CA Misconduct-Non reporting book entry stocks debtors sales and accounts manipulation which was statutory requirement

CA Misconduct-Non reporting book entry stocks debtors sales and  accounts manipulation. Reporting modus operandi of bogus transactions was statutory requirement-High Court

CA Misconduct-Non reporting book entry

ABCAUS Case Law Citation:
ABCAUS 1120 (2017) (02) HC

Brief Facts of the Case:
The Council of the Institute of Chartered Accountants of India (ICAI) received a complaint from State Bank of India (“the bank”) against the respondent chartered accountant being incharge of the Statutory audit of a company (“the company”). It was alleged that the respondent CA while carrying out the audit the company had committed various acts of commission and omission and action needs to be taken against the CA for professional misconduct.

Various financial institutions including SBI (in a consortium) had sanctioned and granted various capital facilities to the company. As per terms of the sanction it was incumbent upon the company to ensure that drawings on the account were covered by the advance value of the stock hypothecated to the bank.

It was noticed that with effect from 1988-89 the increase in stock of the company was much higher than the profits generated and the same observation was made in respect of the sister concern of the company with effect from the year 1992-93.

The consortium directed to carry out a special audit of the stock of the company. Special audit report made starting revelations regarding financial irregularities by the company; fraud and breach of trust by its Directors. The report also highlighted serious irregularities committed by the statutory auditors in discharge of their statutory duties. When confronted,  the chairman of the company confessed that the accounts for the years in question did not correctly reflect the financial position of the company, that its books were manipulated and had submitted a rework financial statement.

The findings of the Disciplinary Committee (DC) were that the main allegations against the company were with respect to overstatement/under-statement of the stocks, debtors, inflation of sales and manipulation of accounts and that the auditor failed to comment on the same, which in turn established that the auditor was in connivance with the management of the company to defraud the bank and the public.

The DC further noted that the Bank failed to produce copies of the monthly stock statement and debtor’s statements submitted by the company. Since the company was under liquidation, the Bank also failed to obtain copies of the ledger’s account, cash book etc. from the official liquidator. It was also noted that as per the terms and conditions on which the working capital facility was sanctioned, the condition of submitting stock statement at the close of each fortnight, were not examined by the Bank.

On the other hand the respondent CA contended that he was not supposed to look  into the statements and his role was to certify the balance sheet only.

The DC observed that the respondent CA was the statutory auditor of the company since its inception and audited the last balance sheet. Further, the respondent was the statutory auditor of the sister concern. Therefore the respondent CA should have had an understanding of the design of the accountant and the internal control system of the company.

As per the balance sheets of the company in the notes to the accounts, the method of valuation of Inventory was showed as Weighted Average Cost Method, whereas in Schedule 7 – Inventories, it was stated that inventories are valued at cost or market value whichever is less. Both disclosures were contrary to each other. However, DC did not took cognizance of the same since the method of valuation of inventory, albeit wrong, was consistently followed by the company.

However the committee highlighted that classification of the inventory ought to have been disclosed in the notes to the accounts. The committee further noted that there were huge payments from the company PCL on behalf of its sister concern but no disclosure of the same was made by the auditor in the report. Further, there were suspicious adjustment entries between the company and its sister concern which ought to have raised a doubt about the genuineness of the transactions and ought to have been detected and reported

The DC observed that the modus operandi which was adopted by the company and its sister concern was booking sales of a software reportedly developed by the company to an outsider party which in turn would be passed on to sister concern as purchaser which again would be supplied to the company as sales. The loop got repeated many times but there was no cash flow while the sales and stock/receivables kept on increasing. It was also observed that the dividends were not paid out of the generated funds but out the borrowed funds.

The committee observed that the respondent as Statutory Auditors of the Company for all those years was unable to assess the modus operandi of these transactions which were in the nature of book entry only even though the same was a statutory requirement within the meaning of Section 227(1A)(b) of the Companies Act, 1956 which makes it incumbent on the Auditor to enquire whether such type of transactions have in fact taken place and if so, whether they are prejudicial to the interest of the Company.

The committee observed that the respondent as the auditor of the company failed to check and report the unusual transaction in his audit reports for all these years under question. Also the perusal of the audit reports for all those years, disclosed that the respondent also did not comments about the internal control procedures of the Company. The respondent did not apply the necessary checks which was expected of an auditor in the circumstances which were prevalent at that time and did not carry out the comprehensive checks about the actual funds having been received by the Company and about the profits whether they were actually in existence or not.

The DC also noted that as per the AAS-4 together with AAS-3, there is a requirement of documentation and the auditor should document fraud risk factors identified as being present during the auditor’s assessment process and document the auditor’s response to any such factors. The auditor must document important matters in providing evidence to support the audit opinion and the working papers must include the auditor’s reasoning on all significant matters which require the auditor’s judgment, together with the auditor’s conclusion thereon.

When the DC insisted the respondent to produce the working papers so as to show whether he had followed the necessary checks while carrying out his audit, the respondent submitted that he was not in possession of working papers any more since he has surrendered the Certificate of Practice. The respondent on the other hand insisted upon the Committee to call for the books of accounts and other papers of the Company from the Bank.

DC noted that, even in the absence of these documents, there were sufficient papers on record to show that the respondent CA had not been able to diligently carry out his role as the auditor of the company for all the years under question.

The Committee noted that from the circumstances which were in existence at the time of audit and the manner in which the loop of transactions had been carried out by the Company along with the other companies revealed that the respondent ought to have applied his professional skepticism and should not have accepted these transactions as genuine. Moreover, in view of the committee, the manner in which the transactions were booked in the books of accounts of the Company ought to have raised an alarm that the financial statements were suspected to have material misstatements which as a prudent auditor, the respondent did not try to assess and accordingly failed in his duties to carry out the audit in a diligent manner and in other words helped the management to defraud the bank and public at large of the funds which they had invested in the company.

Observations made by the High Court:
The Hon’ble High Court noted the following facts highlighted by the DC:

  1. The modus operandi adopted by the company and its sister concern to form a loop with no cash flow but increase in sales, stocks and receivables viz-a-viz the obligation of the auditor concerning transactions which are merely book entries i.e. the duty of the auditor to enquire whether the transactions were prejudicial to the interest of the company
  2. As an auditor it was the obligation of the respondent to comment about the internal control procedures of the company.
  3. AAS-3 and AAS-4, spells out the obligations of the auditor to be discharged in the course of the audit.
  4. The auditor are under duty to maintain the working papers and documents and in spite of repeatedly directed, the respondent did not produce the papers and took the plea that he had surrendered the certificate of practice, therefore he was not keeping the past record.

The Hon’ble Court opined that the least which was expected from the respondent CA was to have filed a counter affidavit dealing with indictments but he had chosen not to file any counter affidavit.

In view of the above, the Hon’ble High Court held the respondent chartered accountant as guilty of committing professional misconduct falling within clauses 5, 6, 7 and 8 of Part 1 of the 2nd Schedule to the Chartered Accountants Act, 1949.  The Court accepted the recommendation of the Council for penalty of removal of the name of the respondent CA from the register of members for a period of 5 years.

CA Misconduct-Non reporting book entry

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