TMI Blog1985 (10) TMI 250X X X X Extracts X X X X X X X X Extracts X X X X ..... The financial year of the plaintiffs is from September 1, to August 31. Defendant No. 1 is a partnership firm of chartered accountants and is carrying on business for last over 85 years and has acquired reputation all over the country. Defendants Nos. 2 to 13 were the partners of defendant No. 1 at the relevant time. Defendant No. 1 was appointed as auditors of the plaintiffs right from the year 1960. Defendant No. 1 was also attending to the income-tax assessment of the plaintiff company. The defendants audited the accounts of the plaintiffs for the year ended August 31, 1974, and the audit work was over by about October, 1974, and defendant No. 1 forwarded the long-form report to the plaintiffs, and the copy thereof to the holding company in the United States of America. The audit showed steep increase in sales and gross profit, taxes payable and net profits compared to the relevant figures for the previous year. The corresponding figures were as follows : Figures submitted for the year ended 31-8-1973 Figures submitted for the year ended 31-8-1974 Rs. Rs. Sales 1,10,33,512 1,85,02,761 Gross ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... he months of June, July and August, 1975. Mr. Grundy, in his turn, communicated the fact to Mr. Richard L. Parish who was also one of directors of the plaintiffs and residing at New York and who was also a director of the holding company. The disclosure by Singaravelu created a stir and Mr. Parish directed Mr. Wheaton to proceed to Bombay to ascertain the magnitude of fraud committed by the staff of the plaintiff company. At the same time, Mr. Parish also advised defendant No. 1 on October 6, 1975, to undertake confidential investigative audit to ascertain the true nature of the transactions alleged to have been effected by the plaintiffs. Defendant No. 1 was informed that there was reason to believe that finished goods were shipped to various godowns in Bombay in order to avoid their being recorded in the year in the inventories and consequently being treated as sold in the financial year. Mr. Wheaton arrived in Bombay on October 10, 1975, and immediately proceeded to the factory of the plaintiffs situate at Mahul, Chembur, and noticed that finished goods were indeed removed to the private godowns and erroneous record was prepared to show increase in sales in the last three months ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... spection notes indicated that after the goods had been inspected, the relevant number of cases were stamped or stencilled with certain identification markings. The inspection, therefore, revealed that though the goods were delivered to the customer subsequent to August 31, 1974, the sales were shown in the earlier financial year with a view to boost the profits. There were several other irregularities noted by defendant No. 1 while undertaking the investigative audit for the financial year 1974-75 and, accordingly, a detailed report was submitted by defendant No. 1 to the plaintiffs on April 20, 1976. During the investigative audit, it came to notice that the accounts were manipulated by K. Shankar Hedge with the active co-operation of heads of various departments of the company. K. Shankar Hegde was working with the plaintiffs since its inception, that is the year 1960, and in January, 1972, was appointed as wholetime director. Hegde was then appointed as managing director on January 21, 1975, but tendered his resignation on October 17, 1975, when manipulations of the accounts came to light and Hegde could not give satisfactory explanation to Mr. Wheaton and Mr. Parish, the two ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... and for the year ended August 3, 1974 ; ( v ) whether there was any change in the prices of prime raw material; ( vi ) whether there was any improvement/deterioration in the usage of material; ( vii ) whether the plaintiffs had got new customers and/or there was any change in the terms of credit to customers ; and ( viii ) whether the production for the year was adequate to support the volume of sale and closing stock for the year. The plaintiffs claim that the defendants were guilty of negligence and breach of their duty as auditors, as the audit work was carried out by ignoring the accepted principles of auditing and certification of the same. The plaintiffs' claim that the defendants failed to obtain relevant information and explanation for the inflated production, sales and profits, this being achieved by manipulation of accounts. The plaintiffs' complain that the defendants did not inquire or seek explanation for the abnormal increase in the turnover and in the sales and profits and made no efforts to reconcile the final production figures with the store transfer slips. The defendants failed to notice that the sales to the tune of Rs. 55 lakhs were not covered by the producti ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... d were not directly concerned with the day-to-day working but declined to do so in respect of Mr. Parish and Mr. Wheaton. In an appeal preferred before the Division Bench of this court, by a judgment dated March 3, 1981, the relief was granted also in favour of Mr. Parish and Mr. Wheaton. The defendants filed their written statement declared on November 15, 1979, and it was pointed out that defendant No. 4 has retired with effect from October 31, 1978, and is no longer a partner. The defendants asserted that the audit work was carried out in accordance with the well-established practice of accountancy and the allegation of the plaintiffs that the defendants were negligent is totally false. The defendants pleaded that the board of directors of the plaintiffs and the officers of the holding company never doubted the figures which were accepted by the auditors or the explanations which were offered by the staff of the plaintiff company from time to time and the charge of negligence against the defendants is levied only to find a scapegoat to cover the failures of the plaintiffs themselves. The defendants further pleaded that the auditors cannot be held responsible for failure of the ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e of auditing and various steps required to be taken by the auditor in the discharge of his duties. The plaintiffs also examined Mohan Narayan Menon who is a plant manager and who was working with the plaintiffs from the year 1972. The next witness examined by the plaintiffs is Arun Madan Kelkar, the accountant, who was working as accounts assistant from July, 1970, and the last witness is Satish Mahadeo Pradhan, a chartered accountant, attending to the income-tax assessment proceedings of the plaintiff company after the year 1976. On behalf of the defendants, Mr. Kaiki Rustom Alpaiwalla, defendant No. 3, entered the witness box and Mr. Mahindra, who had carried out the audit work for the year 1973-74, under the supervision of Mr. Alpaiwalla, was also examined. Mr. Vasant Raiji, a chartered accountant practising from the year 1945, was examined by the defendants and the witness deposed about the practices followed by the auditors in undertaking audit work. The parties by consent filed compilations containing various documents and in addition some documents were produced during the trial and were duly exhibited. From a perusal of the issues, it is obvious that the principal issue ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ss accounts and these statements were sent to America every month. Kelkar was shown a specimen letter accompanying the profit and loss statement and balance-sheet forwarded to the United States and the letter is dated August 29, 1974, and the copy of which is at page 23 of volume 16 of the compilation of the defendants. The letter was signed by Ramamurthi, the accountant in-charge of the accounts department, and also by K. Shankar Hegde. Kelkar at the relevant time was working as a subordinate of Mr. Ramamurthi. Copy of the letter dated August 31, 1974, at page 10 of volume 16 of the compilation of the defendants, indicates that K. Shankar Hegde had issued instructions that the practice of overtime in the factory should be completely stopped and even a copy of this letter was forwarded to America. At page 5 of volume 16 is a copy of a note dated June 4, 1973, from Singaravelu to Hegde in respect of an inspection carried out by the factory inspector on the previous day. A copy of this note was also forwarded to New York. On page 16 of volume 16 is a copy of the letter dated February 12, 1974, from Mr. Ramamurthi to Mr. Yien stationed at New York, and is in reply to the memo received ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the last week of May and the plaintiffs expect to come back to a healthy cash position. The letter further recites that due to the efforts of the supervisory staff, it is possible to make delivery of the sales effected in the year, and the deliveries which were delayed due to the railway strike would be completed in the months of May and June, 1974, and full collection would be recovered. The second letter dated August 8, 1974, is also from Ramamurthi to Mr. Yien and sets out the cash position for the period August, 1974, to January, 1975. The letter recites that the sales for the month of August, 1974, has been taken at Rs. 25 lakhs, but the actuals may turn out to be much higher if the tempo of working was maintained and report would be made during the first week of September. These three letters unmistakably indicate that the fact that the sales were mounting up in the last three months of the financial year ending with August 31, 1974, was known to the directors of the holding company, even before the year was over. The correspondence to which reference is made hereinabove further indicates that Mr. Parish was conscious that Mr. Hegde was sometimes acting contrary to the settl ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... was that inflated figures of sales and profits were shown in the balance-sheets which were handed over by the management of the plaintiffs to the auditors. Now, it is necessary to set out the modus operandi of the staff of the plaintiffs in manipulating the accounts. The auditors were informed by the officers of the company that booking of sales invoices before the actual date of delivery of the goods was mainly done as indicated hereinbelow subject to variations in the method in some cases : ( A )Sales invoices and delivery challans (referred to as "mother" documents) were initially prepared for the purpose of booking the sales in the books of account and in the company's inventory records. These sales invoices were prepared by the company before the actual date of delivery of the goods in order to record the sales in the books of account. In order to make the booking of these sales appear genuine, the procedure that was evolved was to require the transport carriers to sign these delivery challans. These sales invoices and the pre-numbered delivery challans receipted by the company's transport carriers formed the basis of the accounting entries in the sales journal, debtors' le ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the sales and accounts departments; while in respect of delivery challans, it was stores and accounts departments, and in respect of store transfer slips, it was production and stores departments. The costs record was maintained by production and accounts departments ; while gate passes were in charge of stores and security departments. The system of gate passes was introduced on September 23, 1974, for the first time. It is obvious that all the five main departments of the plaintiff company and the heads of those departments, that is, Banerjee, Singaravelu, Ramamurthi, Sudhir and Satish Kumar, had joined hands in manipulating the accounts and with the full connivance or at the instance of the managing director, Hegde. In this connection, it would not be inappropriate if reference is made to contents of paragraph 3 of the affidavit filed by Mr. Parish in Company Petition No. 308 of 1977. Mr. Parish claims that he considered the heads of various departments and Hegde as guilty of a conspiracy to falsify the books and records. Mr. Parish told the conspirators that he would fire the whole lot, but for the fact that the business could not be run without the people they had trained for ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... of accounts with verification by reference to witnesses and vouchers". Audit is concerned with the verification of accounting data, with determining the accuracy and reliability of accounting statements and reports. Auditing primarily involves testing the reliability, competency and adequacy of evidence in support of monetary transactions. The main objective of the company audit is to conduct an independent review of the financial statements and offer an opinion about their reliability in representing the organisation's financial condition and working results. The main function of the auditor is to ascertain whether the financial statements fairly represent the actual financial position and the working results of an organisation. The International Auditing Guideline No. 1 published in January, 1980, prescribes that while the auditor is responsible for forming and expressing his opinion on the financial statements, the responsibility for their preparation is that of the management of the entity. The management's responsibilities include the maintenance of adequate accounting records and internal controls, the selection and application of accounting policies, and the safeguarding ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... regularities ; and (3)In the absence of clear evidence to the contrary, what has held true in the past for the enterprise under examination will hold true in the future. On page 110, the authors state that in view of the limitations of audit evidence in the establishment of incontrovertible truth and the influence of time and other conditions under which an auditor works, truth in auditing may be defined as conformity with reality as the auditor can determine reality at the time of his examination and with the evidence available. Mr. Ronald Irish in his book " Practical Auditing" states that an audit may be said to be a skill and examination of such books, accounts and vouchers as will enable the auditor to verify the balance-sheets. The main objectives of audit are : ( a ) to certify the correctness of the financial position as shown in the balance-sheet and accompanying statements; ( b ) detection of error, and ( c ) detection of fraud. The author states that detection of fraud is generally regarded as being of primary importance. Section 227 of the Companies Act defines the powers and duties of auditors and sub-section (2) prescribes that the auditor shall make a report t ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ffer as to the nature and timing. An accounting system can be defined as a series of tasks in an entity by which transactions are processed as a means of maintaining financial records, and such a system should recognise, calculate, classify, post, summarise and report transactions. The system of internal control is the plan of organisation and all the methods and procedures adopted by the management to assist in achieving the management's objective of ensuring the orderly and efficient conduct of the business. An effective internal control system provides for the communication of the delegation of authority and the scope of responsibilities. It should be so designed as to preclude an individual from overriding the control system and should provide for segregation of incompatible functions. Of course, the proper function of any system depends upon the competence and honesty of those operating it, and the auditor should review the accounting system and related internal controls to gain an understanding of the flow of transactions and make a preliminary evaluation and identification of those internal controls on which it might be effective and efficient to rely in conducting the audit ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... skill which is usual in the profession and calling. Justice McNair in his address to the jury reported in Bolam v. Friern Hospital Management Committee [1957] 2 All ER 118, referred to the statement of law contained in a Scottish case dealing with negligence of a medicial practitioner with approval and the statement reads as under : "In the realm of diagnosis and treatment, there is ample scope for genuine difference of opinion, and one man clearly is not negligent merely because his conclusion differs from that of other professional men, nor because he has displayed less skill or knowledge than others would have shown. The true test for establishing negligence in diagnosis or treatment on the part of a doctor is whether he has been proved to be guilty of such failure as no doctor of ordinary skill would be guilty of if acting with ordinary care." The test is the standard of the ordinary skilled man exercising and professing to have that special skill, but one need not possesss the highest expertise or skill at the risk of being found negligent. It is well established that it is sufficient if one exercises the ordinary skill of an ordinary competent man exercising that par ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ed at the Bar, dealing with the subject of liabilities of auditors. The earliest decision is reported in [1895] 2 Ch 673 ( London and General Bank, In re ( No. 2 ) . In this case, an auditor presented a confidential report to the directors calling their attention to the insufficiency of the securities on which the capital of the company was invested, and the difficulty of realizing them, but in his report to the shareholders merely stated that the value of the assets was dependent on realization, and in the result the shareholders were deceived as to the condition of the company, and a dividend was declared out of capital and not out of income. Subsequently, a petition was presented for winding up of the company and the auditor was held guilty of misfeasance under section 10 of the Companies (Winding-up) Act, 1890, and was liable to make good the amount of the dividend paid. In an appeal, Lord Justice Lindley observed (at pages 682-683): "It is no part of an auditor's duty to give advice, either to directors or shareholders, as to what they ought to do.......His business is to ascertain and state the true financial position of the company at the time of the audit, and his du ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... usted by every one who knew him, and observed that it is not sufficient to say that the frauds must have been detected if the entries in the books had been put together in a way which never occurred to any one before suspicion was aroused. Lord Justice Lopes, in a concurring judgment, observed (at page 288): "But in determining whether any misfeasance or breach of duty has been committed, it is essential to consider what the duties of an auditor are. They are very fully described in In re London and General Bank [1895] 2 Ch 673 to which judgment I was a party. Shortly they may be stated 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 reasonably competent, careful and cautious auditor would use. What is reasonable skill, care and caution must depend on the particular circumstances of each case. An auditor is not bound to be a detective, or, as was said, to approach his work with suspicion or with a foregone conclusion that there is something wrong. He is a watch-dog, but not a bloodhound. He is justified in believing tried servants of the company in whom confidence is placed by the company. He is entitled to ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... he first importance to remember that, in an action against the auditor, one is looking into facts which have been subjected to the scrutiny and have been explained by the ability of the accountants who have come in to look at all the books, and not only the documents which were presented to the auditors at the time of the original audit. It is the duty of the court to endeavour to ascertain what was the problem presented to the auditors, and what was the knowledge available to them at the time of audit. It is not fair to consider the case with hindsight and hold that the auditors were negligent in discharge of their duties. The court must bear in mind the facts available at the time of alleged negligence by the auditors, and it is not fair to determine the fact of negligence by taking into consideration what has come to light after true scrutiny carried out in the special audit. The next decision is of the Supreme Court of Canada and reported in [1941] SCR of Canada 164 ( Guardian Insurance Co. of Canada v. F. W. Sharp ), which approves the earlier decisions of the English Court. Mr. Cooper, learned counsel appearing on behalf of the plaintiffs, submitted that though the prin ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... in Bevan v. Webb [1901] 2 Ch 59, that 'permission to a man to do an act, which he cannot do effectually without the help of an agent, carries with it the right to employ an agent.' So also with an auditor who is employed for the purpose of checking the royalties payable. It is part of his duty to use reasonable care to see that none have been omitted which ought to be included. He is not bound to accept the ipse dixit of the licensee that there are no other articles which attract royalty. He is entitled to check the accuracy of that assertion by inquiring the nature of any other articles which, it appears to him, may come within the patented field. If he cannot be sure, of his own knowledge, whether they attract royalty or not, he can take the advice of a patent agent, just as, within the legal sphere, he can take the advice of a lawyer." Reliance is also placed on the decision of Justice Pennycuick reported in [1968] 1 Ch 455 ( In re Thomas Gerrard and Son Ltd. ) , where the managing director of a company falsified the company's books by three methods : ( i ) causing half-yearly stock valuation to be inflated; ( ii ) causing the price payable on purchases of stock made at ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e summary of the account correctly reflects the account of the company, and whether the balance-sheet and profit and loss account gives a true and fair view of the state of affairs of the company. Mr. Cooper submits that the obligation has been augmented by the requirements of the Companies Act and the amendment of the Schedule in the year 1973. The real thrust, says Mr. Cooper, is not on adding, subtracting and multiplication but on verification by reference to the books, vouchers, papers and by also asking questions to witnesses wherever necessary for the purposes of such verification. It was also claimed that whilst originally it was felt that detection of fraud was a very remote incident of auditing, today, the possibility of fraud is considered, at least by some writers, to be the main objective of such verification. It is undoubtedly true that the complexity of corporate business, interlinking various sister corporations and other changes in modern times, makes the possibility of fraud or error larger and the deception can also be of a varied nature. It is also undoubtedly true that an auditor should not merely rely upon the oral explanation furnished by the management, but b ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... etermining the question of reasonable care and skill is whether the auditor was justified in relying upon the statements of the director or the managing director, and that again must depend on the circumstances of each case and on the nature of the subject-matter which requires explanation. Whether the subject is one which is not capable of direct verification and when to verify properly the result presented in the balance-sheet, it would require investigation rather than checking and where there is nothing at all to excite suspicion and in relying upon the statement of the management, the auditor himself is deceived, then he will not be held to have failed in the discharge of his duties. In judging whether an auditor exercises reasonable care and skill, it would not be appropriate to proceed on matters which have subsequently transpired, but one must place oneself in the position of the auditor as when the accounts were audited and find out how the matters appeared or ought to have appeared to a man of reasonable care and skill. Bearing in mind these principles, it would now be appropriate to ascertain whether the defendants were guilty of negligence or have failed to discharge ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 3-74. The major alterations were : ( i ) to reduce the scope of checking from cent per cent, to one month in each quarter ; and ( ii ) the introduction of in-depth checks or selective verification. The plaintiffs complain that the defendants followed erroneous procedure by resorting to the selective verification for the financial year 1973-74, and the departure from the earlier practice of checking of all transactions was uncalled for. It is not possible to accept the contention of the plaintiffs on this count. In paragraph 1.5 of the Statement on Auditing Practices published by the Institute of Chartered Accountants of India in the year 1968, it is observed: "It is now generally accepted that in the case of business where an adequate system of internal control is in force, the auditor is entitled to apply appropriate test checks. This statement does not attempt to prescribe either the maximum or the minimum amount of work to be performed in an audit. The facts and circumstances of each case have to be taken into account in deciding upon the extent of the checking to be done." The plaintiffs examined Mr. Krishnan as an expert to depose about the practices followed by audito ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s in which people are expected to perform and report in the normal fashion and this is an important facet of the system. Mr. Alpaiwalla stated in paragraph 5 of his evidence that internal control system followed by the plaintiffs was one introduced by the holding company in America for all its subsidiaries. Mr. Alpaiwalla further deposed that there was dual control on each function and the plaintiffs were regularly reporting each and every aspect of the matter to the parent company. The expression "dual control", says Mr. Alpaiwalla, implies that every function of the company would pass through the hands of at least two officers of two different departments. Mr. Mahindra in paragraph 3 of his evidence deposed that a departure was made from the earlier practice and the system of selective verification was introduced as he found that the internal control system was functioning smoothly. In my judgment, in view of the evidence of Mr. Krishnan and Mr. Raiji, well supported by the Statement on Auditing Practices, that the system of selective verification is well recognised in audit procedure and in view of the evidence of Mr. Alpaiwalla and Mr. Mahindra that the internal control syste ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e attention of Mr. Krishnan was also invited to International Auditing Guidelines No. 6, published in July, 1981, on the subject of "Study and Evaluation of the Accounting System and related Internal Control in connection with an audit", and Mr. Krishnan had to concede that even these guidelines do not demand that the auditor should check the procedure from the beginning to the end in respect of the production. The attention of the witness was also invited to Chapter VII on page 142 of R. J. Anderson's The External Audit, volume I, and Mr. Krishnan conceded that there is no specific reference in the Chapter or any other part of the book to the requirement of the auditor to check the procedure from the beginning to the end. Mr. Raiji, on the other hand, in paragraph 5 of his evidence stated that it is outside the ambit of the auditor's work to check specimen production from beginning to end and the auditor is really concerned with examining the financial account. In cross-examination, Mr. Raiji stated that it would be dangerous to rely upon some passage in some book written by a foreigner to ascertain duties cast upon the auditors. It must be held that the evidence of Mr. Krishn ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... t is necessary to examine each of these facts to determine whether any one of the circumstances was so suspicious as to raise an apprehension in the mind of the auditors that there may be certain frauds in the affairs of the company. The first circumstance pointed out is that the plaintiffs had decided to issue to the public equity shares of the face value of Rs. 10 each at a premium of Rs. 7.50 per share with a view to dilute the foreign equity holding and with a view to comply with the Foreign Exchange Regulation Act, 1973. Reliance was placed on paragraph 11 of the International Auditing Guideline No. 4, published in February, 1981, which, inter alia , prescribes that the auditor, while developing his overall plan for the expected scope and conduct of the audit should consider conditions requiring special attention, such as the possibility of material error or fraud or the involvement of related parties. Paragraph 11 of International Auditing Guideline No. 11 published in October, 1982, recites that in planning and performing his examination, the auditor should take into consideration the risk of material misstatement of the financial information caused by fraud or error. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... investors were obsessed with the purchase of shares of a foreign company. In my judgment, this circumstance could not have made the auditors suspicious about the maintenance of the accounts of the relevant financial year. The next circumstance relied upon is the high increase in sales of the company's products in the last quarter of the financial year 1973-74. Mahindra admitted in paragraph 53 of his evidence that he did notice during the regular audit that there was unusual rise in sales in the last two months of the relevant year. The witness claimed that he could not recollect whether the audit team reported to him that 51 per cent, of the total sales of the relevant year were effected in the last three months of the year. Mr. Mahindra deposed in paragraph 15 of his evidence that on calculation, the quantity increase in sales during the relevant year compared to the previous year was in the region of 21% to 10%. Mr. Setalvad, learned counsel appearing on behalf of the defendants, did not dispute that 51% of the total sales were effected in the last three months of the relevant year, but submitted that mere increase in sales during the closing months of the financial year canno ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... nt, it is nothing but a hindsight to suggest that the auditor should have suspected some irregularity after noticing heavy sales in the last quarter of the relevant year 1973-74. A reference was made to A Guide to Company Audit, published in the year 1982, and it was contended that one of the points set out at page 22 of this booklet is whether the auditor paid any particular attention to sales recorded at the close of the accounting year to ascertain that they are genuine. The submission is that this is one of the requirements which the auditor must attend to and the failure to do so amounts to negligence. It is not possible to accept the submission as this guide was published for the first time in the year 1980 and was not available to the auditors during the audit of the relevant year. In my judgment, the circumstance that there was increase in sales in the last quarter of the relevant year could not have rung a bell of suspicion in the mind of the auditors. In this connection, Mr. Setalvad placed strong reliance upon the decision of the Division Bench of this court reported in [1983] 54 Comp. Cas. 197 ( Richard Laurence Parish ( Jr. ) v. Registrar of Companies ) in a ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ement on Auditing Practices, published in 1968, recites : "The figures for the previous year should not only be disclosed but should serve as a guide to the general scrutiny of the current year's item. Comparisons with previous year's figures are very important. A proper scrutiny of comparative figures would indicate important changes in the business of the company. Not only should each item appearing in the profit and loss account be compared with that of the previous year, but important ratios like the gross profit to sales ratio must also be compared. Enquiries may be made into the reason for any material change in the ratios, or for ratios remaining constant where it is believed that there should have been a change. Clients should be asked to explain on each expenditure schedule any material variations from last year's figures and also the major reasons for any material changes in the gross profit ratio (with figures if possible)". International Auditing Guideline No. 12, published in July, 1983, also prescribes that the auditor should obtain analysis of significant ratios and trends including the resulting investigation of unusual fluctuations and items. Paragraph 15 of ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... that is an abnormal variation ; and it was necessary to ascertain the cause of this percentage rise to find out whether the sale prices have gone up or the value of the raw material had decreased. Mr. Krishnan stated that he would consider whether the fluctuation in sale prices or purchase prices of raw material would justify the variation of the gross profit ratio. According to Mr. Krishnan, to ascertain the effect of increase in the sale price, he would compare the average price in the earlier financial year with the prices prevailing in the current year and number of units sold and then would determine the quantum of increase and conclude whether the rise in gross profit ratio was because of increase of sale price. Mr. Raiji in paragraph 10 of his evidence stated that in a case where an auditor finds an abnormal rise in the ratio of gross profits to sales, then the auditor should find out the reasons for the same, and the auditor should seek explanation from the management and satisfy himself that the explanation is reasonable. Mr. Raiji further stated that the satisfaction would depend upon the assessment of the auditor about the working of the company and the credibility of t ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ge increase in the profits of the company by comparison with the profits of the earlier year, he advised his staff to prepare a working of the gross profit ratio for the two years, and to find out the reasons for the increase. On realising that the increase was substantial, Mahindra advised his senior in-charge Mr. Rajadhyaksha to inquire from the plaintiffs the reason for the same. Mr. Rajadhyaksha made the inquiry and reported to Mahindra that it was mainly on account of substantial increase in the selling price of the finished goods. Mahindra then instructed Rajadhyaksha to verify the explanation given by checking the invoices and the price lists and Rajadhyaksha on verification confirmed the accuracy of the explanation. Mahindra claimed that he made the endorsement on the note thereafter and he had kept his superior Mr. Alpaiwalla posted with this development. Mahindra was cross-examined at length on this aspect and deposed in paragraph 29 of his evidence that he took steps to check the sharp increase in the percentage of gross profit by verification of the price list and the relevant sales invoices and also the average cost of purchase of raw material. The work was not carried ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... that rise in gross profit ratio was not inconsistent with what was revealed in the account books of the plaintiffs and, therefore, there was no occasion for the defendants to suspect that something was wrong in the affairs of the company. Learned counsel relied upon the fact that there was sharp increase in price by reference to exhibit 4, which was the price list of the relevant year and which undoubtedly shows that the prices were rising. The accounts maintained by the plaintiffs also clearly indicated that there was a sharp rise in sales effected in the relevant year. If this was the situation existing at the relevant time, then it cannot be concluded that the circumstance of rise of profit ratio should have raised suspicion in the mind of the auditors. Both Mahindra and Alpaiwalla noticed the rise in the gross profit ratio and did contact the managing director, Hegde, to give explanation. There was no reason to discard the explanation offered by Hegde, who was in charge of the management of the plaintiffs and was working with the plaintiffs right from the inception of the company in the year 1960. It is true that the material which has come to light subsequent to the investiga ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... sequent receipts, etc . It is not in dispute that the auditors selected 20 invoices in respect of transactions effected in the month of August, 1974. It is required to be stated at this juncture that during the investigative audit undertaken by the defendants in October, 1975, 35 suspected transactions were noticed in respect of the last three months of the financial year, that is, June, July and August, 1974, and out of which 29 transactions were effected in the month of August, 1974. It must be made very clear that it is not the claim that the transactions were fictitious or unreal, but what was done was that the transactions which were really effected in the next financial year were ante-dated to show high sales and profits in the year ending with August 31, 1974. Out of the 20 invoices of August, 1974, checked by the auditors, 9 invoices formed part of the 35 suspected bills noticed by the auditors during the investigative audit. With this background, it is now necessary to consider the contention that the auditors were in error in selecting 20 invoices only and that too out of the invoices prepared in the month of August, 1974. Mr. Krishnan in paragraph 7 of his evidence de ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... aintiffs the highest sales were efected in the last three months of the financial year, the plaintiffs could have no complaint if 20 invoices were selected from the month of August, 1974, for in-depth checking. The expression "in-depth check" has been described by the witness as "from cradle to grave" and means that the transaction should be checked exhaustively right from the inception to the end. The next ground of challenge to the work of auditors is that the delivery challans in respect of 20 invoices checked were not receipted by the customers. Kelkar in paragraph 4 of his evidence deposed about the system of delivery challans adopted by the plaintiffs, and prevalant in the relevant year. Kelkar deposed that after receipt of the order from the customer, the sales department used to enter the order in the company's form known as "sales order form". The stores department thereafter prepared a challan for despatch of goods to the customer and the challan was prepared in quadruplicate. The copies of the challan were of different colours ; white, yellow, pink and green. The white, yellow and green copies were forwarded to the customers or their agents along with the goods, and th ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... hile closely examining substantial items in the sales register, it is necessary to look into the sale vouchers, invoices and mode of transport, etc . The witness further deposed that he would call for the railway receipts in order to ensure that the goods are in fact despatched by train, and the railway receipt must indicate that it was drawn in favour of the customer and that the goods were despatched within the financial year. Mr. Krishnan stated that the production of delivery challans receipted by the lorry driver employed by the company would not be sufficient proof to establish delivery to the customer. The witness stated that he would make several inquiries by probing into the correspondence, by writing to the customer and by other modes to ascertain whether the goods have been delivered to the customer, and whether payment has been received, and in case he is not satisfied, he would make a point in that regard while submitting the audit report. In cross-examination, Mr. Krishnan stated that in support of the claim that the auditor should satisfy that the goods sold are in fact received by the customer, he placed reliance upon the contents on page 80 of B. N. Tandon's Prac ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ed. Mr. Cooper contended that during the investigative audit, Mr. Mahindra prepared a note in regard to checking of the delivery challans and the following endorsement in the hands of Mahindra speaks volumes: "No query was raised regarding the non-receipt of delivery challans why?" Learned counsel urged that if Mr. Mahindra was careful and not negligent during the regular audit, the deficiency which was noticed at the time of investigative audit would not have escaped and would have been seen and examined. It was contended that Mahindra had no explanation why such query was not raised at the time of original audit. Mr. Setalvad, on the other hand, urged that it was not necessary to suspect the delivery challans receipted by M/s. Sonavane Transport Service because M/s. Sonavane Transport Service was not in the employment of the plaintiffs but was an outside agent appointed by the plaintiffs. Learned counsel pointed out that M/s. Sonavane Transport Service had tendered bills for transport of various goods from the factory of the plaintiffs and the copies of the bills which are at pages 75 to 79 of Volume 'C' of the compilation of the plaintiffs, show quantities of various goods han ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... of the internal control system. It must be remembered that the auditors even in an in-depth check could not have started with the presumption that something was irregular in the working of the company, and not only the staff and the managing director, but even an outside agent, like M/s. Sonavane Transport Service, were out to manipulate the accounts. It is necessary in this connection to make reference to one of the submissions urged by Mr. Setalvad claiming that the property in goods stands transferred to the customer as soon as the company handed over the goods for delivery to M/s. Sonavane Transport Service. Learned counsel relied upon sections 4, 23(2) and 39 of the Sale of Goods Act, 1930, in support of the submission. In my judgment, the submission is not correct. Sub-section (2) of section 23 merely prescribes that where the seller delivers the goods to the buyer or to a carrier or other bailee for the purpose of transmission to the buyer, and does not reserve the right of disposal, then it would be deemed to have unconditionally appropriated the goods to the contract. Sub-section (2) of section 39 prescribes that unless otherwise authorised by the buyer, the seller shal ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ing. It is true that Mahindra did not personally carry out the in-depth checking but the explanation that in case a delivery challan is noticed during in-depth checking as not being receipted, then that explanation would be sought from other documents cannot be ruled out. In the present case, the other documents in the shape of store cards, sales journal and customers ledger corroborate the delivery challans and the mere fact that three delivery challans were not receipted could not have led any reasonable auditor to come to the conclusion that there was something suspicious about the dealings of the plaintiffs. The submission of Mr. Cooper that Mahindra during the investigative audit noticed that the explanation was necessary for non-receipted delivery challans but that fact, could have been noticed during the regular audit and the failure to do so amounts to negligence cannot be accepted, because even though that fact was noticed during the regular audit, the auditing team would not have suspected any foul play in view of the other documents. In my judgment, the auditors could not be held to have been negligent in the in-depth check in respect of 20 delivery challans. The next ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... book the order. If this material was available to the auditors at the time of the regular audit, then it is difficult to accept the submission of Mr. Cooper that the fact that invoices were prepared without written orders should have aroused the suspicion of the auditors while carrying out the in-depth check. The next contention urged by Mr. Cooper is that the auditors failed to scrutinise three invoices which were marked as "pre-paid", but in respect of which the amounts were not received till completion of audit work. Mr. Cooper submitted that the in-depth check demands that the auditors should be satisfied to the hilt that each and every transaction selected for examination is genuine in every respect and it is wholly immaterial whether the amount due under the invoice is petty or large. The three invoices with the endorsement "pre-paid" are invoice No. 954/73 of National Organic Chemical Industries Ltd., invoice No. 944/73 of Rallis India Limited, and invoice No. 961/73 of Hindustan Petroleum Corporation. All these invoices were prepared by the plaintiffs on August 29, 1974. The amounts due under these three invoices are Rs. 16,037.39, Rs. 15,978.60 and Rs. 23,363.03, respe ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... by the plaintiffs. The only grievance is that the sales were predated with a view to inflate the figure of sales and profits of the relevant year. Mahindra admitted that he was not familiar with the procedure of sales to the Directorate General of Supplies and Disposals at the time of the original audit, and he could not state whether his audit team was familiar with that procedure. Mahindra admitted that he became aware of the procedure of sales to the Directorate General of Supplies and Disposals only during the investigative audit, and a note was prepared in that connection by his assistant. The note is at page 73 of volume 4 of the compilation of the defendants, and sets out that the plaintiff company writes to the Directorate General of Supplies and Disposals offering the goods for inspection, and thereafter the customer deputes a representative to inspect the goods. The representative of the customer draws random samples and the samples are tested and thereafter the particulars of quantities accepted are entered in the inspection certificate, which is part of the inspection note prepared by the representative. The inspection note along with the other documents is forwarded t ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... pared on June 29, and July 30, 1974, respectively. The delivery challans are signed by M/s. Sonavane Transport Service. Each of these transactions was of a value of over Rs. 4 lakhs and though the date in respect of these transactions was circularised, no confirmatory letter was received from the customer. Mahindra admitted in his evidence that item 11 in the audit programme requires checking of various journals. The witness further stated in paragraph 25 of his evidence that during the review carried out by him as part of the audit work, he examined the account of Myanma Oil Corporation. Mahindra admitted that on most occasions, the payment in respect of export transactions would be by letter of credit and the payment would be received within 10 to 15 days on presentation of the bill of lading fey the bankers. Mahindra deposed that he did not inquire why payment was not received and whether the bill of lading was presented. In cross-examination, Mahindra admitted that page 63 of exhibit "H", which is the sales journal for the year 1973-74, pertains to export transactions. The witness admitted that under the audit programme, full checking of posting from sales journal to general le ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... itor's duties and functions and, inter alia , prescribes that since the additional information in terms of the new requirement of Schedule VII would be the integral parts of the profit and loss account and the balance-sheet, it would be covered by the normal statutory affirmations in the auditor's report rather than by any separate certification of such information by the auditor. It further recites that the test of the responsibility of the auditor with reference to the additional information is precisely the same as the test of responsibility with reference to the company's accounts taken as a whole. In other words, the auditor must perform his duties diligently and honestly with reasonable care and skill and without any negligence. Reading the contents of this paragraph, it is obvious that the submission of Mr. Setalvad that the auditor is not required to certify the information demanded by Schedule VI, item 4D( e ), of the Companies Act is erroneous and cannot be accepted. Even though the submission is not acceptable, that would not lead to the conclusion that the auditors were negligent in the discharge of their duties for not ascertaining the receipt of payments in respect o ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e failure to ascertain whether the foreign exchange in respect of export sales in fact accrued in the relevant financial year. The next complaint is in respect of improper procedure adopted by the auditors in regard to confirmation of debts. Mr. Krishnan deposed in paragraph 18 of his evidence that it is customary to ascertain the confirmation of debtors' balances at the end of the financial year and normally the auditors make queries with the debtors but in some cases, the company of its own, sends letters to the debtors prior to closing of the accounting year. Mr. Krishnan claims that where the inquiry is made directly by the company about the existence of the debt, then it is necessary for the auditor to further inquire whether such debts continue to remain in existence till the end of the accounting year. Mr. Krishnan further stated that it is necessary for the auditor to ascertain whether any further debts are created between the dates mentioned in the confirmation of the queries and the end of the accounting year. Mr. Krishnan suggested that it is desirable to apply the Roll Forward Method, if there are high value items shown in the column of "debts" which are due for a per ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... bt confirms whether the staff of the company had misappropriated any amount and manoeuvred the account. According to Mr. Raiji, normally the auditor fixes up a date which is earlier than the date of closing of the year for confirmation of the debts as that would enable the auditor to receive back the letters before the dead-line for completion of the audit work. The response to the enquiries would depend upon the nature of the customer and the products supplied to him. Mr. Raiji then stated that it is not necessary for the auditor to take any steps for ascertaining the debts in interregnum unless the auditor suspects some irregularities. In the present case, the auditors had selected July 31, 1974, as the date for confirmation of debts. The debt was circularised and the confirmation letters were sent to the customers by the company under the supervision of the auditors. The confirmation letters were sent to 97.3 per cent, of the total debtors and confirmation was received from 31.9% of the debtors. Mr. Alpaiwalla in paragraph 31 of his evidence admitted that they had applied the Roll Forward Method to ascertain the realisation of debts subsequent to August 31, 1974, and for such as ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... r, Steel Containers Ltd., which was run by Balmer Lawrie Co. Ltd. The copy of the confirmatory letter is at page 8 of volume 4 of the. compilation of the defendants and the customer confirmed the indebtedness by letter dated September 13, 1974, addressed to defendant No. 1. The letter recites that the customer had received the attached statement from the plaintiffs for confirmation of balance of Rs. 13,17,920.70 due as on July 31, 1974. The letter confirms that the balance due is Rs. 13,16,606.40 only according to the accounts of the customer. Now, this confirmation raises several issues. According to the plaintiffs, the delivery of the goods was made to the customer only in the months of October and November, 1974, and the bogus invoice and delivery challans were prepared to pre-date the sales, and if this contention is correct, then it is difficult to believe how the customer acknowledged the indebtedness as on July 31, 1974, on the basis that the goods have been received. It indicates that either the record produced by the plaintiffs during the investigative audit is fabricated or the customer, Steel Containers Ltd. and Balmer Lawrie Co. Ltd. are also hand-in-glove with the ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... of the audit team. Mr. Cooper then submitted that the auditors checked posting of calculations to summary but did not bother to further check whether the entries are posted in general ledger. Learned counsel urged that it was the practice of the auditors to put a tick when an entry in a particular ledger is checked and there are no tick marks in the general ledger to indicate that posting of entries from calculations to summary in exhibit "E" and thereafter in the general ledger was checked. Learned counsel further submitted that the tick mark indicating checking of the entries would be crossed if the entry is further posted in other accounts and checked by the auditors. Mr. Cooper pointed out that there are no tick marks on raw materials, finished goods and sales control account and that indicates that the auditors did not carry out the audit programme by examining the entries in this account. In this connection, Mahindra in paragraph 51 of his evidence expressed his inability to state that what is the significance of the tick marks and its crossing out. Mahindra had to concede that there are no tick marks in respect of raw materials, finished goods and sales control account. Re ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... lteration during the investigative audit could well be accepted as Mr. Parish in the affidavit filed in the proceedings under section 633 of the Companies Act in this court has stated in unmistakable terms that Ramamurthi, the officer-in-charge of the accounts, had admitted before him that he had falsified auditor's initials and markings. Taking all these circumstances into consideration, it is difficult to hold that the auditors did not carry out the audit programme at the time of regular audit. It is necessary in this connection to make a reference to exhibit "C" which is a "material usage variance account". Serious arguments were advanced by Mr. Setalvad claiming that this document was substituted by the plaintiffs at the later stage and a false claim is made that this account was not checked by the auditors at the time of regular audit. The account as produced by the plaintiffs reads as under: Date 1973-74 Particulars Vr. No. Folio Debit Credit Rs. p. Rs. p. Sep. 30 OJE 1 26,237.02 12,982.18 Oct. 31 2 34, ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ed in the accounts section and the entries in the register are made at the end of every month. In cross-examination, in paragraph 25 of the evidence, Kelkar stated that the entries in exhibit "C" are in the handwriting of Ramamurthi and it is Ramamurthi who had written both entries which were scored out and rewritten. Kelkar denied that exhibit "C" was not shown to the auditors at the time of regular audit, but admitted that he had not personally shown exhibit "C" to the defendants. Mahindra in paragraph 8 of his evidence stated that exhibit "C" was never shown at the time of the original audit and his claim was based on the ground that posting ticks of the auditors are not made on the entries and also because the final figure in this account does not tally with the figure which was written in the long form report to the board of directors. The third reason furnished by Mahindra is that the break-up stated in paragraph 6( c ) of long form report is not seen in exhibit "C". It must be stated at once that in paragraph 46 of the evidence in cross-examination, Mahindra gave up the third reason furnished. The two reasons furnished by Mr. Mahindra about absence of tick marks and the fina ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ained thereby contravening section 209(1) of the Companies Act. This involves penalty under section 209(5). That the company's books and records, especially with relation to sales and production, were not properly maintained clearly appears from the special investigative report of Messrs. A. F. Ferguson Co. and was brought to the attention of members additionally by note 1.7 to the 197-1-75 accounts at page 33 of the printed booklet." The relevant portion of the inquires made by the Registrar and the reply given by the plaintiffs are at pages 81 and 111, respectively, of volume 12 of the compilation of the defendants. In this connection, it must also be remembered that the plaintiffs were unable to explain whether exhibit "C" was substituted or whether exhibit "C" was in existence initially and was tampered with subsequent to the date of regular audit. This aspect is important, because the document exhibit "C" is coming from the custody of the plaintiffs and it is necessary for the plaintiffs to explain how exhibit "C" came into existence. It is futile for Mr. Cooper to express his inability to point out as to whether exhibit "C" was tampered with and if so at what stage. It is ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ned to heed that advice after taking an opinion from the senior counsel of this court. Mr. Alpaiwalla further deposed that after receipt of the advice of the counsel, Mr. Yien told him that the decision to extend investigative audit for the financial year 1973-74 would have serious repercussions. There is hardly any cross-examination of Alpaiwalla on this count and I do not see any reason to discard the statement of Alpaiwalla in this connection. This circumstance clearly establishes that Mr. Parish and Mr. Yien and probably the holding company, who were fully aware of the affairs of the plaintiff company were reluctant to allow the auditors to make detailed investigation about the financial accounts of the year 1973-74 for the reasons best known to them. It seems that as a hind-sight and with a view to find some scape-goat for their own defaults, the plaintiffs have instituted the present suit against the auditors. In my judgment, it is not possible to hold that the manipulation of accounts could not have been detected by Mr. Parish and Mr. Yien when the holding company had absolute control over every action of the plaintiffs, and the holding company was kept posted of each transa ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... es Nos. 3 and 6. These issues deal with the damages alleged to have been suffered by the plaintiffs because of the failure of the defendants to properly carry out the audit work for the financial year 1973 - 74 . In paragraph 12 of the plaint, it is claimed that following the publication of the report prepared by the defendants, the credibility, prestige and goodwill of the plaintiffs suffered a severe setback and the price of the plaintiffs' shares of face value of Rs. 10 each had fallen steeply and was quoted at Rs. 7.25 per share in the market. In paragraph 22 of the plaint, the plaintiffs have set out the break-up of their claim in respect of damages. At the outset, it must be pointed out that the plaintiffs did not lead any evidence in respect of the claim for excess sales tax paid and loss of excise rebate, which are items ( iii ) and ( iv ) in paragraph 22. Mr. Cooper, with his usual fairness, conceded that the plaintiffs are not even pressing the claims under these items. As regards the claim in item ( v ) for the loss of reputation, goodwill, dislocation of business and extra expenditure incurred as a result thereof, the plaintiffs have claimed an amount of Rs. 25 lakhs ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... t have been included as profits for the relevant year, and, therefore, the plaintiffs were over-assessed. The Appellate Assistant Commissioner was requested to direct the Income-tax Officer to reduce the business income by Rs. 44,94,449. By an order dated August 11, 1976, the Appellate Assistant Commissioner declined permission to raise the additional grounds. The plaintiffs thereupon preferred appeals to the Tribunal which was numbered as ITA No. 2009 and 2010 (BOM)/1976-77. The Tribunal, by order dated September 30, 1977, allowed the appeal holding that the additional grounds should be permitted to be raised by the Appellate Assistant Commissioner and remitted the matter back to the appellate authority for disposal on merits. Against the order of the Tribunal, the Revenue sought a reference to the High Court and the Tribunal referred the matter on April 27, 1978, and the said reference is still pending hearing. On December 8, 1982, the plaintiffs addressed a letter to the Commissioner of Income-tax, Bombay City (V), making a proposal for settlement of the dispute. The plaintiffs agreed to give up the additional grounds raised in the appeal and conceded the point of taxability o ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ages for a period prior to the date of the suit. The plaintiffs would be entitled to interest only after the quantum of damages are ascertained at the hearing of the suit. In view of my finding that the defendants were not negligent in the discharge of their duties, the question of ascertainment of damages really does not arise, but even if I would have held that the defendants were negligent, still the amount of damages would have been merely token or minimum. Accordingly, my findings on issues Nos. 3 and 6 are in the negative. Issue No. 2 : Mr. Setalvad did not dispute the accuracy of the figures set out in paragraph 11 of the plaint, and, therefore, the answer to this issue is in the affirmative. Issue No. 7 : This issue does not survive in view of my findings on other issues. Before parting with the case, I must place on record my appreciation of the excellent assistance received from counsel on both the sides and the fair manner in which the respective views were presented. But for the able assistance rendered by both counsel and their assistants, it would not have been possible to conclude the hearing of this suit in 19 days. Accordingly, the suit is dismissed wit ..... X X X X Extracts X X X X X X X X Extracts X X X X
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