Surya Foods Pvt Ltd: an auditor who keeps the books
Surya Foods Private Limited was incorporated in August 2024 on conversion of a partnership. Its paid-up capital is ₹40 lakh, turnover for the year ended 31 March 2025 is ₹8 crore, and it has no borrowings. In its first board meeting the board appointed Mr. R, a practising chartered accountant, as statutory auditor for five years. Mr. R's firm has, since 2022, maintained the books of account of the business, filed its GST returns and represented it before the tax authorities. He accepted the appointment and signed the audit report. The company has one retail counter where cash sales average ₹60,000 a day, a single accountant who also handles cash, bank reconciliation and purchase orders, and a storekeeper who issues goods. The director asks you whether the appointment is in order, what the audit report should say about internal control, and how the auditor should satisfy himself about closing stock of ₹1.20 crore, of which ₹35 lakh lies at a third-party cold store and is supported only by a statement signed by the storekeeper.
1. Is Mr. R's appointment valid? Identify every defect and state how it should be cured.
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There are three separate defects.
1. Disqualification (the fatal one). Section 141(3) of the Companies Act 2013 disqualifies a person, or a firm in which he is a partner, from appointment where the relationship falls foul of the prohibited-services rule, and Section 144 forbids an auditor from rendering to the company, directly or indirectly, accounting and book-keeping services, management services, internal audit, design of financial information systems, investment advisory and similar work. Mr. R's firm has maintained the company's books and prepared its GST returns - squarely prohibited. He cannot be the auditor while rendering those services. The cure is either to resign from the audit and let an independent firm be appointed, or to cease the book-keeping and tax-representation engagement, with a clean gap so that he does not audit his own work. He must also satisfy Section 141(3)(d) (no indebtedness), (e) (not a relative holding a key managerial position) and the limit on the number of audits.
2. Wrong term. Section 139(6): the first auditor is appointed by the Board within 30 days of registration and holds office until the conclusion of the first annual general meeting - not for five years. A five-year term belongs to an auditor appointed by members at an AGM under Section 139(1). The appointment should be recast accordingly, and the members should appoint the auditor at the first AGM.
3. Procedure. The appointment needs the auditor's written consent and an eligibility certificate, filing of ADT-1, and a board resolution. His signature on the report is also invalid for a period during which he was disqualified, so the report must be re-issued by a properly appointed auditor after the accounts are re-audited - a bitter but necessary conclusion.
2. Cash sales of ₹60,000 a day through one counter are handled by an accountant who also reconciles the bank. Design the internal check, and distinguish it from internal control.
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The core fault is that one person has custody of cash, records the cash, and verifies the bank. No system of internal check can work where custody and record lie in the same hands. The remedy must separate three functions, and where eight employees are all that exist, substitute the owner's direct supervision for missing staff.
Practical controls:
- Pre-numbered, duplicate cash memos issued for every sale; one copy to the customer, one retained. Daily total of memos must equal cash in the drawer.
- Cash deposited intact the next morning; no payments out of receipts (imprest petty cash only).
- Daily cash summary prepared by the counter salesman and countersigned by the director, comparing memos, cash and deposit slip.
- Bank reconciliation prepared by the director, not the accountant, and initialled.
- Surprise cash counts by the owner at irregular intervals.
- Purchases cycle: purchase order → goods received note → supplier invoice → payment, with the storekeeper's GRN independently matched to the invoice before payment; the storekeeper should not handle cash or the payables ledger.
- Rotation of duties where possible; mandatory annual leave, since fraud often needs unbroken occupancy of a desk.
Distinction. Internal check is the arrangement of duties so that one person's work is automatically verified by another in the ordinary course - the day-to-day mechanical segregation above. Internal control is the whole system, much wider: the control environment and attitude of the director, delegation limits, budgets and variance reports, physical safeguards, internal audit, and the review of the system itself. Internal check is a subset of internal control. Here the retail loss might well pass the retailer's internal check's daily totals yet still be possible because internal control - oversight, surprise inspection, and independent reconciliation - is weak.
3. What should the audit report say about internal control, and how should the auditor satisfy himself about the stock at the cold store?
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On internal control: the auditor's opinion is on the financial statements, but Section 143(3)(i) requires him to report whether the company has adequate internal financial controls with reference to financial statements and their operating effectiveness. Since cash is the dominant risk (₹60,000 × ~300 days ≈ ₹1.8 crore against ₹40 lakh of capital) and the roles are combined, he should report the weakness, describing what it is and what it might affect, and issue a separate management letter. He should not use the audit report to lecture on general control ideas; only matters affecting the financial statements belong there.
On the ₹35 lakh at the cold store (29% of stock, clearly material):
Assertions at risk: existence, rights (owned or customer-owned?), condition and valuation (cold-store stock can deteriorate), completeness.
Evidence sought, in order of persuasiveness:
- Third-party confirmation from the cold store operator of quantity, description and the name of the depositor - external evidence, the most persuasive available.
- Physical inspection or observation at the cold store, with the storekeeper present, including weighment or count sheets signed by both.
- The audited tally to the stock records, GDNs, insurance cover, and subsequent sales invoices proving the goods existed and realised at or above carrying value.
- Costing test for lower of cost and net realisable value, including whether any item is slow-moving.
The storekeeper's own statement is internal evidence generated by a person who is not independent - useful for corroboration only.
If nothing further is obtained, the auditor cannot give an unmodified opinion. He should qualify ('except for') if the possible effect is material but not pervasive; if the whole of stock cannot be verified he would disclaim an opinion. He should not simply accept the statement because management assures him the stock is there.