Issues in Tax Audit. CPE Study Circle. Study Circle Meeting on. held on 07 th September, organised by. of Baroda Branch of WIRC of ICAI

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1 Study Circle Meeting on Issues in Tax Audit held on 07 th September, 2010 organised by CPE Study Circle of Baroda Branch of WIRC of ICAI Convener ~ CA Nayan KOTHARI Co-Convener ~ CA Arpan DODIA Co-Convener ~ CA Hitesh SHAH

2 Profile of CA Mayur K Swadia Professional Qualifications: Partner, K.M. Swadia & Company, Chartered Accountants. Qualified as a Chartered Accountant in the year Fellow Member of The Institute of Chartered Accountants of India. Certified Information Systems Auditor (DISA). Practicing for last two decades. Partner with M/s. K.M. Swadia & Company, Vadodara (Gujarat). Professional Experience: Practicing Chartered Accountant for last two decades. Experience in corporate audits both internal and statutory. Auditing partner for public limited, multinational companies, nationalized banks and insurance companies. Project management advisory services from concept to commissioning. Carried out fund raising for projects, project evaluation studies, project viability studies for banks and corporates. Due diligence exercises, valuations of companies and financial structuring. Investment management for clients. Rendering corporate advisory services. Corporate law services including formation of companies and corporate law advisory services. Academic Exposure: Presented large number of papers at various conferences on the subject of Audits, Accounting Standards, Auditing Standards, internal control systems, investments and financial management etc. organized by the Institute of Chartered Accountants of India and other professional bodies. Conducted in house training programmes on Auditing, internal controls and Accounting standards for PSU s such as NTPC and others on behalf of The Institute of Chartered Accountants of India, New Delhi. Guest faculty at various universities for post graduate courses. 2

3 Exposure to IFRS: Keenly interested in IFRS. Invited as a trainer by the ICAI for training of Chartered Accountants in India and participated in the Trainers training programme organized by ICAI. Delivered lectures at various branches of ICAI on IFRS. Conducted in house training programmes on IFRS for corporates. Other accomplishments: Actively involved with the activities of The Institute of Chartered Accountants of India (ICAI). Vice Chairman of Western India Regional Council of ICAI for the year 2001 (consisting of 50,000 CA s in Gujarat, Maharashtra and Goa). Chairman and member of various committees of WIRC of ICAI. Member of the Financial Reporting Review Group set up by ICAI at Baroda. Director in public and private companies. Trustee with several charitable institutions. 3

4 Issues in Statutory Audit under The Companies Act CA Mayur Swadia Contents Preamble Matching principle v/s Fair valuation principle p Posers as a refresher Points to Ponder Preamble There is nothing new in this subject. The genesis of the subject dates back to centuries. The function of audit commenced at the time the trade and commerce began. Though the subject is old but always gold for the professional fraternity. 4 1

5 Preamble With the ever increasing complexities of trade and business, auditing as a function needed specialized skills and training. The function became so important, that countries created independent institutions to take care of this very important function. Preamble Role of a doctor to diognize, evaluate and report on the financial health of a business enterprise/economy and propose remedial action. With the fast pace of development of economy, increasing complexities of transactions and regulations, increasing volume of transaction, the job of the auditor has become more and more complex and challenging with increasing responsibilities. Preamble Inherent contradiction in the function of the Auditor. Paid by the same person for which he is called upon to give independent report. At every time in the history an event takes place that questions and re-defines the role and responsibility of the auditor. Ever increasing expectations of society puts added pressure on the auditor. What does the society expect from the watch dog? What can the watch dog do more to meet the expectations of society? 5 2

6 Preamble What are the lessons from Satyam? SWOT Analysis Evaluation of our Strengths, weaknesses, opportunities and threats. Important to keep ourselves fully updated with relevant issues at all times. Let us have a quick refresher and re-visit relevant and contemporary issues. Matching principle v/s Fair valuation principle Matching principle ensures that costs are matched with revenue they generate during a period. Matching principle ensures es purity of profit and loss statement. However it did not serve the purpose of getting the balance sheet right as it did not ensure that the assets and liabilities are stated in the balance sheet at fair value. Matching principle v/s Fair valuation principle Matching principal ensured that costs are matched with the revenue they generate, though that may have resulted in assets and liabilities in the Balance sheet at other than fair value. Fixed Assets are stated at cost less depreciation for the period. 6 3

7 Matching principle v/s Fair valuation principle Deferred revenue, preliminary, pre-operative expenses were accounted as assets following the matching principal. Matching principal ensured purity of profit & loss statement. However, it kept open the prospects of recording spurious assets and deferring all kind of expenditure that were claimed to provide some future benefits and accounted as Assets. Matching principle v/s Fair valuation principle The application of fair value principle to all the assets and liabilities would ensure purity of balance sheet. Application of matching concept along with fair valuation principle in the accounting standards has ensures that both profit and loss account and balance sheet reflect true and fair results. Matching principle v/s Fair valuation principle Interesting and significant differences in accounting practices in different countries. As culture, traditions, state of economic development, economic model, legal system etc. vary from country to country, so does the accounting framework. 7 4

8 Matching principle v/s Fair valuation principle Free trade countries encouraged and developed more robust accounting models and framework. Communist countries had far less reasons to do so, as quotas and not economic performance, were of greater concern to their governments. Matching principle v/s Fair valuation principle Nations that are exposed to rapid price changes are more receptive to departure from historical cost financial reporting. Nations that witness complexities in economic activities faster than other countries are quicker in responding by developing accounting standards to meet those challenges. US developed accounting standard on derivatives earlier than other nations. Matching principle v/s Fair valuation principle Japan and Germany have an overriding concern with creditor protection since most financing is by banks and not by private investors. These societies are structured on the collective good of their people. Income smoothing and extra conservatism is permitted in Germany, as it tends to benefit the society at large over a longer period. 8 5

9 Matching principle v/s Fair valuation principle IFRS will have universal applicability over a period of time. IFRS focused on fair value principal as against historical costs. One can have endless debate on this subject. Matching principle v/s Fair valuation principle In the very dynamic scenario in which we are today, it is generally believed that fair value principle would generally result in true and fair representation of the state of affairs. The assets and liabilities must reflect fair value as at a particular date. Matching principle v/s Fair valuation principle The difference between two balance sheets at different dates is reflected in the Profit & Loss Account. Getting the Balance Sheet is right is the most important objective. If the Balance Sheet is right, profit & Loss Account will by implication reflect true and fair result. 9 6

10 Back to Basics In order to keep our knowledge updated, it is important to go back to basics and refresh our knowledge on this important subject. The posers presented are intended to achieve the said objective. Posers as a refresher Note to Accounts: Accounts are maintained on an accrual basis except in case of insurance claims which are accounted on cash basis. What If: There is no insurance claim during the particular year though there have been claims in the past and there are possibilities of claims in the future. Posers as a Refresher Claim amount is material during the year. Claim amount is not material during the year. Claim amount was material in the previous year. What is the role of the auditor in the above circumstances? 10 7

11 Posers as a Refresher Can an enterprise apply different accounting policies for similar items? Can different methods of depreciation for the same class of assets used in different plants be applied? Can different methods of inventory valuation for different plants manufacturing same products/different products be applied? Posers as a Refresher Company has not provided for overdue interest on ICD s due to financial difficulties during the year. What is the view the auditor required to take? Accounting policies to be followed for companies that cease to be a going concern? Posers as a Refresher A ltd is a single product company. The prices of raw materials and finished goods are continuously falling. As at March end, raw material cost per unit was Rs. 10/-. Manufacturing cost per unit was Rs. 5/-. Net realizable value of finished goods was Rs. 9 per unit. The raw materials were valued at Rs. 10/- per unit and finished goods were valued at Rs. 9 per unit. What is your view as an auditor? 11 8

12 Posers as a Refresher Note to accounts of Company X: Inventory includes machine spares valued at cost. What is your view? Note to accounts of Company X: Inventory includes cost of packages and empties at cost. Your opinion as an auditor? Posers as a Refresher Cost of raw materials per unit is Rs. 20/-. Production overheads are Rs. 10/- per unit. Selling price/nrv is Rs. 35/- per unit. However, the raw material cost as on the date of the year end has suddenly reduced and is Rs. 16/- per unit. Therefore, the inventory is Rs. 16/- per unit. Is the above policy in line with AS II? Posers as a Refresher Where the cost has been written down in one year on decline of NRV whether the new value becomes a new/(substituted) cost of inventory valuation in the subsequent year? At what rate the inventories acquired on deferred credit basis are valued? 12 9

13 Posers as a Refresher Whether depreciation on the revalued portion of the fixed assets should be included in the cost of inventories? Whether storage costs are to be included in the valuation of inventory? Can the cost of impairment of fixed assets be considered for the purpose of inventory valuation? Posers as a Refresher Metal prices (raw materials) have been consistently falling after the balance sheet date. The cost at on the balance sheet date was Rs. 50/- per k.g. The market value(nrv) on the date of audit on June 30, 2010 is Rs. 45/- per k.g. Following the principle of cost or net realizable value whichever is lower, at what price the inventory should be valued? Posers as a Refresher On April 7, 2010, due to destruction of the factory by fire, X one of the company s debtors, declared himself insolvent. Advise your client on the treatment for the year ended March 31, In the above case, assume that the fire took place on March 7, 2010.The debtor declared himself insolvent on April 7, What would be your advise? 13 10

14 P & L A/c (Posers) How should the raw material consumption be disclosed? Based on derived consumption or actual consumption? How the normal/abnormal shortages/wastages should be disclosed? P & L Account (Posers) Whether disclosure of internally produced intermediates/components necessary? Whether consumption of imported materials should be disclosed based on cost arrived at based on company s records or at CIF value? Balance Sheet Why not call it a Balance Statement or Statement of Affairs. The word sheet is no longer in vogue to describe any financial statement. (if not spelled correctly, could be badly misunderstood d also???) Required to be stated in any of the forms given in the part I of Schedule VI:- - Horizontal -Vertical 14 11

15 Balance Sheet posers Certain fixed assets have remained idle due to strike. Whether depreciation should be provided on the same? Certain assets have retired from active use. Whether depreciation should be provided on the same? What is the nature of such assets? At what value it should be accounted for? How does one account for machine spares? Balance Sheet posers How should an asset such as an aircraft be capitalized? Whether repair expenses that enhances the useful life of the asset can be capitalized? A company has charged higher rates of depreciation for some assets and lower rates of depreciation then prescribed under Schedule XIV in few cases. Whether this is in order? Posers Whether liquidated damages/penalties received from the suppliers can be netted from the cost of the assets? Advise your client regarding accounting of unclaimed balances of suppliers, salaries/wages etc. that have been capitalized? Whether income received on sale of scrap on construction of an asset can be reduced from the cost of the asset? 15 12

16 Posers For spares of capital nature that have been capitalized, whether depreciation needs to be provided for? A machinery was purchased before three years. The machine was cleared at that time without payment of custom duty. In the current year custom duty along with penalty was paid. Advise your client regarding the accounting of the same? Posers Whether depreciation should be charged on full value of the asset or 95% of the value of asset? Whether depreciation can be charged on the basis of actual hours worked during the year? Posers An enterprising is developing a property for its own use. However, due to delay in construction, the operations were moved to a rented premises. When the development of the property was completed, it was rented out. Should the developed property accounted as a fixed asset or an investment property? If it is treated as an investment property, whether it should be depreciated? 16 13

17 Posers A company acquired a building with existing tanents. It had to pay a huge compensation to the tanents to get the vacant possession of the building for its use. Can the compensation paid be capitalized? Posers A company has an existing building with two floors that is fully depreciated. It has constructed two additional floors. The company seeks your advise on the depreciation policy to be followed for the new floors constructed. Posers Note in the accounts: Balances of debtors, creditors, loans and advances are subject to confirmation. Whether the said note is in order? What are the requirements as per the auditing standards with respect to audit of bank deposits? 17 14

18 Balance Sheet (Posers) How to disclose share application money received in excess of authorized capital? Where to disclose invalid/excess/revoked application money? Whether it is necessary to mention the sources of issue of bonus shares? Allotment of shares in discharge of a debt whether considered as issued for cash or otherwise? Reserves and Surplus (Posers??) What is the difference between a reserve and a reserve fund? Whether and when capital profits on fixed assets sold can be distributed? Whether it is possible to issue bonus shares from revaluation reserve? Whether deferred expenses, share issue expenses, VRS/doubtful debts provision Etc. can be set-off against share premium? Secured Loan (Posers??) Whether loan secured against third party assets can be classified as a secured loan? How to classify a loan where the security value is less then the loan amount? If the loan is secured only by way of personal guarantee of directors, would it be classified as a secured loan? If the assets are mortgaged in favour of third party who guaranteed the loan, whether the loan would be classified as a secured loan? 18 15

19 Secured Loan (Posers??) Whether debentures guaranteed by Government is a secured loan? How would you classify application money received for secured debentures? Accounting standards and schedule VI Areas of conflict - Accounting for exchange rate difference in respect of borrowings in foreign currency for purchasing fixed assets. - Adjustment of diminution in the value of investment directly from reserves. Why Schedule VI needs to be buried? The schedule is as old as the Companies Act and has not kept pace with changing time Does not provide for disclosures with respect to new standards such as deferred taxes, intengibles,leases,consolidation, discontinuing operation, impairment provisions etc., 19 16

20 Why Schedule VI needs to be buried? Contains irrelevant information such as outstanding of SSI, CIF value of imports, expenditure/earnings in foreign currency, license capacity etc., that has no value to users. Provides detailed format of balance sheet but does not contain any format for profit and loss account. Why Schedule VI needs to be buried? Contains interpretations of certain terms such as liabilities and provisions which are more exhaustively defined in AS 29. Schedule VI needs to be continuously updated that demands change in legislation i.e. slow, tedious costly, and inflexible. Why Schedule VI needs to be buried? It may be advisable to have separate accounting standard on presentation of financial statements in line with international accounting standard. With the implementation of IFRS, this issue will get resolved

21 Points to Ponder Auditor and third party liability. Documentation is a key challenge. Changing expectations of society. Increasing complexities and IFRS. Is the remuneration structure keeping pace with the increasing complexities, risks and responsibilities. What can we do together to enhance the image of the profession? Thank You 21 18

22 Profile of CA Narendra Hindocha 1. Graduated in Commerce from Sydenham College in Mumbai in Qualified as Chartered Accountant in 1978 with rank in both Intermediate and Final Examination. 3. Worked with different firms of Chartered Accountants including Price Waterhouse from 1978 to Practising as Chartered Accountant in partnership in the name of Jain & Hindocha at Baroda since Has presented Papers on different provisions of Income tax Act at various seminars 6. Was Convenor of Baroda Study Circle of Chartered Accountants for 2 years. 7. Coauthor of Publication of Bombay Chartered Accountants Society on `Minimum Alternate Tax released in June, Empanelled with Peer Review Board as Reviewer as also with FRRB for review of financial statements of listed companies. 9. Making regular contributions to the Newsletter of Baroda Branch of Institute of Chartered Accountants of India nhindocha@vsnl.net 22

23 Issues relating to tax audit for discussion at the Study Circle Meeting on 7 th September, 2010 By: CA. Narendra Hindocha 1. Depreciation Form 3CD Item 14. Particulars of depreciation allowable. In that context: A car is registered in the name of director of a private company. The payment is made by the company which also bears all the maintenance expenses. The car is shown as asset of the company in its books of accounts. Issue: Whether the company is entitled to depreciation in respect of the value of the car. 2. Capital expenditure Form 3CD Item 14 Expenditure of capital nature: A company spent Rs.36/ lacs for development of its website. Whether such expenditure should be reported here. 3. Expenditure of personal nature Form 3CD Item 17 (g) Travelling expenditure in case of a listed company includes Rs.14/ lacs on foreign travel by Director and his wife, when either one or both of them are working directors. How would you verify and report this item. 4. Remuneration to partners Form 3CD Item 17 (g) Salary inadmissible under section 40(b). In that context: Partnership deed contemplates payment of remuneration as per earlier provisions of section 40(b), including minimum remuneration of Rs.50000/ to partners in case of loss. After amendment in section 40(b), by the Finance (No.2) Act, 2009(which was passed on 19 th August 2009) with effect from , new deed was made on 1 st September, 2009 allowing remuneration at revised higher rates including minimum remuneration of Rs / for the year ended 31 st March,

24 Issues: Whether partnership deed can provide for remuneration for the whole financial year ended 31 st March, 2010 as per the amended higher scale or the higher scale can only be applied for the period after or only after More specifically, in case of loss, whether allowance under Income tax Act should be: Rs / as per new scale. or Rs x 5 months/12 months plus x 5/12 or Nil since the remuneration is not in accordance with section 40(b) 5. Provision for gratuity Form 3CD Item 17(i) Provision for gratuity not allowable under section 40A(7): An LIC agent convinced Managing Director of a private company existing since 5 years to take Group Gratuity Policy explaining that the whole of the premium is tax deductible. He collected premium of Rs.64/ lacs on 24 th March, 2010 on account of cumulative liability for the period until In August, 2010, the auditor observed that no gratuity trust was created and apparently no such trust was approved by the Commissioner as no application was filed. Hence according to him the amount was disallowable under section 40A(7) and informed the company accordingly. When the Managing Director asked the LIC agent whether the amount was deductible, the agent stated that there is no doubt about deductibility of the premiums as he knows hundreds of large companies claiming the same. He added that the Auditor was unnecessarily harassing the company. During discussions, LIC agent gave drafts of haphazardly and halfheartedly filled documents for creation of trust, rules and application for approval and stated that the Auditor should take approval from Income tax Office on the basis of these documents which is routinely granted. How should the auditor deal with the situation. 6. Disallowance under section 14A Form 3CD Item 17(l) A trader in shares borrowed Rs.400 lacs and invested the same in shares. His expenditure on interest is Rs.40/ lacs. Difference between purchase and sale price is Rs.40/ lacs. Dividend is 10 lacs. Extent of disallowance under section 14A: 24

25 Rs.40/ lacs? Rs. Nil Rs.40 x 10/50 =Rs.8/ lacs. 7. Interest Form 3CD Item 17(m) A company replaced old machine with a better machine at a cost of Rs.46/ crores. As a result, the production capacity remained same but the new machine produced articles which increased sale price of per article by 50% due to better precision and shape. Interest cost for period until date of putting it to use amounting to Rs.2/ crores for a period of 6 months is debited to profit and loss Account. How would you report this. 8. Payments to persons specified in section 40A(2) Form 3CD Item 18 As tax auditors of Tata Chemicals Limited, how would you report the following: Tata Steels Limited needed liquidity. Hence they sold machinery having written down value of Rs.100/ lacs at Rs.500/ crores to Tata Chemicals Limited in addition to machinery spare parts sold for Rs.60/ crores. The amount of Rs.60/ crores is arrived at by adding margin of 25% to purchase price. The amount of Rs.500/ lacs is decided on ad hoc basis without any valuation. Tata Chemicals Limited paid Rs.300/ crores for such purchase until and Rs.260/ lacs in April, Then the machinery is leased back to Tata Steel Limited for 5 years on monthly rental of Rs.100/ crores. 9. Repayments of loans and deposits Form 3CD Item 24 A company had credit balance of Rs.20/ lacs in the account of a Director. Director instructed the company to pay LIC premium of Rs / and debit to his account. He also instructed the company to transfer Rs / to his major son s account. There was also a debit entry by cheque for Rs.10000/ which you have a suspicion that represents bearer cheque given to the director for his cash requirement. There is also an entry for sales of Rs / to the Director. How would you verify and report these transactions. 25

26 Issues received from members: Income Tax: 1. The amount of Cash purchase of a Fixed Asset is not disallowed U/s. 40A(3), however the A. O. wants to disallow the depreciation component of the corresponding asset which is debited to P & L A/c. 2. The partnership deed specifies the remuneration to partners to be given as per Sec. 40(b). However, the assessee wants to give lesser remuneration than the maximum allowable. Does this amount to violation of Board circular no. 739, dated March 25,1996, which specifies about categorically mentioning in the partnership deed about the exact quantum of remuneration payable to each individual working partner or to lay down a formula / manner of quantifying such remuneration? 3. Sec. 10(4) deals with exemption of interest from NRE A/c. Does this exemption continue even when the residential status of the person becomes "Resident". What is the practical care / pre requisites to be taken while taking the exemption after the concerned person comes to India/ becomes resident? 4. Interest free Dealership Deposit Rs. 2 Lacs was given by the assessee to a company (XYZ). After the first dispatch of the material to the assessee (for which the money was paid as per their bill), the company (XYZ) was closed down. The assessee after follow ups and waiting for four years writes of this deposit amount to P&L account. What is the success of this claim being allowed by A.O. and on what stand / section as per the I Tax Act? 5. Few assessee do not claim the depreciation in books of accounts since the date of purchase of the Fixed assets (used during the year for business purpose). What should be done regarding this issue in our Tax Audit report? Statutory Audit: 1. If any Pvt Ltd or Ltd company won t be able to gets its account audited under the Company Act, 1956 before 30 th Sep i.e. before the due date of the Tax Audit. Now for Tax audit and Statutory audit there are different auditor, then what is the position of the Tax Auditor?? Whether he can issue his audit report in Form 3CA or 3CB. Further, Tax auditor needs to audit the full balance sheet or he can simply rely on the Provisional Balance 26

27 sheet as certified by the Management and do audit relating to clause provided in the Form 3CD only and provide his report in Form 3CA or 3CB. 2. There is clause in CARO where auditor has to comment whether "accumulated losses" are more than 50 % of "net worth". How to calculate "net worth" because technically "net worth" includes "accumulated losses" For E.g. Share capital 5 lacs Loans 1 lacs Current Liabilties 1 lacs Total 7 lacs ABC Ltd Balance Sheet as on Fixed assets 4 lacs Current Assets 1 lacs Debit balance of P&L (accumulated losses) 2 Lacs Total 7 Lacs If we consider net worth 5 lacs (not considering accumulated losses) then accumulated losses are not more than 50% of net worth. If we consider net worth 3 lacs (after deducting accumulated losses) then accumulated losses are more than 50% of net worth What will be comment regarding this clause in Auditor's Report in case of above Balance Sheet 27