform throughout this project-report. This is as follows:
Books
Author’s surname, First Name, Name of the Book, Vol., edn., Publishers, Place of Publication, Year.
Articles
Author’s surname, First Name, “Name of the Article”, Journal, Vol., No., Year.
Websites
Author’s surname, First name, “Name of Article”, Web Site Address, Date on which visited.
The Companies Act, 1956 makes provision for the appointment, removal, resignation and
remuneration of auditors. Similarly, the English Companies Act also has provisions for the same.
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General Rule of Appointment

To ensure compliance with the statutory requirements and accountability to the shareholders, Section
224 of the Companies Act, 1956 makes the appointment of an auditor or auditors by the company in
general meeting, before which accounts are laid, mandatory. An auditor thus appointed at a general
meeting holds office from the conclusion of that meeting until the conclusion of the next such annual
general meeting.[13] The appointment of auditors at the AGM ensures that they are appointed by the
shareholders.
The exception to this rule of appointment at the annual general meeting is the appointment of the
first auditor/auditors by the board of directors of a company. the Board of Directors of the company
have to appoint the first auditor within one month from the date of its registration. Such auditors hold
office until the conclusion of the first annual general meeting. If the Board fails to appoint the first
auditor, the company may do so at the first annual general meeting. The remuneration of the first
auditor is fixed by the Board or the general meeting as the case may be. The company may, at a
general meeting, remove the first auditor appointed by the Board and appoint in its place another
auditor, of whose nomination a special notice has been given. [14]
An auditor appointed in the above manner should be informed of his appointment within seven days
and he is required to inform the Registrar within thirty days whether or not he has accepted the
appointment.[15] The obligation to give notice to the Registrar is cast only on auditors appointed
under sub-section (1) of Section 224. Persons appointed as auditors under other sub-sections need
not inform the Registrar. Hence, the first auditors who are appointed by the Board of Directors are
under no obligation to inform the Registrar.
Casual Vacancy
A casual vacancy is a vacancy of temporary nature that may occur during the currency of the year after
an appointment is made by the company at its general meeting. Thus, a casual vacancy is not one
created by a deliberate omission on the part of the company to appoint an auditor at its general
meeting.[16] It denotes a vacancy caused by a validly appointed auditor ceasing to act as such, due to
death, disqualifications, etc. The auditor appointed in a casual vacancy shall hold office till the
conclusion of the next annual general meeting.
Ceiling on Number of Company Audits

Before an appointment or re-appointment of auditors is made, a certificate in writing is required by
the company from the auditor regarding compliance of ceiling limit on total number of audits.[17]
Sub-section (1B) places a ceiling on the number of company-audits which a Chartered Accountant in
full time employment, or a firm of Chartered Accountants, can conduct. The limitation on number of
company audits vide Explanation I and II is applicable to
i) a member of the Institute of Chartered Accountants of India who, while being in whole-time
employment elsewhere, also holds operating agency certificate of practice from the Institute, and
ii) a practicing firm of Chartered Accountants.
In other words, the section does not cover (a) a Chartered Accountant, who, while in part-time
employment elsewhere, holds a certificate of practice from the Institute, and (be) a Chartered
Accountant who is practicing in his sole capacity (that is, as a proprietor) and not as a partner of a
firm of Chartered Accountants.[18]
As per the Companies Act, the ‘specified number’ of company audits which a auditor is allowed to
handle, that is, the overall ceiling limit on company audits is twenty. Of these twenty companies, not
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more than ten should be companies should have a paid up capital of Rs. Twenty-five lakhs or more.
In the case of a firm, the specified number is to be calculated with reference to each partner in the
firm, who is not in full time employment elsewhere. For the purpose of ceiling on number of company
audits in the case of a partner of a firm who is also a partner in another firm, the total number of
audits held by him individually or by different firms on his account should be taken into
consideration.
In computing the number of audits for the above purpose, joint audits are to be taken into account,
that is, each of the firms appointed as joint auditors of a company shall count the audit assignment as
one company audit.
An important question which has arisen is with regard to whether the audit of the branches of Indian
companies and the audits of the Indian business of foreign companies which have established places
of business in India and are doing business in India are to be taken into account while calculating the
specified number of company audits a company can take up.
The Department of Company Affairs has clarified that the branch audits are not to be included while
calculating the specified number. The Branch auditor of an Indian company appointed under section
28 audits the accounts of the specific branch only for which he is appointed and forwards his report to
the auditor appointed under section 224 of the Act. Hence the branch auditor cannot be equated with
the company auditor appointed under section 224 of the Act who has to report to the annual general
meeting on the accounts of the company as a whole including the accounts audited by the branch
auditor.
With regard to the auditing of the accounts of foreign companies, the Department has clarified that
since the definition of companies under section 3 of the Act does not include foreign companies, they
are outside the scope of Section 224 of the Companies Act. Therefore, the accounts of foreign
companies are also not to be included within the specified number of twenty.[19]
Also, since there is no legal requirement under the Companies Act to prepare consolidated accounts
or group accounts and a subsidiary is considered to be a separate legal entity, no responsibility is cast
upon the auditors of the holding company in respect of the work of the auditors of the subsidiary
company.
Appointment/Re-appointment of Auditor by Special Resolution

Section 224-A was introduced by the Companies Amendment Act, 1974 enumerating the cases in
which an auditor can be appointed only by a special resolution. Where twenty-five per cent or more of
the subscribed share capital of a company is held jointly or singly by a public financial institution, a
Government company, Central Government, any State Government, any institution established by a
State Act in which the State Government holds not less than 51% of the subscribed capital, a
nationalised bank or an insurance company carrying on general insurance business, the appointment
or re-appointment of an auditor can be made only be made by a special resolution. Thus, this
provision implies that a company in which 25% or more of the subscribed share capital is held by any
of the aforesaid institutions can appoint or re-appoint auditors only with the concurrence of such
institutions.[20]
If a company in which 25% or more of the subscribed share capital is held by any of the institutions
listed in this Section omits or fails to pass at its annual general meeting a special resolution
appointing or re-appointing an auditor, it shall be deemed that no auditor has been appointed by the
company. Even if an ordinary resolution is passed unanimously, the auditors cannot be deemed to
have been validly appointed.
In such an event, the company is required to give notice of that fact within seven days to the Central
Government as required by Section 224(3) and the Central Government may appoint a person to fill
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the vacancy.
Tenure of Office of Auditors

An auditor appointed in the annual general meeting holds the office from the conclusion of the annual
general meeting at which he is appointed until the conclusion of the next annual general meeting. In
any case where an annual general meeting is not held within the period prescribed by the Companies
Act,[21] unlike in the case of directors retiring by rotation who will be deemed to have ceased to hold
office on the last day of the period within which the annual general meeting should have been held, in
the case of an auditor inasmuch as he is appointed to hold office up to the conclusion of the next
annual general meeting, he will continue until the next annual general meeting is held and concluded.
The auditor cannot be deemed to have retired on the date when the meeting ought to have been
held.[22]
Reappointment of Retiring Auditor

At any annual general meeting a retiring auditor is re-appointed, except in the following four
situations[23]:–
(1) when he is not qualified for re-appointment;
(2) when he has given to the company notice in writing of his unwillingness to be re-appointed;
(3) a resolution has been passed at that meeting appointing somebody instead of him or providing
expressly that he shall not be re-appointed; or
(4) where notice has been given of an intended resolution to appoint some person or persons in the
place of a retiring auditor , and by reason of the death, incapacity or disqualification of that person or
of all those persons, as the case maybe, the resolution cannot be proceeded with.
This provision on re-appointment is a step in the direction of ensuring auditor independence as the
auditor cannot be replaced except in the specific circumstances enumerated in the Act.
However, the retiring auditor cannot be deemed to be re-appointed or automatically re-appointed at

the annual general meeting. The expression “shall be re-appointed” used in the provision in the
Companies Act postulates some action on the part of the company resulting in the re-appointment of
the retiring auditor. Thus, the passing of the resolution for this purpose at the annual general meeting
is essential for the re-appointment of the retiring auditor if he is still qualified and willing to act.[24]
For appointing a person other than the retiring auditor or to provide that the retiring auditor shall not
be re-appointed, a special notice has to be given proposing that such a resolution would be moved at
the next annual general meeting.[25] On receipt of the special notice, the company should send a
copy thereof to the retiring auditor.
The form, procedure vis a vis special notice has been laid down in section 190 which mandates that
the special notice be given to the company at least fourteen clear days before the meeting is to be
held. The day on which the notice is served and the day of the meeting itself are to be excluded in
computing the period of fourteen days. The object of giving a special notice is to invite the special or
pointed attention of the members to the particular resolution.
In the absence of such a special notice being given, the resolution would be rendered illegal and
ineffective.[26] And the appointment of a new auditor without complying with the provisions of
Section 225 (that is, without special notice required for a resolution appointing as an auditor a person
other than the retiring auditor), then the resolution passed for appointing the new auditor would be
illegal and ineffective.
Where at any such meeting no auditor is appointed or re-appointed, the Central Government may
appoint a person to fill the vacancy. Notice of the fact that the powers of the Central Government have
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become exercisable has to be given by the company to the Central Government within seven days
thereof. Any delay in giving such notice does not affect the jurisdiction or the capacity of the Central
Government to appoint the auditor. The auditor so appointed by the Central Government holds office
till the next annual general meeting of the company. The Central Government is also authorised to fix
the remuneration of the auditors so appointed by it. Also, in cases where the appointment of the
auditor is void ab initio, the Central Government may fill the vacancy. Similarly where the person
appointed at the annual general meeting is unwilling to accept the appointment, the Central
Government would be eligible to appoint the auditor.
Under English law, the regulations dealing with the appointment, rights and duties of auditors are
contained in Sections 384-394.
General Rule of Appointment

Under English law also, the general rule is that a company shall at every general meeting before which
accounts for an accounting reference period are laid in accordance with Section 241 of the Companies
Act appoint an auditor or auditors who shall hold office from the conclusion of that meeting until the
conclusion of the next such general meeting.[27] Table A, unlike its predecessor in the 1948 Act, no
longer requires the company to appoint auditors, as this is now a statutory requirement.
The provision for automatic “re-appointment”, without a resolution, of an existing auditor who is
willing to continue in office has been repealed. Thus, if the company does not pass a resolution for
the appointing or re-appointing an auditor, the office of auditor will be vacant. A resolution
concerning the appointment or reappointment of auditors should therefore be put before each
meeting held to consider the accounts.
Where at the appropriate general meeting held to consider the accounts no resolution is passed for
the appointment re-appointment of auditors, the Secretary of State may appoint a person to fill the
vacancy. The company must notify the Secretary of State within one week of the company’s failure to
appoint or re-appoint the auditors. The company and every officer in default are liable to a fine for
failure to give this required notice.[28]
The directors or the company in general meeting may fill any casual vacancy in the office of auditor.
But, while the vacancy continues, the surviving or continuing auditor or auditors may act.[29]
Resolution for Appointment or Removal of Auditors

Special notice[30] is required of a resolution:
(1) to fill a casual vacancy in the office of auditor;
(2) to appoint as auditor a retiring auditor who has been appointed by the directors to fill a casual
vacancy;
(3) to appoint as auditor a person other than the retiring auditor, unless the resolution is for the
continuation of the appointment of auditors whose appointment was approved at the previous general
meeting held to consider the accounts;[31] and
(4) to remove an auditor before the expiration of his term of office.[32]
The company is required to send forthwith a copy of the notice to the person proposed to be
appointed or removed, and, where applicable, to any person who by his resignation caused the casual
vacancy in either of the first two situations above, or to the retiring director in the third situation
above.[33]
First Auditors
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The first auditors of the company may be appointed by the directors at any time before the first
general meeting held for the consideration of the accounts, to hold office until the conclusion of that
meeting. If the directors fail to do so, the company in general meeting may appoint them.[34]
Auditors in Private Company

A private company which has elected to dispense with the laying of accounts before the company in
general meeting must appoint auditors in the general meeting held at least twenty-eight days before
copies of the company’s annual accounts are sent to the members. It may, however, elect to dispense
with the annual appointment of auditors, in which case the auditors are deemed to be re-appointed in
each succeeding year unless a resolution is passed ending their appointment.[35]
Within the accountancy profession, it is a requirement of professional ethics, for the person who is
approached on behalf of the company to take the place of retiring auditor, prior to giving assent so to
act, to ascertain from the retiring director whether there are any reasons why it might not be proper or
desirable to accept the appointment.[36]
Exceptions
The first exception to the abovementioned general rule is that a dormant company that is not required
to prepare group accounts may by special resolution exclude the obligation to appoint auditors. Such
a resolution may be passed at any general meeting of the company at any time after copies of the
accounts, prepared under Section 226 of the Companies Act, 1985, have been sent out in accordance
with Section 238 (1), provided that it has been dormant since the end of that financial year.
Where the resolution is passed at a general meeting that is not the first such meeting, the company
must in addition, be entitled to the benefit of accounting exemptions available to small companies, or
must be ineligible for those exemptions only on account of the fact that it is a member of an ineligible
group.[37]
Alternatively, such a resolution may be passed at any time, provided that the company has been
dormant from the time of its formation, and provided that it is not a public company, a banking or
insurance company, or an authorised person under the Financial Services Act, 1986.
The other exception is with regard to private companies which are exempt from the audit
requirement, in which case they are also exempt from the obligation to appoint an auditor.[38]
General Rule of Resignation of Auditor

An auditor may resign before his term of office expires by depositing a notice in writing to that effect
at the company’s registered office. His resignation becomes effective on the date he lodges such
notice or on such later date as may be specified in the notice. The auditor’s notice of resignation is
not effective unless it is accompanied either by a statement to the effect that there are no
circumstances connected with his resignation which the auditor considers should be brought to the
notice of members or creditors of the company, or a statement of any such circumstances. The
vacancy caused by the resignation of auditors is to be filled by the company in general meeting.
Removal of Auditors
Any auditor appointed under Section 224 except the auditors appointed by the Board of Directors in
pursuance of the proviso to Section 224(5) can be removed before the expiry of his term only by the
company in the general meeting.[39] Additionally, a prior approval from the Central government is
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also necessary for such removal of the auditors.
A company may remove an auditor by ordinary resolution before the expiration of his term of office,
notwithstanding any previous agreement to the contrary. The registrar of Companies must be
informed by the company on the prescribed form within 14 days of any such resolution having been
passed.[40]
Removal of Auditors
An auditor who has been removed is entitled to be notified of, to attend and to be heard at the
general meeting at which his term of office would otherwise have ended and any general meeting at
which it is proposed to fill the vacancy caused by his removal.[41]
If a company receives special notice of a resolution proposing the removal of an auditor before the
expiration of his term of office or proposing a change of office when the present auditor’s term of
office expires, it must forward a copy of that notice to the retiring auditor or to the auditor who is to
be removed. The auditor may make representations in writing to the company and, if he so requests
and the representations are not received too late, the company must, in any notice of the resolution
given to members of the company, state that representations have been received and send a copy to
each member to whom notice of the meeting is sent.
If a copy of the representation is not sent, the auditor who has made them may require that they be
read out at the meeting. The Court has power to waive these requirements for notifying
representations if it is satisfied that the rights conferred have been abused to secure needless
publicity for defamatory matter.[42]
Resignation of Auditors
The 1976 Companies Act introduced regulations governing the resignation of auditors which prevents
an auditor from resigning without reporting to the members on a problem situation of which he is
aware. To be effective, an auditor’s notice of resignation must be sent in writing to the registered
office of the company and must either state that there are no circumstances connected with his
resignation which he considers should be brought to the notice members or creditors or include a
statement of any such circumstances.[43]
The company must send a copy of notice of resignation to the registrar of companies within fourteen
days. If the notice includes a “statement of circumstances connected with the auditors’ resignation” the
company must also send a copy of the notice of resignation to all persons entitled to receive copies of
accounts under the Companies Act.[44] The auditor must send a copy of the any statement that
contains details of such circumstances to the Registrar of Companies unless the company has made
an application to the Court.
The Court may, on application, direct that copies of the notice should not be sent out if it is satisfied
that the auditor is using the notice to secure needless publicity for defamatory matter; in this case the
company must send out a statement setting out the effect of the order.[45]
If the company does not, within fourteen days, circulate an auditor’s statement of circumstances, or
does not, within twenty-one days, convene an extraordinary general meeting which has been
requisitioned by the auditor for a day not more than twenty-eight days after the date0 on which notice
convening the meeting is given then, unless the company has obtained a Court order excusing it from
so doing, the company and every officer who is in default will be liable to fine.[46]
In addition to his duties to report the circumstances of his resignation, the auditor is given the right
under Section 391 to make further statements to the members. If the notice of resignation also
includes a statement of circumstances to be brought to the notice of the members or creditors, it may
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also be accompanied by a requisition signed by the auditor requiring the auditors to convene an
extraordinary general meeting for the purpose of considering such explanation of the circumstances
concerned with his resignation as he may wish to place before the meeting. He may also attend and
be heard at the general meeting of the company at which his term of office would have expired if he
had not expired or at any general meeting convened at his requisition or at which it is proposed to fill
the casual vacancy caused by his resignation.
The auditor who has resigned has the same rights to have statements circulated to members before
such meetings as an auditor who is proposed to be removed and subject to the proviso about
“needless publicity for defamatory matter.”[47]
The qualifications and disqualifications of auditors are provided in Section 226 of the Companies Act.
The main purpose of this Section is to ensure that only qualified person possessing the requisite
knowledge and technical skill acts as the auditor of the company so that he may discharge his duties
effectively. This is to ensure that the auditor is independent in carrying out his work so that he be able
to give an unbiased opinion based on the objective assessment of the facts.
Auditor’s Qualifications
Sub-sections (1) and (2) of Section 226 enumerate the qualifications required to be an auditor.
A person who is a Chartered Accountant within the meaning of the Chartered Accountants Act, 1949
and holds a certificate of practice, or a partnership firm whereof all the partners are Chartered
Accountants holding certificates of practice may be appointed as auditor, of a company. In the latter
case, the appointment of an auditor may be made in the firm name and any of its partners may act in
the name of the firm.
Sub-section (2) provides for recognition of certain persons though not Chartered Accountants or
possessed of similar qualifications, for appointment as auditors, if they have been functioning as such
in the erstwhile Part ‘B’ States, or in Jammu and Kashmir, subject to the Rules framed in this behalf.
Disqualification of Auditors
Sub-section (3) of Section 226 enumerates the categories of persons who are disqualified for
appointment as auditors. The object of these disqualifications is to make the position of auditors as
independent as possible from the affairs if the companies whose affairs they handle. Also, if under the
Chartered Accountants Act any other disqualifications are added, they shall also apply.
None of the following persons are qualified for appointment as auditor of a company:
(1) a body corporate;
(2) an officer or employee of the company;
(3) a person who is a partner, or who is in employment of an officer or employee of the company;
(4) a person indebted to the company for an amount exceeding one thousand rupees, or who has
given any guarantee or provided any security in connection with indebtedness of any third person to
the company for an amount exceeding one thousand rupees;
(5) a person who is director or member of a private company, or a partner of a firm, which is the
managing agent or the secretaries and treasurers of the company;
(6) a person holding any security of that company after a period of one year from the date of
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commencement of the Companies (Amendment) Act, 2000.
(7) further, a person disqualified for appointment as auditor under the above disqualifications of any
other body corporate which is that company’s subsidiary or holding company or a subsidiary of that
company’s holding company, or would be disqualified if that body corporate were a company
Section 226(5) further provides that “if an auditor becomes subject, after his appointment, to any of
the disqualifications, he shall be deemed to have vacated his office”.
Apart from the disqualifications laid down in Section 226, the Institute of Chartered Accountants of
India has prepared its own code of ethics which is mandatory for its members.
In order to ensure independence of the auditors and also to prevent conflict of interest and duty, the
Council has decided not to permit a Chartered Accountant in employment to certify the financial
statements of the concern in which he is employed, or of a concern under the same management as
the concern in which he is employed, even though he is holding a certificate of practice and even
though such certification can be done by any chartered accountant in practice. This restriction does
not apply where the certification is permitted by any law. Further, it has also been decided that a
chartered accountant should not by himself or in his firm name:–
(1) accept the auditorship of a collage, if he is working as a part-time lecturer in the college.
(2) Accept the auditorship of a trust where his partner is either an employee or a trustee of the trust.
Qualifications of Auditors
The Companies Act1989 implemented the Eight EC Company Law Directive on the qualifications and
training of auditors. The stated purpose of the Act is ‘to secure that only persons who are properly
supervised and appropriately qualified are appointed as company auditors and that audits by persons
so appointed are carried out properly and with integrity and with a proper degree of
independence’.[48]
To qualify for appointment as a company auditor, a person, either an individual or a firm, must be:
(1) a member of a recognised supervisory body; and
(2) eligible for appointment under the rules of that body.
To be eligible, the auditor must hold an appropriate qualification. This may be:
(1) by virtue of membership immediately before 1 January 1990 of a body recognised for the
purposes of Section 389(1) (a) of the Companies Act, 1985;[49] or
(2) a recognised professional qualification obtained in the United Kingdom from a qualifying body;
or
(3) an overseas qualification approved by the Secretary of State, provided that the person also
satisfies any traditional educational qualifications that the Secretary of State may require.
Regulations relating to recognised supervisory bodies, qualifying bodies and recognised professional
qualifications are set out in the Companies Act 1989, Schedules 11, 12, 13, and 14 and Sections 30
to 42. From 1 October 1991 all those accepting appointments as company auditors must be
registered with a recognised supervisory body.
Certain classes of persons are disqualified from appointment as auditors. They include:
(1) an officer or servant of the company (Section 389(6)(a));
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(2) a person who is a partner or employee of an officer or servant of the company (Section
389(6)(b));
(3) a body corporate (Section 389(6)(c));
(4) a person disqualified for appointment as auditor of a subsidiary or holding company or a fellow
subsidiary (Section 389(7)).
An officer of the company for this purpose includes a director, manager or secretary (Section 744),
but not an auditor (Section 389(6)).
Any person who acts as auditor of a company when he knows he is disqualified, or who fails to vacate
his office and to give notice of that fact to the company when to his knowledge he becomes
disqualified, is liable to a fine. Section 28 (5) of the Companies Act 1989 provides that it is defence
for a person to show that he did not know and had no reason to believe that he was, or had become,
ineligible for appointment.
Section 224(8) of the Companies act provides that the remuneration of the auditor of a company may
be fixed by the Board of directors, if the appointment has been made by the Board or by the Central
Government, if the appointment was made by the Government. Subject to this, the remuneration has
to be fixed by the company in general meeting.
The company at the annual general meeting, however, need not fix the remuneration. It may be fixed
in any manner as determined by the general meeting. The remuneration fixed for an auditor is
inclusive of all expenses allowed to him so that he cannot claim any amount additional to the
remuneration fixed either as expenses or otherwise.
Where the auditor seeks expert advice in respect of any legal or technical matter for the proper
discharge of his duties the cost of such advice is permissible extra expenditure which can properly be
claimed from the company. Besides remuneration for audit work, the auditor may also be paid
remuneration for services rendered in any other capacity.[50]
The remuneration of the auditor of a company is to be fixed by the company in general meeting or in
such manner as the company in general meeting may determine in the case of an auditor appointed
by the directors or by the Secretary of State, it may be fixed by the directors or the Secretary of State,
as the case may be (Section 385).
The Companies Act requires that in the profit and loss account of the company the auditor’s
remuneration be shown separately.[51] A consolidated profit and loss account must show the
remuneration of the auditors of all the companies included in the consolidated accounts. Any sum
paid by the company in respect of auditors’ expenses is deemed to be included in the expression
“remuneration”.[52] This provision applies only to audit fees and expenses, and not to remuneration
for accounting work. Disclosure of remuneration including expenses paid to auditors or their
associates in respect of services other than audit must also be made.[53]
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The duties and responsibilities of the auditor are laid down in Section 227 of the Companies Act,
1956.
While examining the duties of the auditor, it is important to keep in mind the position of the auditor’s
within the framework of company law. The role and responsibilities of the auditor’s cannot be isolated
from the position that the auditor has been assigned by the law and judiciary. Over the years, the
position ascribed to the auditor’s has changed with the judiciary playing an important role in
expanding their role and responsibilities.
“The audit is intended for the protection of the shareholders and the auditor is expected to examine
the true financial position of the company. The directors occupy a fiduciary position in relation to the
shareholders and in auditing the accounts maintained by the directors the auditor acts in the interest
of the shareholders who are in the position of beneficiaries. The auditor is like a trustee for
shareholders.” [54]
Thus, auditors have a fiduciary relationship vis-a-vis the shareholders as a body.[55] The statutory
auditors are the watchdogs of the company and they have access to the books of accounts, vouchers
and documents which no member of the company has. These powers are given to the auditors to
facilitate discharge of their functions and responsibilities.
The reason for the fiduciary relationship of the auditors with the company has been explained by the
Calcutta High Court in the case of Deputy Secretary v. S.N. Das Gupta: [56]
“A joint stock company carries on business with capital furnished by persons who buy its shares. The
owners of the capital are, however, not in direct control of its application, which is left to the executive
of the company. In those circumstances, some arrangement is obviously called for by which those who
provide the capital know periodically what is being done with their money, how the affairs of the
company stand and what the present value of their investment is. The Companies Act, therefore,
provides for the employment of an auditor who is the servant of the shareholder and whose duty is to
examine the affairs of the company on their behalf at the end of a year and to report to them what he
has found. That examination by an independent agency such as the auditors is practically the only
safeguard which the shareholders have against the enterprise being carried on in an unbusiness like
way or their money being misapplied or misappropriated without their knowing anything about it. The
Act provides the safeguard in two forms. It makes the duty of the auditor to give an expression of
opinion on certain specified matters of a vital character and it makes him liable, along with the
directors, for misfeasance, if he fails to perform his duties as required by law and the approved audit
procedure.”
The auditor, being an appointee of the shareholders has a duty to take care of their interests and thus
any failure to report any major flaws and deficiencies may result in the non-fulfillment of the duties of
the Auditors.[57]
“The auditor is a watchdog and not a bloodhound.”
Beginning with In Re Kingston Cotton Mills Case,[58] the Courts have held that while it is true that the
auditors primary function is to look into the account books of the company, it is also the law of the
land that where there is adequate material before the auditor to arouse suspicion, he should probe
into the matter in detail and attempt to get under the skin of the problem and thus help resolve the
issue.[59]
The Court held in this case that “an auditor is not bound to be a detective or … to approach his work
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with suspicion. He is a watchdog and not a bloodhound. He is justified in believing the tried servants
of the company in whom confidence is placed by the company. He is entitled to assume that they are
honest and rely on their representations, provided he takes reasonable care. If there is anything
calculated to excite suspicion, he should probe it to the bottom, but in the absence of anything of that
kind he is only bound to be reasonably cautious and careful. His duty is verification and not detection.
If in the course of his sniffing around he detects something suspicious he must track it down to verify
it.”
In the recent past, a higher standard has been applied to the auditor’s requiring them to apply an
“enquiring mind” to their task. This higher standard been discussed in research paper while dealing
with the standard of care expected of an auditor.
The auditor is an officer of the company only for limited purposes as given in Section 2(30) of the
Companies Act, 1956.[60] As far as maintenance of the books of account, preparation of financial
statements and their audit is concerned, the auditor is not an officer of the company and therefore can
not be prosecuted for contravention of the provisions of the Company Act, 1956 which are required to
be complied with by the management of the Company.
Numerous duties are owed by the auditors to the company and its shareholders. The foremost of
these duties is to check the accuracy of accounts. But this duty is “not confined merely to the task of
verifying the arithmetical accuracy of the balance sheet, but also to inquire into its substantial
accuracy, and to ascertain that it was properly drawn up, so as to contain a true and correct
representation of the state of the company’s affairs”.[61]
The duties of the auditor do not include the giving of advise to the company on the prudence or
otherwise of giving loans. Whether or not the business of the company is being conducted prudently is
not a concern of the auditor. The sole duty of the auditors is to ascertain the true financial position of
the company at the time of the audit.[62]
Thus, the auditor is not an adviser to the Company or to the shareholders of the company. Neither
does the auditor sit in judgment on the management decisions and policies or the commercial
prudence of transactions. His primary function is to carry out what is termed a “verificatory audit”[63]
This position has been slightly modified by the introduction of the Section 227(1A) and the issuance
of the Order under Section 227(4A). The duty has been now extended to include making a statement
on various matters involving management functions like inventory control, adequacy of internal audit
procedures, etc.[64]
The auditor of a company is not the insurer and does not guarantee that the books of account of the
company show the true position of its affairs or that its balance sheet is accurate according to its
books. It is, however, the duty of the auditors to ascertain and certify to the shareholders the true
financial position of the company at the time of the audit.[65]
In carrying out certain functions of which company audit is a prime example, the auditor is subject to
certain duties. The duties of an auditor may be effectively divided into three categories, viz., statutory
duties; contractual duties; and duties owed to third parties.
Statutory duties:
The Companies Act, 1956 requires the appointment by a company of an auditor and performance of
certain duties by him. Section 227 of the Companies Act specifies the powers and duties of the
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auditor. Section 209(1) requires every company to maintain ‘proper’ books of account with respect to
matters stated therein. Section 209(3) provides that books of account, to be proper, must provide a
true and fair view of the state of the company or its branches, as the case may be, and explain its
transactions.
To establish if the books of accounts have been maintained as required, and whether the provisions of
the Act have been complied with, the auditor is appointed, and is required, inter alia, to report on
these aspects. The examination by an independent agency such as the auditor is practically the only
safeguard which shareholders have against the enterprise being carried on in an unbusiness-like way
or their money being misapplied or misappropriated.[66]
The purpose of statutory audit is to provide such a mechanism to enable those who have a proprietary
interest in the company or are concerned with its management and control, to have access to accurate
financial information about the company. When those persons have such information, the statutory
purpose is satisfied.[67]
It is the duty of the auditor to protect the shareholders by examining the accounts maintained by the
directors with a view to informing the shareholders of the true financial position of the company.[68]
While the directors occupy a fiduciary position in relation to the shareholders, in auditing the accounts
maintained by them, the auditor acts in the interest of the shareholders who are in the position of
beneficiaries.
The duties cast upon the auditor are accompanied by certain powers; for example, access to the
books of account of the company, to enable him to discharge these functions effectively. Any
regulations which preclude the auditors from availing themselves of all the information to which they
are entitled are inconsistent with the Act.
Contractual duties:
The contractual duties of the auditors depend upon the contract between the auditor and the client.
The contract will regulate the nature and extent of the task and the standard of the performance. Even
when the nature of the engagement is established as audit, questions may arise as to whether the
audit contract requires the taking of certain steps. Where the extent of the audit is described in some
detail, whether expressly in the contract of engagement or in the case of statutory audit, in the statute
concerned, these questions are less likely to arise.
Duties owed to third parties:
Another important duty of the auditors is with regard to third parties. An issue that has been
addressed by the Courts in numerous cases is whether the auditors owe any duty and are liable to
third parties in the absence of any contractual relationship. This issue has been examined in detail
while discussing the liability of the auditors.
The prevailing view is that even in the absence of contractual relationship, in certain circumstances the
auditor’s could be held to be liable. The parameters of such responsibility are limited by the
“neighborhood principle laid down by Lord Atkin in Donaghue v. Stevenson.[69]
The three broad aspects that the duties of the auditor’s cover are (a) the duty to make certain
enquiries; (b) the duty to make a report to the members of the company on the accounts examined by
him, and on every balance sheet and profit and loss account including on all documents annexed
thereto; and (c) the duty to make statements in terms of the provisions of MAOCARO, 1988.[70]
The duties of the auditor can be broadly classified as:
General duties;
Duty of care;
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Duty to prepare auditors report.
These duties are discussed in detail in the following chapters of this research paper.
An auditor of a company has, equally, rights and duties, which have to be performed, in order to
satisfy the position he is holding in the company. The duties of the auditors has been discussed and
elucidated by the Courts in numerous cases.
While describing the general duties of an auditor the Courts have opined:[71]
“An auditor is not to be confined to the mechanics of checking vouchers and making arithmetical
computations. He is not to be written off as a professional adder-upper or a subtractor. His vital task
is to take care to see that errors are not made, be the errors of computation or errors of omission or
commission or downright untruths. To perform this task, he must come to it with an inquiring mind —
not suspicious of dishonesty — but suspecting that someone may have made a mistake somewhere
and that a check must be made to ensure that there has been none.”
In exercise of his duty, an auditor must use reasonable care and skill, and must certify to the
shareholders only what he believes to be true. Essentially, an auditor should give a true and fair view
of the company’s annual financial statement. One of the earliest cases establishing this principle is In
Re London and General Bank,[72] where the Court held:
The duty of the auditor “is to ascertain and state the true financial position of the company at the time
of the audit, and his duty is confined to that. He discharges his duty by examining the books the
company. But he does not discharge his duty by doing this without inquiry and without taking any
trouble to see that the books themselves show the company’s true position.”
True and Fair view

The phrase “true and fair” was inserted in the Companies Act, 1956 in place of the phrase “true and
correct” in the earlier Companies Act. This amendment was introduced since the term “true and
correct” could be interpreted as implying that the auditor had to merely examine whether the financial
statements were arithmetically correct and corresponded to the figures in the books of account and
was not required to examine whether these books reflected a fair view of the affairs of the
companies.[73] With this amendment, the burden cast on the auditor is much higher. The Auditor, in
his report, has to show whether the accounts reflect a fair view of the company’s financial position.
The true and fair view may be taken to represent and signify that the auditor gives an opinion as to
whether the financial statements represent the actual financial position. Thus, what constitutes a true
and fair view is a matter of opinion of the auditor in the circumstances of the case. There are certain
broad indicators which the auditors are required to take into consideration while determining whether
the book of accounts represent a true and fair view of the company’s financial position. These include:
The balance sheet and profit and loss account should be drawn up in conformity with the
provisions of Schedule VI of the Companies Act and/or as per requirements of the special
provisions governing special categories of companies.
The balance sheet and profit and loss account should be drawn up in keeping with the generally
accepted principles of accounting which should be applied consistently. In the event of any
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deviation from these principles, the reason and effect should be suitably disclosed.
The information should be so disclosed in the balance sheet and the profit and loss account that
there is neither an overstatement nor an understatement with regard to the financial position and
working results.
The Auditor should see the situation as it exists at the end of the accounting period. The auditor
must also take into account post accounting period events, if material in making a better
assessment of the position as at the date of the balance sheet.
The financial statements should convey the requisite information clearly. In this context, it
should be understood by the auditor that information and means of information are not the
same term.[74]
Thus, the duty of the auditor to ascertain and state the true financial position of the company at the
time of the audit will be fulfilled if the above considerations are kept in mind while preparing the
audit report.
“An auditor is not bound to do more than exercise reasonable care and skill in making inquiries and
investigations. He is not an insurer; he does not guarantee that the books do correctly show the true
position of the company’s affairs, he does not even guarantee that the balance sheet is accurate
according to the books of the company…he must be honest, that is, he must not certify what he does
not believe to be true, and he must take reasonable care and skill before he believes that what he
certifies is true…Where there is nothing to excite suspicion very little inquiry will be reasonably
sufficient…Where suspicion is aroused more care is obviously necessary; but still an auditor is not
bound to exercise more than reasonable care and skill even in case of suspicion, and he is perfectly
justified in acting on the opinion of an expert where special knowledge is required.”
Thus, it is not the auditor’s duty to give advice to members or directors about giving loans or about
the business prudence of the company but the true financial position of the company must be stated
at the time of the audit. The auditor has the duty to take reasonable care to ascertain that accounts
books show the true position. The auditor is not a insurer and does not guarantee that the books
show the company’s position directly.[75]
This point was further reiterated in Trisure India v. A.F.Fergueson & Co. where it was held that the
auditor must be honest and should have reasonable skill and care in ascertaining the accuracy of the
company’s books of account, balance sheet and profit and loss account.
Reasonable care and skill is not exercised when in spite of the presence of unusual features in the
accounts which prima facie, give reason for believing that the accounts of the company are not in
order, the examination is not detailed.
Neither legislation nor the normal contract of engagement indicates the standard of care required of
the auditor. However, this issue has been subject to detailed consideration by the Courts. It has been
the law that the auditor must exercise reasonable skill and care in the discharge of his duties.
This has been best described in the following words of Romer J. in City Equitable Fire Ins. Co., Re:[76]
“He must be honest, that is, he must not certify what he does not believe to n true and he must take
reasonable care and skill before he believes that what he certifies is true. What is reasonable care in
any particular case must depend upon the circumstances of that case. Where there is nothing to excite
suspicion very little inquiry will be reasonably sufficient. Where suspicion is aroused more care is
obviously necessary; but, still an auditor is not bound to exercise more than reasonable care and skill
even in case of suspicion and he is perfectly justified in acting on the opinion of an expert where
special knowledge is required.”
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The early cases suggested a standard of care based on the concept of the auditor as a watchdog. In Re
Kingston Cotton Mills Case,[77] the Court while holding the auditors liable for not personally
inspecting the securities, it was opined that while it may be easy to charge the auditors with
negligence after the event, the auditor did not have advantage of hindsight.
More recent authorities, however, have higher standard of care based on the auditor’s applying an
‘inquiring mind’ to his task. In Fomento Sterling Area Limited Selsdson Fountain Pen Co.,[78] Lord
Denning observed that “to perform his tasks properly, he (the auditor) must come to it with an
inquiring mind — not suspicious of dishonesty, but suspecting that somebody may have made a
mistake somewhere, and a check must be made to ensure that there has been none”.
This point was further reiterated in Re Thomas Gerrad & Sons Ltd.,[79] where the auditors failed to
detect fraudulent accounting principles although they discovered altered invoices. They were held
liable as “suspicion ought to automatically have been aroused by the discovery”. Commonwealth cases
have also emphasised that the auditor can no longer limit their investigation to a “watch-dog-role”
and a more active inquiring role is required.[80]
Thus, it is the duty of an auditor to bring to bear on the work he has to perform that skill, care and
caution which a reasonable competent, careful and cautious auditor would use. The particular
circumstances of each case determine whether reasonable skill, care, and caution have been
exercised.
The trend of the Courts seems to be in the direction of enforcing liability on the auditors if they fail to
take a degree of care which would be required to ensure that there is no fraud or irregularity. Once the
suspicion is raised they must investigate thoroughly and ensure that any discrepancy in the accounts
is brought to light.
One of the most important duties of the auditor is with regard to the report on the accounts of the
company which the auditor has to submit to the members of the company. “The scheme of the Act…is
that the directors must prepare the accounts; the auditor must make a report tot he members on the
accounts; and this report must contain statements on certain specified matters.”[81] This report
should state whether the accounts are kept in accordance with the provisions of the Act and whether
they give a true and fair view of the state of affairs of the company.[82]
Sub section (2) of Section 227 requires the Auditor to make a report to the members on the findings
of the Audit done by him. This Report is based on the accounts examined by them and on every
balance sheet and the profit and loss account and all group accounts, a copy of which is laid before
the company in general meeting during their tenure of office. In this report, the auditors are required
to state whether the accounts give the information required by the Companies Act in the manner so
required. Thus the duty cast on the auditors is not merely to report on the balance-sheet but on the
accounts which they are required to examine; and they are also required to state whether in their
opinion proper books of accounts as required by law have been kept by the company.[83]
The requirement of law includes the requirement of Section 209 (3), i. e., that the books should be so
kept as to give a “true and fair view”[84] of the state of affairs of the company and explain its
transactions. Furthermore, the law does not mandate that this Report be sent to each and every
shareholder.[85]
The Companies (Amendment) Act, 2000 have brought in some amendments affecting the
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responsibilities of the auditors. Sub-section (3) of section 227 describes the scope of an audit report,
and lays down the matters to be stated therein. Clauses (e) and (f) have been inserted in this
sub-section which provides that observation or comments of auditors, which may have an adverse
effect on the functioning of the company, are required to be stated in thick type or italics in the
auditor’s report. With this amendment, the responsibilities of the auditor have been widened
substantially, it is now not confined only to the accounts but extends to the total functioning of the
company. Further, as per this amendment the Report should also state whether any director is
disqualified from being appointed as director under Section 274 of the Companies Act. For this, the
auditor has to confirm and verify the details of other directorships in public companies of all the
directors of the company.
Though under Section 227(1A) of the Companies Act the Auditor is not required to make report on
the results of his inquiry, he will certainly have to mention in his report anything serious, which the
inquiry may have revealed, or give a warning. In his Report, the auditor is required to state the reasons
and the justifications if the report is in the negative or is qualified.
This report is distinct from a mere certificate. The distinction is that a certificate has no expression of
opinion. The report is a formal statement made after inquiry and examination of the records and
includes the opinion of the Auditor.[86]
In view of the above it is not enough for the report of the auditor merely to repeat the language of the
section and barely state that in his opinion and to the best of his information and according to the
explanations given to him the accounts of the company give the information required by the Act in the
manner so required.
Under the Indian Companies Act, 1913, the report made by the auditor was in most cases a mere
formality. The requirement in the present Act that the report of the auditor shall state whether in his
opinion the accounts give the information required by the Act in the manner required and whether in
his opinion proper books of account as required by law have been kept by the company so far as
appears from his examination of those books would seem now to require from the auditor a more
exacting duty as regards verification than under the previous Act.
In this connection, the Ninth Annual Report submitted to the Parliament in pursuance of Section 638
is relevant. In this Report it was explained that “the Company Law Board has been of the view that it is
necessary to ensure a high standard of audit of companies because it is only by doing so that a high
standard of integrity in company affairs could be maintained. In order to attain this required standard
it is necessary for auditors to be fully alert and to satisfy themselves by examining such basic
materials and documents as they consider necessary, that the accounts which they certify really reflect
a true and fair view of the state of affairs of the company concerned”.[87]
Language of the Report

The auditor should be careful about the use of language in the report, which should be clear and
unambiguous. The Auditor while drafting the report must keep in mind that the shareholders, whose
agent he is and to whom he is submitting the report, and with whom he shares a fiduciary relationship
are ordinary persons who do not possess technical knowledge and skill of accountancy or auditing.
His opinions and observations should, therefore, be communicated in no uncertain terms so that the
reader of the report is able to know what they are.
In London and General Bank Ltd.[88] the Court held that a person whose duty it is to convey
information to others, does not discharge that duty by simply giving them, so much information as is
calculated to induce them, or some of them, to ask for more. Information and means of information
are by no means equivalent terms. An auditor who gives shareholders means of information instead of
information in respect of a company’s financial position does so at his peril, and runs the very serious
risk of being held, judicially, to have failed to discharge his duty.
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The duty of an auditor is to convey information, not to arouse inquiry, and although an auditor might
infer from an unusual statement that something was seriously wrong, it by no means follows that
ordinary people would have their suspicions aroused by a similar statement if, as in this case, its
language expresses no more than any ordinary person would infer without it.
Report should be complete

The auditor should give a complete report. If he gives his report, subject to separate notes, those
notes also should be given simultaneously. In Hitkarini Mahavidyalaya, Jabalpur v. P.C. Madan[89]
where the auditor made his report on the accounts of an institution subject to separate notes which
were not submitted within a reasonable time, the Court held him guilty of gross negligence. The
reasoning for this was that any one going through the report would assume that those notes were
prepared and were ready at the time when the report was signed by him. It could not be supposed
that those notes were not in existence at that time and were written at some later date on some facts,
which were still to be verified or ascertained. Though this was not a case of bad or vicious intention, it
was still held to be an act of gross negligence.
Qualified opinion
Where an auditor gives a qualified opinion, that is, he expresses an opinion subject to certain
reservations, he should express clearly the nature of the qualification in the report. The reasons for
the qualification should also be stated. In the case of companies, this is a legal requirement under
Section 227(4) of the Companies Act, which requires that where the auditor answers any of the
statutory affirmations in the negative or with a qualification, his report should state the reasons for
such answers.
Qualified audit reports may be classified into four categories:
Disclaimer: In a disclaimer of opinion the auditor states that he is unable to form an opinion as to
whether the financial statements give a true and fair view.
Adverse: In an adverse opinion the auditor states that in his opinion the financial statements do not
give a true and fair view.
‘Subject to’: In a ‘subject to’ opinion the auditor effectively disclaims an opinion on a particular
matter which is not considered fundamental.
Exception: In an ‘except for’ opinion the auditor expresses an adverse opinion on a particular matter
which is not considered fundamental.
Auditors who wrongfully fail to qualify company accounts are not liable to the company for
subsequent loss if the company did not actually rely upon them and was not misled by the
information contained in the accounts. Certification of accounts by auditors does not on the basis of
the Caparo principle[90] expose them to the risk of being sued by lenders who may rely on those
accounts when considering whether to make finance available to the company.[91]
Adverse or negative opinion: If, based on his examination, the auditor does not agree with the
affirmations to be made, the auditor may give an adverse opinion. For example, the opinion given by
the auditor is adverse or negative when he states that the financial statements do not represent a true
and fair view of the state of affairs and the working results of an undertaking.
An adverse opinion is appropriate where the reservations or the objections of the auditor are so
material that he feels that the overall view of the accounts is materially distorted. Where the auditor
gives an adverse opinion, he should disclose all material reasons therefor. For example, in case the
company is engaged in hire purchase and finance business where provision for doubtful debts was
not made in spite of the fact that a sizeable proportions of sundry debtors were not recoverable, the
auditor is expected to state that the said accounts do not give a true and fair view of the state of
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affairs of the company in as much as no provision for bad and doubtful debts has been made.
Disclaimer of opinion
If an auditor fails to obtain sufficient information which results in his inability to express an opinion,
he makes a disclaimer of opinion. The auditor may state that he is unable to express an opinion
because he has not been able to obtain sufficient evidence to form an opinion. The necessity of
disclaiming an opinion may arise due to many reasons. For example, the auditor may not get access
to all the books of account for any reason; there may exist material items, the value of which may be
totally uncertain, or, certain material information may not be forthcoming. Whenever an auditor
disclaims an opinion, he should give reasons for the same. For example, the auditor could say that
“we have not been unable to verify the existence and value of the fixed assets of the company and,
therefore, we are unable to state whether the balance sheet shows a true and fair-view”.
The right of a statutory auditor to give a qualified report is a great deterrent and prevents the
management of a company from resorting to accounting practices and methods of disclosure which
are not in accordance with the law. A qualified report is normally not necessary, unless the issues
involved are material. However, items requiring disclosure under the law such as directors
remuneration, whether material or not, have to be specifically disclosed. If this is not done, it is the
duty of the auditor to qualify his report.[92]
An auditor of a company is appointed by shareholders to perform certain statutory functions and

duties and it is expected of him that he will in fact perform these functions and duties. The failure to
perform a statutory duty in the manner required is not excused merely by giving a qualification or
reservation in auditor’s report. In such circumstances, the auditor should, while giving a qualification
or reservation indicate clearly the reasons why he was unable to perform the audit in accordance with
generally accepted procedures and standards. [93]
In a majority of cases, items which are the subject matter of qualification are not so material as to
affect the truth and fairness of the accounts, taken as a whole, but merely create uncertainty about a
particular item. In such cases, the auditor may report that in his opinion, but subject to specific
qualifications mentioned, the accounts present a true and fair view.
On the other hand there may be cases where the reservations may be so material that it would be
meaningless to state that subject to the qualifications, the accounts disclose a true and fair view. The
auditor then should make a disclaimer of opinion or give an adverse/negative opinion, as
appropriate. In this context, the nature of the facts, their materiality and their bearing upon the truth
and fairness of the accounts should be taken into consideration.[94]
The auditors must give full information about the subject matter of their qualification and not merely
create grounds for suspicion or inquiry and leave it to the shareholders to ascertain the facts by
making diligent inquiry. The distinction between “information” and “means of information” made in
the London and General Bank’s case[95] is still valid. A qualification should be clear and precise and
the manner in which qualifications are made in the auditor’s report should be such as not to leave any
room for doubt in the minds of the public.
The company’s auditor should mention clearly whether in his opinion a particular matter stated in his
report is in the nature of a qualification or is merely an explanation. A factual reference in the report
does not automatically become a qualification. The use of the expression ‘read with the notes
thereon’ does not qualify the contents of the auditor’s report. In any case, the notes are necessarily a
part of the accounts and even if the auditor does not make a specific reference thereto, his report
automatically covers them.
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The report prepared by the auditor’s should be comprehensive and brief and specify the matters in
respect of which the auditors have reservations or qualifications, and the amounts involved in clear
and unambiguous manner, leaving no scope for misinterpretation. Full information and if that is not
available as much information as is available should be given in the report. Vague statements, the
effect of which is not ascertainable on the accounts should be avoided. The auditor should avoid
making qualifications in his report, which do not contain any real objection on his report. Further, it is
not a good practice to qualify the present Report by reference to a report made in an earlier year
because the shareholders may not have access to such reports. Each year’s accounts being
independent, the essential facts relating to a qualification made in an earlier year must be repeated
where appropriate.
All qualifications should be contained in the auditor’s report itself and should appear at one place in
order to give the reader a clear view thereof.
Notes in the Report

Notes appended at the foot of the financial statements normally represent the explanations given by
the directors elucidating or clarifying various items of accounts. The notes may include those giving
specific information required by Schedule VI to the Companies Act, for example, arrears of dividends
on preference shares’, computation of managerial Remuneration, etc. If the auditor qualifies his report
by making reference to the notes or if the qualifications made by the auditor are also included in
these notes, the shareholders may be unable to appreciate the significance of such qualifications. It
is, therefore, necessary that the notes to accounts should not contain the opinion of the auditor.
Further, the auditor should only reproduce notes of a qualificatory nature in his report to enable the
reader to know the importance of the qualifications. The word ‘reproduce’ does not imply a verbatim
reproduction of the qualificatory notes. Where notes of a qualificatory nature appear in the accounts,
the auditor should state all qualifications independently of his report in an adequate manner so as to
enable a reader to assess the significance of these qualifications. However, where a note has already
been given in detail by the management, it is not necessary to reproduce it verbatim in the audit
report and a brief self-explanatory statement may be sufficient.[96]
The auditor should quantify, wherever possible, the effect of the qualifications on the financial
statements, if the same is material. Where it is not possible to precisely quantify the effect of the
qualifications, the auditor may do so on the basis of estimates made by the management after
carrying out such tests as is possible and he may then indicate that the figures are based on the
management’s estimates.
An auditor should not be satisfied merely by vouchers, apparently formal and regular but should by
fair and reasonable examination of them, see that they are not for payments in any way unauthorized
or illegal or improper.
Report on annexed documents

The report has to deal not only with the accounts and balance sheet and profit and loss accounts, but
also every other document declared to be part of or annexed to the balance sheet and profit and loss
account. Among the documents required to be annexed is also included a list relating to investments,
if any, specified in Section 372(9) of the Companies Act with all the particulars required to be stated
therein.
A statement in the auditor’s report that he has dealt with the branch auditor’s report in such manner
as he considers necessary is not a sufficient compliance of these Provisions. The company’s auditor
has to make disclosure of anything in regard to the branch which he thinks is not in order and which
has come to his notice.[97]
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The company’s auditor need refer in his report to the branch audit when a person other than himself
audits the branch accounts.[98]
Conversion of a deemed public company to a Private Limited

Company-clarification regarding Auditor’s Report.
The Auditor’s Report is issued to the members of the company on a particular date. The report should
be addressed to the members of that company, which is in existence at the time the report, is issued.
Accordingly, if the status of the company changes from that of a deemed public company to private
company changes after the close of its financial year but before the Auditor’s Report is issued, it
should be addressed to the members of the “deemed public company”. If the Auditor’s Report is
issued after the change, in status, as aforesaid, the report should be addressed to the members of the
private company. However, the Auditor’s Report relates to period during which the company was a
deemed public company. In view of this, the fact that the Auditor’s Report relates to the period
during which the company was a deemed public company should be disclosed in the beginning
thereof .[99]
The liability of Auditors is unique from that of other white collar professionals in so much as they are
liable not only to the who has appointed them. Another noteworthy fact is that there have been far
lesser cases against accountants than any other professionals.[100]
The liability of Auditors may be classified under the following heads:
(1) Negligence;
(2) Misfeasance; and
(3) Criminal liability.
The first and foremost issue which arises as far as the liability of the auditors are concerned is with
regard to the nature of their liability. They may arise from either:
(1) Negligent Acts, that is, where the acts of the auditors lead to the damage being suffered by the
plaintiffs, or
(2) Negligent Statements, that is, the incorrectness of a statement given to the client causing loss or
damage to the clients interests.
There have been cases which have followed different principles at different points of time as per the
circumstances of the case. The case of Hedley Byrne v. Heller[101] is a case where the liability had
arisen from negligent misrepresentation. The essence of the liability arises from the fact that the
parties have a special/contractual relationship and the negligent behaviour results in the breach of the
contract.
There has been a great discussion on this aspect for a number of years and the legal position seems
to have settled that if the misrepresentation was of a very general nature and had not been specific in
nature as pursuant to a contract then the tort action would be a better option for the client. Thus, now
the narrow scope, which would have been the result of negligence based on contractual relationship
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has been expanded a great deal.[102] Negligence is a tort in which a breach of duty of care results in
damage to person to whom such duty is owed. We now seek to examine the scope and extent of such
tortuous liability of the auditor.
Liability to the Company.

To hold the Auditors liable for negligence at common law it is necessary for the company to show that
loss has been caused to the company through the failure of the Auditors to perform their duty with
reasonable care and skill. This was held in Leeds Estate Building and Investment Co. v.
Shepherd[103] and London Oil Storage Co. v. Seear Hasluck & Co.[104] amongst other cases.
Where an individual is appointed as an auditor and that individual is a partner in a firm of

professional accountants, that firm may be held liable for his negligence in performing his duties, at
least where the audit fee is paid directly to the firm.
The duty of auditors in case of private companies was considered in Pendleburys Ltd. v.Ellis Green
and Co.[105] The courts held that where interests of the Companies are limited to a very small
number of people and there are no outsiders because all interests are held by the Directors
themselves, if the auditor has reported to the directors, then there is not much else which he can do.
This decision underlines the fact that the negligence of Auditors arises when the issues of public,
shareholder interests are paramount.
Another factor which is a crucial element in negligence is that of the standards by which the work of
the auditors are measured. It has been submitted that standards of skill and care change over time.
The standards have become stricter over time and the explanations of directors are no longer
accepted without making probes and inquiries into the matter in great detail. The report must reflect
the fact that they were suspicious of the functioning of the company and were given explanations
which were either satisfactory or not for them.
The Cannons of Foreseeability and Proximity

The law in relation to the auditors duty of care and the liability for negligent misstatement by auditors
has been subject of comprehensive analysis in England, in the case Caparo Industries Plc v.
Dickman[106] . The court held that the auditors owe a duty of care to the members but not to
potential investors in the company. They owe a duty of care to the members because they are under a
statutory obligation to report to them and because the members have a corresponding statutory
entitlement to receive such a report. The Auditors have no duty of care to the lenders and creditors of
the company. This is an extension of the same logic which makes them liable to members.
The case has laid down the following propositions as regards the auditor’s duty of care and
liability:[107]
In cases of negligent misstatement, foreseeability that the plaintiff or someone in a similar

position will rely upon the statement is a necessary but not sufficient condition for liability.
In addition, it is necessary to establish a nexus or relationship between the parties sufficient to
create a duty of care. That relationship can only be determined by a close analysis in each case.
The label applied to such a relationship is ‘proximity’, but there is no single definitive test. In
some cases, it may be useful to consider whether there has been a voluntary assumption of
responsibility in the others, whether the relationship is ‘equivalent to contract’.
The necessary relationship exists between the auditors and the members because there is a
statutory duty to send reports to the later by the former and a corresponding entitlement of the
members to receive such a report.
The relationship may also exist if the circumstances are such that the auditors can be taken
implied to have represented the accuracy of the accounts to the plaintiff, and perhaps whenever
they provide the accounts to the company with the intention, or in knowledge that it is the
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company’s intention, that they are to be supplied to the plaintiff or to persons in a class of which
the plaintiff is one.
It is not necessary that the auditors should have any particular transaction in contemplation, or
should intend the recipient of their report to rely upon it in any such transaction. If the necessary
relationship exists, it is enough if it is foreseeable that the recipient of the report may rely upon
it in some future transaction, whether contemplated by the auditors or not, and whether with
reference to his existing shareholding or not.
The necessary relationship does not exist between a companies auditors and potential investors who
are not existing shareholders in the company. The fact that it is foreseeable that their report may
come into their hands and be relied upon by them is not sufficient in itself to create a relationship.
Hence, in order to establish the existence of duty of care owed to the plaintiff, who claims damages,
by auditor who is alleged to have made a negligent misstatement, three requirements must be
satisfied. These are:
i) It must be reasonably foreseeable by the defendant that the statement will be relied on by the
plaintiff;
ii) There must exist the relevant degree of proximity between the parties; and
iii) It must be just and reasonable in all circumstances to impose a duty of care on part of the
defendant to the plaintiff.
This however, leads us into the issue of liability to third parties.
Liability to Third Parties

There was formerly the prevailing view that there is no liability for negligent misrepresentation made
by one person to another who had relied upon it to his detriment, in the absence of any contractual or
fiduciary relationship between the parties or the fraud.[108]
This position was overruled in Hedley Byrne & Co. v. Heller & Partners[109] where it was held that in
certain circumstances contractual liability could be incurred for a negligent misstatement made by
one person to another, even in the absence of any contractual or fiduciary relationship.
The parameters of such responsibility were limited by the “neighbourhood principle” laid down by
Lord Atkin in Donaghue v. Stevenson.[110] In Jeb Fastners v. Marks Bloom & Co.,[111] the
appropriate test for establishing whether a degree of care exists was laid down to be whether the
defendant knew or reasonably should have foreseen at the time the accounts were audited that a
person might rely upon those accounts for the purpose of deciding whether or not to take over the
company and, therefore could suffer a loss if the accounts were inaccurate. Firstly, they must have
relied upon the accounts and secondly, they must have done so in circumstances where either the
auditor’s knew they would, or ought to have known, that they might.
The decision in Hedley Byrne v. Heller[112] held that liability for negligent statements resulting in the
financial loss is not limited only to cases where there is an existing contractual or fiduciary
relationship. This raised the question of the limits of such liability. The test of a reasonable man
would not make the auditors liable. The rule thus was that the auditors would not be liable to third
parties unless the facts of the case showed otherwise.
Thus, in Candler v. Crane, Christmas and Co[113], where the accounts were prepared specifically for
the purpose of inducing the plaintiff to invest in the company, to the knowledge of the auditors, there
was a duty of care even though the plaintiffs were not members or shareholders of the Company. This
can however, be negated by a clear clause expressly disclaiming liability.[114] There are recent cases
which state that the auditors should have foreseen that the accounts may be relied on by future
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investors for the purpose of making decisions regarding their investments..[115]
In order to carry out the duties as laid down with regard to the accounts presented to the members,
the Companies Act has also given the auditors certain rights. These rights, enshrined in Sub-section
(1) of Section 227 of the Companies Act, 1956, are primarily:
1.The right to call for information and explanations;
2.The right to have access to the books of accounts; and
3.The right to notices and to attend meetings.
The scope and ambit of these rights of the auditor are studied in detail in this part of the research
paper.
An auditor has the right to require from the officers of the company such information, as the auditors
may think necessary for the performance of their duties. The auditor can call for any explanations or
information that he considers necessary. It is obligatory on the part of the officers of the Company to
furnish the relevant information to the auditor. In the event of the information not being furnished or
explanation given, the auditor is required to report the same in his report. This is to ensure that the
shareholders are made aware of the fact and such awareness may give critical clues to them and
indicate that all is not well with the Company.[116]
The power to ask for information includes the exercise of such powers over the officers of the
company and includes the Directors and Managing Directors. This power is not extinguished by the
winding up of the Company.[117]
Where a Company is under Liquidation, the courts can call upon the directors to appear before the
Auditors to submit explanations to the questions raised by them. This is based on the logic that while
directors may cease to enjoy powers, the obligations and liabilities incurred by them in the time when
they were directors are not extinguished with the passing of the order of winding up. This was held in
Bhawnagar Vegetable Products Ltd., In Re.[118]
Under English law, an officer of the company who makes to an auditor (orally or in writing) a
misleading statement which conveys, or purports to convey, any information or explanation which the
auditor requires, or is entitled to in his capacity as auditor is guilty of a statutory offence and may be
liable to fine or imprisonment or both.[119] For the officer to be guilty of an offence, the statement
must be misleading, false or deceptive in a material particular and made knowingly or recklessly.
Section 227 confers on the auditors the right of access to the books of accounts of the company at all
times for the performance of his duties. The auditor’s powers cannot be limited or abridged in any
way.
A Company Articles may not limit the auditor’s statutory right to information. In Newton v.
Birmingham Small Arms[120] the Court held that
“The auditor has the right to access to books of accounts of a company. Any provision in the
company’s articles precluding auditors from obtaining or availing themselves of the information they
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are entitled to by statute is void. They must have free access to all the material necessary for their
report. A resolution limiting the powers of the auditor or a provision to this effect in the effect in the
articles will be void.”
The auditor is also entitled to request access to other documents necessary for audit. The books of
accounts of the company may be kept in the headquarters of the Company or elsewhere. The right of
access to the books can be enforced by mandatory injunction but not where litigation is pending
between the company and the auditors.
This right is inclusive of the right to see vouchers also. The term Vouchers includes all documents,
correspondence, agreements and evidence which support any transaction or data disclosed in the
financial statements whether directly or indirectly. The term book also includes the financial, statutory
and statistical books including cost records. The auditor can also examine the books which record
quantities of production, stock, sales, etc.
The inspection is inclusive of the minutes of the general meetings and the Directors meetings. It has
been held as early as 1906, in England that any regulation precluding the Auditors from availing all
the information required by them is invalid.[121] Such a rule is also valid in India and is essential to
protect the sanctity of the Auditors Report.
The term “at all times” enables the auditor to check the records without waiting for financial year to
end, but it means the examination only during office business hours.[122]
The auditor can visit any branch office at any time for his purposes. There is a limitation to this power
and that is with regard to the foreign branches of a Banking Company, under section 228(2) of the
Companies Act, 1956.
The auditors of a company are entitled to attend any general meeting of the company and to receive
notice of, and communications relating to, any general meeting which any member of the company is
entitled to receive.
Thus, the Auditor has the right to receive notices and other communications relating to the general
meetings. The auditors also have the right to attend the meeting and speak on any part of the
business of such meetings which concerns them as auditors. Where a company is proposing a
resolution as a written resolution, they are entitled to receive copies of all communications supplied to
members.
However, the mere fact that the Auditor has said something in the meeting does not mean that he is
absolved of all responsibilities to say material facts in the Report.
In Woolworth v. Conroy, [123] the Court of Appeal held that ‘accountants in the course of doing their
ordinary professional work of producing and auditing accounts, advising on financial problems and
carrying on negotiations in relation to taxation have at least a particular lien over any books of
accounts, files and papers which their clients have delivered to them, and also over documents which
have come into their possession in the course of acting as their clients’ agents in the course of their
ordinary professional work.’
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When an auditor conducts the audit of accounts of a business entity such as a company there are three
fundamental accounting assumptions that he must keep in mind. These are laid down by the
Accounting Standard (AS-I) prescribed by the Institute of Chartered Accountants of India.[124] These
fundamental accounting assumptions are as follows:
(1) Going Concern,
(2) Consistency;
(3) Accrual.
The above mentioned accounting assumptions underlie the preparation and presentation of financial
statements. Each one of these accounting assumptions has been dealt with in detail in this research
paper.
Going Concern as per AS-I

The definition of a going concern as given in AS-I states that “the continuance of an entity is assumed
for a foreseeable future and that there is neither an intention nor necessity of liquidation or of
curtailing materially the scale of operations”.[125]
Thus, if an entity is in a position to normally produce and sell its goods and perform its obligations
towards various bodies, whether governmental or otherwise, then it could be called a ‘going concern’.
SAP 16 has now specified that the “foreseeable period” should be a period not exceeding one year
after the balance sheet date. There may be situations within the fundamental accounting assumptions
of going concern, consistency and accrual, when an entity may not satisfy any one of them and as a
consequence shows results which may not affect its liquidity, though theoretically there may be a
possibility of technical insolvency. The standard is not clear as to the manner of consideration of the
same.[126]
For example, if a company with a small capital base has been showing marginal profits after
depreciation but without accounting for gratuity. Gratuity is paid as and when liability arises on cash
basis. If the gratuity is provided, the company will come under the purview of potential sickness under
SICA. Such a policy is violative of the accrual concept. The company’s activities may not be affected
because gratuity is only a contingent liability and the liability to pay arises only when all workers
decide to retire on the same day.[127]
Hence, the auditor need not doubt the condition of the company, as days to day activities are not
affected.
Indicators
There are a number of indicators which can help the Auditor in determining whether the status of a
company as a going concern is affected. These indicators can be categorized into three sets. These
are:
1.Financial Indicators;
2.Operation Indicators;
3.Other indicators.
The financial indicators that indicate whether the company is a ‘going concern’ are as follows:
Negative net worth or negative working capital;

Fixed term borrowings approaching maturity without realistic prospects of renewal or repayment
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or excessive reliance on short term borrowings to finance long term assets;

Adverse key financial ratios;
Substantial operating losses;
Substantial negative cash flows from operations;
Arrears or discontinuance of dividends;
Inability to pay creditors on due dates;
Difficulty in complying with terms of loan agreements;
Change from credit to cash on delivery transactions with suppliers;
Inability to obtain finance for essential new product development or other essential investments;
Entering into a scheme of arrangement with creditors for reduction of liability.
The operating indicators showing that the company is a ‘going concern’ are as follows:
Loss of key management without replacement;

Loss of major market, franchise, license or principal supplier;
Labour difficulties or shortage of important supplies.
The other indicators of the same are:
Non Compliance with capital or other statutory requirements;

Pending legal proceedings against the entity that may, if successful result in judgments that
could not be met;
Changes in Legislation or Governmental policy
Sickness of the company under any statutory definition.
Thus, it can be stated that the role of the Auditor has been made more proactive than ever before as
far as the ‘going concern’ is concerned. Any of the above factors if present or apprehended will entail
a detailed enquiry by the Auditors.
While looking at the above mentioned criteria the AS- 3 which is regarding cash flow has to be kept in
mind. The moment a cash flow statement is prepared, normally it would show the true colours of the
company. However, a fund flow statement would also be of great value as then the various sources of
funds would also have been revealed and also indicate how the same have been utilised. If short-term
funds have been used for long term purposes, then that would amount to diversion of funds. The
impact of such diversion would then have to be studied in terms of SAP -16 to ascertain whether such
diversion would affect the liquidity of the company on a long-term basis.
As far as negative working capital is concerned, there are a few issues which a re rather complicated.
The fact that there is negative working capital may not always be an indication of sickness. Many
businesses today work on trust. There are units which have been technically sick nut have the backing
and confidence of creditors, workers, bankers, etc. They continue to get credit and bankers have
reposed their faith on the units due to either the ingenuity of the promoters, honesty, work ethics, etc.
Any adverse report by the Auditor under SAP -16 would have a negative impact on the units such as
these. The role of the Auditor in such a situation becomes very tricky as the aim is not to threaten the
very existence of the company.
As far as Non financial indicators are concerned, they are to be looked into with great care as any
mistaken reading of the same may result in the devastation of the business of the company. It is thus,
critical that the Auditor after having applied his mind to the indicators has a discussion with the
management and seeks explanations from them and to see what measures are being taken to reverse
any adverse situation which may have arisen.
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The validity of the going concern status may be judged on the following scale:
Going concern status being appropriate;

Going concern status being questionable and resolved by management explanations;
Going concern status being questionable and managements explanations being inadequate;
Going concern status being inappropriate.
This being a basic accounting assumption, if in the opinion of the Auditor, an entity is found to being
a ‘going concern’ then the Auditor need not qualify so in the Report.
The Auditor has to exercise his judgment as to the factors, which point to the entity’s stature as a
non-going concern. If he thinks that the company may have a chance to recover and will not become
insolvent then he may not have it in the report.
In case the explanations given by the management are not found to be adequate by the Auditor, he
should consider whether the financial statements:
Adequately describe the principal condition that raises substantial doubt about the company’s
ability to continue in operation for the foreseeable future;
State that there is significant uncertainty that the entity will be able to continue as a going
concern and therefore, may be unable to realize its assets and discharge its liabilities in the
normal course of its business.
State that the financial statements do not include any adjustments relating to recoverability and
classification of recorded assets and classification of liabilities that may be necessary if the entity
is unable to continue as a ‘going concern’.
SAP 16 states that if adequate disclosure of the above facts is made in the financial statements, the
auditor need not qualify his report. However, he is required to highlight the problem by drawing
attention to the note in the financial statement which discloses the matter as set out above.
The Auditor can also issue a disclaimer of opinion for going concern uncertainty. Adverse opinion or
qualified opinion should be expressed where the Auditor feels that the disclosure is not adequate.
If the Auditor feels that the company will not be able to maintain its status as a going concern he
should state that the assumption of the company being a going concern is not applicable in the
particular case.
SAP 16 has become operational for all Audits relating to accounting periods beginning April 1999.
There may be a few problems in the areas where the judgment of auditor is sought regarding
non-financial matters. The high responsibility given to the auditor has also meant that the liabilities
for failure to deliver are also enhanced. There are doubts as to whether the profession is ready to
deliver such high levels of expectations.
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The emergence of corporate governance, which refers to the establishment of a structural framework
or reforming the existing framework to ensure the governing of the company to best serve interests of
all stakeholders, as an important concept and indispensable to resilient and vibrant capital markets
and is an important instrument of investor protection has resulted in efforts to find ways of ensuring
strong corporate governance. The spate of Committees and recommendations on the code of
corporate governance starting for the Cadbury Committee for Corporate governance constituted in the
United Kingdom to the Committee on Corporate governance constituted by the Securities Exchange
Board of India under the Chairmanship of Kumaramangalam Birla have all recommended the setting
up of an Audit Committee in companies to ensure the ‘enhancement of shareholder value, keeping in
view the interests of other stakeholders’.
‘A system of good corporate governance promotes relationships of accountability between the

principal actors of sound financial reporting – the Board, the management and the auditor.’ To this
end the setting up of Audit Committee by the Board of the company will ensure proper accountability
to the stakeholders especially the shareholders and other investors. The Board of a company is
responsible and accountable for sound financial reporting.
The Board of a company is responsible and accountable for sound financial reporting. The Audit
Committee being a sub-group of the full board is charged with the responsibility of monitoring the
process supporting responsible financial disclosure and active and participatory supervision. It is not
the role of the audit committee to prepare financial statements or engage in the myriad of decisions
relating to the preparation of these statements. The Committee’s function is clearly one of overseeing
and monitoring, and in carrying out this function it relies on the senior financial management of the
company and the outside auditors. Thus, the role of the Audit Committee is to act as a catalyst for
effective financial reporting.
Historical evolution:
In the United States, the New York Stock Exchange has required all listed Companies to have audit
committees composed solely of independent directors. The 1987 report of the American Treadway
Commission concluded that audit committees had a critical role to play in ensuring the integrity of US
company financial reports. Experience in the United States has shown that even where audit
committees might have been set up mainly to meet listing requirements, they have developed into an
essential and important committee of the Board.
Similarly in the United Kingdom, the results of a published research shows that companies with audit
committees offer added assurance to the shareholders that the auditors, who act on their behalf, are
in a position to safeguard their interests.
The Cadbury Committee which was set up in 1991 by the Financial Reporting Council, UK, the London
Stock Exchange and the accountancy profession in UK to address the financial aspects of corporate
governance, after reviewing the relevant issues, recommended that all listed companies should
establish an audit committee.
The following further recommendations of the Cadbury Committee spell out in detail the role,
functions, and duties of the audit committee:
1)Audit committees should be formally constituted to ensure that the have a clear relationship with
the Boards to whom they are answerable and to whom they should report regularly. They should be
given written terms of reference which deal adequately with their membership, authority and duties,
and they should normally meet at least twice a year.
2)There should be a minimum of three members. Membership should be confined to non-executive
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directors of the company and a majority of the non-executives serving on the committee should be
independent. Membership of the committee should be disclosed in the annual report.
3)The external auditor should normally attend audit committee meetings, as should the finance
director. As the Board as a whole is responsible for the financial statements, other board members
should also have the right to attend. The company should have a discussion with the external
auditors, at least once a year, without executive Board members present, to ensure that there are no
unresolved issues of concern.
4)The audit committees should have explicit authority to investigate any matter within its terms of
reference, the resources which it needs for this purpose, and full access to information. The
committee should be able to achieve external professional advice and to invite outsiders with relevant
experience to attend, if necessary.
5)The audit committee’s duties should be determined in the light of the company’s needs but should
normally include:
ØMaking recommendations to the Board on the appointment of the external auditor, the audit
fee, and any questions of resignations or dismissal;
ØReview of the half-year and annual financial statements before submission of the Board;
ØDiscussion with the external auditor about the nature and scope of the audit, co-ordination
where more than one audit firm is involved, any problems or reservations arising from the audit,
and any matters which the external auditor wishes to discuss, without executive Board members
present;
ØReview of the external auditor’s management letter;
ØReview of the company’s statement on internal control systems prior to endorsement by the
Board; and
ØReview of any significant findings of internal investigations.
6.Where an internal audit function exists, the audit committee should ensure that it is adequately
resourced and has appropriate standing within the company. The audit committee should review the
internal audit programme, and the head of internal audit should normally attend its meetings.
7.The chairman of the audit committee should be available to answer questions bout its work at the
annual general meeting.
The Cadbury Committee has expressed its belief that Boards should appoint audit committees, rather
than aiming to carry out this function themselves. A separate audit committee enables a Board to
delegate to the subordinate-committee a thorough and detailed review of audit matters, it enables
the non-executive directors to contribute an independent judgement and play a positive role in an
area for which they are particularly fitted, and it offers the auditor a direct link with the non-executive
directors. The ultimate responsibility of the Board for reviewing and approving the annual report and
accounts and the quarterly or half-yearly reports remain undiminished by the appointment of an audit
committee, but it provides an important assurance that a key area of the Board’s duties will be
discharged.
The appointment of the audit committee is considered to be an important step in raising standards of
corporate governance. The effectiveness of such a committee would depend largely on the strength of
the Chairman, who has the confidence of the Board and auditors, and on the quality of the
non-executive directors.
The Greenbury and the Hampel Committee established in the United Kingdom in 1993 and 1995
respectively have reiterated the need to establish an audit committee of at least three non-executive
directors, at least two of whom are independent.
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In India, the origin of audit committee lies in the conditions laid down by financial institutions while
sanctioning term-loans and/or subscribing to shares and/or debentures. It is at the instance of the
financial institutions that the companies assisted by them constituted audit sub-committees with the
nominee director(s) being made a compulsory member(s) thereof. The meetings of the audit
sub-committee were held prior to the meetings of the Board of Directors. Their decisions were
referred to the directors of their meetings. However, the desired results did not flow from the setting
up such audit sub-committees and an increasing number of companies, which were assisted by
financial institutions, became sick companies.[128]
The Reserve bank of India, in its guidelines and regulations to Non-Banking Financial Companies also
requires NBFC’s having assets of Rs. 50 crore or more as per their last audited balance sheet to
appoint audit committees on the lines of the scheduled Banks, as per directions dated January 13,
2000 of the Reserve Bank of India. The audit committee constituted under these directions shall have
a minimum of three directors of the Board of directors.
The concept of audit committee gained further ground during the economic recession when about
2200 companies disappeared after raising funds from the public. At around the same time, the larger
concept of corporate governance gained currency and the top industrialists and chambers of trade
and commerce in the country initiated steps towards better corporate governance. The key role of the
audit committee in corporate governance was recognised and the Confederation of Indian Industries
(CII) set up a committee in 1996 to report on the subject.
The CII Report on corporate governance also emphasises the need and importance of the audit
committee. The Confederation of Indian Industries report on corporate governance also emphasised
the need and importance of the audit committees. This report provided that:
“There should be an audit committee in every organisation. The terms of reference of the audit
committee should, inter alia, include the following:
ØReview the draft annual accounts prior to their approval by the Board focusing in particular on
(1) significant changes in accounting policies and practices; (2) major judgmental areas; and (3)
significant audit adjustments;
ØReview the compliance with statutory and stock exchange requirements for financial reporting;
ØDiscuss the scope of the audit with external auditors;
ØDiscuss the matters arising from the audit with the external auditors;
ØReview the preliminary announcements of results prior to publication;
ØReview the annual reports taken as a whole;
ØEnsure that the Board receives reliable and timely management information;
ØMake recommendations on the appointment and remuneration of external auditors;
ØStatutory auditors and the finance directors of the companies should attend audit committee
meetings as invitees;
ØThe audit committee needs to identify the areas of non-compliance draw attention to it in their
report on the financial health of the company; and
ØThe audit committee needs to ensure that an objective and professional relationship is
maintained with the auditors.
The Securities and Exchange Board of India also set up a committee which went into the question of
corporate governance. The initiative of SEBI was with the twin objective of enhancing shareholders’
wealth, and protecting the interest of other stakeholders in the company. The Shri Kumaramangalam
Birla Committee on Corporate Governance came out with numerous recommendations which were
accepted by SEBI and came to be inserted in the listing agreement.
The Kumaramangalam Committee Report has recommended that a qualified and independent Audit
Committee be set up by the Board of the company, thus enhancing the credibility of the financial
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disclosures of the company and promoting transparency. It provides, inter alia, for constitution of an
audit committee to achieve the aforesaid objectives and it is applicable to all listed companies.
Further, the Companies Act has also incorporated Section 292A in the Companies Act providing for
the constitution of an Audit Committee in every public company having a paid up capital of not less
five crore rupees.
Thus, there are three different regulations in respect of incorporated companies providing for the
constitution audit committees to achieve the common object of better corporate governance.
Meaning and Purpose of Audit Committee:
The audit committee plays an important role in the corporate governance of the company as it relates
to the overseeing of financial reporting. The three main groups responsible for financial reporting —
the Board, the internal auditors, and the external auditors form the three legged stand that supports
responsible financial disclosure and active and participatory supervision. The Audit Committee has an
important role to play in this process, as it is a sub-group of the full Board and hence the monitor of
the process.
The Audit Committee is a committee of the Board of Directors with no management responsibility for
the company’s financial operations, which reports directly to the main Board and has no executive
powers of its own. Its job is clearly one of overseeing and monitoring, and to perform this function it
depend on senior financial management and the outside auditors.
The principle purpose of the audit committee is to assist the Board of directors in discharging their
individual and collective legal responsibilities for ensuring the following things:
1)the company’s financial and accounting systems are providing accurate and up-to-date information
on its current financial position;
2)the company’s published financial statements represent a true and fair reflection of this position;
3)the external audit, which the law requires to provide independent confirmation that these legal
responsibilities are being met, is conducted in a thorough, efficient and effective manner.
The task of the company directors and external auditors in fulfilling their separate duties has grown
as the commercial operations of companies and the financial systems needed to support them have
become more complex. The audit committee can serve as a useful Board of Directors to provide a
mechanism whereby this task is given additional attention by those who are not themselves involved
in the day-to-day management of the company.
The Kumaramangalam Birla Committee Report on Corporate Governance has made numerous
recommendations with regard to the composition of the Audit Committee and other aspects which are
as mentioned below:
Composition:
While recommending the composition of the Audit Committee the factor that was considered was the
independence of the Committee.
ØThe Audit Committee should have a minimum of three members all being non-executive
directors, with the majority being independent and with atleast one director having financial and
accounting knowledge;
ØThe Chairman of the Committee should be an independent director;
ØThe Chairman should be present at the annual general meeting to answer shareholder queries;
ØThe Audit Committee should invite such of the executives, as it considers appropriate to be
present at the meetings of the Committee,
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ØThe Company Secretary should act as the Secretary of the Committee.
Frequency of Meetings and quorum:
As per the recommendations, the Audit Committee should meet at least thrice a year. One of these
meetings should be held before finalisation of the annual accounts and one necessarily every sixth
month.
The quorum of these meetings should be either two members or one-third of the members of the
Committee, whichever is higher and there should be a minimum of two independent directors.
Powers of the Audit Committee:
Being a Sub-committee of the Board, the Audit Committee derives its powers from the authorisation
of the Board. Hence its powers should include:
ØTo investigate any activity within its terms of reference;

ØTo seek information from any employee;
ØTo seek outside legal or other professional advice;
ØTo secure attendance of outsiders with relevant expertise, if it considers necessary.
Functions of the Audit Committee:
As the Audit Committee acts as a bridge between the Board, the statutory auditors and internal
auditors, the following role has been recommended for it:
ØOverseeing the company’s financial reporting process and the disclosure of its financial
information to ensure that the financial statements are correct, sufficient and credible.
ØRecommending the appointment and removal of external auditors, fixation of audit fee, and
also approval for payment for any others services.
ØReviewing with management the annual financial statements before submission to the Board,
focusing primarily on:
·Any changes in accounting policies and practices;
·Major accounting entries based on exercise of judgement by management;
·Qualification in draft audit reports;
·Significant adjustments arising out of audit;
·The going concern assumptions;
·Compliance with accounting standards;
·Any related party transaction;
·Reviewing with the management and external and internal auditors, the adequacy of internal
control systems, etc.
Thus, the Committee is expected to play an important role in corporate governance. The
recommendations provide scope for the Audit Committee to evolve its own guidelines for its day to
day functioning.
Amendments to the Listing Agreement:
The Securities Exchange Board of India has decided to make amendments to the listing agreement
and incorporation of Clause 49 to incorporate the Kumarangalam Committee recommendations.
Part II of Clause 49 relates to the Audit Committee. Almost all the recommendations of the
Kumaramangalam Committee relating to Audit Committees are incorporated in this part. The Clause
further stipulates that if the company has set up an audit committee pursuant to provisions of the
Companies act, the company shall agree that the said Audit Committee shall have such other
functions/features as are contained in the Listing agreement. Thus, the Committees recommendations
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concerning Audit Committee have come into force through the Stock Exchange Listing Agreement.
Requirements of the Companies (Amendment) Act, 2000:
A new Section 292A has been inserted in the Companies Act to the effect that every public company
(listed or unlisted) having a paid-up capital (equity and preference) of not less than five crores of
rupees should constitute a committee of the Board of directors to be known as the “Audit Committee”
which shall consist of not less than three directors and such other number of directors as the Board
may determine. Two-thirds of such directors should be directors other than managing or whole-time
directors.
The audit committee should act in accordance with terms of reference specified in writing by the
board. The Committee should elect a chairman from amongst themselves. The annual report of the
company should disclose the composition of the Audit Committee. It should discuss with the auditors
the scope of the audit and internal control systems. The Audit Committee shall have the authority to
investigate into an matter in relation to the items specified in the provisions of Section 292A or
referred to it by the Board and for this purpose shall have full access to information contained in the
records of the company and external professional advice, if necessary.
The auditor, the internal auditor, and the director of finance shall attend and participate at meetings
of the Audit Committee but they shall not have the right to vote. Recommendations of the Audit
Committee on any matter relating to financial management including the audit report shall be binding
on the board. If the board does not accept the recommendations of the Committee, the reason for
disagreement shall be recorded and shall be intimated to the shareholders to be discussed in the
annual general meeting and the view of the shareholders shall be final. The chairman of the Audit
Committee shall attend the annual general meeting to provide clarifications on accounts and matters
relating to audits.
Subordinate-section (1) to Section 292A provides that penalty for default in complying with the
provisions of this section would be imprisonment for a term upto one year or a fine upto Rs. 50,000
or both.
The provisions relating to the periodical discussions with the auditors, internal as well as external,
about internal control systems and the scope of audit including the observations of the auditors,
which are intended to make the functioning of the corporate sector more transparent are quite
welcome.
The reach and the range of provisions of the Companies Act are much wider than those of the Kumara
Mangalam Birla Committee Code as the provisions of the Act are applicable to both listed and
unlisted companies. Also, unlike the Birla Committee Code, there is no phased schedule of
implementation.
There are certain variations between the Kumara Mangalam Committee Code and the Companies Act
regarding the constitution and the function of the Audit Committee. Such variations are as follows:
(1)Chairpersons of the Committee: there is no provision in the Companies Act regarding

independence of the chairperson.
(2)Composition of the committee: although both the Companies Act and the K.M. Birla Committee
Code stipulate that the committees should consist of at least 3 members, there is no stipulation
regarding qualification of members in the Companies Act. on the other hand the Birla Committee
Code stipulates that one member of the Committee should have financial and accounting knowledge.
Moreover, the Companies Act allows induction of executive directors in the committee. Also, no
provision is there in the Companies Act to ensure independence of the Committee. The Birla
Committee report also requires that the majority of the members should be independent.
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(3)Functions of the Audit Committee: the Kumaramangalam Committee report is more explicit
regarding the role of the audit committee. However, the Companies (Amendment) Act, 2000 has
given much wider powers to the Audit Committee by providing that the recommendations of the audit
committee on any matter relating to financial management, including the audit report, shall be
binding on the Board.
The basic objective sought to be achieved through the instrumentality of the Audit Committee is to
ensure smooth, transparent and efficient management of the corporate sector, inter alia, from the
point of view of the stakeholders in the company in particular shareholders and investors.
The concept of corporate governance and audit committee is an evolving concept in India, though
audit committees were formed in the past by many companies on account of the stipulation by the
financial institutions. However, it is important to understand the effectiveness of such a committee in
other parts of the However, there are other provisions such as the one providing that the
recommendations of the Audit Committee in relation to financial management, including the audit
report, shall be binding on the Board. This provision may result in obliteration of the lines of
demarcation between the domains of the auditors, directors, and the audit committee. Further, the
auditor’s independence may get affected if the Audit Committee is to sit in judgement over the audit
report. Legally the audit report is submitted after the board of directors adopts the accounts. If the
Audit Committee is to make recommendations on the auditors’ report, thereafter to the Board, it
would amount to sitting in judgement of its won actions or revising the accounts adopted earlier by
the Board. There are other such provisions in the Companies Act which require clarifications.
While elaborating on the role of audit committee, the Kumarmangalam Birla Committee on Corporate
Governance, in India, has stated that it is not the role of the audit committee to prepare financial
statements or engage in the myriad of decisions relating to the preparation of those statements. The
audit committee is required to overview and monitor and in performing this function it relies on
senior financial management and the outside auditors. However it is important to ensure that the
boards function efficiently for if the boards are dysfunctional, the audit committees will do no
better.[129]
“Independence, adequate competence and due professional care in conducting an audit are the three
essential attributes of an auditor.”
Audit has been universally recognised and accepted as a corner stone of corporate governance. Given
the separation of ownership from management, the directors are required to report on their
stewardship by means of the annual report and their financial statements sent to the shareholders.
The audit provides an external, impartial and objective check on the preparation of the financial
statements of a company and their presentation to the shareholders and the public at large, and it is
an essential part of the checks and balances required. Shareholders and others rely upon the auditor’s
report on company accounts as reassurance of the accuracy or otherwise of reports and accounts
published by the company. In this context, company auditors have a fiduciary obligation towards the
users of the audited financial statements.
The auditors’ position is akin to that of company directors who are accountable to shareholders of the
company in the discharge of their stewardship obligations. Auditors thus become virtual trustees of
the shareholders ensuring that disclosures by the company are a true and fair reflection of reality.
Thus, to fulfil its primary function of giving a true and fair view of the financial affairs of the company,
it has necessarily to be independent of the management.
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From the investors’ point of view, if it is not believed that the auditor is truly independent from the
issuer, they will derive little confidence from the auditor’s opinion and will be far less likely to invest
in the issuer’s securities. Fostering auditor confidence, therefore, requires not only that reasonable
investors perceive them to be independent.
An auditor is expected to apply generally accepted auditing standards in the course of audit
examination and preparation of financial statements. However, a lack of independence could lead to a
lower application of accounting standards.
It is often argued that auditors are trained by their professional discipline to shoulder the onerous
responsibilities placed on them. However, from time to time, issues of bias and lack of independence
on their part comes up for discussion. Though theoretically it is the shareholders who approve
auditors’ appointment, it is the management that proposes their appointment in the first place.
Therefore, it is believed, a sense of obligation towards the management is unavoidable.
Another reason why the issue of auditor independence is often questioned is the increasing trend of
other services which auditors are called upon to provide to their audit companies.
As in the case of directors, establishing independence of auditors may not be easy. But, auditors more
than directors, must be above suspicion and seem to be independent for the abovementioned
reasons. Thus, the interests of the shareholders demand the independence of the statutory auditor
from the influence of the management itself is not involved in its own audit.
Companies Act provisions on Auditor Independence:
The Companies act ensures in many ways that the power to appoint auditors is not in the hands of the
management and that it vests in the general body of shareholders. Where the shareholders fail to
exercise this power, the Central Government appoints the auditor. However, the directors of the
company can appoint the first auditors and can also fill a casual vacancy. To prevent the power of
casual vacancy from being abused by the Board, it is enacted that a vacancy caused by resignation
shall only be filled by the company in general meeting.
The Act also gives shareholders the opportunity to repeatedly exercise their power of appointment by
providing that the appointment would have to be renewed every year and that the shareholders may
even replace the various appointees. Special notice of every such move of replacement has to be given
so that the auditor sought to be replaced may have an opportunity of explaining matters to the body
of shareholders. Important information may be revealed in this process.
Section 276(3) of the Companies Act bars the following persons from being appointed as auditors of
the company:
1.A body corporate;
2.An officer or employee of the company;
3.A person who is a partner, or who is in the employment, of an officer or employee of the company;
and
4.A person who is indebted to the company for an amount exceeding one thousand rupees, or who
has given any guarantee or provided any security in connection with the indebtedness of any third
person to the company for an amount exceeding one thousand rupees.
Further, a person attracting any of the abovementioned disqualifications is also disqualified from
being appointed as an auditor in any of the group body corporates. Section 226(5) is the logical
extension of the rule mentioned above, and is applicable to a person even after his appointment as an
auditor. Thus, a person attracting any of the disqualifications mentioned in section 226(3) and (4) can
neither be appointed nor continue in office as auditor.
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The restrictions mentioned in the Companies act, however, are not exhaustive. They are
supplemented by the Chartered Accountants Act, 1949 and the Chartered Accountants’ Regulations,
1988.
§Clause 10 of Part I of the First Schedule to the Act deems as professional misconduct the
charging or offering to change in respect of any professional employment fees which are based
on a percentage of profits which are contingent upon the findings or results of such
employment.[130]
§Clause 4 of Part I of the Second Schedule provides that a chartered accountant in practice shall
be deemed to be guilty of professional misconduct if he expresses his opinion on financial
statements of any business or enterprise in which he, his firm, or a partner in his firm has
‘substantial interest’ unless he discloses his interest in the report. The expression ‘substantial
interest’ has the same meaning as in Appendix 10 to the Chartered Accountants’ Regulations,
1988. Thus, a member shall be deemed to have a ‘substantial interest’ in a concern –
(1)In a case where a concern is a company, if its shares (not being shares entitled to a fixed rate of
dividend whether with or without a further right to participate in profits) carrying not less than 20 per
cent of the voting power at any time, during the ‘relevant years are owned beneficially by such
member or by anyone or more of the following persons: (a) one or more relatives of the member; (b)
any concern in which any of the persons referred to above has a substantial interest;
(2)In the case of any other concern, if such member is entitled or the other persons referred to above
or such member and one or more of the other persons referred to above are entitled in the aggregate,
at any time during the relevant years to not less than 20 per cent of the profits of such concern.
Though theoretically it is the shareholders who approve auditors’ appointment, it is the management
which proposes their appointment in the first place, and, therefore, a sense of obligation towards
management is unavoidable. This is further compounded by the inevitably close working relationship
that develops between auditors and management during the audit.
The other issue bearing upon auditor independence is the increasing trend of other services which
auditors are called upon to provide. The trend of providing such non-audit services has been
described as a “worrisome trend as growing reliance on non-audit services has the potential to
compromise the objectivity or independence of the auditor by diverting firm leadership away from the
public responsibility associated with the independent audit function…” According to an estimate,
non-audit revenues of firms in the US in recent years were four times their audit fee income.
Under Indian law, Section 2(2)(iv) of the Chartered Accountants Act allows a chartered accountant to
render such other services as, in the opinion of the Council, are or may be rendered by a chartered
accountant in practice. However, Clause 11 of Part I of the First Schedule bars a chartered accountant
in practice from engaging in any business or occupation other than profession of chartered
accountants unless permitted by the Council. Subject to the prohibition in Section 226(3)(b) and (c), a
chartered accountant in practice can be the director of a company. Under the Chartered Accountants
Act, the chartered accountants in service can offer services that cannot be strictly classified as those
arising from their competence as accountants. Consequently, the Council of the Institute of Chartered
Accountants of India has often opined in favour of a number of other services which can be offered by
a chartered accountant in practice, such as:
§Taxation representation before the tax authorities and tax planning and advisory services;
§Management services: inclusive of financial planning and financial policy determination, capital
structure planning and advice regarding raising of finance, preparing project reports and
feasibility reports, preparing case budgets, etc.
§Company law advisory services in relation to compliance with the various provisions and
procedures under the Companies Act;
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§Investigation of accounts for various purposes;

§Valuation of shares of limited companies for various purposes;
§Issue of certificates as required by the Government and other authorities for various purposes;
§Special assignments required by the company for its own benefit, for example, a surprise
verification of cash or inventories or surprise visits to branches under special circumstances;
§Review of systems and procedures;
§Audit of ancillary institutions of the company like the Employees Provident Fund in respect of
which the fees are paid by the company itself.
The Council justifies these ‘opinions’ with the observation that these services are to some extent
‘complementary’ in character to the main function of the auditor.[131] Further, Clause 4b, Part II of
Schedule VI to the Companies Act requires disclosure in the profit and loss account of amounts paid
to the auditors as advisors, or in any other capacity, or in any other manner.
However, the ‘complementarity’ between auditor and management services leads to concerns with
regard to corporate governance. This could result in enormous pressure on auditors to give way to the
management on audit matters in order not to jeopardise their other business services.
This issue was addressed by the Cadbury Committee on corporate governance which opined that
‘such a prohibition would limit the freedom of companies to choose their sources of advice and could
increase their costs’.
In the United States, the Securities and Exchange Commission and the American Institute of Certified
Public Accountants (AICPA) established a separate Independence Standards Board in March, 1997,
with the principal objective of setting out well-conceived and debated guidelines for establishing
auditor independence. The SEC believes that an accountant is not independent when the accountant
(1) has a mutual or conflicting interest with the audit client; (2) audits his or her own work; (3)
functions as management or an employee of the audit client; (4) acts as an advocate for the audit
client. These principles are rooted in the philosophy of the profession that auditors must be
independent in fact and in appearance.
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One of the biggest stories to have hit the market in the last one year is the fall of the energy monolith,
Enron Corp. There are a number of issues, of great interest to financial analysts related to Enron. One
of the major issues is that of the role and responsibilities of the auditors and whether in the present
case it was their failure to identify the rot in the company which further magnified the problem and
resulted in such huge losses for the stakeholders.
Before we examine that issues and causes of the fall of Enron, we seek to briefly summarise the rise
and fall of Enron.
In the past, Enron was greatly admired for its innovative business strategies and superior
management skills. The rise of Enron demonstrated that the Internet could be used to enhance
business performance. The stocks of Enron were skyrocketing, the juggernaut was unstoppable and
the executives were eager to take the company to the uncharted markets of energy trading, water,
optical fiber, etc. there was diversification into areas with which the original business had no link.
The fact that the stock markets and the value of the stock was critical to the company meant that
these risks had to be hedged in a manner that any loss or risk of losses were not to be reflected in the
balance sheets of the company. Thus, the Company was in a catch 22 situation, where on the one
hand they had to keep their balance sheets free of losses in order to maintain the stock prices and on
the other hand they had very little real assets to fall back on in the event of the stock prices crashing.
The rising stock prices gave the executives the hot currency to lure private equity investors into
investing in Enron’s new ventures. Further, Enron’s assets and debts were kept off the balance sheets,
and investment grade credit ratings were maintained.
Hence, accounting jugglery was the reason for the growth rate shown to the investors. A complex web
of partnerships was created. These partnerships helped the company keep the debts off its balance
sheets all through these years, though the money itself has been going into the coffers of the company
without the market noticing it. There is a strong possibility that the jugglery with accounts was done to
ensure that the markets were bullish about the company’s growth prospects. Hence, there was
unbridled pouring of money into its businesses and yet there was reluctance to show these debts in
the balance sheets. The method used to circumvent was that of using partnerships and showing the
debts in the accounts of partners.
No one, including the auditors, Arthur Andersen, took the pain to look into the murky waters of these
partnership dealings. The bubble was first pierced in October 2000, when the company announced
that it had to restate its profits of the last four years, from 1997 and had to take a hit of around $600
million. This put the auditors on a very sticky wicket as it plainly showed them to have been negligent.
The stock of the company crashed by 50% by April 2001. The market capitalization, which at one time
was at $200 billion had crashed to less than 50% of that sum.
All this took the market by surprise. The company revealed that several of its off balance sheet,
Special Purpose Entities, partnerships made for special businesses were now being consolidated into
the accounts of the company. One of the best examples of such financial jugglery is provided by
Sterling Marlin. Enron took water assets, primarily based in the United Kingdom, off its balance sheets
and the Marlin II trust took a stake in them. Meanwhile Marlin II issued senior debt to investors, the
proceeds of which went to Enron. The company did not recognise these notes as debts on its balance
sheets, due to the structure of the trust. Marlin II replaced a similar trust called Marlin I. Ideally the
aim was to maximise the value of the assets of these trusts and then sell them off and cover the trusts.
To cover the risks that such sale would not be able to raise enough money, Enron also pledged to
issue as much new stock as may be needed to pay off the notes. The assets did not perform well. In
fact, the Merlin II trust was set up so that Enron did not have to issue fresh stock to cover the losses as
it had promised to do. Hence, suddenly there was apprehension that the company would not be
willing to abide by its commitments. Thus, the faith of investors was shaken and the downfall became
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imminent. There were several such transactions.
As a result a loss of $560 million has occurred. The effect was to reduce earnings dramatically.[132]
The company further announced a $1.2 billion in shareholders equity and a $1.01 billion charge on
account of some investments that went awry. The bottom line was that Enron appears to have thought
that it could defy market scrutiny by nifty accounting but its luck ran out.
There are several issues arising out of the Enron fiasco related to Auditing. One of the main ones
being that of independence of auditors.
The first issue which arises relates to the duty of care owed by the auditors to not only the
shareholders of the company but also to the future investors in the company. There is a view that the
auditors have to present a true and fair view of the accounts of the company for the benefit of the
shareholders only. It is unfortunate that the position has not yet been cleared up in India either by the
legislature or by the department through a clarificatory note.
The role of the auditors of Enron Corp., Arthur Anderson, has been under fire arising out of a conflict
of interest situation. The question that has been raised time and again has been whether the auditors
in this case did a bad job in not spotting the bad accounting practices and the company’s
overstatement of profits, or whether it was complicit in the accounting gimmickry. Though it has
become common for accountancy firms to provide non-audit services, concerns arise as regards
independence of the auditors. The issue that arises in the context of an accountancy firm providing a
vast gamut of services, including audit, would be that of conflict of interest. This results in the
question: how can one be sure that a firm has been unprejudiced in an audit of a company that could
be a client for its consultancy services. In the United States, the SEC Rules prohibit an independent
accountant from providing any service that wold involve stepping into the shoes of the management of
the company and that involves any kind of decision making on behalf of the management.
Non-audit services have been listed, though this is not an exhaustive list, and include services
involving book-keeping, design and implementation of financial information systems, appraisal and
valuation and fairness opinions, legal services, broker/dealer services et al. Internal audit services
cannot exceed 40 per cent of the total hours spent an internal audit activities of the client. This
applies to firms with over $200m in assets.
Arthur Anderson derived $25 million towards audit fees and $27 million towards consulting
contracts. There is a clear conflict of interest since an auditor is supposed to provide an independent
view of the company’s accounts. Unlike in many countries in Europe, auditors in the US even represent
the company in tax matters to the Internal Revenue Services. If they are truly independent of the
company, they should not be doing this. Moreover, the almost automatic renewal of auditing contracts
is another important factor to be considered.
Andersen the company’s auditors have admitted to an error of judgment in its treatment of the debt
of one of Enron’s off balance sheet partnerships. Such ventures in which the former chief financial
officer of the company is alleged to have reaped over $30 million as profits are stated to have led to
an overstatement of profits by almost $600 million over the years 1997-2000, as has been stated
before. The failure of the auditors to point these out has led to the accusations of failure to present
fair and true view of the financial status of the company. The auditors have failed to blow the whistle
and the Audit Report can only be taken to have presented a view aimed at hoodwinking the
shareholders and the investing public at large.
This raises the question of the independence, integrity and the neutrality of auditors. In the USA as in
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India, auditors are also allowed to be the accountants of the company. There are provisions relating to
disclosure of fees, etc, yet incidents like Enron are a proof of the fact that the systemic safeguards, if
any, are inadequate.
Andersen has derived more money out of Enron as their accountants than as their auditors. They have
earned around $27 million as fees for non-auditing services and only $25 million as auditors. Such
huge payments raise issues of conflict of interests. The firm has in the past vehemently opposed any
attempts to bar the usage of the auditors as accountants of the same company stating that there is no
evidence that this is required. Now, there may be just that evidence.
Proposed amendments to the Section 224 of the Companies Act, 1956 seeks to exclude the statutory
auditor from having any other role in the Company. This amendment should have language such that
the indirect and disguised consideration should also be taken care of. It is admittedly difficult to have
a fool proof solution to the problem as there may be a firm which is not related on the face of it but
has deeper organic connections with the auditing firm. One example could be a partner breaking off
and becoming the accountant while the firm is the auditor. These are issues which will have to be seen
in the light of the facts of the case. The language will have to be such that there is enough flexibility to
accommodate the various manipulations by the accounting firms.
Accounting standards are the minimum requirements that need to be adhered to while maintaining
the accounts of a company. But by no means can they assure and guarantee the detection of
illegal/extralegal activity by the companies.
With the collapse of the energy giant, Enron Corp. concerns regarding the effectiveness of the
Generally Accepted Accounting Principles (GAAPs) in presenting a true and fair view of the
performance and statement of affairs of a company have been raised.
One of the issues that needs to be addressed is with regard to revenue recognition. Enron’s revenue
growth from 1996 to 2000 was 50 per cent per annum.
Year Sales Profits Margins

1996 13.3 0.6 4.4
1997 20.3 0.9 0.5
1998 31.3 0.7 2.2
1999 40.1 0.9 2.2
2000 100.8 1.0 1.0
Carg. 50.0 10.9 -26.1
However, the profits remained the same over the same period. This was possible on account of a
loophole in Statement 133 on accounting of derivative transactions that allowed the company to book
revenue from energy-derivative contracts at their gross value instead of their net value.
The major part of Enron’s revenue came from “wholesale business”, which had all the unconsolidated
entities in its fold. This gave rise to the issue of accounting of transactions between Enron and its
unconsolidated entities and the lacunae in the statement of consolidation. According to the
consolidation norms laid down by the Financial Accounting Standards Board, a Special Purpose
Vehicle (SPE) need not be merged with the company, if the company owns 97 per cent or less in the
SPE. Hence, the SPEs were created by Enron to acquire assets and keep it off the books. Even Dabhol
Power Corporation was an unconsolidated Special Purpose Vehicle in which Enron held a 50 per cent
share. Thus, the company was able to create and trade in assets having high risk and negative returns
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without bringing it in the books. Further, these Special Purpose Vehicles enabled the company to enter
into multiple transactions and thus boost its toplines.[133]
This is very normal practice in India, where the listed companies enters into dealings with unlisted
group companies and thus are able to hike or deflate sales according to the needs of moment. The
Chartered Accountants who participated in the Companies Act, 1956 survey conducted by the ET
Intelligence Group, stated that the companies could tamper with sales and profit figures both ways,
through dealing with the group companies.
Enron case has illustrated that the companies can easily circumvent the standards and still not be in
violation of any laws. There is enough scope for manipulation and the integrity of the people involved
is what is the most important thing in the final analysis.
The fact that standards can be manipulated around is not a case to not have them at all. They have
their useful purpose as well and at least form the bench mark which can be used to detect
non-compliance or circumvention.
Though there can be no standard which can be fool proof, the standards can be in a perpetual state of
evolution so that they are able to keep pace with the manipulations of the companies.
There have been proposals to have an independent body which could have a control over the auditing
undertaken by the various firms. These proposals have gained ground in the light of the fact that the
Enron papers were shredded by Andersen. This destruction of documentary evidence has raised
serious questions over the feasibility and trustworthiness of the self-regulatory model of supervision
of the auditors.
Thus, in the Indian context also a question needs to be asked as to the integrity of accounting firms.
The SEBI could be a body which could act as a body to supervise the accounting firms. The Institute of
Chartered Accountants does not have a great record as far as disciplinary actions are concerned. The
ICAI, after all is fiercely protective of the chartered accountants.
Even in the case of Enron the self regulation process has been discredited and there have been calls
for the Securities Exchange Commission to probe into the affairs of Andersen.
Enron’s collapse has also exposed the limitations of Audit Committees. It shows that independent
directors are not really independent. The chairman of Enron’s Audit Committee is a Stanford
professor with 30 years experience of auditing and accounts. There is no ban on the members of the
Audit Committee from holding stock in the company. This may seriously question their status as
independent directors forming part of the audit committee. Apart from that the fact that the members
of the Audit Committee, with all the experience they have were just not competent enough to
understand the complexities of the transactions being undertaken by the company is a serious and
grave reflection on the reliability of the Audit Committee.
There have been large donations to the institutions were members of the Audit Committee are
employed by Enron. It is therefore not an exaggeration to state that the Audit Committee has lost any
semblance of independence.
Another issue that arises in this context relates to transactions with related parties. The Institute of
Chartered Accountants of India issued an accounting standard (AS 18) which requires companies to
disclose details of its transactions with related parties. Here again, the auditor is required to mention
in the Manufacturing and Other Companies Auditor’s Report Order, whether the transaction entered
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into by the company with related companies are at arm’s length or not. However, if such companies,
SPVs and partnerships are formed by creating a layer, such as another company, between the
directors and the company itself, then it may be difficult to lift the corporate veil, according to
experts.
Hence, such structures can be efficiently used to transfer funds and assets of the company and also
help the company to trade with its group company, without attracting disclosure requirements.
Another issue that is raised is about the accounting of value investments in subsidiaries, associate
companies and joint ventures. The Institute of Chartered Accountants, India has taken measures,
making companies consolidate their interest in such entities. However, if the company holds less than
20 per cent in a company, then the requirement of consolidation of interest in the associate company
is not required. Thus, a company can flout with this provision by making an investment of an amount
less than 20 per cent and having provisions which do not dilute the management control overt he
other company.
Independence of Auditors:
The role of Auditors in the open market economy is critical. An audit is an examination on a test basis
of numerical data and explanations of such data presented in a companies financial statement. An
Audit includes an assessment of the principles and methods used in the preparation of those financial
statements. An audit, however, does not represent a review of each transaction or a qualitative
assessment of the companies performance. The role of an independent Audit is to provide an
independent opinion on the fairness of the companies financial statements. As required by law, it is
the responsibility of auditors to give their opinion as to whether these financial statements are fairly
presented and comply with the rules on book keeping.
Audit is a key component of good Corporate Governance. As a result of their audit work, the auditors
often make recommendations to the board of directors and to management on ways to improve
corporate governance, internal controls and financial reporting. However, it is the responsibility of the
client to decide on whether and to what extent the auditors’ recommendations are to be implemented.
Independence is a fundamental feature of the audit profession and, along with objectivity and
unquestioned technical expertise. From the business perspective it is more than reasonable to avoid
situations which may compromise the reputation which generations of professionals have been
developing for decades. Yet there have been a number of incidents which have raised questions over
the integrity of auditors and auditing firms.
One may then ask: why are auditors so protective with respect to attempts of third parites to discuss
their work? The answer to this is simple: client confidentiality, which is a contractual, professional and
regulatory requirement. However, as has been proved by the Enron case, such an argument can not be
used to avoid inspection any more as now the larger interests of shareholders and other investors are
the primary concern. As a result there is no avoiding scrutiny by third party regulators.
Enron has presented before us the perfect example of what can go wrong if the Auditors do not
perform their duties in accordance with accepted legal principles and accounting practices. The
Independent nature of Auditing is severely questioned in such a scenario. The nature of liabilities of
auditors is also brought into focus. The integrity of auditors and the mixing of audit and non-audit
functions also raise questions regarding their independence.
[1] Majumdar, Ankit, “Auditor’s Duty to Care”, 18 SCL (Mag.) 134 (1998).
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[2] See: Sections 209-223 and Schedules V & VI of the Companies Act, 1956.
[3] Infra.
[4] Institute of Chartered Accountants v. P.K. Mukherjee, AIR 1968 SC 1104.
[5]K. Srinivasan, “Corporate Governance- Audit as a key factor”, [2001] CLA (Mag.) 25.
[6] Ibid,
[7] Cadbury Commission,Report of the Committee on the Financial Aspects of Corporate Governance
(December 1992). at www.worldbank.org/html/fpd/privatesector/cg/docs/cadbury.pdf.
[8] Ibid.
[9] R.K. Aggarwal, COMPANY AUDIT REPORTS, 1996.
[10] Travis Morgan Dodd, “Accounting Malpractice and Contributory Negligence: Justifying Disparate
Treatment Based Upon the Auditor’s Unique Role”, 80 Geo. L.J. 909.
[11] Ibid.,
[12] Supra note 3.
[13] Section 224(1) of the Companies Act provides that “every company shall at each annual general
meeting appoint an auditor or auditors to hold office from the conclusion of that, until the conclusion
of the next, annual general meeting.”
[14] ICAI, Compendium of Opinions, Vol. VII, 1st edn., 1990 Reprint, p. 81.
[15] Section 224 (1-A), Companies Act, 1956, this rule is applicable to auditors who are not retiring
auditors.
[16] Institute of Chartered Accountants v. Jnanendranath Saikia, (1955) 25 Com Cases 53, 56
(Assam).
[17] Section 224 (1-B), Companies Act, 1956.
[18] Exclusion of these two categories of auditors from the ceiling on company audits was, perhaps,
not intended by the legislature. This could be a drafting error or omission. The desirable legal
position would be that no Chartered Accountant in practice (whether individually or as a partner in a
firm of Chartered Accountants. Ramaiya, p. 1745.
[19] Departmental Clarification, Circular Number 21 of 75; F. No. 35/3/75-CL-III, dated 24-9-1975.
[20] Ramaiya, p. 1755.
[21] Section 166 lays down the period within which the annual general meeting is to be held.
[22] “The tenure of an auditor is laid down in section 224(1); it is from the conclusion of the annual
general meeting to the conclusion of the next annual general meeting and cannot therefore be for any
particular year or financial year. The duty of the auditor is laid down in Section 227(2), whereunder
the auditor in office has to audit ‘every balance sheet and profit and loss account’ and every other
document in it or annexed to it which are laid before the general meeting held during his tenure of
office of any particular auditor. That also shows that the office of any auditor is not related to any
particular balance sheet or profit or loss account or to any particular financial year.” ICAI,
Compendium of Opinions, Vol. I, 3rd edn., 1986, p. 206.
[23] Section 224 (2), Companies Act.
[24] Departmental Clarification, Circular No. 5/72, dated 21-2-1972.
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[25] Section 225, Companies Act.
[26] Department Clarification, Circular No. 2/72, dated 21-2-1972.
[27] Section 384(1), English Companies Act.
[28] Section 387, English Companies Act. The fines to be imposed are specified in Schedule 24.
[29] Section 384 (4), English Companies Act.
[30] Section 379 provides that at least twenty-eight days’ notice of the intention to move such a
resolution must be given to the company and that the company must give at least twenty-one days’
notice to its members.
[31] Sections 388 (1) and 391A, English Companies Act.
[33] section 388 (2), English Companies Act.
[34] Section 385 (3) (4), English Companies Act.
[35] Sections 385A and 386, English Companies Act.
[36] In relation to the Institute of Chartered Accountants in England and Wales, Sections 1.2 and
1.309 respectively, Statement 8 of the “Guide to Professional Ethics” and the Council Statement
“Changes in Professional Appointment”, Member’s Handbook.
[37] Section 250 as amended by the Companies Amendment of Section 250 and 251) Regulations
1992 (SI 1992 No. 3003), Regulation 2.
[38] Section 388A, English Companies Act.
[39] Section 224(7), Companies Act, 1956.
[40] Section 391 (1), (2), English Companies Act, as amended by the Companies Act 1989, Section
122.
[42] Section 388 (3), (4), (5), English Companies Act.
[44] Refer to Section 240, English Companies Act.
[45] Section 390(4), (5), (6), English Companies act.
[46] Section 392(3) & 392A(5), as amended by English Companies Act 1989, Section 122 and
Schedule X.
[47] Section 391 (2)-(7), English Companies Act, 1985.
[48] Section 24, English Companies Act 1989.
[49] The Institute of Chartered Accountants in England and Wales, the Institute of the Chartered
Accountants of Scotland, the Chartered Association of Certified Accountants, the Institute of Chartered
Accountants in Ireland and the Association of Authorised Public Accountants.
[50] Ramaiya, p. 1751.
[51] Schedule 4, Para. 53(7); Schedule 9, Para 16, English Companies act.
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[52] Section 390A, as inserted by the Companies Act, 1989, Section 121.
[53] SI 1991/2128.
[54] Institute of Chartered Accountants v. P.K. Mukherjee, AIR 1968 SC 1104.
[55] Ramaiya, 14th ed, p. 1781
[56] Deputy Secretary v. S.N. Das Gupta, (1955) 25 Com Cas 413.
[57]CIT v. Dandekar, (1952) 22 Com Cases 1153 ( Mad).
[58] In Re Kingston Mill Company, [1896] 2 Ch. 279. See also: In Re City Equitable Fire Insurance
Company, [1924] All ER Rep 485.
[59]Institute of Chartered Accountants v. P.K. Mukherjee, AIR 1968 SC 1104.
[60] Section 2(30) states that the auditor is an officer of the Company as far as winding up is
concerned and gives a list of provisions under which the auditor is considered to be an officer of the
company. These provisions are section 477, section 478, section 539, section 543, section 545,
section 625, and section 633.
[61] Leeds Estate Co. v. Shepherd, (1887) 36 Ch D 787 at 802. See also: London & General Bank, Re,
[1895-9] All ER 953.
[62]Re London & General Bank , (1895-9) All ER 953 (CA).
[63]Ramaiya, 14th ed, p. 1782.
[64] Ibid.
[65] City Equitable Fire Insurance Co. Re., [1924] All E R Ref 485 (CA).
[66] Deputy Secretary to Government of India, Ministry of Finance v. S.N. Das Gupta, AIR 1955 Cal
414.
[67] Berg Sons & Co. v. Meruyn Flampton Adams, 1993 BCLC 1045 QBD.
[68] I.C.A.I. v. P.K. Mukherjee, AIR 1968 SC 1104.
[69] Donoghue v. Stevenson, [1932] AC 562.
[70]Manufacturing And Other Companies ( Auditors Report) Order, 1988. Notification no G.S.R. 909 (
E), dated 7th September, 1988.
[71]
[72] In Re London and General Bank, [1895-96] All ER Rep 953.
[73]Ramaiya, 14th ed.,p.1786.
[74]Ibid.,
[75] In Re London and General Bank, [1895-96] All ER Rep 953.
[76] City Equitable Fire Ins. Co., Re, [1924] All ER Rep 485.
[77] Re Kingston Cotton Mill Co, (1896) 2 Ch. 279 (CA).
[78] Fomento Sterling Area Limited Selsdson Fountain Pen Co.,
[79] [1968] Ch. 455.
[80] Pacific Acceptance Corpn. Ltd. v. Forsyth, [1970] 92 WN (NSW) 29.
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[81] Thomas Gerrard Son Ltd., Re, [1967] 2 All ER 525 Ch D.
[82] Section 227(3) also requires that the auditor’s report state whether he has obtained all the
information and explanations which to the best of his knowledge and belief were necessary for the
purpose of the audit; whether the company’s final accounts are in agreement with the books of
accounts and returns; whether he has received report on the accounts of any branch office.
[83] Section 227 (3)(b), Companies Act, 1956.
[84]We shall examine the concept of ‘true and fair view’ in detail in a subsequent part of this paper.
[85] Allen Craig & Co, Re, (1934) All ER Rep 301.
[86]Ramaiya, 14th ed, p. 1786.
[87] Ninth Annual Report, dated 5th August, 1965 on the Working and Administration of the
Companies Act, 1956, page 23.
[88](1895) 2 Ch 166.
[89] ICAI Disciplinary cases, Vol. IV, Judgment of the High Court delivered on 11th April 1963.
[90] Infra.
[91]Berg Sons & Co. Ltd. v. Adams, 1993 BCLC 1045 (QBD).
[92] ICAI’s Statement on Qualification in Auditor’s Report, Paragraphs 3.1 and 3.2.
[93] ICAI’s, Statement on Qualification in Auditor’s Report, Paragraph 3.5.
[94]ICAI’s, Statement on Qualification in Auditors Report, Paragraph 3.7.
[95] London and General Bank’s case, (1895) 2 Ch 166.
[96] ICAI’s, Statement on Qualifications in Auditor’s Reports, Paras 3.10, 3.12.
[97]Research Committee of the Institute of Chartered Accountants of India, Opinion Regarding Certain
Provisions of the Companies Act, 1969, p. 17.
[98]Department’s File No. 8/16(1)/61 -PR.
[99]ICAI’s Comm of pendium of opinions, Vol. X, Pp. 177-178.
[100] Jon H. Holyoak, “Accountancy and Negligence”, Journal of Business Laws, 1986, p. 120.
[101] (1964) A.C. 465.
[102] Jon H. Holyoak, “Accountancy and Negligence”, Journal of Business Laws, 1986, p. 121.
[103] (1887) 36 Ch. D. 787.
[104] (1904) 30 Acct. L.R 93, cited from, P.A. Bird, et al, “Annual Accounts and Returns”, Ed., Clive M.
Schmitthoff, Palmer’s Company Law at 1091 (Vol. 1, 24th ed., 1987).
[105] (1936) 80 Acct. L. R. 39.
[106] [1990] BCC 164.
[107] K.R. Chandratre, “Auditors duty of care and liability for negligence: Recent Judicial Exposition”,
[2002] 35 SCL ( Mag) 109 at 112.
[108] In Candler v. Crane, Christmas & Co., [1951] 2 KB 164, a majority of the Court of appeal
dismissed the claim of the plaintiff who had invested money a company, in reliance upon the accounts
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prepared by the accountants and consequently lost his investment.
[109] Hedley Byrne & Co. v. Heller & Partners, [1964] AC 465.
[110] Donoghue v. Stevenson, [1932] AC 562.
[111] Jeb Fastners v. Marks Bloom & Co., [1981]3 All E. R. 289.
[112] (1964) A.C. 465.
[113] [1951] 2 K.B. 164.
[114] P.A. Bird, et al, “Annual Accounts and Returns”, Ed., Clive M. Schmitthoff, Palmer’s Company
Law at 1091 ( Vol. 1, 24th ed., 1987).
[115] JEB Fastners Ltd v. Marks, Bloom and Co, [1981] 3 All ER 289.
[116]Ramaiya, 14th ed, p. 1783.
[117]Secrtion 2(30) of the Companies Act makes it clear that the Directors, Managing or otherwise are
all Officers of the Company.
[118] (1977) 47 Com Cases 128 (133).
[119] Section 393, English Companies Act, 19__.
[120] Newton v. Birmingham Small Arms, (1895) 2 Ch. 166.
[121]Newton v. Birmingham Small Arms Co Ltd., (1906) 2 Ch 378.
[122]Ramaiya, 14th ed, p. 1784.
[123] Woolworth v. Conroy, [1976] 2 WLR 338, 342.
[124] ICAI.
[125] M. Ramji, “Going Concern and the Auditors Duties”, 1999 SCL( Mag.) 225.
[126] Ibid.,
[127] Ibid.,
[128] Agrawal, G.D., “Audit Committee – Multiple Rules Need Codification”, (2001) 32 SCL 112.
[129]See, www.sebi.gov.in/report/corpgovern.html.
[130] Exceptions can be made, however, under the Regulations.
[131] Code of Conduct, Institute of Chartered Accountants of India, 1980, p. 47.
[132]In 1997, the earning were reduced from $105million to 9 million; In 1998 the change was from
$703 to $590 million; In 1999 it was $893 to $643 million; In 2000 $979 to $847 Million.
[133] Mehta, Sumeet, Kalloor, Roshni, “Bridging the GAAPs”, The Economic Times, Bangalore, 13 April
2002.
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Auditor's Liability

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Auditors Distinguished from Other White-collar Professionals………… 5

Problem Areas in Auditing………………………………………………………………………. 5

Appointment, Removal, Resignation and Remuneration of Auditors 8

Removal or Resignation of Auditors…………………………………………………….. 14

Qualifications and Disqualifications of Auditors……………………………….. 16

Duties and Responsibilities of Auditors…………………………………. 20

Position of the Auditors………………………………………………………………………… 20

GENERAL DUTIES IN CARRYING OUT AUDIT……………………………………. 24

Qualifications in auditor’s report………………………………………………………… 30

Accounts of branch office…………………………………………………………………….. 32

Nature of negligence liability…………………………………………………………………….. 34

Right to call for information and explanations………………………………….. 38

Right to have access to books of accounts……………………………………………. 38

Right to notices and to attend meetings……………………………………………….. 39

Audit and Accounting Standards……………………………………………… 41

Four Stages on scale of assessment……………………………………………………….. 43

1. Going concern status being appropriate…………………………………………………. 44

2. Going concern status being QUESTIONABLE AND resolved by management explanations. 44

4. Going concern status being inappropriate………………………………………………. 44

The Rise and fall of Enron Corp: Lessons for Auditing…… 57

Auditing Issues Relating to Enron………………………………………………………… 58

Reliability of Accounting Standards…………………………………………………………… 59

Independent Authority to Oversee the Auditing……………………………………………. 60

Is the Audit Committee Enough?……………………………………………………………….. 61

Transactions with Related Parties……………………………………………………………… 61

While describing the position of the auditor Ramaswamy J. has opined:[4]

The main objects of an audit are:

Verification of the book of account and financial statements

audit is open to serious questioning.[9]

The research questions addressed in this project report include:

General Rule of Appointment

Ceiling on Number of Company Audits

ii) a practicing firm of Chartered Accountants.

Appointment/Re-appointment of Auditor by Special Resolution

Tenure of Office of Auditors

Reappointment of Retiring Auditor

(1) when he is not qualified for re-appointment;

However, the retiring auditor cannot be deemed to be re-appointed or automatically re-appointed at

General Rule of Appointment

Resolution for Appointment or Removal of Auditors

(1) to fill a casual vacancy in the office of auditor;

(4) to remove an auditor before the expiration of his term of office.[32]

Auditors in Private Company

General Rule of Resignation of Auditor

also necessary for such removal of the auditors.

(1) a body corporate;

(2) an officer or employee of the company;

commencement of the Companies (Amendment) Act, 2000.

(1) a member of a recognised supervisory body; and

(2) eligible for appointment under the rules of that body.

(1) an officer or servant of the company (Section 389(6)(a));

(3) a body corporate (Section 389(6)(c));

“The auditor is a watchdog and not a bloodhound.”

Duties owed to third parties:

The duties of the auditor can be broadly classified as:

Duty to prepare auditors report.

True and Fair view

Language of the Report

Report should be complete

Qualified audit reports may be classified into four categories: