TaxTMI 
TaxTMI 
1985 (10) TMI 250
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....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 profit 24,48,563 82,42,226 Income-tax 11,38,807 44,45,557 Surtax 34,091 9....
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....aintiffs 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. Mr. Wheaton carried out the inspection in the presence of K. Shankar Hegde who was the managing director at the relevant time. During the investigativ....
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....ngs. 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 American directors of the holding company as well as the plaintiff company. Ultimately, on April 27, 1976, the plaintiffs filed a private criminal complaint....
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.... 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 production records and there was no corresponding consumption of raw materials for the sales/production appearing in the accounts. According to the plaintiffs, as a result of the neg....
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....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 plaintiffs to detect the fraud committed by their managing director, K. Shankar Hegde, and other officers and the staff. The defendants denied that the plaintiffs suffered any set-back in their credibility, prestige or goodwill and ....
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.... 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 required to be determined is whether the defendants failed and neglected to carry out their audit in accordance with the accepted principles of accounting and whether such failure or neglect has caused damages to the plaintiffs. Before consideration of this issue, it is necessar....
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.... 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 from America in respect of the expenditure of gasoline for the month of November, 1973, and processing charges paid to Gannon Dunkerley in 1974. These letters and the note unmistakably establish that the holding company was exercising absolute control over the functioning of the....
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....ilway 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 settled practice of the company and instructions were given to ensure that the plaintiff company does not depart from settled principles. This correspondence coupled with the evidence of Kelkar establishes that the information supplied by the plaintiffs to the holding company was extensiv....
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....nformed 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' ledger, finished goods car-dex and finished goods ledgers. (B)When the finished goods relating to the sales invoices booked before the actual date of delivery of the goods were actually sold/delivered to customers on subsequent dates, the procedure adopted was : (i)in cases where the delive....
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....ores 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 many years. Mr. Parish further claimed that each one of the conspirators admitted his part in the complicity and Mr. Ramamurthi agreed to work with the investigative auditors. Mr. Parish stated that Ramamurthi showed to the auditors in his presence a number of entries made while the 1974 audit was being car....
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....pport 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 of the assets of the entity. The audit of the financial statements does not relieve the management of its responsibilities. The auditor assesses the reliability and sufficiency of the information contained in the underlying accounting records and other source data by making a study and evaluation of accounting s....
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....me 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 to the members of the company on the accounts examined by him, and on every balance-sheet and profit and loss account and on every other document declared by the Act to be part of or annexed to the balance-sheet or profit and loss account, which are laid before the company in general meeting, and the report shall state whether in the....
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....l 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. The next stage is known as selective verification or compliance procedure. After being satisfied that the internal controls are adequate and function effectively throughout the period, the auditor selects certain transactions for verification. This procedure is known as "indepth audit". It is now generally accepted that in the case of business....
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....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 particular art. It hardly requires to be stated that burden to prove any action of negligence rests primarily on the plaintiffs, who, to maintain action, must show that he was injured by a negligent act or omission for which the defendant in law is responsible. This was to prove some duty owed by the defendant to the plaintiff, some breach of duty, and an inju....
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....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 duty is confined to that......An auditor, however, is not bound to do more than exercise reasonable care and skill in making inquiries and investigations. He is not an insurer ; he does not guarantee that the books do correctly shew the true position of the company's affairs; he does not even guarantee that his balance-sheet is accurate according to the books of the company. If he....
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....t 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 assume that they are honest, and to rely upon their representations, provided he takes reasonable care. If there is anything calculated to excite suspicion he should probe it to the bottom; but in the absence of anything of that kind he is only bound to be reasonably cautious and careful." The learned judge further observed (at page 290): "The duties of auditors must not be rendered too oner....
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....em 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 principles laid down by the English Court in the later part of the 19th century are sound, such principles are required to be revised as the standards of reasonable care and skill required from the auditors are more exacting in modern times. Learned counsel relied upon the decision of the House of Lords reported in [1958] 1 WLR 45 (Fomento (Sterling Area) Ltd. v. Selsdon Fountain Pen Co. Ltd.), and the part of speech o....
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....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 the end of each half-yearly period to be included in the outgoings of the succeeding period by altering the invoices in a manner immediately apparent to anyone looking at the invoices; and (iii) causing the price payable for sales made after the end of the relevant period to be included in the preceding period. The company's auditors obtained the information about the various matters and accepted the explanation of the alterations believing that t....
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...., 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 by indepth checking must ascertain whether there is adequate internal control and whether the affairs of the company are in order. The auditor's duty is internal verification with a watchful eye, to detect an error or to detect a fraud and to see whether the accounts and the summary in the balance-sheet and the profit and loss account present a reasonably fair and true picture of the affairs of the company; the verification, of course, has to be in consonance with the requirements o....
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....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 their duties properly. Issues Nos. 1, 4 and 5.-These are the principal issues dealing with the claim of the plaintiffs that the defendants were negligent in the discharge of their duties. The averments in this respect are to be found in paragraphs 5 and 21 of the plaint. Paragraph 5 of the plaint sets out eight areas which, according to the plaintiffs, the defendants were bound to and should have examined and ascertained. It may be stated at the outset that in respect of items (ii), (ii....
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....t. 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 auditors in undertaking the audit work and the witness deposed in paragraph 7 of his evidence that after examining the internal control system, he would determine whether there should be a sample audit or audit in extenso depending upon the satisfaction about the effectiveness of the internal control. The witness also deposed that the compliance test which, inter alia, means selective verification is well recognised in the audit work and is resorted to when the auditor is satisfied about the existence of the internal con....
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....s 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 system was functioning smoothly and was introduced by the holding company and one which was common for its all subsidiaries, it may be well concluded that defendant No. 1 was justified in resorting to the practice of selective verification or an in depth check or the compliance test while carrying out the audit work of the relevant year. The plaintiffs then complain that even assuming that the introduction of selective verification was not erroneous, still defendant No. 1 was guilty of negligence, as the auditors failed to....
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.... 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. Krishnan on this aspect is not acceptable, as not supported by any authoritative publication and the evidence on record is wholly unsatisfactory to come to the conclusion that it is the duty of the auditor to check the procedure of production from beginning to end to ascertain the effectiveness of the internal control system. There is one more aspect of the matter which must be noted. Mr. Krishnan stated in paragraph 26 of his evidence that the method suggested by him is possible where the production is on batch basis. Kelkar, who....
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....eliance 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. Paragraph 12 recites that in addition to weaknesses in the design of the internal control system and non-compliance with identified control procedures, conditions or events which increase the risk of fraud or error include unusual pressure within an entity. One of the unusual pressures within an entity is that the entity needs a rising profit trend to support the market price of its shares due to a contemplated public offering, as set out in appendix B(4) of these guidelines. Mr. Krishnan in paragraph 15 of his evidence deposed that i....
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....he 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 cannot lead to any suspicion in the mind of the auditors as it is not an unusual feature. The claim that rise in sales in the last quarter of the year is not an unusual feature is accepted by Mr. Krishnan by stating in paragraph 47 of the evidence: "I would not say that increase in sales in last three months of an accounting year is an unusual feature." Mr. Raiji has also stated in paragraph 8 of his evidence that an auditor need not suspect merely because there are large sales in the last month of the accounting year, unless there are rea....
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....uide 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 proceeding adopted by Mr. Parish and Mr. Wheaton under section 633 of the Companies Act. The Division Bench, while dealing with the circumstances relied upon by the trial judge about the phenomenal increase shown in the sales from June, 1974, onwards month by month, observed that though, according to Mr. Parish, he was struck by looking at the sales figures, it is not possible to hold that it should have aroused any suspicion in the mind of the directors for doubting the correctness of the figures. Mr. Setalvad contended that if the increase in figures of sales would not have created any suspicion in the mind of the directors, then equally it could not create suspicion in....
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....elieved 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 this publication recites that when analytical review procedures identify unusual fluctuations and items, that is, relationships that are unexpected or inconsistent with evidence obtained from other sources, the auditor should investigate them. The investigation begins with the inquiries of management and includes the evaluation or adequacy of replies and then it is for the auditor to determine whether there is need to apply other audit procedures based upon the result of such inquiries. In case the management is unable to provide an explanation or if the explanation is not considered adequate, then further investigation is necessary. Now, before turning to the evidence on this asp....
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....s 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 the management. Alpaiwalla in paragraph 6 of his evidence stated that before finalisation of the audit work for the relevant year, Mahindra reported to him that there was unusual spurt in the profits of the plaintiffs and also there was unusual variance. Alpaiwalla thereupon advised Mahindra to ask Mr. Hegde, the Director and the General Manager of the plaintiffs, to come and see him. Alpaiwalla deposed that Hegde met him on October 11, 1974, and informed him that there was favourable variance due to increase of the prices of the goods and availability of raw materials to secure higher production. Alpaiwalla advised Mahindra to check this variance, and claims that the fact was reporte....
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.... 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 out by Mr. Mahindra himself, but was entrusted to his team. Mahindra deposed that his audit team checked up the average purchase price of the steel in the previous year, that is year 1972-73, but subsequently changed his version and stated that the average purchase price of flange steel was checked and not that of steel. The witness deposed that the average purchase price of flange steel was approximately Rs. 3.30 per kilogram and the actual average purchase price of flange steel was determined by taking into consideration the standard. The witness conceded that the main ingredient for the manufacture of the products of the plaintiffs is steel; and flange steel is only a part of it and he did not work out the average purchase price of steel. The witness further admitted that the actual price of steel consumed in the year 1973-74 was higher than the average price at Rs. 4.32 per kilogram, and t....
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....here 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 investigative audit and which is now highlighted at the trial, would certainly make one wonder why the explanation of the management and of Hegde was accepted by the auditors, but it is well said that it is easier to be wise after the event. One should put oneself back to the situation existing at the time of original audit and it is necessary to keep out of mind all the facts which have come to light subsequently. In my judgment, the fact that internal control system of the plaintiffs was functioning efficiently for over several years, the fact that the defendants carried out the audit work of the plaintiffs for over 12 years, and without finding any irregularity, the fact that an independent outside agency, like the holding company was in the full know of the working of the plaintiffs and the directors of that company never suspected any irregularity in the affairs of the company, and the board of dire....
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....itors 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 deposed that an audit programme necessarily contains examination of cut-off transactions, and the expression "cut-off" means "the transactions effected in the first month and the last month of the given financial year". In paragraph 20 of the evidence, Mr. Krishnan stated that it is not necessary to take into account each and every transaction and it is sufficient if representative high value transactions spread over throughout the year, with emphasis on cut-off transactions, are taken into consideration. Alpaiwalla in paragraph 8 of his deposition, stated that he did not suggest to Mahindra or the audit team as to how the invoices should be selected, but normally the invoices are selected at random and the selection is left to the discretion of the person undertaking the audit work. Alpaiwalla deposed that the spectrum of selection must cover a wide range and both high value and low value invoices sh....
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....allan 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 the customer was expected to retain the white copy and return the yellow and green to the company after being duly acknowledged. The pink copy was retained with the stores department till the receipt of the two copies from the customer, and the pink copy was thereafter forwarded to the accounts section, the yellow copy to the sales section and the green copy to the stores department. Kelkar further deposed in paragraph 6 of his evidence that goods to be despatched to the customer at outstation by railway were taken to Wadibunder station by the company's transport agent and subsequently the agent used to produce the railway receipt to establish the fact of despatch of goods. In respect of export transactions, the goods were sent to the forwarding and clearing agent and the agent used to send the requisite documents, like bill of lading, port trust receipts, etc., to the company and the said documents we....
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....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 Practical Auditing. In paragraph 30, the witness conceded that there is no authority in support of the claim that it is necessary for the auditor to look into the mode of transport. The witness also conceded that his claim in examination-in-chief that the railway receipt should be called for to ensure that the goods are in fact despatched is not just because the railway receipt would not be with the company. The witness added that he would call for the register in which the railway receipt numbers are entered. In paragraph 38 of the evidence, Krishnan deposed that the delivery challan would not include the number of the bill of lading as that document is prepared when the goods are loaded on the ship, and his statement in examination-in-chief that the delivery challan is an unsatisfactory document because it does not indicate the number of the bill of lading is not correct. Raiji in paragraph 8 of his evidence....
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....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 handed over to M/s. Sonavane Transport Service for being transported. The bills also set out the number of invoices of the delivery challans. The amount due to M/s. Sonavane Transport Service under these bills was included in the amount of expenses and accruals-other than petty cash-of August 31, 1974. Kelkar conceded that the liability of M/s. Sonavane Transport Service in respect of the goods carried under these bills was not disputed. Mr. Setalvad is right in his submission that the auditors could not have suspected that something was amiss only because the delivery challans were receipted by M/s. Sonavane Transport Service and not by customers. Learned counsel is right in claiming that the bills tendered by M/s. Sonavane Transport Service were on the record of the company and the accounts clearly indicate that the plaintiffs were liable to pay the amount of the bill to M/s. Sonavane Transport Service. There ....
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....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 shall make such contract with the carrier on behalf of the buyer as may be reasonable having regard to the nature of the goods, and if the seller omits to do so and the goods are lost or damaged in course of transit, the buyer may decline to treat the delivery to the carrier as a delivery to himself and hold the seller responsible in damages. A plain reading of these sections indicates that the property in goods does not stand transferred from the seller to the buyer by mere delivery of the goods to a carrier. In the present case, the goods were handed over to M/s. Sonavane Transport Service for being removed from the factory to Wadibunder Railway Station for further despatch by railway, or from the factory to the warehouse of the shipping agent for further export. The handing over of the goods to M/s. Sonavane Transport Service can by no stretch of imagination be held to be transferring of the property in the goo....
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....s 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 grievance urged by Mr. Cooper is that the auditors failed to notice that the plaintiffs prepared invoices without receipt of orders from the customers. Out of the suspected 35 transactions which are set out in Appendix IV in Volume 15 of the compilation of the defendants, only in respect of seven cases, there were no orders and the total value in respect of those seven transactions was approximately 2½ lakhs. Mr. Setalvad submitted that the complaint of the plaintiffs on this ground is misconceived, and though it is true that there were no written orders in respect of the seven transactions, there was ample evidence available to the auditors at the time of regular audit to hold that the transactions were genuine. The submission of learned counsel is correct and deserves acceptance. In respect of two transactions with Standard Drum & Barrel Manufacturing Co., dated August 29, 1974, and August 22, 1974, of a value of a....
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....e 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, respectively. Mahindra deposed in paragraph 20 of his evidence that he is not aware as to what inquiries were made by his assistant for non-receipt of the amounts in respect of these invoices, but he would not find anything irregular because the balance amount was not received till the completion of the audit work, as the amount covered by these three invoices is very small compared to the amount due from various debtors of the company, and set out in the debtors' schedule, copy of which is at page 1 of volume 2 of the compilation of the defendants. Mahindra also stated that he would not be perturbed by non-recovery of amount till the completion of the audit work as the amounts were not due for a long duration. Now, turning to the debtors' schedule of the company, it is clear that the debtors' dues were to the tune of Rs. 61,72,400.47 and out of that amount, an amount of Rs. 79,245 was due for a period over six months. Mah....
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....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 to the plaintiffs implying instructions to despatch the goods. The plaintiffs then despatch the goods along with the inspection note, and then payment is obtained on the basis of the receipt of the inspection note. The grievance of Mr. Cooper is that the auditors did not bother to get familiar with this procedure, and, therefore, overlooked the fact that there could not have been any transaction in favour of this customer without the existence of the inspection note. Learned counsel also urged that if the auditors had carried out the in-depth check in respect of these transactions, it would have been noticed that the payment was not received till the completion of the audit and an explanation would have been sought. Mahindra in his evidence gave two reasons for not seeking an explanation for non-receipt of payment till completion of the audit and those are, (i) that the account of the customer was of a long standing and w....
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....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 ledger was necessary but on perusal of exhibit "H" and entries in Freight on Export Shipments, Account No. 19A, it is clear that the entries were not fully checked. Mahindra further admitted that in respect of three entries in the sales journal, the corresponding entries in the general ledger were not posted, and the three entries included the export items of Myanma Oil Corporation and Oil Refineries Administration, Iraq. Mahindra further admitted that the auditor is required to ascertain the export earnings of the company on the basis of FOB value. On the strength of these admission, Mr. Cooper submitted that the auditors were negligent in not ascertaining whether the amount was received in respect of the export sales and in not seeking an explanation for the same. Learned counsel urged that Schedule VI, item 4D(e), of the Companies Act demands that the auditor should inquire into several aspects and certify that the informati....
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....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 of the export sales. It has come to light during the investigative audit and that fact is set out in paragraph 4.6 of the auditor's report, part of the 15th annual report of the company that out of export shipment of 472 cases, 450 cases were removed to a godown belonging to a warehousing agent prior to August 31, 1974. These cases were removed to the godown of Madhavdas Khetan and subsequently shipped in October, 1974. These facts became clear from the correspondence entered into with the clearing agents. Now, the invoices selected by the auditors do not include any transaction in respect of export sales and, therefore, no fault could be found with the auditors for not ascertaining whether the goods were in fact shipped during the relevant year. The complaint is in respect of non-receipt of the payment and here it should be remembered that the debt was not due for a period over six months. The auditors had no occasion to suspect that the ....
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....s 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 period of more than six months. In support of the claim, reliance was placed on the contents of paragraph 7.10 of the Statement of Auditing Practices published by the Institute of Chartered Accountants of India. In cross-examination, Krishnan admitted in paragraph 30 that the confirmation of balance from the debtors need not be on a date ending with the financial year. The witness further stated that it would be difficult to obtain confirmatory letters from the customers, in case the audit work is required to be completed within a period of two months from the end of the financial year. Krishnan further stated that the auditor should ascertain how many debtors have responded to the circularisation of the debts and then find out whether the payments have been received till the completion of the audit work bearing in mind the terms of credit agreed between the company and the customer. In respect of debts created in the interregnum, says Mr. Kris....
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....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 ascertainment had checked the actual realisations. Mr. Cooper made two grievances in respect of the system adopted by the auditors, and those are, (i) that it was wrong to select July 31, 1974, as the date for confirmation of debts ; and (ii) the auditors failed to ascertain the debts created in the month of August, 1974, when the sales in that month were highest compared to the sales for the remaining months of the financial year. There is no merit in the submission of learned counsel in respect of both the grievances. It is not in dispute that the auditors were advised by the management to complete the audit work within two months of the year ending and in fact the work was completed by October, 1974. Taking into consideration the evidence of Krishnan and Raiji, it is obvious that the auditors faced with the demand that the audit work should be completed within two months of the end of the financial year, could not have selected the last date of t....
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....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 management of the plaintiffs, including Hegde, the managing director, in manipulating the accounts. In this state of affairs, it would be highly unjust to hold that the auditors were negligent in employing the procedure regarding confirmation of debts. The last ground urged by Mr. Cooper is that the auditors were negligent in not checking the control account at the time of audit. Item 9 of the audit programme refers to costing journal and costing ledger, and demands, checking of vouching journal entries and posting to cost ledgers. In both the cases, checking was to be carried out in respect of the entries of one month out of six months. The first grievance of Mr. Cooper is that though the audit programme specifically refers to checking of entries of one month in six months, the auditor carried out the checking of entries in respect of one month out of the entire year. Mahindra admitted in paragraph 44 of his evidence that the entries were checked onl....
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....ce 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. Relying upon the admissions made by Mahindra in this connection in paragraph 51 of evidence, it was urged by Mr. Cooper that the auditors failed to carry out the audit programme which demanded checking of various control accounts. In this connection, the defendants produced on record exhibit 11, which is a chart maintained by the defendants prescribing rules for effecting tick marks during the audit. These rules, which appear to have been prepared in January, 1951, do not assist in ascertaining the exact significance of the tick marks, but it cannot be denied that there are no tick marks whatsoever on raw material, finished goods and sales control account, and also in the general ledger to indicate that the entries posted in calculation to summary in exhibit "E" were further posted in general ledger. In this connection, reference is also required to be made to exhibit 8 and exhibit 10. Exhibit 8 and exhibit 10 are notes prepared during the investigative au....
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....nbsp; Rs. p. Rs. p. Sep. 30 OJE 1 26,237.02 12,982.18 Oct. 31 2 34,252.93 25,520.20 Nov. 30 3 5,131.32 42,755.32 Dec. 31 4 19,521.32 43,702.62 Jan. 31 5 80,323.56 82,061.60 Feb. 28 6 40,109.42 38,310.50 Mar. 31 7 3,555.88 39,754.83 Apr. 30 8 1,520.11 May 31 9 13,391.72 June 30 10 24,220.37 1,10,538.78 July 31 11 2,45,372.90 Aug. 31 12 76,526.16 1,47,132.16 ---------------- --------------- 3,09,967.98 8,03,042.92 Balance: 4,93,074.94 Mat. price variance 600.01 M. P. V. adjusted 20,79,230.00 A bare perusal of this document indicates that the entries for the months of September, October and November, 1973, were scored out and rewritten with a view to show further increase in the material usage account. Mr. Setalvad urged that this document was ....
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....h some sense would not notice the doubtful nature of exhibit "C" where not only the entries have been scored out and rewritten, but some of the entries have been rubbed out and the document gives a highly suspicious look. The absence of tick marks by the auditors in this document is one of the important circumstances to indicate that exhibit "C" was not shown to the auditors at the time of regular audit. In the long form report dated October 28, 1974, made by the auditors to the board of directors, a copy of which is at page 110 of volume 10 of the compilation of the defendants, the amount in respect of the direct materials-quantity variance (favourable) is shown as Rs. 6,84,345. This figure could have been gathered by the auditors only from the material usage variance account. If exhibit "C" is perused and the entries as originally made and not scored out are taken into consideration, then the total amount of the credit is Rs. 4,15,724.49, while if the corrected entries are taken into consideration, the total amount of credit is Rs. 4,93,074.94. Either of these figures does not tally with the figure of Rs. 6,84,345 mentioned in the long form report, and, therefore, Mr. Setalvad is....
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....In my judgment, the claim of Mr. Mahindra that it was not shown is more preferable to that of Kelkar. It would not be out of place to point out that it is difficult to give any credence to the testimony of Kelkar because Kelkar was not only working as an assistant of Ramamurthi at the relevant time, but had also a hand in preparing duplicate set of documents. Kelkar had admitted in his evidence that he was instrumental in preparing invoices and delivery challans and not entering the same in the register. The deposition unmistakably shows that Kelkar was fully conscious of the manipulation of accounts done by Ramamurthi with the assistance of other staff members and probably at the dictation of the managing director. In these circumstances, it is not possible to place any reliance upon exhibit "C" and conclude that the material usage variance account was not checked by the auditors at the time of regular audit. These are the circumstances pointed out by Mr. Cooper in support of the claim that the auditors were negligent in carrying out their duties at the time of the regular audit. In my judgment, these circumstances, either taken individually or cumulatively, do not establish that....
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.... managing director, Hegde, was acting contrary to instructions and the settled practice of the holding company in operating the affairs of the plaintiffs. In spite of this notice, Mr. Parish never felt it necessary to doubt the veracity of the balance-sheets and the accounts submitted by the plaintiffs for the financial year 1973-74. In my judgment, it is only an after-thought to find some scape-goat for the alleged loss suffered by the plaintiff company which has given rise to filing of this suit. While holding that the professional man is guilty of negligence, the court must expect strong and conclusive evidence and it would not be fair to rely upon some stray circumstances giving faint suspicion that the professional man may not have taken absolute care in the performance of his duties. The court cannot loose sight that the professional man has to take decision by taking into consideration several circumstances while discharging his function and it would be erroneous to rely upon some observations in a book to claim that the professional man failed to carry out what was expected of him. Take for instance, a case of a medical practitioner, who has to take a decision as to which ....
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....1979, and the quantum of loss in respect of item (v) has been stated as (i) loss of reputation Rs. 2 lakhs ; (ii) loss of goodwill Rs. 2 lakhs; and (iii) loss on account of dislocation of business Rs. 1 lakh. An amount of Rs. 20 lakhs was claimed towards loss of interest and extra expenditure incurred. Now, the only evidence as regards loss of reputation is of Kelkar, who deposed that the company's reputation suffered due to the inflation of sales and the Income-tax Officer raided the premises and seized the books. In cross-examination at paragraph 41 of the evidence, Kelkar admitted that the publication of the investigative audit report led to wide prejudicial publicity in the newspaper. Save and except this statement, the plaintiffs have led no evidence to establish the damage suffered for loss of reputation or goodwill or dislocation of business. It is, therefore, obvious that the plaintiffs have miserably failed to establish any damage on this count. Mr. Cooper, realising the lack of evidence, submitted that the plaintiffs should be awarded token or nominal damages. The remaining two claims are in respect of excess income-tax paid by the plaintiffs and excess surtax paid by th....
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....the plaintiffs were losers of an amount of Rs. 8,30,513, calculations of which are set out at page 70 of volume "G" of the compilation of the plaintiffs. Mr. Cooper submits that the plaintiffs are entitled to this amount as damages suffered due to the negligence of the auditors. It is not possible to accept the claim of learned counsel. The proposal for settlement was made by the plaintiffs to the Commissioner of Income-tax for factors which were totally unconnected with the alleged negligence of the auditors. In fact, a favourable order was secured by the plaintiffs from the Tribunal and the mere fact that proceedings were pending in reference in this court was not enough for the plaintiffs to settle the dispute with the Income-tax Authorities. As a result of the settlement, the plaintiffs might have suffered some loss, but that cannot be traced to alleged negligence of the auditors. Mr. Satish Pradhan was examined by the plaintiffs on this count and the witness deposed that the reason which prompted the company to suggest settlement was that the assessment proceedings of the plaintiffs remained pending for a considerable period due to pendency of reference with the result that la....