Tag: University of Mumbai BMS Notes

A cash flow statement shows the inflows and outflows of cash and cash equivalents. Cash includes cash in hand and demand deposits with the banks while cash equivalents are highly liquid investments i.e., they can be readily converted into cash like marketable securities, commercial papers, and short-term government bonds. It explains the changes in the cash in hand and cash at bank at the beginning and the end of the accounting period.

Accounting standard 3 deals with the cash flow statement. It has been classified into three broad categories:

• Operating Activities: Representing movements of money due to regular business operations like the purchase, sale, production, etc. of goods.
• Investing Activities: Representing the movement of cash due to the purchase or sale of assets or any other investment activities of the business.
• Financing Activities: Accounts for the funds raised through the issue of shares or debentures, long term loans, etc. and utilised for the redemption of shares or debentures and payment of dividend, etc.

There are two methods of preparation of a Cash Flow Statement, they are:

• Direct Method
• Indirect Method

Fund Flow Statement

Funds refer to the working capital of the company, so fund flow statement is a statement that studies the changes in the working capital of the business between two accounting years. It shows the additions in the working capital through various sources like issuing shares, debentures or raising loans, etc. and reduction in it through different applications like the redemption of shares or debentures, repayment of loans, purchase of fixed assets, etc.

Fund Flow Statement explain the reasons for the change in the working capital of the business between two Balance Sheet dates through various Non-Current Assets and Non-Current Liabilities, which are responsible for the increase or decrease in the working capital. A fund flow statement displays the financial status of an organisation, which ensures easy comparison and analysis between two accounting periods. It clarifies the variability in the assets, liabilities and equity of the company.

Based on function or test, the ratios are classified as liquidity ratios, profitability ratios, activity ratios and solvency ratios.

Liquidity Ratios:

Liquidity ratios measure the adequacy of current and liquid assets and help evaluate the ability of the business to pay its short-term debts. The ability of a business to pay its short-term debts is frequently referred to as short-term solvency position or liquidity position of the business.

Generally a business with sufficient current and liquid assets to pay its current liabilities as and when they become due is considered to have a strong liquidity position and a businesses with insufficient current and liquid assets is considered to have weak liquidity position.

Short-term creditors like suppliers of goods and commercial banks use liquidity ratios to know whether the business has adequate current and liquid assets to meet its current obligations. Financial institutions hesitate to offer short-term loans to businesses with weak short-term solvency position.

Four commonly used liquidity ratios are given below:

• Current ratio or working capital ratio
• Quick ratio or acid test ratio
• Absolute liquid ratio
• Current cash debt coverage ratio

Unfortunately, liquidity ratios are not true measure of liquidity because they tell about the quantity but nothing about the quality of the current assets and, therefore, should be used carefully. For a useful analysis of liquidity, these ratios are used in conjunction with activity ratios (also known as current assets movement ratios). Examples of activity ratios are receivables turnover ratio, accounts payable turnover ratio and inventory turnover ratio etc.

Profitability Ratios:

Profit is the primary objective of all businesses. All businesses need a consistent improvement in profit to survive and prosper. A business that continually suffers losses cannot survive for a long period.

Profitability ratios measure the efficiency of management in the employment of business resources to earn profits. These ratios indicate the success or failure of a business enterprise for a particular period of time.

Profitability ratios are used by almost all the parties connected with the business.

A strong profitability position ensures common stockholders a higher dividend income and appreciation in the value of the common stock in future.

Creditors, financial institutions and preferred stockholders expect a prompt payment of interest and fixed dividend income if the business has good profitability position.

Management needs higher profits to pay dividends and reinvest a portion in the business to increase the production capacity and strengthen the overall financial position of the company.

Some important profitability ratios are given below:

• Net profit (NP) ratio
• Gross profit (GP) ratio
• Price earnings ratio (P/E ratio)
• Operating ratio
• Expense ratio
• Dividend yield ratio
• Dividend payout ratio
• Return on capital employed ratio
• Earnings per share (EPS) ratio
• Return on shareholder’s investment/Return on equity
• Return on common stockholders’ equity ratio

Activity Ratios:

Activity ratios (also known as turnover ratios) measure the efficiency of a firm or company in generating revenues by converting its production into cash or sales. Generally a fast conversion increases revenues and profits.

Activity ratios show how frequently the assets are converted into cash or sales and, therefore, are frequently used in conjunction with liquidity ratios for a deep analysis of liquidity.

Some important activity ratios are:

• Inventory turnover ratio
• Receivables turnover ratio
• Average collection period
• Accounts payable turnover ratio
• Average payment period
• Asset turnover ratio
• Working capital turnover ratio
• Fixed assets turnover ratio

Solvency Ratios:

Solvency ratios (also known as long-term solvency ratios) measure the ability of a business to survive for a long period of time. These ratios are very important for stockholders and creditors.

Solvency ratios are normally used to:

• Analyze the capital structure of the company
• Evaluate the ability of the company to pay interest on long term borrowings
• Evaluate the ability of the the company to repay principal amount of the long term loans (debentures, bonds, medium and long term loans etc.).
• Evaluate whether the internal equities (stockholders’ funds) and external equities (creditors’ funds) are in right proportion.

Some frequently used long-term solvency ratios are given below:

• Debt to equity ratio
• Times interest earned (TIE) ratio
• Proprietary ratio
• Fixed assets to equity ratio
• Current assets to equity ratio
• Capital gearing ratio

Classification on the basis of financial statements:

Income statement/profit and loss ratios:

Income statement/profit and loss account ratios are those ratios that are calculated by using the items of income statement/profit and loss account of a particular period only. Examples of income statement/profit and loss account ratios are net profit ratio, gross profit ratio, operating ratio, and times interest earned ratio etc.

Balance sheet ratios:

Balance sheet ratios are those ratios that are calculated by using figures from the balance sheet only. The figures must be used from the balance sheet of the same period. Examples of balance sheet ratios are current ratio, liquid ratio, and debt to equity ratio etc.

Composite ratios:

These ratios are calculated by using the items of both income statement and balance sheet for the same period. Composite ratios are, therefore, also known as mixed ratios and inter-statement ratios. Numerous composite ratios are computed depending on the need of analyst. Some examples are inventory turnover ratio, receivables turnover ratio, accounts payable turnover ratio, and working capital turnover ratio etc.

Classification on the basis of importance:

On the basis of importance or significance, the ratios are classified as primary ratios and secondary ratios.  The most important ratios are called primary ratios and less important ratios are called secondary ratios. Secondary ratios are usually used to explain the primary ratios.

Examples of primary ratios for a commercial undertaking are return on capital employed ratio and net profit ratio because the basic purpose of these undertakings is to earn profit.

Importance of ratios significantly varies among industries therefore each industry has its own primary and secondary ratios. A ratio that is of primary importance in one industry may be of secondary importance in another industry.

Management Accounting is a branch of accounting focused on providing financial and non-financial information to help managers make informed decisions, plan and control business operations, and optimize performance. It involves the preparation and analysis of financial data, cost identification and control, budgeting, forecasting, and performance evaluation, tailored to the needs of internal management. Unlike financial accounting, which aims at providing information to external stakeholders, management accounting is oriented towards the internal analysis for strategic and operational decision-making. It supports the management in policy formulation, enhances efficiency through cost reduction and profit maximization strategies, and aids in risk management. Through its diverse tools and techniques, management accounting facilitates strategic planning, resource allocation, and operational control, contributing to the overall growth and sustainability of an organization.

Objectives of Management Accounting

• Aiding Decision Making:

To provide relevant financial and non-financial information that assists managers in making informed decisions about various aspects of the business, such as pricing, budget allocation, and resource utilization.

• Facilitating Planning and Budgeting:

To assist in setting short-term and long-term goals, developing strategic plans, and preparing budgets that align with the organization’s objectives.

• Enhancing Operational Control:

To help in monitoring day-to-day operations, ensuring activities are aligned with plans and budgets, and identifying areas where improvements are needed.

• Improving Efficiency and Reducing Costs:

To analyze operational processes and cost structures, identifying opportunities for cost reduction and efficiency enhancement.

• Supporting Strategic Management:

To provide insights and analyses that support strategic decision-making, including market analysis, competitive analysis, and internal capability assessment.

• Risk Management:

To identify, assess, and manage risks, ensuring that the organization is aware of potential challenges and is prepared to address them.

Functions of Management Accounting

• Cost Accounting:

Analyzing the cost of acquiring or producing goods and services to provide a basis for cost control and pricing decisions.

• Budgeting:

Preparing detailed budgets that forecast revenues, expenses, and cash flows, helping managers plan for future operations.

• Financial Analysis and Interpretation:

Evaluating financial statements and other data to assess the organization’s financial performance and position.

• Performance Measurement:

Using key performance indicators (KPIs) and other metrics to evaluate the efficiency and effectiveness of operations and the achievement of business objectives.

• Variance Analysis:

Comparing actual results to budgeted or planned figures to identify deviations, understand their causes, and take corrective actions.

• Capital Budgeting:

Evaluating investment opportunities and making decisions about long-term capital projects based on their potential to generate value.

• Internal Reporting:

Preparing internal reports that provide managers with timely and relevant information about financial and operational performance.

• Strategic Analysis:

Conducting analyses that help in formulating, evaluating, and implementing strategic plans.

Trend analysis is a technique employed by technical analyst in the financial industry to predict the future movements of a given asset. They employ historical data to determine the direction of the trend. The goal of this procedure is to identify attractive investment opportunities that are currently showing an upward trend; and of course, to identify downtrends too, so investors can get out before losing money.

Perhaps one of the disadvantages of trend analysis is that past behavior is not always consistent in the future, in other words, whatever the price of a given security did in the past is not necessary an indication of what it will do in the future because there are a lot of other significant elements that come into play when it comes to determining the value a financial security.

Trend analysis involves the collection of information from multiple time periods and plotting the information on a horizontal line for further review. The intent of this analysis is to spot actionable patterns in the presented information. In business, trend analysis is typically used in two ways, which are as follows:

• Revenue and cost analysis: Revenue and cost information from a company’s income statement can be arranged on a trend line for multiple reporting periods and examined for trends and inconsistencies. For example, a sudden spike in expense in one period followed by a sharp decline in the next period can indicate that an expense was booked twice in the first month. Thus, trend analysis is quite useful for examining preliminary financial statements for inaccuracies, to see if adjustments should be made before the statements are released for general use.
• Investment analysis. An investor can create a trend line of historical share prices and use this information to predict future changes in the price of a stock. The trend line can be associated with other information for which a cause-and-effect relationship may exist, to see if the causal relationship can be used as a predictor of future stock prices. Trend analysis can also be used for the entire stock market, to detect signs of an impending change from a bull to a bear market, or the reverse. The logic behind this analysis is that moving with a trend is more likely to generate profits for an investor.

When used internally (the revenue and cost analysis function), trend analysis is one of the most useful management tools available. The following are examples of this type of usage:

• Examine revenue patterns to see if sales are declining for certain products, customers, or sales regions.
• Examine expense report claims for evidence of fraudulent claims.
• Examine expense line items to see if there are any unusual expenditures in a reporting period that require additional investigation.
• Extend revenue and expense line items into the future for budgeting purposes, to estimate future results.

When trend analysis is being used to predict the future, keep in mind that the factors formerly impacting a data point may no longer be doing so to the same extent. This means that an extrapolation of a historical time series will not necessarily yield a valid prediction of the future. Thus, a considerable amount of additional research should accompany trend analysis when using it to make predictions.

Advantages of Trend Analysis:

(a) Possibility of making Inter-firm Comparison:

Trend analysis helps the analyst to make a proper comparison between the two or more firms over a period of time. It can also be compared with industry average. That is, it helps to understand the strength or weakness of a particular firm in comparison with other related firm in the industry.

(b) Usefulness:

Trend analysis (in terms of percentage) is found to be more effective in comparison with the absolutes figures/data on the basis of which the management can take the decisions.

(c) Useful for Comparative Analysis:

Trend analyses is very useful for comparative analysis of date in order to measure the financial performances of firm over a period of time and which helps the management to take decisions for the future i.e. it helps to predict the future.

(d) Measuring Liquidity and Solvency:

Trend analysis helps the analyst/and the management to understand the short-term liquidity position as well as the long-term solvency position of a firm over the years with the help of related financial Trend ratios.

(e) Measuring Profitability Position:

Trend analysis also helps to measure the profitability positions of an enterprise or a firm over the years with the help of some related financial trend ratios (e.g. Operating Ratio, Net Profit Ratio, Gross Profit Ratio etc.).

Disadvantages of Trend Analysis:

(a) Selection of Base Year:

It is not so easy to select the base year. Usually, a normal year is taken as the base year. But it is very difficult to select such a base year for the propose of ascertaining the trend. Otherwise, comparison or trend analyses will be of no value.

(b) Consistency:

It is also very difficult to follow a consistent accounting principle and policy particularly when the trends of business accounting are constantly changing.

(c) Useless in Inflationary Situations:

Analysis of trend percentage is useless at the time of price-level change (i.e. in inflation). Trends of data which are taken for comparison will present a misleading result.

Types of trend

Uptrend

It is the trend when financial markets and assets move in upward directions, resulting in an increase in the price. It is usually the time of boom in the economy, where overall sentiments are favorable.

Downtrend

In the downtrend or the bear market, the economy, financial markets, and assets prices move in the downward direction. It is the time when companies shrink operations and overall investor sentiment is not favorable.

Sideways / Horizontal Trend

In this, the assets prices or the broader economy-level are not moving in any direction, rather are moving sideways. This means, moving up for some time and then down on the same level.  It is a risky movement as investors are unsure of what will happen to their investment.

The co-operative societies Act,1912, a central act, contain fundamental law regarding the formation and working of co-operative societies in India and is applicable in many states with or without amendments.

Co-operative society is a business organization with a special mode of doing business , by pulling together all the means of production co-operatively, eliminating the middlemen and exploitation from outside force.

Any ten persons who are competent to enter into contract may make an application to the Registrar of Co-operative Societies as per section 6 of the Co-operative Societies Act, 1912. By-laws may be framed by each society and should be registered with Co-operative Societies. Effectiveness of change in by-laws of societies is applicable only when changes are approved by Registrar of Societies. There are two types of society’s, limited liabilities and un-limited liabilities societies. Any member is not liable to pay more than the nominal value of share held by them and no member can own more than 20% of shares of societies.

Government is encouraging co-operative societies to help society. Co-operative societies are operative in various sections like consumer, industrial, service, marketing, etc.

Under accounting system of Co-operative societies, the terms receipt and payment are used for two-fold aspect of double entry system.

Members are elected at the annual general meeting of the society. Day-to-day work of cooperative society is managed by the managing committee.

Audit of Co-operative Society

Let us now discuss the provisions for Audit as Per Section 17 of the Co-operative Society Act, 1912 −

The Registrar shall audit or cause to be audited by some person authorized by him by general or special order in writing on his behalf, the accounts of every registered society once at least every year.

The Audit under sub-section (1) shall include an examination of overdue debts, if any, and a valuation of the assets and liabilities of the society.

The Registrar, the Collector or any person authorized by general or special order in writing on his behalf by the Registrar, shall at all-time have access to all the books, accounts, papers and securities of a society, and every officer of the society shall furnish such information concerning the transactions and working of the society as the person making such inspection may require.

Audit as per Section 17 of the Co-operative Societies Act , 1912.

• The registrar shall audit or cause to be audited by some person authorized by him, the accounts of every registered society at least once a year.
• The audit under shall include an examination of overdue debts , if any, and a valuation of assts and liabilities of the society.
• The registrar, the collector or any person authorized shall at all the times have access to all the books , accounts, papers and securities of a society, and every officer of the society shall furnish such information in regard to the transactions and working of the society as the person making such inspection may require.

REGISTRAR means a person appointed to perform the duties of registrar of co-operative societies under this act.

The following points are required to be kept in mind in connection with the audit of co-operative society:

• Qualification of auditor: Apart from the chartered Accountant within the meaning of the Chartered Accountancy Act, 1949, some of the state co-operative Acts have permitted persons holding a government diploma in co-operative accounts or in co-operation and accountancy and also a person who has served as an auditor in the co-operative department of government to act as an auditor.
• Appointment of the auditor: An auditor of co-operative society is appointed by the registrar of co-operative societies and the auditor so appointed conducts the audit in behalf of registrar and also submits his audit report to him as well as to the society.
• Books, Accounts and other records of co: operative societies-under section 43(h) of the Act . a state government can frame rules prescribing the books and accounts to be kept by a co-operative society.

Special features of co-operative Audit

The general process of auditing involved in audit work such as checking of posting , ascertainment of arithmetical accuracy ,vouching , verification of assets and liabilities and final scrutiny of balance sheet are well known by everyone. But in case of co-operative society audit certain special features are there to be borne in mind while doing audit of it. These features are as follows:

• Examination of overdue debts: Auditor shall report these overdue debts as for period from 6 months to 5 years and more than 5 years. Furthermore, analysis is done by the auditor in viewpoint of recovery of these debts and these are classified as good debt or bad debts. Now auditor is also liable to checkout whether provision regarding bad debts is provided or not and if provided then that is appropriate or not for current situation of bad debts of the society.
• Overdue interest: Overdue interest should be excluded from interest outstanding and accrued due while calculating profit. In practice an overdue interest reserve is created and the credit of overdue interest credited to interest account is reduced.
• Certification of bad debts: As per the law, bad debts can be written off only when they are being certified by the auditor as bad where the law requires it and if not then managing committee of society must authorize the write-off.
• Valuation of assets and liabilities: They will have to ascertain the existence, ownership and valuation of assets. Fixed assets should be valued at cost less adequate provision for depreciation. The incidental expenses incurred in acquisition and the installation expenses of assets should be properly capitalized. The current assets be valued at cost or market price , whichever is lower. Regarding liabilities, the auditor should see that all the known liabilities are brought into the account, the contingent liabilities are stated by way of a note.
• Adherence to co-operative principles: The auditor will have to ascertain that how far the objective for which the co-operative organization is set up , have been achieved in the course of its working. The assessment is not necessary in terms of profits, but in terms of extension of benefits to its members who have formed it. While auditing the expense, the auditor should see that they are economically incurred and no wastage of funds. The principle of propriety audit should be followed for this purpose.
• Observations of the provisions of the act and rules: The financial implications of the infringements which are pointed out by the co-operative societies Act and rules and bye-laws, should be assessed by the auditor and they should be reported properly.
• Verification of member’s register and examination of their pass books: Examination of the entries in member’s pass books regarding the loan given and its repayment and confirmation of loan balances in person is very much important in co-operative societies to assure that the entries in books of accounts are free from manipulation.
• Special report to registrar: During the course of audit if the auditor notices that there is some serious irregularity then he has report this irregularity to the registrar by drawing his specific attention to the point. The registrar on receipt of such special report may take necessary action against the society.
• Audit classification of the society: After the judgement of an overall society, the auditor has to award a class to the society. This specific class is awarded by the auditor as accordance to the criteria given by the registrar. It is to be noted that if management is not satisfied by the class given by the auditor then they may appeal to the registrar.
• Discussion of draft audit report with managing committee: On conclusion of the audit , they should ask to the secretary of the society to convene managing committee meeting to discuss the audit draft report. The audit report should never be finalized without the discussion with the managing committee.

Form of Audit Report

The form of audit report to be submitted by the auditor, as prescribed in various states , contains a number of matters which the auditor has to state or comment upon. In addition to the report the auditor has to attach schedules to the report regarding the following Information:

• All transactions which appears to be contrary to the provisions of the Act , the rules and bye-laws of the society.
• All sums which ought to have been, but have not been brought into account by the society.
• Any material, or property belonging to society which appears to the auditor to be bad or doubtful of recovery.
• Any material, or property belonging to society which appears to the auditor to be bad or doubtful of recovery.
• Any material irregularity or impropriety in expenditure or in the realization or monies due to society.
• Any other matters specified by the registrar in this behalf.

The Insurance auditors shall examine policy and liability procedures, risk valuation, tax documents, and various other financial records of insurance. It is to ensure that proper insurance rates and premiums are implemented and regulators laws are being followed by insurance companies. Claims and commissions are also the core areas to verify during the course of insurance audits. In addition to these responsibilities, insurance auditors might be expected to maintain quality control between insurance companies and policyholders.

An Indian insurance company is formed and registered under the Companies Act, 2013 and the aggregate holdings of equity shares by a foreign company, either by itself or through its subsidiary companies or its nominees, do not exceed twenty-six per cent of the paid-up equity capital of such Indian insurance company. The sole objects of the Indian Insurance Company shall be to carry on life insurance business or general insurance business or re-insurance business. The said definition is according to section 2 of Insurance Act 1938.

The Insurance Audit & Role of Insurance Auditors

As per Section 12 of the Insurance Act, 1938, the financial statements of every insurer are required to be audited annually by an auditor. According to IRDA Act, 1999, every insurer, in respect of insurance business transacted by him and in respect of his shareholders ‘funds, should prepare, a Balance Sheet, a Profit and Loss Account, a separate Account of Receipts and Payments and a Revenue Account in accordance with the regulations made by the IRDA at the end of each financial year.

The central and branch auditors of an insurance company are appointed at the annual general meeting of the company and the approval of the C & AG required before the appointment is made. With the latest amendment to the Insurance Act, 1938 and the Companies Act, 2013, Authority (IRDAI) has issued the revised guidelines that Insurers shall comply with the provisions relating to appointment of Auditors as contained in the Companies Act, 2013. Additionally, insurers shall also comply with the provisions contained in such guidelines. Further the recommendation of the Audit Committee, the Board shall appoint the statutory auditors, subject to the shareholders’ approval at the general meeting of an Indian insurance company. The branch auditors is appointed to conduct the audit of the divisions have the same rights and obligations under the statute as those of the, statutory auditors to whom they are expected to submit their report. However the branch auditors at division level certified the Trial balance of the division duly incorporated the financial statements of the branches under divisions.

An insurer cannot remove its statutory auditor without the prior approval of the Authority. An audit firm cannot accept the audits of more than three insurers (Life/Nonlife/Health /Reinsurer) at a time. The appointment can be cancelled if found that the appointment of auditors by insurers is not in line with the guidelines.

Four Important Audit Points in Insurance Company Profit & Loss Account

1. Verification of Premium

The premium collections are credited to a separate bank account and no withdrawals are normally permitted from that account for meeting the general expenditure. As per the policy of the insurance company, the collections are transferred to the Regional Office or Head Office. No Risk shall be assumed by the insurer without receipt of premium according to section 64VB of the Insurance Act, 1938. Verification of premium is of utmost importance to an auditor because Insurance premium is collected upon issuing policies. It is the consideration for bearing the risk by the insurance company. The auditor should apply the following procedures: –

• Before commencing verification of premium income, the auditor should look into the internal controls and compliance which are laid down for collection and recording of the premiums.
• Cover notes should be serially numbered
• The auditor should check whether Premium Registers have been maintained chronologically, giving full particulars including GST charged as per acceptance advice on a day -to-day basis.
• The auditor should verify whether the figures of premium mentioned in the register tally with those in General Ledger.
• The auditor should verify whether instalments falling due on or before the balance sheet date, whether received or not, have been accounted for as premium income as for the year under audit.

2. Verification of Claims

The auditor should obtain from the divisions/branches, the information for each class of business. The auditor should determine the total number of documents to be checked giving due importance to claim provisions of higher value. The claims under policies comprise the claims paid for losses incurred, and those estimated or anticipated claims pending settlements under the policies. Settlement cost of claims includes surveyor fee, legal expenses, etc. The Claim Account is debited with all the payments including repair charges, fire fighting expenses, police report fees, survey fees, amount decreed by the Courts, travel expenses, photograph charges, etc. The auditor should-

• Check whether provision has been made for all unsettled claims.
• Check whether provision has been made for only such claims for which the company is legally liable.
• Check whether provision made is normally not in excess of the amount insured.
• Check in case of co-insurance arrangements, the company has made provisions only in respect of its own share of anticipated liability.
• Check claimed paid should be duly sanctioned by the authority concerned

3. Verification of Commission

The remuneration of an agent is paid by way of commission which is calculated by applying a percentage to the premium collected by him. Commission is payable to the agents for the business procured and is debited to Commission on Direct Business Account. An insurance business is solicited by insurance agents. The auditor should verify-

• Voucher disbursement entries with reference to the disbursement vouchers with copies of commission bills and commission statements.
• Check whether the vouchers are authorized by the officers- in –charge as per rules and income tax is deducted at source, as applicable.
• Test check correctness of amounts of commission allowed.
• To check whether commission outgo for the period under audit been duly accounted or not.

4. Verification of Operating Expenses

All the administrative expenses in an insurance company are broadly classified under 13 heads as mentioned in Schedule IV. The auditor should check-

• Expenses in excess of Rs.5 Lakhs or 1% of net premium, whichever is higher, should be shown separately.
  
• Expenses not directly relating to insurance business should be shown separately for example, expenses relating to investment department, bank charges etc.

Professional ethics refers to the professionally accepted standards of personal and business behavior, values, and guiding principles.

It encompasses the personal, organizational, and corporate standards of behavior expected of professionals.

Professionals and those working in acknowledged professions, exercise specialist knowledge, and skill.

How the use of this knowledge should be governed when providing a service to the public can be considered a moral issue and is termed professional ethics.

Professionals are capable of making judgments, applying their skills, and reaching informed decisions in situations that the general public cannot because they have not received the relevant training.

Codes of professional ethics are often established by professional organizations to help guide members in performing their job functions according to sound and consistent ethical principles.

Objectives of Professional Ethics

Professional accountants play an important role in building up the economic well­being of their community and country with their attitude, behavior, and unique services.

They have common objectives, whether they work in capacities of external auditors, internal auditors, financial experts, tax experts, and management accountants.

Their common objectives are to perform their duties and responsibilities and to attain the highest levels of performance by the ethical requirements generally to meet the public interest and maintain the reputation of the accounting profession.

Personal self-interest must not prevail over these duties. The IFAC and ICAEW Codes of Ethics help accountants to meet these obligations by setting out ethical guidance to be followed.

To achieve these objectives, they have to establish creditability, professionalism, quality of service, and confidence.

Acting in the public interest involves having regard to the legitimate interests of clients, government, financial institutions, employees, investors, the business and financial community, and others who rely upon the objectivity and integrity of the accounting profession to support the dignity and orderly functioning of commerce.

In summary, then, the key reason accountants need to have an ethical code is that people rely on them and their expertise. It is important to note that this reliance extends beyond clients to the general community.

Accountants deal with a range of issues on behalf of clients. They often have access to confidential and sensitive information.

Auditors claim to give an independent view. It is, therefore, critical that accountants are independent.

Compliance with a shared set of ethical guidelines gives protection to accountants as well, as they cannot be accused of behaving differently from other accountants.

Codes of Professional Ethics

Here we will describe the two well-known codes of professional ethics;

• IFAC code of ethics for professional accountants,
• AICPA code of professional conduct.

IFAC Code of Ethics for Professional Accountants

A distinguishing mark of the accountancy profession is its acceptance of the responsibility to act in the public interest.

In acting in the public interest, a professional accountant should observe and comply with the ethical requirements of this Code.

A professional accountant is required to comply with the following fundamental principles:

1. Integrity

A professional accountant should be straightforward and honest in all professional and business relationships.

2. Objectivity

A professional accountant should not allow bias, conflict of interest or undue influence of others to override professional or business judgments.

3. Professional Competence and Due Care

A professional accountant has a continuing duty to maintain professional knowledge and skill at the level required to ensure that a client or employer receives competent professional service based on current developments in practice, legislation, and techniques.

Professional accountants should act diligently and by applicable technical and professional standards when providing professional services.

4. Confidentiality

A professional accountant should respect the confidentiality of information acquired as a result of professional and business relationships and should not disclose any such information to third parties without proper and specific authority unless there is a legal or professional right or duty to disclose.

Confidential information acquired as a result of professional and business relationships should not be used for the personal advantage of the professional accountant or third parties.

5. Professional Behavior

A professional accountant should comply with relevant laws and regulations and should avoid any action that discredits the profession.

Cost accounting is the accounting method for ensuring cost-effectiveness by accumulating, organising, recording, calculating, analysing and assessing the overall expenses incurred on a product, process or project, etc. It is mostly used in industrial units or factories where the goods are manufactured.

Unlike financial accounting, cost accounting is a broader perspective to review and control the performance of the industries by the management. To know more about the different types of expenses incurred in operating a business, one must be aware of the cost classification.

Qualification of an Auditor

According to law, no specific qualification is recommended for the auditor in case of the proprietary concern, but in the case of the companies, the following qualification is must:

• A chartered accountant, having a certificate of practice from the institute of chartered accountants of India.
• A person, having an authentication in “Part B” stating that he designated to act as an auditor.

Qualities of a Company Auditor

1. Sovereignty

He should not aide his intuition to the will of his clients or any other person and should keep himself free from any sympathy allegedly and prepare financial statement of the management in an impartial way.

2. Honesty

He should always maintain sincerity while operating his duties.

3. Conversation skills

In the course of managing an audit, the auditor has to collaborate with numerous officers and parties; thus, he should have excellent communication skill.

4. Maintain confidentiality

The auditor should maintain the privacy of the accounts unless authorized by the client or enforced by the law.

5. Expertise

The auditor must have an awareness about the client’s business and the current economic direction, etc. Consciousness about the laws like taxation laws, companies act, partnership act.

6. Sensitivity

The auditor has to deal with different persons while performing his duties; he has to handle his sub-ordinates as well as clients; thus, he should have the tact to handle them in any situations.

7. Coherent skills

The auditor must have the ability to analyze and illustrate the problems so that he can appropriately handle them when faced.

Responsibilities of an Auditor

• Examination: Interrogation of the accounting system and internal control is must to safeguard their suitability.
• Checking of books: The books of accounts should be checked thoroughly to ensure its arithmetical accuracy.
• Documentation: Investigating documentary pieces of evidence to reinforce the books of accounts.
• Full incorporation: Analyzing whether all entries have been recorded in the books of accounts or not while preparing the financial statement.
• Conventionality: Examining that the books of accounts or financial statement should not contain any fraudulent or faulty entry.
• Authentication of assets and liabilities: Verification of assets and liabilities for checking their existence, valuation, completeness and disclosure in financial statements.
• Statutory Consent: In case of audit of general insurance companies, bank the auditor, secure compliance of financial statements with the compatible decree.
• Disclosure: Auditor examines whether the data in the financial statement acknowledged adequately or not.
• Facts and integrity: Auditor ensure whether financial statement as a whole serves accurate and fair view of profit/loss, assets and liabilities in the appropriate forms.

Duties of an Auditor

Duties of Company Auditor

Duty under Section 227: It is otherwise known as the duty to give report. After completion of audit work, the auditor should give a report expressing his opinion. The report may be long or summarized. It may be in the form of a letter or statement. Whatever the form may be, it must be addressed to shareholders. And its report may be with condition or without condition. An unconditional report is called a clean report and a conditional report is called a qualified report.

The audit report should include the following:

• Whether the company is maintaining proper books and records or not.
• Whether financial explanations from company staff are received or not.
• Whether financial statements are prepared in accordance with the requirements of companies act or not.
• Whether the balance sheet is giving a true and fair view or not.
• Whether profit and loss account is giving a true and fair view or not.
• If there are branches, whether statements from branch auditors under Sec. 228 are properly received or not.

Duties of Company Auditor: The Companies Act, 1956

• Section 227: Duty to give report.
• Section 165: Duty to certify statutory report.
• Section 240: Duty to assist government inspector.
• Section 58 (A) and 58 (B): Duty with regard to public deposits.
• Section 62 and 63: Duty to certify prospectus.
• Section 227 (1A): Duty to conduct an inquiry with regard to matters mention in the section.

The new regime of Companies Act 2013 has changed the requirement for appointment of the auditor in Companies. There has been a paradigm shift in the provisions relating to appointment of Statutory Auditor. This article broadly covers the provisional requirement for appointment of the auditor under Companies Act, 2013. The responsibility of evaluating the validity and reliability of financial statements is to the auditors.

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 giving a clean and clear picture of the business. Hence, the need to appoint Statutory Auditor arises.

Appointment of First Auditor of of Company Auditor under Companies Act, 2013

As per section 139(6) the first auditor of the company other than a government company shall be appointed by the Board within 30 days of Incorporation. In case of Board’s failure, an EGM shall be called within 90 days to appoint the first auditor. The law is silent regarding from when this time limit of 90 days be reckoned, it is better to take a stricter view and interpret that the 90 days limit starts from Incorporation rather than expiry of 30 days.

In case of Government Companies the first auditor shall be appointed by the Comptroller and Auditor-General of India within sixty days from the date of registration of the company and in case the Comptroller and Auditor-General of India does not appoint such auditor within the said period, the Board of Directors of the company shall appoint such auditor within the next thirty days; and in the case of failure of the Board to appoint such auditor within the next thirty days, it shall inform the members of the company who shall appoint such auditor within the sixty days at an extraordinary general meeting

The first auditor shall hold office till the conclusion of 1st Annual General Meeting.

Appointment of Subsequent Auditor of Company Auditor under Companies Act, 2013

Every company shall, at the first annual general meeting, appoint an individual or a firm as an auditor who shall hold office from the conclusion of that meeting till the conclusion of its sixth annual general meeting and thereafter till the conclusion of every sixth meeting.

Tenure of Auditors appointed under Companies Act, 2013

The following class of Companies shall not appoint or reappoint:

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

(b) An audit firm as auditor for more than two terms of five consecutive years:

The class of companies shall mean the following classes of companies excluding one person companies and small companies:

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

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

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

Purpose for the appointment of the Auditor

The purpose of the auditors in the company is to protect the interests of the shareholders. The auditor is obligated by law to examine the accounts maintained by the directors and inform them of the true financial position of the company. Auditor gives his independent opinion to the owners or shareholders of the company to protect and keep the company in a safe financial condition.

Appointment Of Auditor Other Than Retiring Auditor By A Special Notice

Where a person other than the retiring auditor is proposed to be appointed as an auditor, or where it is proposed that the retiring auditor shall not be re-appointed, a special notice under Section 115 of the companies Act, 2013 has to be given proposing that such a resolution would be moved at the next annual general meeting.

In case where the retiring auditor has completed a consecutive tenure of five years or, as the case may be – ten years then such special notice can be avoided.

For the purpose of special notice the relevant points are as under:

If the auditor makes a representation in writing to the company and requests for a notification to the members, the company shall

• State the fact of representation in any notice regarding the resolution
• The copy of representation should be sent to those members by the company to whom notice of meeting is sent, whether before or after the receipt of representation.
• If the copy of representation is not so sent, copy thereof should be filed with the Registrar.

(ii) On receipt of the special notice for removing the auditor, the company should send a copy of the same to the retiring auditor.

(iii) Such representation should be of a reasonable length and not too long.

(iv) The special notice should not be received by the company too late for the purpose of circulation to members.

Auditor may require the company to read out the representation in the meeting if it is not so notified to members because it was too late or because of company’s default.

If the Tribunal is satisfied that the rights are being abused by the auditor based on an application either of the company or of any other aggrieved person, then:

• The copy of the representation may not be sent, and
• The representation need not be read out at the meeting.

Contingent liabilities are liabilities that may be incurred by an entity depending on the outcome of an uncertain future event such as the outcome of a pending lawsuit. These liabilities are not recorded in a company’s accounts and shown in the balance sheet when both probable and reasonably estimable as ‘contingency’ or ‘worst case’ financial outcome. A footnote to the balance sheet may describe the nature and extent of the contingent liabilities. The likelihood of loss is described as probable, reasonably possible, or remote. The ability to estimate a loss is described as known, reasonably estimable, or not reasonably estimable. It may or may not occur.

Before understanding contingent liabilities, one must learn about what is considered as a liability in the accounting and economic context. A liability is any financial event that poses as an obligation to a company, and the company needs to make a monetary settlement regarding it in the future. In other words, it refers to the financial obligations of a company.

These events need to be quantified into monetary terms to be recorded in the books of a company.

Majorly, liabilities are categorised into three subtypes i.e non-current liabilities, current liabilities, and contingent liabilities. A contingent liability is thus a type of financial event that might or might not evolve into an obligation in the future for the company. As per the definition provided by General Accepted Accounting Standards (GAAP), a contingent liability is any potential future expense that depends on a “triggering event” to convert it into an actual loss. A contingent liabilities example is a lawsuit.

As the concept of contingent liability borders on vagueness and considerations regarding which event is recognisable as a potential expense are unclear, there are two yardsticks to follow when dealing with a contingent liability:

• Whether an event is 50% or more likely to occur in the future.
• Whether it can be expressed in monetary figures.

If any contingency satisfies these two yardsticks, such an event can be posted in the books. A contingent liability is recorded first as an expense in the Profit & Loss Account and then on the liabilities side in the Balance sheet.

Types of Contingent Liabilities

Contingent liabilities are classified based on the scale of their probability, i.e. likeliness of an event occurring in the future. These types are mentioned below.

1. Probable contingency

Any financial obligation that has at least 50% chance of occurring in the future is considered a probable contingency, and the loss thus to be realised is considered as a probable contingent liability.

For instance, if a company faces a lawsuit where the plaintiff poses a strong case, then such an event can be considered as a probable contingency. A professional such as a legal counsel will assess the weight of a lawsuit, derive its probability, and if chances of a loss are 50% or higher then express the loss in monetary terms. Following that, it shall be recorded in the books of the company.

Here, it is essential to note why a contingency is recorded in the books even when there is only a 50% chance of a liability arising. It is because, in accountancy, law of conservatism is followed which states the principle that loss is always impending and thus, shall be recorded at a 50% or higher probability of occurrence; whereas profits are unlikely and hence, recording them in the books shall be withheld till profit realisation, or chances are more likely than a loss.

2. Possible contingency

A possible contingency is when a liability might or might not arise, but chances of its occurrence are less likely than that of a probable contingency, i.e. lower than 50%. Therefore, a possible contingency is usually not recorded in the books, but rather mentioned in the footnotes.

Another reason behind why a possible contingency is not recorded in the books is because it cannot be expressed in monetary terms due to its limited likeliness of occurrence. As mentioned earlier, any contingency that does not satisfy the two yardsticks shall not be recorded in the books of a company.

3. Remote contingency

As the name suggests, any liability that has minimal chances of occurring and is not possible under normal circumstances is known as a remote contingency. As chances of such contingencies translating to losses for the company are negligible, they are not recorded in the books or mentioned in footnotes.

How to Recognise a Contingent Liability?

Contingent liability has a broad definition, and it is challenging for companies to either rule out or include a contingent liability in their books.

Hence, it is always advisable that companies shall consult professionals who are reasonably adept in the subject matter. This way, companies abide by the rules of GAAP and also possess a substantial argument when being audited.

For instance, if a company faces litigation, it shall consult a lawyer and rely upon his/her discretion regarding inclusion or exclusion of a liability in the books.

Like, if as per precedent and the discretion of a lawyer, a case’s outcome is deemed as ambiguous, then such contingency shall only be mentioned in the footnotes. In this manner, companies shall navigate the vagaries of contingent liabilities.

How Does Contingent Liability Affect Investors?

When a company can recognise in time the possibility of a loss, it then has the opportunity to set up provisions against such losses, thus attempting to attenuate the impact of such future loss. However, that is not the motive behind the recording of a contingency as a liability in the books.

Rather, when a contingent liability is recorded in the books of a company, that information becomes available to the shareholders and auditors as well. Hence, it can be construed that registering a contingent liability is to safeguard shareholders against probable losses.

Even though cases such as lawsuits can be closely followed by shareholders of a company, information regarding warranty, which is also a form of a contingent liability, is not easily accessible by shareholders.

Therefore, to safeguard investors’ interests, probable contingent liabilities (chances of occurrence of at least 50%) of all kinds shall be recorded in a company’s books. It allows individuals to make sound investment decisions.