Financial statements attain sanctity when they are attested by an auditor. Auditors, in turn should exercise certain precautions before lending their names to the financial statements lest they are held liable for negligence. Certain heads are not capable of being cross-checked and the risk attached to such lines such as travelling, etc., is less than those of others where a cross-check can be made even by an outsider. Upon completion of substantive procedures, the auditor would do well to ponder over certain aspects.

The following are some areas where caution is to be exercised

Capital vs revenue: There are several case laws deciding whether a particular expenditure or income is to be treated as revenue or capital. Error of judgment results in distorting the true and fair view. The auditor should document the reasons for treating a particular expenditure as capital or as revenue.

Write off of bad debts: The auditor should require of the management to explain the circumstances under which the debts are written off as bad. The normal course is that a provision is to be made when there exists a suspicion about recovery of these debts.

The auditor should seek conclusive proof that the entity has exhausted all the recourses open to it before writing it off. S 227(1A) requires the auditor to ensure that all the transactions are properly made and are not prejudicial to the interests of the company or of the shareholders.

Interest on loans: Interest on loans bears a relation to the loans outstanding. The auditor would do well to seek the confirmation from the lenders before accepting the value of interest as true. When the loans are being serviced, the interest component also should come down correspondingly.

Overdue interest on secured loans is better disclosed alongside the loan rather than as a current liability as in the case of secured debentures. The reason is that the lenders exercise their lien on the security not only for the principal, but for interest also.

Share application Money: The company does not get any right on the share application money until the allotment is made. Law requires these funds to be kept deposited in a separate bank account till the shares are allotted. Therefore, share application money cannot be considered as part of shareholders funds until the shares have been allotted. Such amounts are to be included under the head ‘Current liabilities'. No doubt, such inclusion might distort the current ratio. This can always be explained to the reader by way of a specific note.

Such ratio may be calculated both including and excluding the value of share application money for abundant clarity. An alternative way of carrying such amounts would be by way of unsecured loans in case they are carried longer than one financial statement, though not justifiable.

In case of public issues, the Securities and Exchange Board of India regulates the time frame within which allotment is to be made. Inan unlisted company or the promoters pumping in funds, it would do good to allot the shares and carry them as share capital instead of retaining them as share application money. This would boost the paid-up capital and improve the debt-equity ratio substantially.

Current liabilities and provisions: Expenditure such as sales tax, salaries, rents, electricity charges, PF and ESI payments, etc for the month ended on the date of balance sheet are made in the subsequent financial period. At the year-end, the statements should contain appropriate entries for all these expenses. The entity would have paid such items by the time audit is completed. It would be a simple matter for the auditor to ensure provisions are made for such items.The auditor should exercise caution on the disclosure of such provisions in the financial statements.

Deferred tax liabilities: Accounting Standard requires that the deferred tax liabilities are disclosed on the financial statements. The auditor should and scrutinise the workings of such deferments. This item is to be cross-checked by the auditor with the tax computations.

Capital works in progress: The auditor should insist on corroborating evidence for capital works in progress. The value cannot be the same over a period of time unless the work is suspended. It is very rare that no further expenditure is incurred on capital works in progress during the year under review.

Either capital work in progress should continue to be so or be converted into fixed asset. Once it is converted into fixed assets, the auditor should seek a management representation to that effect and consider the applicability of depreciation on such fixed assets. Seeking the services of an expert to value the work in progress would be justified.

Expenditure and income during construction period: Guidance note on expenditure during construction period has been withdrawn after the Accounting Standard on intangible Assets (AS 26) was issued. Whether an item of expenditure should be added to the cost of a specific asset or not needs careful assessment and judgment on the part of the auditor.

Since the entity is at a project stage, the income if any generated (by way of interest on fixed deposits for example) cannot be taken to revenue.

Pre-paid and outstanding expenditure:

Basic accounting assumption of accrual gives rise to expenditure being treated as pre-paid or as outstanding. Only those expenses which accrue (on a time basis) can be classified as pre-paid or outstanding. But there are certain expenses which arise. These have to be charged off to the revenue statement the moment they are paid.

Retirement benefits:The entity should disclose in the financial statements, the provisions made for the retirement benefits to employees. Provision for gratuity, pensions, medical benefits, etc should be properly evaluated by an actuary and properly disclosed on the face of the financial statements. If this is not done by the entity, it amounts to non-compliance with the Accounting Standard 15 and calls for a qualification in the audit report.

(The author is a Hyderabad-based chartered accountant.)

(This article was published on May 1, 2011)
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