financial system and auditingjnujprdistance.com/assets/lms/lms jnu/bba/sem iii/financial system and...

Financial System and Auditing

Board of Studies

Prof. H. N. Verma Prof. M. K. GhadoliyaVice- Chancellor Director, Jaipur National University, Jaipur School of Distance Education and Learning Jaipur National University, JaipurDr. Rajendra Takale Prof. and Head AcademicsSBPIM, Pune

___________________________________________________________________________________________

Subject Expert Panel

Dr. S. U. Gawade Somrita MitraHead Research, SIOM Subject Matter ExpertPune

___________________________________________________________________________________________

Content Review Panel

Shreya Saraf Shweta MutttalmaniSubject Matter Expert Subject Matter Expert

___________________________________________________________________________________________Copyright ©

This book contains the course content for Financial System and Auditing.

First Edition 2013

Printed byUniversal Training Solutions Private Limited

Address05th Floor, I-Space, Bavdhan, Pune 411021.

All rights reserved. This book or any portion thereof may not, in any form or by any means including electronic or mechanical or photocopying or recording, be reproduced or distributed or transmitted or stored in a retrieval system or be broadcasted or transmitted.

___________________________________________________________________________________________

I

Index

ContentI. ...................................................................... II

List of FiguresII. ........................................................ VII

AbbreviationsIII. ......................................................VIII

Case StudyIV. ............................................................ 148

BibliographyV. .......................................................... 152

Self Assessment AnswersVI. ..................................... 155

Book at a Glance

II

Contents

Chapter I ....................................................................................................................................................... 1Financial System .......................................................................................................................................... 1Aim ................................................................................................................................................................ 1Objectives ...................................................................................................................................................... 1Learning outcome .......................................................................................................................................... 11.1 Introduction to Financial System ............................................................................................................. 21.2 Functions of Financial System ................................................................................................................. 21.3 Components of Financial System ............................................................................................................ 31.4 Overview of Indian Financial System ...................................................................................................... 41.5 Structure of Financial System .................................................................................................................. 4 1.5.1 Financial Institutions ................................................................................................................ 5 1.5.2 Financial Instruments ............................................................................................................... 6 1.5.3 Financial Markets .................................................................................................................... 6 1.5.4 Financial Services .................................................................................................................... 71.6 Reserve Bank of India (RBI) ................................................................................................................... 8 1.6.1 Functions of RBI ...................................................................................................................... 91.7 Monetary Policy ......................................................................................................................................11 1.7.1 Monetary Policy in India ........................................................................................................11 1.7.2 Monetary Policy Instruments ..................................................................................................11 1.7.3 Credit Control Measures of Reserve Bank of India ............................................................... 12Summary ..................................................................................................................................................... 13References ................................................................................................................................................... 13Recommended Reading ............................................................................................................................. 13Self Assessment ........................................................................................................................................... 14

Chapter II ................................................................................................................................................... 16Commercial Banks ..................................................................................................................................... 16Aim .............................................................................................................................................................. 16Objectives .................................................................................................................................................... 16Learning outcome ........................................................................................................................................ 162.1 Introduction ............................................................................................................................................ 172.2 Evolution of Commercial Banks in India .............................................................................................. 172.3 Functions of Commercial Banks ............................................................................................................ 182.4 Recent Trends in Commercial Banking ................................................................................................. 19 2.4.1 Technology ............................................................................................................................. 19 2.4.2 Outsourcing of Services ......................................................................................................... 20 2.4.3 Financial Inclusion ................................................................................................................. 202.5 Development Banks .............................................................................................................................. 22 2.5.1 Features of a Development Bank ........................................................................................... 22 2.5.2 Functions of Development Banks ......................................................................................... 23 2.5.3 Major Objectives of Development Bank ............................................................................... 242.6 IFCI ........................................................................................................................................................ 24 2.6.1 Objectives .............................................................................................................................. 25 2.6.2 Functions ................................................................................................................................ 252.7 IDBI ...................................................................................................................................................... 26 2.7.1 Objectives of IDBI ................................................................................................................. 26 2.7.2 Functions of IDBI .................................................................................................................. 262.8 IIBI ......................................................................................................................................................... 262.9 SIDBI ..................................................................................................................................................... 272.10 ICICI .................................................................................................................................................... 28 2.10.1 Objectives ............................................................................................................................ 28 2.10.2 Functions .............................................................................................................................. 282.11 NABARD ............................................................................................................................................. 28

III

2.11.1 Objectives ............................................................................................................................ 28 2.11.2 Roles and Functions ............................................................................................................. 29 2.11.3 NABARD in Present Scenario ........................................................................................... 292.12 EXIM ................................................................................................................................................... 29Summary ..................................................................................................................................................... 31References ................................................................................................................................................... 31Recommended Reading ............................................................................................................................. 32Self Assessment ........................................................................................................................................... 33

Chapter III .................................................................................................................................................. 35Financial Services and Financial Markets in India ................................................................................ 35Aim .............................................................................................................................................................. 35Objectives .................................................................................................................................................... 35Learning outcome ........................................................................................................................................ 353.1 Introduction ............................................................................................................................................ 363.2 Characteristics of Money Market ........................................................................................................... 363.3 Functions of Money Market ................................................................................................................... 373.4 Importance of Money Market ................................................................................................................ 383.5 Difference between Capital and Money Market .................................................................................... 393.6 Indian Money Market Instruments ......................................................................................................... 393.7 Drawbacks of Indian Money Market ..................................................................................................... 413.8 Reforms in Indian Money Market .......................................................................................................... 423.9 Depository System ................................................................................................................................. 433.10 Merchant Banking ................................................................................................................................ 433.11 SEBI ..................................................................................................................................................... 453.12 Securities and Exchange Board of India Act, 1992 ............................................................................. 463.13 Functions of SEBI ................................................................................................................................ 473.14 Credit Rating ........................................................................................................................................ 48 3.14.1 Meaning of Credit Rating .................................................................................................... 48 3.14.2 Credit Rating Agencies in India ........................................................................................... 49 3.14.3 Benefits of Credit Rating .................................................................................................... 50 3.14.4 Factors for Successful Credit Rating Systems .................................................................... 51 3.14.5 Process of Rating ................................................................................................................. 51Summary ..................................................................................................................................................... 52References ................................................................................................................................................... 52Recommended Reading ............................................................................................................................. 52Self Assessment ........................................................................................................................................... 53

Chapter IV .................................................................................................................................................. 55Capital Market ........................................................................................................................................... 55Aim .............................................................................................................................................................. 55Objectives .................................................................................................................................................... 55Learning outcome ........................................................................................................................................ 554.1 Introduction ............................................................................................................................................ 564.2 Classification of Capital Market ........................................................................................................... 56 4.2.1 Distinction between Primary Market and Secondary Market ................................................ 574.3 Capital Market Efficiency ...................................................................................................................... 58 4.3.1 Forms of Capital Market Efficiency ...................................................................................... 594.4 Capital Market in India .......................................................................................................................... 60 4.4.1 Structure of Indian Capital Market ........................................................................................ 61 4.4.2 Capital Market Operations ..................................................................................................... 624.5 Role of Capital Market in India ............................................................................................................. 634.6 Importance of Capital Market ................................................................................................................ 644.7 PESTEL Analysis of Indian Capital Market .......................................................................................... 644.8 Capital Market Regulations ................................................................................................................... 66

IV

4.9 Reforms in the Capital Market ............................................................................................................... 674.10 Introduction to Stock Exchanges ......................................................................................................... 67 4.10.1 Characteristics of Stock Exchange ...................................................................................... 68 4.10.2 Functions of a Stock Exchange ............................................................................................ 68 4.10.3 Advantages of Stock Exchange ............................................................................................ 69 4.10.4 Limitations of Stock Exchanges .......................................................................................... 70 4.10.5 National Stock Exchange of India ....................................................................................... 70Summary ..................................................................................................................................................... 71References ................................................................................................................................................... 71Recommended Reading ............................................................................................................................. 71Self Assessment ........................................................................................................................................... 72

Chapter V .................................................................................................................................................... 74Auditing ...................................................................................................................................................... 74Aim .............................................................................................................................................................. 74Objectives .................................................................................................................................................... 74Learning outcome ........................................................................................................................................ 745.1 Introduction ............................................................................................................................................ 755.2 Types of Audit ........................................................................................................................................ 76 5.2.1 Regularity Audit ................................................................................................................... 76 5.2.2 Financial Audit ....................................................................................................................... 76 5.2.3 Receipt Audit ......................................................................................................................... 77 5.2.4 Performance Audit ................................................................................................................. 775.3 Need for Auditing .................................................................................................................................. 785.4 Limitations of Audit and Detection of Fraud ......................................................................................... 795.5 Auditing Standards ................................................................................................................................. 795.6 Internal Audit ......................................................................................................................................... 805.7 Professional Practices Framework ......................................................................................................... 815.8 Audit Process ......................................................................................................................................... 825.9 Auditing Documentation ........................................................................................................................ 84 5.9.1 Form and Content of Documentation .................................................................................... 85 5.9.2 Permanent and Current Audit Files ........................................................................................ 85 5.9.3 Need for Audit Documentation .............................................................................................. 86 5.9.4 Retention of Working Papers/ Documents ............................................................................. 87 5.9.5 Tips for Auditors on Documentation / Working Papers ......................................................... 885.10 Internal Control System ....................................................................................................................... 88 5.10.1 Scope of Internal Control ..................................................................................................... 89 5.10.2 Internal Control System Components .................................................................................. 89 5.10.3 Limitations Inherent in Internal Control ............................................................................. 91Summary ..................................................................................................................................................... 92References ................................................................................................................................................... 92Recommended Reading ............................................................................................................................. 92Self Assessment ........................................................................................................................................... 93

Chapter VI .................................................................................................................................................. 95Audit of Limited Companies ..................................................................................................................... 95Aim .............................................................................................................................................................. 95Objectives .................................................................................................................................................... 95Learning outcome ........................................................................................................................................ 956.1 Introduction ............................................................................................................................................ 966.2 Need for a Company Auditor ................................................................................................................. 966.3 Qualification of a Company Auditor ...................................................................................................... 966.4 Disqualification of a Company Auditor ................................................................................................. 976.5 Appointment of an Auditor .................................................................................................................... 97 6.5.1 First Auditor of a Company ................................................................................................... 98

V

6.5.2 Reappointment of Auditors .................................................................................................... 986.6 Removal of an Auditor ........................................................................................................................... 986.7 Status of an Auditor ............................................................................................................................... 996.8 Rights and Duties of a Company Auditor .............................................................................................. 99 6.8.1 Rights ..................................................................................................................................... 99 6.8.2 Duties ................................................................................................................................... 100 6.8.3 Some Legal Decisions ........................................................................................................ 1016.9 Auditing Standards ............................................................................................................................... 1016.10 Divisible Profits and Dividend ........................................................................................................... 1026.11 Audit Report ....................................................................................................................................... 103 6.11.1 Responsibilities of an Auditor for making a Report .......................................................... 104 6.11.2 Requisites of a Good Audit Report .................................................................................... 104 6.11.3 Types of Audit Report ........................................................................................................ 1056.12 Special Audit of Banking Companies ................................................................................................ 106 6.12.1 Legislations Relevant to Audit of Banks ........................................................................... 106 6.12.2 Provision Relating to Audit ................................................................................................ 106 6.12.3 Powers of the Auditor ........................................................................................................ 107 6.12.4 Auditor’s Report................................................................................................................. 107 6.12.5 Special Audit ...................................................................................................................... 108 6.12.6 Approach to Banks' Audits ................................................................................................. 1086.13 Audit of Educational Institutions ....................................................................................................... 1086.14 Audit of Insurance Companies ............................................................................................................110Summary ....................................................................................................................................................111References ..................................................................................................................................................111Recommended Reading ............................................................................................................................111Self Assessment ..........................................................................................................................................112

Chapter VII ...............................................................................................................................................114Audit of Non-profit Companies and Fraud Detection ...........................................................................114Aim .............................................................................................................................................................114Objectives ...................................................................................................................................................114Learning outcome .......................................................................................................................................1147.1 Audit of Non-profit Organisations ........................................................................................................1157.2 Accounting and Auditing in not-for-profit Organisations — some Critical Issues ...............................1157.3 Non-profit Audit Committee Charter ................................................................................................... 1227.4 Fraud .................................................................................................................................................... 123 7.4.1 Characteristics of Fraud and Error ....................................................................................... 1247.5 Types of Fraud ..................................................................................................................................... 1257.6 Preventing Fraud .................................................................................................................................. 1257.7 Auditor’s Responsibility in Finding Fraud .......................................................................................... 1267.8 Clauses of Fraud in Auditing in India .................................................................................................. 127Summary ................................................................................................................................................... 130References ................................................................................................................................................. 130Recommended Reading ........................................................................................................................... 130Self Assessment ......................................................................................................................................... 131

Chapter VIII ............................................................................................................................................. 133Audit of Limited Companies ................................................................................................................... 133Aim ............................................................................................................................................................ 133Objectives .................................................................................................................................................. 133Learning outcome ...................................................................................................................................... 1338.1 Recent Trends in Auditing ................................................................................................................... 1348.2 Cost Audit ............................................................................................................................................ 136 8.2.1 Features of Cost Audit ......................................................................................................... 136 8.2.2 Objectives of Cost Audit ...................................................................................................... 136

VI

8.2.3 Scope of Cost Audit ............................................................................................................. 137 8.2.4 Cost Auditor ......................................................................................................................... 138 8.2.5 Qualification of Cost Auditor .............................................................................................. 138 8.2.6 Powers of a Cost Auditor ..................................................................................................... 139 8.2.7 Duties of a Cost Auditor ...................................................................................................... 1398.3 Tax Audit .............................................................................................................................................. 140 8.3.1 Purpose of Tax Audit ........................................................................................................... 140 8.3.2 Books of Accounts and List of Documents/Papers Required for Tax Audit Purpose .......... 140 8.3.3 Standard Procedures or Steps for Tax Audit ........................................................................ 141 8.3.4 Requirements of Tax Audit .................................................................................................. 141 8.3.5 Tax Auditor .......................................................................................................................... 1418.4 Management Audit ............................................................................................................................... 143 8.4.1 Process of Management Audit ............................................................................................. 143 8.4.2 Advantages of Management Audit ....................................................................................... 143 8.4.3 Management Audit Report ................................................................................................... 143Summary ................................................................................................................................................... 145References ................................................................................................................................................. 145Recommended Reading ........................................................................................................................... 145Self Assessment ......................................................................................................................................... 146

VII

List of Figures

Fig. 1.1 Financial system ............................................................................................................................... 2Fig. 1.2 Components of financial system ....................................................................................................... 3Fig. 1.3 Structure of Indian financial system ................................................................................................. 5Fig. 1.4 Types of financial markets ................................................................................................................ 7Fig. 1.5 RBI as an Organisation ..................................................................................................................... 8Fig. 2.1 Functions of commercial banks ...................................................................................................... 18Fig. 2.2 Recent trends in commercial banking ............................................................................................ 19Fig. 3.1 Characteristics of money market .................................................................................................... 36Fig. 3.2 Indian money market instruments .................................................................................................. 39Fig. 3.3 Credit rating agencies in India ........................................................................................................ 49Fig. 4.1 Classification of capital market ...................................................................................................... 56Fig. 4.2 Functions of capital market ............................................................................................................ 58Fig. 4.3 Forms of capital market efficiency ................................................................................................. 59Fig. 4.4 Indian capital market ...................................................................................................................... 61Fig. 4.5 Structure of capital market in India ................................................................................................ 62

VIII

Abbreviations

AAS - Auditing and Assurance StandardsAPR - Annual Percentage RateAPY - Annual Percentage YieldARDC - AgricultureRefinanceandDevelopmentCorporationAS - Accounting StandardATM - Automated Teller MachineBC - Business CorrespondentBF - Business FacilitatorBPT Act - Bombay Public Trusts ActBSE - Bombay Stock ExchangeCA - Chartered AccountantCAE - Chief Audit ExecutiveCAG - Comptroller and Auditor GeneralCARE - Credit Analysis and Research LimitedCARO - Companies Audit Report OrderCCI - Controller of Capital IssuesCCIL - Clearing Corporation of India limitedCD - CertificateofDepositsCDSL - Central Depository Service LimitedCEO - ChiefExecutiveOfficerCFO - ChiefFinanceOfficerCII - Chartered Insurance InstituteCP - Commercial PaperCRISIL - Credit Rating and Information Services of India LimitedCRR - Cash Reserve RatioCRR - Cash Reserve RatioDFHI - Discount and Finance House of IndiaDFI - Development Financial InstitutionsEBT - ElectronicBenefitTransferEMS - Export Marketing ServicesEPRA - Earnings Prospects and Risk AnalysisETF - Exchange Traded FundsEXIM - Export-Import Bank of IndiaFCA - FunctionConfigurationAuditFCCB - Foreign Currency Convertible BondsFII - Foreign Institutional InvestorsGAAP - Generally Accepted Accounting PrinciplesGAAP - Generally Accepted Accounting PrinciplesGBDT - Central Board of Direct TaxesGDR - Global Depository ReceiptsIAS - International Accounting StandardsICAI - Institute of Chartered Accountants of IndiaICICI - Industrial Credit and Investment Corporation of IndiaICRA - Investment Information and Credit Rating Agency of India Limited ICT - Information and Communication TechnologyICWAI - Institute of Cost and Works Accountants of IndiaIDBI - Industrial Development Bank of IndiaIFCI - Industrial Financial Corporation of IndiaIIBI - Industrial Investment Bank of IndiaIRDP - Institute of Rural Development PlanningIT - Information Technology

IX

LAF - Liquidity Adjustment FacilityLAF - Liquidity Adjustment FacilityLFAR - Longform Audit ReportLIC - Life Insurance CorporationLLC - Limited Liability companyMCI - Micro Credit InstitutionMMMF - Money market mutual fundMSS - Market Stabilisation SchemeNABARD - National Bank for Agriculture and Rural DevelopmentNBF - Non-Banking Financial InstitutionsNBFC - Non-Banking Financial CompaniesNCFM - NSE’sCertificationinFinancialMarketsNDS - Negotiated Dealing SystemNDTL - Net Demand And Time LiabilitiesNGO - Non Government OrganisationNOC - NoObjectionCertificateNPA - Non-performing AssetsNPO - Not-for-ProfitOrganisationsNREGA - National Rural Employment Guarantee ActNSDL - National Securities Depository LimitedNSE - National Stock ExchangeOMO - Open Market OperationsOTCEI - Over The Counter Exchange of IndiaPCD - Partly Convertible DebenturesPF - Provident FundPOS - Point of SalePPF - Professional Practice FrameworkPSU - Public Sector UndertakingsRBI - Reserve Bank of IndiaRRB - Regional Rural BanksSAI - Special Audit InitiativeSAP - Standard Auditing PracticesSAS - Statement of Auditing StandardsSCRA - Securities Contracts (Regulation) ActSEBI - Securities and Exchange Board of IndiaSEC - Securities and Exchange CommissionSFC - State Finance CorporationsSHG - Self Help GroupsSIDBI - Small Industrial Development Bank of IndiaSIDC - State Industrial Development CorporationsSLR - Statutory Liquidity RatioSLR - Statutory Liquidity RatioSME - Small and Medium EnterpriseSTPA - Sales Tax Practitioners’ AssociationTDS - Tax Deducted at SourceUTI - Unit Trust of India

1

Chapter I

Financial System

Aim

The aim of this chapter is to:

introducethefinancialsystem•

defineIndianfinancialsystem•

describethecomponentsoffinancialsystem•

Objectives

The objectives of this chapter are to:

elucidatethestructureoffinancialsystem•

explain the Reserve Bank of India•

explicate the monetary policy•

Learning outcome

At the end of this chapter, you will be able to:

understand the monetary policy instruments•

comprehend the functions of Reserve Bank of India•

enlistthefunctionsoffinancialsystem•


2

1.1 Introduction to Financial SystemEconomicgrowthanddevelopmentofanycountrydependsuponawell-knitfinancialsystem.Financialsystemcomprisesasetofsub-systemsoffinancialinstitutionsfinancialmarkets,financialinstruments,andserviceswhichhelpintheformationofcapital.Thus,afinancialsystemprovidesamechanismbywhichsavingsaretransformedintoinvestmentsanditcanbesaidthatfinancialsystemplayansignificantroleineconomicgrowthofthecountryby mobilising surplus funds and utilising them effectively for productive purpose.

Thefinancial system is characterisedby thepresenceof integrated,organisedand regulatedfinancialmarkets,andinstitutionsthatmeettheshorttermandlongtermfinancialneedsofboththehouseholdandcorporatesector.Bothfinancialmarketsandfinancialinstitutionsplayanimportantroleinthefinancialsystembyrenderingvariousfinancialservicestothecommunity.Theyoperateinclosecombinationwitheachother.

Thefinancialsystemisthesystemthatallowsthetransferofmoneybetweensaversandborrowers.Itcomprisesasetofcomplexandcloselyinterconnectedfinancialinstitutions,markets, instruments,services,practices,andtransactions. Financial systems are crucial to the allocation of resources in a modern economy. They channel householdsavingstothecorporatesectorandallocateinvestmentfundsamongfirms;theyallowinter-temporalsmoothingofconsumptionbyhouseholdsandexpendituresbyfirms;andtheyenablehouseholdsandfirmstosharerisks.Thesefunctionsarecommontothefinancialsystemsofmostdevelopedeconomies.Yettheformofthesefinancialsystemsvarieswidely.

Seekers of funds (mainlybusinessfirms

and government)

Supplies of funds (mainly households)

Flow of funds (savings)

Flowoffinancialservices

Incomesandfinancialclaims

Fig. 1.1 Financial system(Source: http://www.scribd.com/doc/8727176/Indian-Financial-System)

Financialsystemsareofcrucialsignificancetocapitalformation.Theadequatecapitalformationisindispensabletoaspeedyeconomicdevelopmentisuniversallyrecognisedinacademicliterature.Themainfunctionoffinancialsystem is the collection of savings and their distribution for industrial investment, thereby stimulating the capital formation and to that extent, accelerating the process of economic growth. The process of capital formation involves three distinct, although inter-related activities.

Savings: The ability by which claims to resources are set aside and become available for other purpose,•Finance: The activity by which claims to resources are either assembled from those released by domestic savings •obtained from abroad or specially created usually as bank deposits or notes and then placed in the hands of the investors.Investment: The activity by which resources are actually committed to production.•

1.2 Functions of Financial SystemAfinancialsystemperformsthefollowingfunctions:

It serves as a link between savers and investors. It helps in utilising the mobilised savings of scattered savers in •moreefficientandeffectivemanner.Itchannelisesflowofsavingintoproductiveinvestment.It assists in the selectionof theprojects tobefinancedandalso reviews theperformanceof suchprojects•periodically. It provides payment mechanism for exchange of goods and services.•It provides a mechanism for the transfer of resources across geographic boundaries.•

3

It provides a mechanism for managing and controlling the risk involved in mobilising savings and allocating •credit.It promotes the process of capital formation by bringing together the supply of saving and the demand for •investible funds.It helps in lowering the cost of transaction and increase returns. Reduce cost motives people to save more.•It provides you detailed information to the operators/ players in the market such as individuals, business houses, •Governments etc.

1.3 Components of Financial SystemThefinancialsystemcomprisesoffourmajorcomponents.Thesecomponentsare:

Components of Financial

System

FInancial Services

Financial Market

Financial Institution

Financial Instruments

Fig. 1.2 Components of financial system

FinancialInstitutionsmobilisethesavingseitherdirectlyorindirectlythroughfinancialmarketsbyusingvariousfinancialinstrumentsandintheprocessutilisingtheservicesofvariousfinancialserviceproviders.

Financial marketsThisisaplaceormechanismwherefundsorsavingsaretransferredfromonesectiontoanothersectionoffinancialsystem.Thesemarketscanbebroadlyclassifiedinto

Money market and capital market •Primary and secondary market •

Moneymarketdealswithshort-termclaimsorfinancialassetswhereascapitalmarketsdealwiththosefinancialassetswhichhavematurityperiodofmorethanayear.Thisclassificationisartificialasboththesemarketsperformthe same function of transferring surplus funds to needy units.

Anotherclassificationcouldbeprimarymarketsandsecondarymarkets.Primarymarketsdeal innewissueofsecurities whereas secondary markets deal with securities, which are already issued and available in the market. Primary markets by issuing new securities mobilise the savings directly. Secondary markets provide liquidity to the securities and thereby indirectly help in mobilising the savings.


4

Financial institutionsTheseareinstitutionswhicharedealinginthefinancialmarket.Theymobiliseandtransferthesavingsorfundsfromsurplusunitstodeficitunits.Theyarethebackboneoffinancialsystem.Theseinstitutionsunlikecommercialorganisationsdealwithonlyfinancialassetslikedeposits,securities,loans,etc.

Financial instrumentsThecommoditiesthataretradedordealtinafinancialmarketarefinancialassetsorsecuritiesorfinancialinstruments.Therearevarioustypeofsecuritieswhicharetradedinthefinancialmarketastherequirementsoflendersandborrowers are varied. Financial assets represent a claim on the repayment of principal at a future date and or payment ofaperiodicorterminalsumintheformofinterestordividend.Someoftheexamplesofthesefinancialinstrumentsare equity shares, preferences shares, debentures, bonds, etc.

Financial servicesFinancialservicesincludetheservicesofferedbyfinancialinstitutions.Theyincludetheleasingcompanies,mutualfunds,merchantbankers,issue/portfoliomanagers,billdiscountinghousesandacceptancehouses.Thefinancialserviceshelpnotonlytoraisetherequiredfundsbutalsoensuretheirefficientuse.Thevariousfinancialservicesprovided includes, leasing credit cards, factoring, banking, insurance, etc.

1.4 Overview of Indian Financial SystemIndianfinancialsystemconsistsoffinancialmarkets,financialintermediationandfinancialinstrumentsorfinancialproducts.Thereareareasorpeoplewithsurplusfundsandtherearethosewithadeficit.Afinancialsystemorfinancialsectorfunctionsasanintermediaryandfacilitatestheflowoffundsfromtheareasofsurplustotheareasofdeficit.Afinancialsystemisacompositionofvariousinstitutions,markets,regulationsandlaws,practices,moneymanager, analysts, transaction and claims and liabilities.

Indianfinancialmarketconsistsof:Money market: • The money market is a wholesale debt market for low-risk, highly-liquid, short-term instrument. Funds are available in this market for periods ranging from a single day up to a year. This market is dominated mostlybygovernment,banksandfinancialinstitutions.Capital market: • Thecapitalmarketisdesignedtofinancethelong-terminvestments.Thetransactionstakingplace in this market will be for periods over a year.Forex market: • The Forex market deals with the multicurrency requirements, which are met by the exchange of currencies. Depending on the exchange rate that is applicable, the transfer of funds takes place in this market. This is one of the most developed and integrated market across the globe.Credit market: • Creditmarketisaplacewherebanks,financialinstitutions,andNBFCspurveyshort,mediumand long-term loans to corporate and individuals.

1.5 Structure of Financial SystemThefinancialstructurereferstoshape,constituentsandtheirorderinthefinancialsystem.Thefinancialsystemconsistsofspecialisedandunspecialisedfinancialinstitutions,organisedandunorganisedfinancialmarkets,financialinstruments and services which facilitate transfer of funds.

Thefinancialsystemconsistsoffinancialinstitutions,financialmarkets,financialinstrumentsandfinancialservices,which are all regulated by regulators like ministry of Finance, the Company Law Board, RBI, SEBI, IRDA, Department of Economic Affairs, Department of Company Affairs, etc., which facilitate the process of smooth and efficienttransferoffunds.ThefollowingfigureshowsthestructureofIndianfinancialsystem.

5

Structure of Indian Financial System

Financial Institutions

Financial Instruments

Financial Markets

Money Market

Corporate Securities

Govt. Securities

Derivatives

Capital Market

Financial Services

Banking Non-Banking

Fig. 1.3 Structure of Indian financial system(Source: Murthy, D. K. and Venugopal, K. R., 2006. Indian Financial System, I. K. International Pvt Ltd.)

1.5.1 Financial InstitutionsFinancial institutions are business organisations that acts as mobilisers and depositories of savings, and as purveyors of credit orfinance.They also provide variousfinancial services to the community. Financial institutions areprincipally concerned with garnering the savings of myriad of savers and channelling them into productive outlets. They, thus, serve as conduits between savings and investment. There are numerous ways (and forms), in which the savings of different types of persons may be mobilised and transferred to different types of investors to satisfy their varied needs. Each of these ways represents a specialised activity, requiring expert knowledge and information, andiscarriedonbyspecialistinstitutions.Thefinancialinstitutions,whichcatertothenotionsofsaversofhighliquidityandsafetyalongwithprofitability,andwhichprovideworkingcapitaltotradeandindustries,mainlyinthe form of loans and advances, are collectively designated as the money market. On the other hand, institutions, which raise resources from savers who are not very liquidity-conscious, who are more venturesome, and who have greaterpreferenceforprofitability,andmakesuchresourcesavailable to industriesformeetingtheir long-termcapital requirements, are known as capital market.

Advantages of financial institutionsFinancial institutions have the following advantages:

Diversification: • Thepoolof fundsmobilisedby afinancial institution is invested in abroadlydiversifiedportfoliooffinancialassets(stocks,bonds,moneymarket instruments,andloans).Individual investorscanscarcelyachievesuchdiversificationontheirown.Remember,thatadiversifiedportfolioreducesrisk.Lower transaction cost:• Theaveragesizeofatransactionofafinancialinstitutionismuchhigherthanthatof an individual investor. The transaction cost, in percentage terms, tends to decrease as the transaction size increases.Hence,financialinstitutions,comparedtoindividualinvestors,incurlowertransactioncosts.Economies of scale:• Buying and holding securities (or for that matter granting loans and supervising them), calls for information gathering and processing and regular monitoring. These functions entail costs. Financial institutions, thanks to their bigger size and professional resources, enjoy economies of scale in performing these functions. Hence, they have a comparative advantage over the individual investors. Confidentiality:• Companies seeking funds or the continuing support of existing investors are required to disclose informationthattheyliketokeepconfidentialforcompetitivereasons.Theywouldfeelmorecomfortableindealingwith fewfinancial ·institutions rather thannumerous individual investors. Information sharedwithfinancial institutions is generally kept confidential,whereas informationdisclosed to numerous individualinvestors falls in the domain of public knowledge. Signalling:• Withgreaterprofessionalexpertiseattheircommand,financialinstitutionscanpickupandinterpretsignalsandcuesprovidedbyoperatingcompaniesmoreefficiently.Hence,theycanofferbettertermstooperatingcompanies,whichare likelytogravitate to them.In thismanner,financial institutionsperformasignallingfunction for the investing community.


6

Financialinstitutionsareclassifiedasbankinginstitutionsandnon-bankinginstitutions.

Banking financial institutionsBanking institutions are those institutions, which participate in the economy’s payments systems, i.e., they provide transaction services. Their deposits liabilities constitute a major part of the national money supply and they can, as a whole, create deposits or credit, which is money.

Non-banking financial institutionsNon-bankingfinancialinstitutionsarethoseinstitutionswhichactasmerepurveyorsofcreditandtheywillnotcreate credit. For instance, LIC, UTI, IDBI.

1.5.2 Financial InstrumentsSeveralfinancialinstrumentsareavailableintheIndianmoneymarket.Thesearegovernmentsecurities,orG-sec,preference shares, commercial papers, equity shares, certificate of deposits, callmoneymarket and industrialsecurities. These are discussed below.

Government securities:• In India, mainly the institutional investors buy the government securities. The government, both State and Central, and the government authorities, for example, state electricity boards, municipalities etc issue it. Commercial banks are the biggest investors who buy the G-secs. The government collectsmoneythroughtheG-secstofinanceitsseveralnewinfrastructuredevelopmentprojectsortomeetitspresent needs. The government itself issues the risk of default for G-sec, for it. Preference shares:• Thesecarryafixeddividendrateandaspecialrighttodividendsovertheprivateequityholders. Currently, all the preference shares in the Indian market are `redeemable and risqué, that is, they have afixedperiodofmaturity.Therefore,sometimestheyaretermedas`hybridvariety’.Commercial Papers (CP): • These are issued mainly by the corporate businessmen to fund their working capital needs. Commercial Papers are issued generally for short-term maturities. Commercial papers are not secure and subject to market risks, so those corporate bodies that have a good credit history will only be able to use thisfinancialinstrument.Equity shares:• Itisa“highreturnrisk”instrument.Equitysharesdon’thaveanyfixedreturnrateandthereby,no period of maturity. Certificate of Deposits (CD): • These are very similar to the Commercial papers. But the CDs are issued mainly by the commercial banks.Call money market:• The loans made in the call money market are mainly short term in nature. Call money marketmainlydealswiththeinterbankmarkets.Thosebanksthataresufferingfromashort-termcashdeficitborrow cap from the call money market. The interest rate varies with the market rate and depends upon the banking system.Industrial securities:• Normally the big corporate bodies are used to issue this to fulfil their long-termrequirements regarding working capital. The debentures and equity shares fall under this category.

1.5.3 Financial MarketsAfinancialmarketisanintegralpartoffinancialsystemofanycountry.Afinancialmarketisamarketinwhichfinancialassetsaretraded.Inadditiontoenablingexchangeofpreviouslyissuedfinancialassets,financialmarketsfacilitateborrowingandlendingbyfacilitatingthesaleofnewlyissuedfinancialassets.

Types of financial marketsAfinancialmarketconsistsoftwomajorsegments:(a)Moneymarket;and(b)Capitalmarket.Whilethemoneymarket deals in short-term credit, the capital market handles the medium term and long-term credit.

7

Financial Markets

Money Market

Capital Market

Fig. 1.4 Types of financial markets

Money marketThemoneymarketisamarketforshort-termfunds,whichdealsinfinancialassetswhoseperiodofmaturityisupto one year. It should be noted that money market does not deal in cash or money as such but simply provides a market for credit instruments such as bills of exchange, promissory notes, commercial paper, treasury bills, etc. These financialinstrumentsareclosesubstituteofmoney.Theseinstrumentshelpthebusinessunits,otherorganisationsand the Government to borrow the funds to meet their short-term requirement. Money market does not imply to any specificmarketplace.Ratheritreferstothewholenetworksoffinancialinstitutionsdealinginshort-termfunds,which provides an outlet to lenders and a source of supply for such funds to borrowers. Most of the money market transactions are taken place on telephone, fax or Internet. The Indian money market consists of Reserve Bank of India,Commercialbanks,Co-operativebanks,andotherspecialisedfinancialinstitutions.TheReserveBankofIndiaistheleaderofthemoneymarketinIndia.SomeNon-BankingFinancialCompanies(NBFCs)andfinancialinstitutions like LIC, GIC, UTI, etc. also operate in the Indian money market.

Capital marketCapitalMarketmaybedefinedasamarketdealinginmediumandlong-termfunds.Itisaninstitutionalarrangementfor borrowing medium and long-term funds and which provides facilities for marketing and trading of securities. Soitconstitutesalllong-termborrowingsfrombanksandfinancialinstitutions,borrowingsfromforeignmarketsand raising of capital by issue various securities such as shares debentures, bonds, etc. In the present chapter let us discuss about the market for trading of securities. The market where securities are traded known as Securities market. It consists of two different segments namely primary and secondary market. The primary market deals with neworfreshissueofsecuritiesandis,therefore,alsoknownasnewissuemarket;whereasthesecondarymarketprovides a place for purchase and sale of existing securities and is often termed as stock market or stock exchange. Capital market is further divided as Primary and Secondary market.

1.5.4 Financial ServicesFinancialservicesareanimportantcomponentofafinancialsystem.Financialservicescatertotheneedsoffinancialinstitutions,financialmarketsandfinancialinstruments.Financialinstitutionsserveindividualsandinstitutionalinvestors.Thefinancialinstitutionsandfinancialmarketshelpthefinancialsystemthroughfinancialinstruments.Theyrequireanumberofservicesoffinancialnatureinorderofulfilthetasksassigned;thefunctioningoffinancialsystemverymuchdependsontherangeoffinancialservicesprovidedbytheprovidersandtheirefficient.Followingaresomeofthefunctionsoffinancialserviceinstitutions.

Thesefirmsnotonlyhelptoraisetherequiredfundsbutalsoassuretheefficientdeploymentoffunds.•Theyassistindecidingthefinancingmix.•


8

They extend their services like bill discounting, factoring of debtors, parking of short-terms funds in the money •market,e-commerce,securitisingofdebts,=andsoontoensureanefficientmanagementiffunds.Thesefirmsprovide somespecialised services likecredit rating,venturecapitalfinancing, leasefinancing,•factoring,mutualfunds,merchantbanking,stocklending,depository,creditcards,housingfinanceandmerchantbanking and so on. These services are generally provided by banking companies, insurance companies, stock exchangesandnon-bankingfinancecompanies.

1.6 Reserve Bank of India (RBI)The Reserve Bank of India was established on April 1, 1935 in accordance with the provisions of the Reserve Bank ofIndiaAct,1934.TheCentralOfficeoftheReserveBankwasinitiallyestablishedinCalcuttabutwaspermanentlymovedtoMumbaiin1937.TheCentralOfficeiswheretheGovernorsitsandwherepoliciesareformulated.Thoughoriginally privately owned, since nationalisation in 1949, the Reserve Bank is fully owned by the Government of India.

Central Board of Directors

Governor

Deputy Governors

Executive Directors

Principal Chief General Manager

Chief General Managers

General Managers

Deputy General Managers

Assistant General Managers

Managers

Assistant Managers

Fig. 1.5 RBI as an Organisation(Source: http://rbidocs.rbi.org.in/rdocs/Content/PDFs/FUNCWWE080910.pdf)

9

1.6.1 Functions of RBIForsimplification,thefunctionsoftheReserveBankareclassifiedintothetraditionalfunctions,thedevelopmentfunctions and supervisory functions.

Traditional functions of RBI Traditional functions are those functions which every central bank of each nation performs all over the world. Basically these functions are in line with the objectives with which the bank is set up. It includes fundamental functions of the Central Bank. They comprise the following tasks:

Issue of currency notes:• The RBI has the sole right or authority or monopoly of issuing currency notes except one rupee note and coins of smaller denomination. These currency notes are legal tender issued by the RBI. Currently it is in denominations of Rs. 2, 5, 10, 20, 50, 100, 500, and 1,000. The RBI has powers not only to issue and withdraw but even to exchange these currency notes for other denominations. It issues these notes against the security of gold bullion, foreign securities, rupee coins, exchange bills and promissory notes and government of India bonds.Banker to other banks:• The RBI being an apex monitory institution has obligatory powers to guide, help and direct other commercial banks in the country. The RBI can control the volumes of banks reserves and allow other banks to create credit in that proportion. Every commercial bank has to maintain a part of their reserves with its parent’s viz. the RBI. Similarly in need or in urgency these banks approach the RBI for fund. Thus, it is called as the lender of the last resort.Banker to the government:• The RBI being the apex monitory body has to work as an agent of the central and state governments. It performs various banking function such as to accept deposits, taxes and make payments on behalf of the government. It works as a representative of the government even at the international level. It maintainsgovernmentaccounts,providesfinancialadvicetothegovernment.Itmanagesgovernmentpublicdebts and maintains foreign exchange reserves on behalf of the government. It provides overdraft facility to the governmentwhenitfacesfinancialcrunch.Exchange rate management:• It is an essential function of the RBI. In order to maintain stability in the external value of rupee, it has to prepare domestic policies in that direction. Also it needs to prepare and implement the foreign exchange rate policy which will help in attaining the exchange rate stability. In order to maintain the exchange rate stability it has to bring demand and supply of the foreign currency (U.S Dollar) close to each other.Credit control function: • Commercial bank in the country creates credit according to the demand in the economy. Butifthiscreditcreationisuncheckedorunregulatedthenitleadstheeconomyintoinflationarycycles.Ontheother credit creation is below the required limit then it harms the growth of the economy. As a central bank of the nation the RBI has to look for growth with price stability. Thus it regulates the credit creation capacity of commercial banks by using various credit control tools.Supervisory function• : The RBI has been endowed with vast powers for supervising the banking system in the country. It has powers to issue license for setting up new banks, to open new braches, to decide minimum reserves, to inspect functioning of commercial banks in India and abroad, and to guide and direct the commercial banks in India. It can have periodical inspections an audit of the commercial banks in India.

Developmental / promotional functions of RBIAlong with the routine traditional functions, central banks especially in the developing country like India have toperformnumerousfunctions.Thesefunctionsarecountryspecificfunctionsandcanchangeaccordingtotherequirementsofthatcountry.TheRBIhasbeenperformingasapromoterofthefinancialsystemsinceitsinception.Some of the major development functions of the RBI are maintained below.

Development of the financial system:• Thefinancialsystemcomprisesthefinancialinstitutions,financialmarketsandfinancialinstruments.Thesoundandefficientfinancialsystemisapreconditionoftherapideconomicdevelopment of the nation. The RBI has encouraged establishment of main banking and non-banking institutions to cater to the credit requirements of diverse sectors of the economy.


10

Development of agriculture:• In an agrarian economy like ours, the RBI has to provide special attention for the credit need of agriculture and allied activities. It has successfully rendered service in this direction by increasing theflowofcredittothissector.IthasearliertheAgricultureRefinanceandDevelopmentCorporation(ARDC)to look after the credit, National Bank for Agriculture and Rural Development (NABARD) and Regional Rural Banks (RRBs).Provision of industrial finance:• Rapid industrial growth is the key to faster economic development. In this regard,theadequateandtimelyavailabilityofcredittosmall,mediumandlargeindustryisverysignificant.InthisregardtheRBIhasalwaysbeeninstrumentalinsettingupspecialfinancialinstitutionssuchasICICILtd.IDBI, SIDBI and EXIM BANK etc.Provisions of training:• The RBI has always tried to provide essential training to the staff of the banking industry. The RBI has set up the bankers’ training colleges at several places. National Institute of Bank Management, i.e., NIBM, Bankers Staff College, i.e., BSC and College of Agriculture Banking, i.e., CAB are few to mention.Collection of data: • Being the apex monetary authority of the country, the RBI collects process and disseminates statisticaldataonseveraltopics.Itincludesinterestrate,inflation,savingsandinvestmentsetc.Thisdataprovesto be quite useful for researchers and policy makers.Publication of the reports:• The Reserve Bank has its separate publication division. This division collects and publishes data on several sectors of the economy. The reports and bulletins are regularly published by the RBI. It includes RBI weekly reports, RBI Annual Report, Report on Trend and Progress of Commercial Banks India., etc. This information is made available to the public also at cheaper rates.Promotion of banking habits:• As an apex organisation, the RBI always tries to promote the banking habits in the country. It institutionalises savings and takes measures for an expansion of the banking network. It has set up many institutions such as the Deposit Insurance Corporation-1962, UTI-1964, IDBI-1964, NABARD-1982, NHB-1988, etc. These organisations develop and promote banking habits among the people. During economic reforms it has taken many initiatives for encouraging and promoting banking in India.Promotion of export through refinance:• TheRBIalwaystriestoencouragethefacilitiesforprovidingfinancefor foreign trade especially exports from India. The Export-Import Bank of India (EXIM Bank India) and the ExportCreditGuaranteeCorporationofIndia(ECGC)aresupportedbyrefinancingtheirlendingforexportpurpose.

Supervisory functions of RBIThe reserve bank also performs many supervisory functions. It has authority to regulate and administer the entire bankingandfinancialsystem.Someofitssupervisoryfunctionsaregivenbelow.

Granting license to banks: • The RBI grants license to banks for carrying its business. License is also given for opening extension counters, new branches, even to close down existing branches.Bank inspection:• The RBI grants license to banks working as per the directives and in a prudent manner without undue risk. In addition to this it can ask for periodical information from banks on various components of assets and liabilities.Control over NBFIs:• TheNon-BankFinancialInstitutionsarenotinfluencedbytheworkingofamonitorypolicy. However RBI has a right to issue directives to the NBFIs from time to time regarding their functioning. Through periodic inspection, it can control the NBFIs.Implementation of the deposit insurance scheme:• The RBI has set up the Deposit Insurance Guarantee Corporation in order to protect the deposits of small depositors. All bank deposits below Rs. One lakh are insured with this corporation. The RBI work to implement the Deposit Insurance Scheme in case of a bank failure.

11

1.7 Monetary PolicyOne of the most important functions of central banks is formulation and execution of monetary policy. In the Indian context, the basic functions of the Reserve Bank of India as enunciated in the Preamble to the RBI Act, 1934 are: “to regulate the issue of Bank notes and the keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage.” Thus, the Reserve Bank’s mandate formonetarypolicyflowsfromitsmonetarystabilityobjective.Essentially,monetarypolicydealswiththeuseofvariouspolicyinstrumentsforinfluencingthecostandavailabilityofmoneyintheeconomy.Asmacroeconomicconditions change, a central bank may change the choice of instruments in its monetary policy. The overall goal is to promote economic growth and ensure price stability.

1.7.1 Monetary Policy in IndiaOver time, the objectives of monetary policy in India have evolved to include maintaining price stability, ensuring adequateflowof credit to productive sectors of the economy for supporting economicgrowth, and achievingfinancialstability.

Basedonitsassessmentofmacroeconomicandfinancialconditions,theReserveBanktakesthecallonthestanceofmonetarypolicyandmonetarymeasures.Itsmonetarypolicystatementsreflectthechangingcircumstancesandpriorities of the Reserve Bank and the thrust of policy measures for the future.

Faced with multiple tasks and a complex mandate, the Reserve Bank emphasises clear and structured communication for effective functioning of the monetary policy. Improving transparency in its decisions and actions is a constant endeavour at the Reserve Bank.

TheGovernoroftheReserveBankannouncestheMonetaryPolicyinAprileveryyearforthefinancialyearthatends in the following March. This is followed by three quarterly reviews in July, October and January. However, depending on the evolving situation, the Reserve Bank may announce monetary measures at any point of time. The Monetary Policy in April and its Second Quarter Review in October consist of two parts:

Part A provides a review of the macroeconomic and monetary developments and sets the stance of the monetary •policy and the monetary measures. Part B provides a synopsis of the action taken and the status of past policy announcements together with fresh •policymeasures.Italsodealswithimportanttopics,suchas,financialstability,financialmarkets,interestrates,creditdelivery,regulatorynorms,financialinclusionandinstitutionaldevelopments.

However, the First Quarter Review in July and the Third Quarter Review in January consist of only Part ‘A’.

1.7.2 Monetary Policy InstrumentsThe Reserve Bank traditionally relied on direct instruments of monetary control such as Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR). Cash Reserve Ratio indicates the quantum of cash that banks are required to keep with the Reserve Bank as a proportion of their net demand and time liabilities. SLR prescribes the amount of money that banks must invest in securities issued by the government.

In the late 1990s, the Reserve Bank restructured its operating framework for monetary policy to rely more on indirect instruments such as Open Market Operations (OMOs). In addition, in the early 2000s, the Reserve Bank instituted Liquidity Adjustment Facility (LAF) to manage day-to-day liquidity in the banking system. These facilities enable injection or absorption of liquidity that is consistent with the prevailing monetary policy stance. The repo rate (at which liquidity is injected) and reverse repo rate (at which liquidity is absorbed) under the LAF have emerged as the main instruments for the Reserve Bank’s interest rate signalling in the Indian economy. The armour of instruments with the Reserve Bank to manage liquidity was strengthened in April 2004 with the Market Stabilisation Scheme (MSS).TheMSSwasspecificallyintroducedtomanageexcessliquidityarisingoutofhugecapitalflowscomingto India from abroad.


12

Inaddition,theReserveBankalsousesprudentialtoolstomodulatetheflowofcredittocertainsectorssoastoensurefinancialstability.TheavailabilityofmultipleinstrumentsandtheirflexibleuseintheimplementationofmonetarypolicyhaveenabledtheReserveBanktosuccessfullyinfluencetheliquidityandinterestrateconditionsin the economy. While the Reserve Bank prefers indirect instruments of monetary policy, it has not hesitated in taking recourse to direct instruments if circumstances warrant such actions. Often, complex situations require varied combination of direct and indirect instruments to make the policy transmission effective.

TherecentlegislativeamendmentstotheReserveBankofIndiaAct,1934enableaflexibleuseofCRRformonetarymanagement,withoutbeingconstrainedbyastatutoryfloororceilingontheleveloftheCRR.TheamendmentstotheBankingRegulationAct,1949alsoprovidefurtherflexibilityinliquiditymanagementbyenablingtheReserveBank to lower the SLR to levels below the pre-amendment statutory minimum of 25 per cent of net demand and time liabilities (NDTL) of banks.

1.7.3 Credit Control Measures of Reserve Bank of IndiaCredit control is most important function of Reserve Bank of India. Credit control in the economy is required for the smooth functioning of the economy. By using credit control methods RBI tries to maintain monetary stability. There are two types of methods:Quantitative methods: These include:

Manipulation of bank rate: • Bank rate is the rate at which the reserve bank is prepared to buy or re discount bills of exchange or other commercial paper eligible for purchase under the act. Increase the bank rate reduces the credit creation power of banks and decrease in bank rate increases the credit creation power of the banks.Open market operations:• The term open market operation refers to purchase or sale of government securities by the central bank. Purchase of securities by the central bank in open market reduces in multiple expansion of credit and sale of securities leads to credit contraction by the bank.Manipulation of cash reserve ratio (CRR): The • central bank can control credit by variation of cash reserve ratio. A raise in this ratio reduces the credit creation ability of the banks and results it in increasing the credit creation ability of the banks.

Repo and reverse repo �Altering statutory liquidity ratio �

Qualitative methods: These include:Selective qualitative credit controls: • With the help of selective credit control methods the central bank can controlanddirecttheflowofcreditinthecountry.Rationingofcreditisinvolvedinthis.Thesecontrolsregulatethe use of credit by discriminating between essential and non essential purposes.Moral persuasion and direct action: • Central bank may refuse to grant further loans or re discount of bill for the banks to control their credit creation ability. The central bank may request banks not to use the accommodation ofobtainedforfinancingspeculativeornonessentialtransactions.

13

SummaryThefinancialsystemischaracterisedbythepresenceofintegrated,organisedandregulatedfinancialmarkets,and•institutionsthatmeettheshorttermandlongtermfinancialneedsofboththehouseholdandcorporatesector.Thefinancialsystemisthesystemthatallowsthetransferofmoneybetweensaversandborrowers.•Financial market is a place or mechanism where funds or savings are transferred from one section to another •sectionoffinancialsystem.Moneymarketdealswithshort-termclaimsorfinancialassetswhereascapitalmarketsdealwiththosefinancial•assets which have maturity period of more than a year.Indianfinancial systemconsists offinancialmarkets, financial intermediation andfinancial instruments or•financialproducts.Thefinancialsystemconsistsoffinancial institutions,financialmarkets,financial instrumentsandfinancial•services, which are all regulated by regulators like ministry of Finance, the Company Law Board, RBI, SEBI, IRDA, Department of Economic Affairs, Department of Company Affairs, etc., which facilitate the process of smoothandefficienttransferoffunds.The Reserve Bank of India was established on April 1, 1935 in accordance with the provisions of the Reserve •Bank of India Act, 1934.One of the most important functions of central banks is formulation and execution of monetary policy.•Credit control is most important function of Reserve Bank of India. Credit control in the economy is required •for the smooth functioning of the economy.

ReferencesKalyancity. • Functions of Reserve Bank of India RBI - RBI Credit Policy [Online] Available at: <http://kalyan-city.blogspot.com/2010/09/functions-of-reserve-bank-of-india-rbi.html> [Accessed 9 December 2011].Reserve Bank of India. • Reserve Bank of India: Functions and Working [pdf] Available at: <http://rbidocs.rbi.org.in/rdocs/Content/PDFs/FUNCWWE080910.pdf> [Accessed 9 December 2011].Financial Institutions, Lecture 01 • [Video Online] Available at: <http://www.youtube.com/watch?v=btdTkebcwSs> [Accessed 9 December 2011].Financial Institutions, Lecture 02 • [Video Online] Available at: <http://www.youtube.com/watch?v=btdTkebcwSs> [Accessed 9 December 2011].Murthy, D. K. & Venugopal, K. R• ., Indian Financial System, I. K. International Pvt. Ltd, p.152.Madura, J., 2010. Financial Institutions and Markets, Cengage South-Western, p.250.•Joshi, I., 2010. • RBI Monetary Policy [Video Online] Available at: <http://www.youtube.com/watch?v=jqb2DoWKL9I&feature=related>. [Accessed 13 December 2011].Reservebankindia, 2010. • The Reserve Bank of India: Making a Difference [Video Online] Available at: <http://www.youtube.com/watch?v=YwTxuRMXjg0>. [Accessed 13 December 2011].

Recommended ReadingBarger, T., International Finance Corporation, World Bank, 1998. • Financial institutions, World Bank Publications, p.135.Pathak, 2007. • The Indian Financial System: Markets, Institutions and Services, 2nd ed., Pearson Education India, p.752.Khan, 2006. Indian Financial System 5E, • Tata McGraw-Hill Education.


14

Self AssessmentEconomic growth and development of any country depends upon a well-knit ___________.1.

financialgrowtha. financialsystemb. financialaccountingc. financialauditingd.

Whichof the followingcomprisesasetofsub-systemsoffinancial institutionsfinancialmarkets,financial2. instruments and services which help in the formation of capital?

financialgrowtha. financialauditingb. financialsystemc. financialaccountingd.

Thefinancialsystemcomprisesof__________majorcomponents.3. onea. twob. threec. fourd.

Match the following.4.

Financial markets1. equity shares, preferences shares, debentures, bonds, etc.A.

Financial institutional2. Money and Capital marketB.

Financial instruments3. leasing credit cards, factoring, banking, insurance, etc.C.

Financial services4. mobilise and transfer the savings or funds from surplus D. unitstodeficitunits

1-D, 2-C, 3-B, 4-Aa. 1-A, 2-B, 3-C, 4-Db. 1-B, 2-D, 3-A, 4-Cc. 1-C, 2-A, 3-D, 4-Bd.

Which of the following is a wholesale debt market for low-risk, highly-liquid, short-term instrument?5. Capital marketa. Money marketb. Financial systemc. Primary marketd.

__________isdesignedtofinancethelong-terminvestments.6. Capital marketa. Money marketb. Forex marketc. Primary marketd.

15

Which of the following deals with the multicurrency requirements, which are met by the exchange of 7. currencies?

Capital marketa. Money marketb. Forex marketc. Primary marketd.

_____________isaplacewherebanks,financialinstitutions,andNBFCspurviewshort,mediumandlong-term8. loans to corporate and individuals.

Forex marketa. Capital marketb. Secondary marketc. Credit marketd.


Savings1. three distinct, although inter-related activitiesA.

Finance2. The activity by which resources are actually B. committed to production

Investment3. The activity by which claims to resources are either C. assembled from those released by domestic savings

Process of capital formation4. The ability by which claims to resources are set aside D. and become available for other purpose


Which of the following are issued mainly by the corporate businessmen to fund their working capital needs?10. Government securitiesa. CertificateofDepositb. Commercial papersc. Call money marketd.


16

Chapter II

Commercial Banks

Aim


introduce commercial banks•

definebanks•

describe the functions of commercial banks•

Objectives


elucidate the evolution of commercial banks in India•

explain the recent trends in commercial banking•

discuss about the development banks•

Learning outcome


understand the Industrial Finance Corporation of India (IFCI)•

comprehend the objectives of IDBI•

enlist the functions and objectives of NABARD•

17

2.1 IntroductionBanks have played a critical role in the economic development of some developed countries such as Japan and Germany and most of the emerging economies including India. Banks today are important not just from the point of viewofeconomicgrowth,butalsofinancialstability.Inemergingeconomies,banksarespecialforthreeimportantreasons.First,theytakealeadingroleindevelopingotherfinancialintermediariesandmarkets.Second,duetothe absence of well-developed equity and bond markets, the corporate sector depends heavily on banks to meet its financingneeds.Finally,inemergingmarketssuchasIndia,bankscatertotheneedsofavastnumberofsaversfromthe household sector, which prefer assured income and liquidity and safety of funds, because of their inadequate capacitytomanagefinancialrisks.

Forms of banking have changed over the years and evolved with the needs of the economy. The transformation of the banking system has been brought about by deregulation, technological innovation and globalisation. While banks have been expanding into areas which were traditionally out of bounds for them, non-bank intermediaries have begun to perform many of the functions of banks. Banks thus, compete not only among themselves, but also withnonbankfinancialintermediaries,andovertheyears,thiscompetitionhasonlygrowninintensity.Globally, this has forced the banks to introduce innovative products, seek newer sources of income and diversify into non-traditional activities.

Definition of bankInIndia,thedefinitionofthebusinessofbankinghasbeengivenintheBankingRegulationAct,(BRAct),1949.According to Section 5(c) of the BR Act, ‘a banking company is a company which transacts the business of banking inIndia.’Further,Section5(b)oftheBRActdefinesbankingas,‘accepting,forthepurposeoflendingorinvestment,of deposits of money from the public, repayable on demand or otherwise, and withdrawable, by cheque, draft, order orotherwise.’Thisdefinitionpointstothethreeprimaryactivitiesofacommercialbankwhichdistinguishitfromtheotherfinancialinstitutions.Theseare:(i)maintainingdepositaccountsincludingcurrentaccounts,(ii)issueandpay cheques, and (iii) collect cheques for the bank’s customers.

2.2 Evolution of Commercial Banks in IndiaEnhancement of the RBI Act 1935 gave birth to scheduled banks in India, and some of these banks had already been established around 1881. The prominent among the scheduled banks is the Allahabad Bank, which was set up in1865withEuropeanmanagement.ThefirstbankwhichwasestablishedwithIndianownershipandmanagementwas the Oudh Commercial Bank, formed in 1881, followed by the Ayodhya Bank in 1884, the Punjab National Bankin1894andNedungadiBankin1899.Thus,therewerefiveBanksinexistenceinthe19thcentury.Duringthe period 1901-1914, twelve more banks were established, prominent among which were the Bank of Baroda (1906), the Canara Bank (1906), the Indian Bank (1907), the Bank of India (1908) and the Central Bank of India (1911).Thus,thefivebigbanksoftodayhadcomeintobeingpriortothecommencementoftheFirstWorldWar.In 1913, and also in 1929, the Indian Banks faced serious crises. Several banks succumbed to these crises. Public confidenceinbanksreceivedajolt.Therewasaheavyrushonbanks.Animportantpointtobenotedhereisthatno commercial bank was established during the First World War, while as many as twenty scheduled banks came into existence after independence - two in the public sector and one in the private sector.

The United Bank of India was formed in 1950 by the merger of four existing commercial banks. Certain non-scheduled banks were included in the second schedule of the Reserve Bank. In view of these facts, the number of scheduled banks rose to 81. Out of 81 Indian scheduled banks, as many as 23 were either liquidated or merged into or amalgamated with other scheduled banks in 1968, leaving 58 Indian schedule banks.

It may be emphasised at this stage that banking system in India came to be recognised in the beginning of 20th centuryaspowerfulinstrumenttoinfluencethepaceandpatternofeconomicdevelopmentofthecountry.In1921need was felt to have a State Bank endowed with all support and resources of the Government with a view to helping industries and banking facilities to grow in all parts of the country. It is towards the accomplishment of this objective that the three Presidency Banks were amalgamated to form the Imperial Bank of India. The role of the Imperial Bank was envisaged as “to extend banking facilities, and to render the money resources of India more accessible tothetradeandindustryofthiscountry,therebypromotingfinancialsystemwhichisanindisputableconditionofthe social and economic advancement of India.”


18

Until 1935 when RBI came into existence to play the role of Central Bank of the county and regulatory authority for the banks, Imperial Bank of India played the role of a quasi-central bank. It functioned as a commercial bank butattimestheGovernmentuseditforregulatingthemoneysupplybyinfluencingitspolicies.Thus,theroleofcommercialbanksinIndiaremainedconfinedtoprovidingvehicleforthecommunity’ssavingsandattendingtothe credit needs of only certain selected and limited segments of the economy.

2.3 Functions of Commercial BanksThe functions of commercial banks are divided into two categories:

Primary Functions

Granting Loans and Advances

Fig. 2.1 Functions of commercial banks

Primary functions• : The primary functions of a commercial bank include:Accepting deposits: The most important activity of a commercial bank is to mobilise deposits from the �public.Peoplewhohavesurplusincomeandsavingsfinditconvenienttodeposittheamountswithbanks.Depending upon the nature of deposits, funds deposited with bank also earn interest. Thus, deposits with the bank grow along with the interest earned. If the rate of interest is higher, public are motivated to deposit more funds with the bank. There is also safety of funds deposited with the bank.

Granting loans and advances• : The second important function of a commercial bank is to grant loans and advances. Such loans and advances are given to members of the public and to the business community at a higher rate of interest than allowed by banks on various deposit accounts. The rate of interest charged on loans and advances varies depending upon the purpose, period and the mode of repayment. The difference between the rate of interest allowed on deposits and the rate charged on the Loans is the main source of a bank’s income.

Loans:Aloanisgrantedforaspecifictimeperiod.Generally,commercialbanksgrantshort-termloans. �But term loans, that is, loan for more than a year, may also be granted. The borrower may withdraw the entire amount in lump sum or in instalments. However, interest is charged on the full amount of loan. Loans are generally granted against the security of certain assets. A loan may be repaid either in lump sum or in instalments.Advances: An advance is a credit facility provided by the bank to its customers. It differs from loan in the �sense that loans may be granted for longer period, but advances are normally granted for a short period of time. Further the purpose of granting advances is to meet the day to day requirements of business. The rate of interest charged on advances varies from bank to bank. Interest is charged only on the amount withdrawn and not on the sanctioned amount.

19

2.4 Recent Trends in Commercial BankingThere are a number of trends evolving in modern banking, the most important of which relate to (a) technology, (b) outsourcingofservicesand(c)financialinclusion.

Technology Outsourcing of Services

Financial Inclusion

Fig. 2.2 Recent trends in commercial banking

2.4.1 TechnologyBanks in India have started using technology in a proactive manner. The huge number of bank customers and their myriad needs are being met in increasingly sophisticated ways. In a number of areas, the foreign banks and the new privatesectorbankshavebeenthefirstmoversintheapplicationoftechnology,butpublicsectorbanksarealsocatching up. One major advantage that Indian banks have is the availability of major IT companies in India who are the world leaders in IT applications.

Internet bankingThrough its website, a bank may offer its customers online access to account information and payment and fund transfer facilities. The range of services offered differs from bank to bank depending mainly on the type and size of the bank. Internet banking is changing the banking industry and affecting banking relationships in a major way.

Mobile banking transactionsSome banks have started offering mobile banking and telebanking to customers. The expansion in the use and geographical reach of mobile phones has created new opportunities for banks to use this mode for banking transactions and also provide an opportunity to extend banking facilities to the hitherto excluded sections of the society. The RBI has adopted Bank Led Model in which mobile phone banking is promoted through business correspondents of banks.

Point of sale (PoS) terminalsTo use smart cards/debit cards/credit cards for the purchase of an item or for payment of a service at a merchant’s store, the card has to be swiped in a terminal (known as Point of Sale or POS terminal) kept at the merchant’s store. As soon as the card is put on the terminal, the details of the card are transmitted through dial-up or leased lines to a hostcomputer.Onverificationofthegenuinenessofthecard,thetransactionisauthorisedandconcluded.Itisthusa means to ‘check out’ whether the cardholder is authorised to make a transaction using the card. POS terminal is a relatively new concept.


20

A Point of Sale (PoS) terminal is an integrated PC-based device, with a monitor (CRT), PoS keyboard, PoS printer, Customer Display, Magnetic Swipe Reader and an electronic cash drawer all rolled into one. More generally, the POS terminal refers to the hardware and software used for checkouts.

2.4.2 Outsourcing of ServicesOutsourcing can enable banks to stay ahead of competition. Growing competition in the banking sector has forced banks to outsource some of their activities to maintain their competitive edge. Decision to outsource could be on cost considerations as well as lack of expertise in banks in delivering certain services. Banks typically outsource their non-core functions so that they can concentrate on their core functions. However, there are risks involved in the process of outsourcing to a third party. These risks include non-compliance with regulations, loss of control over business, leakage of customer data, lack of expertise of the third party, poor service from third party, etc.

Outsourcing activities of banks in IndiaDuring the recent years, Indian banks also have started outsourcing their non-core activities. The outsourced services may include software application support, maintenance of hardware and software, hosting services, managing data centres, managing ATM networks across the country, and disaster management. Further, banks are also giving contracts to third parties in order to manage other support services such as call-support services, help-desk support, credit card processing, cheque processing and clearing, ATM cash replenishment, cheque clearing and collection, loan servicing, data processing, etc. The two main reasons for Indian banks outsourcing non-core activities are similar to the overseas banks, i.e., cost consideration and lack of expertise in certain areas. Through outsourcing, bankscanalsobenefitfromthedomainexpertiseoftheserviceproviders.

Outsourcing helps banks not only to focus on their core activities, but also in certain cases to reduce the capital investment in developing the required infrastructure. Further, in-house provision of services may be more expensive because they do not enjoy any economy of scale. Service providers on the other hand may enjoy economies of scale because they cater to the outsourcing requirements of a number of banks and companies and pass on some of thebenefitsofscaletotheoutsourcingbanks.Itisnotonlythesmallbankswhohavestartedoutsourcingnon-coreactivities;largepublicsectorbanksarealsooutsourcingtheirnon-coreservices.

2.4.3 Financial InclusionDespite the expansion of the banking network in India since independence, a sizeable proportion of the households, especially in rural areas, still do not have a bank account. Considerable efforts have to be made to reach these unbankedregionsandpopulation.FinancialInclusionimpliesprovidingfinancialservices,viz.,accesstopaymentsand remittance facilities, savings, loans and insurance services at affordable cost to those who are excluded from theformalfinancialsystem.

Initiative taken by RBITheRBI’srecentmeasurestopromotefinancialinclusionincludes:advisingbankstoopen‘nofrills’accounts,introduction of Business Correspondent (BC)/ Business Facilitator (BF) model and adoption of Information and Communication Technology (ICT) solutions for achieving greater outreach.

Basic banking ‘no-frills’ accountToachievetheobjectiveofgreaterfinancialinclusion,allbankshavebeenadvisedbytheRBItomakeavailableabasic banking ‘no-frills’ account either with ‘nil’ or very low minimum balances. They have also been advised to keep the transaction charges low, which would make such accounts accessible to vast sections of population. The nature and number of transactions in such accounts could be restricted by the banks, but such restrictions must be made known to the customer in advance in a transparent manner. The growth of such deposits should be encouraged with affordable infrastructure and low operational costs through the use of appropriate technology.

Use of business facilitators and correspondentsThe RBI has introduced business facilitators and business correspondent models to enable banks to use the services ofNGOs,SelfHelpGroups(SHGs)andmicrofinanceinstitutionsas intermediaries inprovidingfinancialandbanking services. These intermediaries serve as the facilitators /correspondents of the banks.

21

Inthebusinessfacilitatormodel,theseintermediarieshelpthebanksfacilitateservicessuchasidentificationofborrowers, collection and preliminary processing of loan applications, creating awareness about savings and other products, processing and submission of applications to banks and post-sanction monitoring.

In addition to activities which the intermediaries can engage in the business facilitator model, the scope of activities under the business correspondent’s models include disbursal of small value credit, recovery of principal/collection of interest, collection of small value deposits, receipt and delivery of small value remittances etc. As the engagement ofintermediariesasbusinessfacilitators/correspondentsinvolvesasignificantreputational,legalandoperationalrisks, banks need to give due consideration to those risks. The bank’s arrangement with the business correspondents should:

Specify the suitable limits on cash holding by intermediaries, as also limits on individual customer payments •and receipts.Requirethatthetransactionsareaccountedforandreflectedinthebank’sbooksbytheendofthedayornext•working day.Require all agreements/contracts with the customer to clearly specify that the bank is responsible to the customer •for acts of omission and commission of the business facilitator / correspondent.

Banks pay reasonable commission/ fees to the Business Facilitators/ Correspondents. The banks’ agreement with themhowevershouldspecificallyprohibitthemfromcharginganyfeestothecustomersfortheservicesrenderedby them on behalf of the banks.

Adoption of technologyThe RBI has formulated a scheme to accelerate the pace of adoption of the biometric access/ smart card based ElectronicBenefitTransfer(EBT)mechanismbythebanksandrollouttheEBTsystemintheStatesthatarereadyto adopt the scheme. As per the scheme, RBI would partially reimburse the banks, for a limited period, the cost of openingaccountswithbiometricaccess/smartcards.Throughtheseaccounts,paymentofsocialsecuritybenefits,NationalRuralEmploymentGuaranteeAct(NREGA)paymentsandpaymentsunderothergovernmentbenefitprogrammes would be routed. The potential of information technology (IT) in extending banking services to under-served markets in rural and semi-urban areas is enormous. The use of Smart Card technology, mobile ATMs, coverage ofruralpostofficesunderelectronicpaymentsnetworks-allcouldcontributetoprovidingfinancialservicestomorepeopleandtherebyservefinancialinclusion.

Micro creditMicroCreditisdefinedasprovisionofcreditandotherfinancialservicesandproductsofverysmallamount to the poor in rural, semi-urban and urban areas for enabling them to raise their income levels. Micro Credit Institutions (MCIs) are those which provide these facilities. Banks are allowed to devise appropriate loan and savings products and the related terms and conditions including size of the loan, unit cost, unit size, maturity period, grace period, margins, etc. Such credit covers not only consumption and production loans for various farm and nonfarm activities of the poor but also includes their other credit needs such as housing and shelter improvements.

Self help groupA Self-Help Group (SHG) is a registered or unregistered group of 15-20 people who voluntarily join together to save small amounts regularly. These pooled savings are used to make interest bearing loans to group members. In addition to inculcating the habit of thrift, SHG activity develops among its members the capacity to handle resources. When the group matures and stabilises, it gets linked to the banks under a SHG-banks linkage program and banks start providing credit to SHGs. Note that the banks provides credit to SHGs and not to individuals belonging to the SHG. It is the SHGs who pass on the loans to the individuals. Thus, the SHGs become responsible for repayment to the banks. The group members use collective wisdom and peer pressure to ensure proper end-use of credit and timely repayment thereof. Peer pressure acts as an effective substitute for collaterals.


22

Advantages of financing through SHGsAneconomicallypoorindividualgainsstrengthaspartofagroup.Besides,financingthroughSHGsreduces•transaction costs for both lenders and borrowers. While lenders have to handle only a single SHG account instead of a large number of small-sized individual •accounts, borrowers as part of a SHG cut down expenses on travel for completing paper work and on the loss of workdays in availing loans. Since 1991-92, the National Bank for Agriculture and Rural Development (NABARD) has been encouraging •banks to extend micro credit loans to SHGs. The scheme was then extended to RRBs and co-operative banks. More than 90 per cent of the groups linked with banks are exclusive women’s groups.WhiletheSHG-banklinkageprogrammehasemergedasthedominantmicrofinancedispensationmodelin•India,othermodelstoohaveevolved.Forexample,microfinancedeliverythroughmicrofinanceinstitutions(MFIs) has also emerged as an important delivery channel.

2.5 Development Banks Business often requires medium and long-term capital for purchase of machinery and equipment, for using latest technology,orforexpansionandmodernisation.SuchfinancialassistanceisprovidedbyDevelopmentBanks.Theyalso undertake other development measures like subscribing to the shares and debentures issued by companies, in case of under subscription of the issue by the public. Industrial Finance Corporation of India (IFCI) and State Financial Corporations (SFCs) are examples of development banks in India.

ADevelopmentBankisapolygonaldevelopmentfinanceinstitutiondevotedtoimprovingthesocialandmonetarydevelopment of its associate nations. The main emphasis is the welfare of the people. For example, the Asian DevelopmentBank’soverarchinggoalistodecreasepovertyinAsiaandthePacific.Ithelpsimprovethevalueofpeople’slivesbyprovidingloansandscientificsupportforabroadvarietyofdevelopmentactivities.

A development bank’s policies or programs centre on the following priorities:Economic Growth•Human Development•Gender and Development•Good Governance•Environmental Protection•Private Sector Development•Regional cooperation•

2.5.1 Features of a Development BankA development bank has the following features or characteristics:

Adevelopment bankdoes not accept deposits from the public like commercial banks andotherfinancial•institutions who entirely depend upon saving mobilisation. Itisaspecialisedfinancialinstitutionwhichprovidesmediumtermandlong-termlendingfacilities.•Itisamultipurposefinancialinstitution.Besidesprovidingfinancialhelpitundertakespromotionalactivities•also. It helps an enterprises from planning to operational level. Itprovidesfinancialassistancetobothprivateaswellaspublicsectorinstitutions.•Theroleofadevelopmentbankisofgapfiller.Whenassistancefromothersourcesisnotsufficientthenthis•channelhelps.Itdoesnotcompetewithnormalchannelsoffinance.Developmentbanksprimarilyaimtoacceleratetherateofgrowth.Ithelpsindustrialisationspecificandeconomic•development in general Theobjectiveofthesebanksistoservepublicinterestratherthanearningprofits.•Development banks react to the socio-economic needs of development.•

23

2.5.2 Functions of Development Banks Development banks have been started with the motive of increasing the pace of industrialisation. The traditional financial institutions could not take up this challenge because of their limitations. In order to help all roundindustrialisationdevelopmentbanksweremademultipurposeinstitutions.Besidesfinancingtheywereassignedpromotional work also. Some important functions of these institutions are discussed as follows: Financial gap fillers Development banks do not provide medium-term and long-term loans only but they help industrial enterprises in many other ways too. These banks subscribe to the bonds and debentures of the companies, underwrite to their shares and debentures and, guarantee the loans raised from foreign and domestic sources. They also help ‘undertakings to acquire machinery from with in and outside the country.

Undertake entrepreneurial role Developing countries lack entrepreneurs who can take up the job of setting up new projects. It may be due to lack ofexpertiseandmanagerialability.Developmentbankswereassignedthejobofentrepreneurialgapfilling.Theyundertake the task of discovering investment projects, promotion of industrial enterprises, provide technical and managerial assistance, undertaking economic and technical research, conducting surveys, feasibility studies etc. The promotionalroleofdevelopmentbankisverysignificantforincreasingthepaceofindustrialisation.

Commercial banking business Development banks normally provide medium and long-term funds to industrial enterprises. The working capital needs of the units are met by commercial banks. In developing countries, commercial banks have not been able to take up this job properly. Their traditional approach in dealing with lending proposals and assistance on securities hasnothelpedtheindustry.Developmentbanksextendfinancialassistanceformeetingworkingcapitalneedstotheir loan if they fail to arrange such funds from other sources. So far as taking up of other functions of banks such as accepting of deposits, opening letters of credit, discounting of bills, etc. there is no uniform practice in development banks.

Joint finance Anotherfeatureofdevelopmentbank’soperationsistotakeupjointfinancingalongwithotherfinancialinstitutions.Theremaybeconstraintsoffinancialresourcesandlegalproblems(prescribingmaximumlimitsoflending)whichmayforcebankstoassociatewithotherinstitutionsfortakingupthefinancingofsomeprojectsjointly.Itmayalsonot be possible to meet all the requirements of a concern by one institution, So more than one institution may join hands. Not only in large projects but also in medium-size projects it may be desirable for a concern to have, for instance, the requirements of a foreign loan in a particular currency, met by one institution and under writing of securities met by another.

Refinance facility Developmentbanksalsoextendrefinancefacilitytothelendinginstitutions.Inthisschemethereisnodirectlendingto the enterprise. The lending institutions are provided funds by development banks against loans extended’ to industrialconcerns.Inthiswaytheinstitutionswhichprovidefundstounitsarerefinancedbydevelopmentbanks.In India, Industrial Development Bank of India provides reliance against (‘term loans granted to industrial ‘concerns bystatefinancialcorporations.commercialbanksandstateco-operativebanks.

Credit guarantee Thesmallscalesectorisnotgettingproperfinancialfacilitiesduetotheclementofrisksincetheseunitsdonothavesufficientsecuritiestoofferforloans,lendinginstitutionsarehesitanttoextendthemloans.ToovercomethisdifficultymanycountriesincludingIndiaandJapanhavedevisedcreditguaranteeschemeandcreditinsurancescheme.In India, credit guarantee scheme was introduced in 1960 with the object of enlarging the supply of institutional credit to small industrial units by granting a degree of protection to lending institutions against possible losses in respect of such advances. In Japan besides credit guarantee, insurance is also provided. These schemes help small scale concerns to avail loan facilities without hesitation.


24

Underwriting of securitiesDevelopment banks acquire securities of industrial units through either direct subscribing or underwriting or both. The securities may also be acquired through promotion work or by converting loans into equity shares or preference shares. So development banks may build portfolios of industrial stocks and bonds. These banks do not hold these securities on a permanent basis. They try to disinvest in these securities in a systematic way which should not influencemarketpricesofthesesecuritiesandalsoshouldnotlosemanagerialcontroloftheunits.Developmentbanks have become world wide phenomena. Their functions depend upon the requirements of the economy and thestateofdevelopmentofthecountry.Theyhavebecomewellrecognisedsegmentsoffinancialmarket.Theyareplaying an important role in the promotion of industries in developing and underdeveloped countries.

2.5.3 Major Objectives of Development BankEvery country felt the need to accelerate the rate of development in post world war era. Some countries were directly involved in war while many others were indirectly affected by it. There was a need for reconstructing economics at a fasterspeed.Theexistingmachineryfordevelopmentalactivitieswasnotsufficienttotherequirementsofindustry.Therewasaneedtosetupsuchinstitutionswhichwouldtakeuppromotionalactivitiesbesidesfinancing.Inthisbackground developmental banks were needed for the following reasons:Lay foundations for industrialisationA number of countries got independence from colonial rule. Their economies needed to be rehabilitated. Other underdeveloped and developing countries too needed to accelerate the pace of industrialisation. To lay a solid foundation for growth, establishment of certain key industries such as cement, engineering, machine making, chemicals, etc. is essential. Private entrepreneurs were not forthcoming to invest in these vital areas due to risk involved and long gestation period in those industries. The governments of under developed countries set up developmentandinstitutionstofillthevacuum.

Meet capital needsThere was a dearth of capital needed to foster industrial growth in underdeveloped countries. Owing to the low levelofincomeofthepeopletherewerenosufficientsurplusesforcapitalisation.Therewasaneedforinstitutionswhich could meet this gap between demand and supply for capital.

Need for promotional activitiesBesides capital needs, underdeveloped countries suffered from lack of expertise, managerial and technical know-how. Developmental banks could take up the job of and joint sectors and provide managerial and resources and skillsandofchannellingthemintoapprovedfieldsunderprivateauspicesareneededinthesecountries.

Help small and medium sectorsThe large scale was, to some extent, able to meet its needs. There was a need to mitigate sufferings of small and medium size industries which form a sizeable sector of the industrial economy. Despite the important role played by these sectors they experience scarcity of capital owing to the apathy of investors to invest their savings because oftheircreditworthinessandprofitability.Therewasaneedforspecialinstitutionstohelpthesesectorsinplayingvital role in the industrialisation of developing and under developed countries.

2.6 IFCIAt the time of independence in 1947, India’s capital market was relatively under-developed. Although there was significantdemand fornewcapital, therewasadearthofproviders.Merchantbankers andunderwritingfirmswerealmostnon-existentandcommercialbankswerenotequippedtoprovidelong-termindustrialfinanceinanysignificantmanner.

It is against this backdrop that the government established The Industrial Finance Corporation of India (IFCI) on July1,1948,asthefirstDevelopmentFinancialInstitutioninthecountrytocatertothelong-termfinanceneedsofthe industrial sector. The newly-established DFI was provided access to low-cost funds through the central bank’s Statutory Liquidity Ratio or SLR which in turn enabled it to provide loans and advances to corporate borrowers at concessional rates.

25

IFCIhasbeenabletoachieveafinancialturnaroundwiththeconsistentsupportandcooperationofallitsstakeholdersand is now endeavouring to re-position itself.

In addition to its core competence in long term lending to industrial and infrastructure sectors, IFCI aims to enhance its organisational value through better realisation of its Non-performing Assets (NPAs) and unlocking of value of its investment port-folio including unquoted investments as well as real estate assets.

2.6.1 ObjectivesTheprimaryroleofIFCIistoprovide‘directfinancialassistance’onmediumandlongtermbasistoindustrialprojects in the corporate and co-operative sectors. Over the years, the scope of activities of the corporation has widened. The objectives of the corporation are stated below.

To provide long and medium-term credit to industrial concerns engaged in manufacturing, mining, shipping •and electricity generation and distribution.Theperiodofcreditcanbeaslongas25yearsandshouldnotexceedthatperiod;•To grant credit to a single concern up to a maximum amount of rupees one crore. This limit can be exceeded •withthepermissionofthegovernmentundercertaincircumstances;guaranteeloansanddeferredpayments;•underwriteanddirectlysubscribetosharesanddebenturesissuedbycompanies;•assist in setting up new projects as well as in modernisation of existing industrial concerns in medium and large •scalesector;assist projects under co-operatives and in backward areas.•

2.6.2 FunctionsThe main functions of IFCI are as under:

Grantingloansandadvancesfortheestablishment,expansion,diversificationandmodernisationofindustries•in corporate and co-operative sectors.Guaranteeing loans raised by industrial concerns in the capital market, both in rupees and foreign currencies. •Subscribing or underwriting the issue of shares and debentures by industries. Such investment can be held up •to 7 years.Guaranteeing credit purchase of capital goods, imported as well as purchased within the country.•Providing assistance, under the soft loans scheme, to selected industries such as cement, cotton textiles, jute, •engineering goods, etc.Providing technical, legal, marketing and administrative assistance to any industrial concern for the promotion, •management and expansion of the industrial concern.Providing equipment (imported or indigenous) to the existing industrial concerns on lease under its ‘equipment •leasing scheme’.Procuring and reselling equipment to eligible existing industrial concerns in corporate or co-operative •sectors.Renderingmerchantbankingservicestoindustrialconcerns.In1995-96,67%ofthetotalfinancialassistance•distributed by IFCI was in the form of rupee term loans, while foreign currency loans accounted for approximately 17%oftotalfinancialassistance.Thus,thetwotypesofassistanceaccountedforatotalof84%ofthetotalfinancialassistancebyIFCI.Theremaining16%offinancialassistance,wasintheformofunderwriting,directsubscription, guarantees and equipment leasing.


26

2.7 IDBI The Industrial Development Bank of India Limited (IDBI) is one of India’s leading public sector banks and 4th largest Bank in overall ratings. RBI categorised IDBI as an “other public sector bank”. It was established in 1964 byanActofParliamenttoprovidecreditandotherfacilitiesforthedevelopmentofthefledglingIndianindustry.Itis currently 10th largest development bank in the world in terms of reach with 1392 ATMs, 833 branches including one overseas branch at DIFC, Dubai and 555 centres including two overseas centres at Singapore and Beijing.

2.7.1 Objectives of IDBIThemainobjectivesofIDBIaretoserveastheapexinstitutionfortermfinanceforindustryinIndia.Itsobjectivesinclude

Co-ordination,regulationandsupervisionoftheworkingofotherfinancialinstitutionssuchasIFCI,ICICI,•UTI, LIC, Commercial Banks and SFCs.Supplementingtheresourcesofotherfinancialinstitutionsandtherebywideningthescopeoftheirassistance.•Planning,promotionanddevelopmentofkeyindustriesanddiversificationsofindustrialgrowth.•Devising and enforcing a system of industrial growth that conforms to national priorities.•

2.7.2 Functions of IDBIThe IDBI has been established to perform the following functions

TograntloansandadvancestoIFCI,SFCsoranyotherfinancialinstitutionbywayofrefinancingofloans•granted by such institutions which are repayable within 25 year.Tograntloansandadvancestoscheduledbanksorstateco-operativebanksbywayofrefinancingofloans•granted by such institutions which are repayable in 15 years.To grant loans and advances to IFCI, SFCs, other institutions, scheduled banks, state co-operative banks by way •ofrefinancingofloansgrantedbysuchinstitutiontoindustrialconcernsforexports.To discount or rediscount bills of industrial concerns.•To underwrite or to subscribe to shares or debentures of industrial concerns.•Tosubscribetoorpurchasestock,shares,bondsanddebenturesofotherfinancialinstitutions.•TograntlineofcreditorloansandadvancestootherfinancialinstitutionssuchasIFCI,SFCs,etc.•To grant loans to any industrial concern.•To guarantee deferred payment due from any industrial concern.•To guarantee loans raised by industrial concerns in the market or from institutions.•To provide consultancy and merchant banking services in or outside India.•To provide technical, legal, marketing and administrative assistance to any industrial concern or person for •promotion, management or expansion of any industry.Planning,promotinganddevelopingindustriestofillupgapsintheindustrialstructureinIndia.•To act as trustee for the holders of debentures or other securities.•

2.8 IIBIIndustrial Investment Bank of India (IIBI) was originally set-up as Industrial Reconstruction Bank of India under the Industrial Reconstruction Bank of India Act, 1084, as a principal credit and reconstruction agency for industrial revival byundertakingmodernisation, expansion, re-organisation, diversificationor rationalisationof industry.However, with the establishment of the Board for Industrial and Financial Reconstruction (BIFR), the role of IRBI as a principal agency for industrial reconstruction was marginalised. Hence, it was considered prudent to convert

IRBIintoafullfledgedallpurposedevelopmentalfinancialinstitution.IRBIwasconvertedintoaGovernmentcompany under the Companies Act, 1956 and was re-named as Industrial Investment Bank of India (IIBI). This restructuringaimsatprovidingadequateoperationalflexibilityandfunctionalautonomytomeetitthechallengesof the changing environment.

27

IIBI undertakes all the functions of a development bank. These functions include providing long/medium-term loan/ assistance to medium and large industrial units, and providing under-writing support to, issuing of shares and bonds.

2.9 SIDBISIDBI was established on April 2, 1990 under an act of Parliament. The business domain of SIDBI consists of small scale industrial units (Units in which the investment in plant and machinery does not exceed Rs.10 million). Inaddition,SIDBI’sassistanceflowstothetransport,healthcare,hotelandtourismsectors,infrastructure,etc,andalso to the professional and self-employed persons setting up small-sized professional ventures.

SIDBIistheprincipalinstitutioninthecountryforpromotion,financinganddevelopmentofindustriesinthetinyandsmall-scale sectors. It coordinates the functions of other institutions engaged in similar activities. SIDBI undertakes bothfinancingactivitiesaswellaspromotionalactivitiesandprovidessupportservices.SIDBIsfinancingactivitiesarebroadlyclassifiedintotwocategories:

Direct assistance•Indirect assistance•

Direct assistance: Direct assistance to small industries is provided in the following ways: Projectfinancing:Projectfinance isprovidedforsettingupofnewunitsandforexpansion/diversification/•modernisation/technology up-gradation of existing units.Equipmentfinance scheme:Under this scheme,assistance isprovided forexpansionandmodernisationof•existing units. Technology development and modernisation fund scheme: Technology Development and Modernisation Fund •Scheme is a new scheme of SIDBI under which assistance is granted to units belonging to engineering, garments, electrical and electronics, crockery, pottery, etc. Billfinancingscheme:BillfinanceaccountsforthelargestamountofdirectassistancegrantedbySIDBI.Bills•discounted fall in two categories:

Direct discounting of usance bills arising out of sale of equipments by manufacturers of machinery/ �capital goods in the small sector. This enables them to offer deferred payment facilities to their prospective purchasers/users.Direct discounting of short-term bills arising from sale of parts, components, sub-assemblies accessories and �intermediate manufactured by small-scale units and supplied to medium and large industries on credit. The aimofthisschemeistoimprovetheliquidityandcashflowofsmallunitsastheyreceivepromptpaymentin respect of their supplies made to medium and large companies.

Equity assistance scheme: SIDBI provides equity assistance to different types of companies. It provides lines •of credit to merchant bankers to put through bought out deals in respect of their small industrial unit clients. Assistance is provided to shall units under National Equity Fund Scheme. Seed Capital is also provided under Mahila Udyam Nidhi Scheme and Scheme for Employment of EX-Servicemen. Under the National Equity Fund assistance of Rs 6.8 crore was provided to 730 entrepreneurs during 1995-96 as compared to R s .3.1 crore to 536 entrepreneurs during 1994-95. Venture capital assistance: SlDBI also grants assistance from the Venture Capital Fund. SIDBI also subscribes •to the funds of other Venture Capital Companies. The projects for which venture capital assistance is provided by SIDBI are in the high risks, specialised and import substitutive areas. Most of these projects propose to use indigenously developed technology and are promoted by experienced technical entrepreneurs.

Indirect assistance: SIDBI grants indirect assistance to industries through:RefinanceoftermloansgrantedbyBanks,StateFinanceCorporations(SFCs)andStateIndustrialDevelopment•Corporations (SIDCs), andBy rediscounting of bills of small-scale industries.•


28

2.10 ICICIDecember 1990, the Bank approved a $120 million line of credit to the Industrial Credit and Investment Corporation of IndiaLimited(ICICI) toaugment its foreignexchangeresources tofinancedevelopmentprojectsofprivateenterprises. The loan aimed primarily to assist the modernisation and expansion of existing production facilities and also to serve new industrial projects with outstanding economic merit designed to introduce new technology intoIndia.ThiswastheBankssecondloantoICICIandbroadlyfollowedthepatternofthefirstloan.Thesecondloan became effective in February 1991 and was closed in January 1995.

2.10.1 ObjectivesThe primary objectives of ICICI is to assist industrial units in the private-sector. The main objectives of ICICI are as follows:

To assist in the creation, expansion and modernisation at industrial units in the private sector.•Toencouragetheinflowandparticipationofforeigncapitalintheprivatesectorindustrialunits.•To expand the investment market in India.•

2.10.2 FunctionsThe main functions of ICICI are as follows:

To sponsor and underwrite new issues.•To provide medium and long-term loans to industrial units in the private sector.•To guarantee loans taken from other private sources.•To furnish managerial, technical and administrative advice to industrial units by the private sector.•To make funds available for reinvestment.•To advance loans in foreign currency towards the cost of imported capital equipments.•To extend guarantee for deferred payments.•To purchase the shares and debentures of new companies.•

2.11 NABARDNABARDissetupasanapexDevelopmentBankwithamandateforfacilitatingcreditflowforpromotionanddevelopment of agriculture, small-scale industries, cottage and village industries, handicrafts and other rural crafts. It also has the mandate to support all other allied economic activities in rural areas, promote integrated and sustainable rural development and secure prosperity of rural areas. In discharging its role as a facilitator for rural prosperity NABARD is entrusted with

Providingrefinancetolendinginstitutionsinruralareas•Bringing about or promoting institutional development and•Evaluating, monitoring and inspecting the client banks•

2.11.1 ObjectivesNABARD was established in terms of the Preamble to the Act, “for providing credit for the promotion of agriculture, small scale industries, cottage and village industries, handicrafts and other rural crafts and other allied economic activities in rural areas with a view to promoting IRDP and securing prosperity of rural areas and for matters connected therewith in incidental thereto”. The main objectives of the NABARD as stated in the statement of objectives while placing the bill before the Lok Sabha were categorised as under:

The National Bank will be an apex organisation in respect of all matters relating to policy, planning operational •aspectsinthefieldofcreditforpromotionofAgriculture,SmallScaleIndustries,CottageandVillageIndustries,Handicrafts and other rural crafts and other allied economic activities in rural areas.

29

TheBankwillserveasarefinancinginstitutionforinstitutionalcreditsuchaslong-term,short-termforthe•promotion of activities in the rural areas.The Bank will also provide direct lending to any institution as may approved by the Central Government.•The Bank will have organic links with the Reserve Bank and maintain a close link with in.•

2.11.2 Roles and FunctionsThe role and functions of NABARD is explained below.

NABARD is an apex institution accredited with all matters concerning policy, planning and operations in the •fieldofcreditforagricultureandothereconomicactivitiesinruralareas. Itisanapexrefinancingagencyfortheinstitutionsprovidinginvestmentandproductioncreditforpromoting•the various developmental activities in rural areasIt takes measures towards institution building for improving absorptive capacity of the credit delivery system, •including monitoring, formulation of rehabilitation schemes, restructuring of credit institutions, training of personnel, etc.Itco-ordinatestheruralfinancingactivitiesofalltheinstitutionsengagedindevelopmentalworkatthefield•level and maintains liaison with Government of India, State Governments, Reserve Bank of India and other national level institutions concerned with policy formulation.Itprepares,onannualbasis,ruralcreditplansforalldistrictsinthecountry;theseplansformthebaseforannual•creditplansofallruralfinancialinstitutionsItundertakesmonitoringandevaluationofprojectsrefinancedbyit.•Itpromotesresearchinthefieldsofruralbanking,agricultureandruraldevelopment•

2.11.3 NABARD in Present Scenario Initiates measures toward institution-building for improving absorptive capacity of the credit delivery system, including monitoring, formulation of rehabilitation schemes, restructuring of credit institutions, training of personnel, etc.

Coordinatestheruralfinancingactivitiesofalltheinstitutionsengagedindevelopmentalworkatthefieldlevel•and maintains liaison with the government of India , State governments, the Reserve Bank of India and other national level institutions concerned with policy formulationPrepares, on annual basis, rural credit plans for all the districts in the country. These plans form the base for •annualcreditplansofallruralfinancialinstitutionsUndertakesmonitoringandevaluationofprojectsrefinancedbyit•Promotesresearchinthefieldsofruralbanking,agricultureandruraldevelopment•Functions as a regulatory authority, supervising, monitoring and guiding cooperative banks and regional rural •banks.

2.12 EXIMExport-ImportBankofIndiaisthepremierexportfinanceinstitutionofthecountry,setupin1982undertheExport-Import Bank of India Act 1981. Government of India launched the institution with a mandate, not just to enhance exports from India, but to integrate the country’s foreign trade and investment with the overall economic growth. Since its inception, Exim Bank of India has been both a catalyst and a key player in the promotion of cross border trade and investment. Commencing operations as a purveyor of export credit, like other Export Credit Agencies in the world, Exim Bank of India has, over the period, evolved into an institution that plays a major role in partnering Indian industries, particularly the Small and Medium Enterprises, in their globalisation efforts, through a wide range of products and services offered at all stages of the business cycle, starting from import of technology and export product development to export production, export marketing, pre-shipment and post-shipment and overseas investment.


30

The Initiatives Exim Bank of India has been the prime mover in encouraging project exports from India. The Bank provides •Indian project exporters with a comprehensive range of services to enhance the prospect of their securing export contracts, particularly those funded by Multilateral Funding Agencies like the World Bank, Asian Development Bank, African Development Bank and European Bank for Reconstruction and Development. TheBankextends linesofcredit tooverseasfinancial institutions,foreigngovernmentsandtheiragencies,•enablingthemtofinanceimportsofgoodsandservicesfromIndiaondeferredcreditterms.EximBank’slinesof Credit obviate credit risks for Indian exporters and are of particular relevance to SME exporters. The Bank’s Overseas Investment Finance programme offers a variety of facilities for Indian investments and •acquisitions overseas. The facilities include loan to Indian companies for equity participation in overseas ventures, direct equity participation by Exim Bank in the overseas venture and non-funded facilities such as letters of credit and guarantees to facilitate local borrowings by the overseas venture. TheBankprovidesfinancialassistancebywayoftermloansinIndianrupees/foreigncurrenciesforsetting•up new production facility, expansion/modernisation/upgradation of existing facilities and for acquisition of production equipment/technology. Such facilities particularly help export oriented Small and Medium Enterprises for creation of export capabilities and enhancement of international competitiveness. Under its Export Marketing Finance programme, Exim Bank supports Small and Medium Enterprises in their •exportmarketingeffortsincludingfinancingthesoftexpenditurerelatingtoimplementationofstrategicandsystematic export market development plans. The Bank has launched the Rural Initiatives Programme with the objective of linking Indian rural industry to •theglobalmarket.Theprogrammeisintendedtobenefitruralpoorthroughcreationofexportcapabilityinrural enterprises. In order to assist the Small and Medium Enterprises, the Bank has put in place the Export Marketing Services •(EMS) Programme. Through EMS, the Bank seeks to establish, on best efforts basis, SME sector products in overseasmarkets,startingfromidentificationofprospectivebusinesspartnerstofacilitatingplacementoffinalorders. The service is provided on success fee basis. EximBanksupplements itsfinancingprogrammeswithawiderangeofvalue-addedinformation,advisory•and support services, which enable exporters to evaluate international risks, exploit export opportunities and improve competitiveness, thereby helping them in their globalisation efforts.

31

SummaryBankstodayareimportantnotjustfromthepointofviewofeconomicgrowth,butalsofinancialstability.•The transformation of the banking system has been brought about by deregulation, technological innovation •and globalisation.InIndia,thedefinitionofthebusinessofbankinghasbeengivenintheBankingRegulationAct,(BRAct),•1949.ThefirstbankwhichwasestablishedwithIndianownershipandmanagementwastheOudhCommercialBank,•formed in 1881, followed by the Ayodhya Bank in 1884, the Punjab National Bank in 1894 and Nedungadi Bank in 1899.There are a number of trends evolving in modern banking, the most important of which relate to (a) technology, •(b)outsourcingofservicesand(c)financialinclusion.Outsourcing can enable banks to stay ahead of competition. Growing competition in the banking sector has •forced banks to outsource some of their activities to maintain their competitive edge. MicroCreditisdefinedasprovisionofcreditandotherfinancialservicesandproductsofverysmallamountto•the poor in rural, semi-urban and urban areas for enabling them to raise their income levels. Business often requires medium and long-term capital for purchase of machinery and equipment, for using •latesttechnology,orforexpansionandmodernisation.SuchfinancialassistanceisprovidedbyDevelopmentBanks. It is against this backdrop that the government established The Industrial Finance Corporation of India (IFCI) •onJuly1,1948,asthefirstDevelopmentFinancialInstitutioninthecountrytocatertothelong-termfinanceneeds of the industrial sector. The Industrial Development Bank of India Limited (IDBI) is one of India’s leading public sector banks and 4th •largest Bank in overall ratings. RBI categorised IDBI as an “other public sector bank”. Industrial Investment Bank of India (IIBI) was originally set-up as Industrial Reconstruction Bank of India •under the Industrial Reconstruction Bank of India Act, 1084, as a principal credit and reconstruction agency for industrialrevivalbyundertakingmodernisation,expansion,re-organisation,diversificationorrationalisationof industry. SIDBI was established on April 2, 1990 under an act of Parliament. The business domain of SIDBI consists •of small scale industrial units (Units in which the investment in plant and machinery does not exceed Rs.10 million). December 1990, the Bank approved a $120 million line of credit to the Industrial Credit and Investment •CorporationofIndiaLimited(ICICI)toaugmentitsforeignexchangeresourcestofinancedevelopmentprojectsof private enterprises. NABARDissetupasanapexDevelopmentBankwithamandateforfacilitatingcreditflowforpromotion•and development of agriculture, small-scale industries, cottage and village industries, handicrafts and other rural crafts. Export-ImportBankofIndiaisthepremierexportfinanceinstitutionofthecountry,setupin1982underthe•Export-Import Bank of India Act 1981.

ReferencesMachiraju, H.R., 2008. Modern Commercial Banking, New Age International.•Kapoor, G. P., 2004. Commercial Banking, APH Publishing.•Nos.org. Functions of Commercial Banks [PDF] Available at: <http://www.nos.org/srsec319/319-33.pdf>. •[Accessed 5 December 2011].Egyankosh, All India Financial Institutions [PDF] Available at: <http://www.egyankosh.ac.in/•bitstream/123456789/25900/1/Unit11.pdf>. [Accessed 5 December 2011].


32

NABARD, 2007. Introduction to NABARD [Online] Available at: <http://www.nabard.org/introduction.asp>. •[Accessed 5 December 2011].NDTVProfit,2011.• BankingLawsAmendmentBilltobenefitcommercialbanks [Video Online] Available at: <http://www.youtube.com/watch?v=Aim-XDYCm4Q>. [Accessed 13 December 2011].Moneycontrol, 2003. • IFCIfinancialstrengthstrong;CARat20% [Video Online] Available at: <http://www.youtube.com/watch?v=Yprr-EDO-mw>. [Accessed 13 December 2011].

Recommended ReadingGup, B. E., Kolari, J. W. and Fraser, D. R., 2005. • Commercial banking: the management of risk, J. Wiley.Basu, C. R. • Commercial Banking in the Planned Economy of India, Mittal Publication.Ray, P., Academic Foundation, 2008. • Commercial Banks and monetary policy in India, Volume 2, Academic Foundation.

33

Self Assessment_________competenotonlyamongthemselves,butalsowithnonbankfinancialintermediaries,andoverthe1. years, this competition has only grown in intensity.

Banksa. Limited companiesb. Nonprofitmakingorganisationsc. Insurance companiesd.

InIndia,thedefinitionofthebusinessofbankinghasbeengivenintheBankingRegulationAct,(BRAct),2. ________.

1929a. 1939b. 1949c. 1959d.

Recentmeasurestakenby________topromotefinancialinclusionincludeadvisingbankstoopen‘nofrills’3. accounts.

ICICIa. IDBIb. NABARDc. RBId.

Whichofthefollowingisdefinedasaprovisionofcreditandotherfinancialservicesandproductsofverysmall4. amount to the poor in rural, semi-urban and urban areas for enabling them to raise their income levels?

Commercial banksa. Micro creditb. Self help groupc. Adoption of technologyd.

Which of the following is a registered or unregistered group of 15-20 people who voluntarily join together to 5. save small amounts regularly?

Commercial banksa. Micro creditb. Self help groupc. Adoption of technologyd.

Whichofthefollowingisapolygonaldevelopmentfinanceinstitutiondevotedtoimprovingthesocialand6. monetary development of its associate nations?

Commercial banka. Development bankb. RBIc. IDBId.


34

Match the following7.

Features of Development banks1. Industrial Finance Corporation of India (IFCI)A.

Functions of Development banks2. Lay foundations for industrialisation B.

Objectives of Development banks3. FinancialgapfillersC.

Development banks4. providesfinancialassistancetobothprivateaswellD. as public sector institutions


Which statement is false?8. Owingtothelowlevelofincomeofthepeopletherewerenosufficientsurplusesforcapitalisation.a. Commercial banks could take up the job of and joint sectors and provide managerial and resources and skills b. andofchannellingthemintoapprovedfieldsunderprivateauspicesareneededinthesecountries.Theexistingmachineryfordevelopmentalactivitieswasnotsufficienttotherequirementsofindustry.c. Development banks acquire securities of industrial units through either direct subscribing or underwriting d. or both.

The government established The Industrial Finance Corporation of India (IFCI) on ___________.9. July 1, 1948a. June 1, 1948b. July 1, 1949c. July 1, 1984d.

______________ was originally set-up as Industrial Reconstruction Bank of India under the Industrial 10. Reconstruction Bank of India Act, 1084, as a principal credit and reconstruction agency for industrial revival.

IDBIa. ICICIb. RBIc. IIBId.

35

Chapter III

Financial Services and Financial Markets in India

Aim


introducefinancialmarkets•

definefinancialservices•

describe the characteristics and functions of money market•

Objectives


highlight the importance of money market•

explain SEBI as a regulatory body•

describe the depository system•

Learning outcome


understand merchant banking•

comprehend money market instruments in India•

differentiate between capital and money market•


36

3.1 IntroductionMoney market means market where money or its equivalent can be traded. Money is synonym of liquidity. Money marketconsistsoffinancialinstitutionsanddealersinmoneyorcreditwhowishtogenerateliquidity.Itisbetterknown as a place where large institutions and government manage their short term cash needs. For generation of liquidity,shorttermborrowingandlendingisdonebythesefinancialinstitutionsanddealers.MoneyMarketispartoffinancialmarketwhereinstrumentswithhighliquidityandveryshorttermmaturitiesaretraded.Duetohighly liquid nature of securities and their short term maturities, money market is treated as a safe place. Hence, money market is a market where short term obligations such as treasury bills, commercial papers, and banker’s acceptances are bought and sold.

DefinitionAccordingtoCrowther,“Themoneymarketisanamegiventothevariousfirmsandinstitutionsthatdealinthevarious grades of near money.”

AccordingtotheRBI,“Themoneymarketisthecentrefordealingmainlyofshortcharacter,inmonetaryassets;itmeets the short term requirements of borrowers and provides liquidity or cash to the lenders. It is a place where short termsurplusinvestiblefundsatthedisposaloffinancialandotherinstitutionsandindividualsarebidbyborrowers,again comprising institutions and individuals and also by the government.”

According to Nadler and Shipman, “A money market is a mechanical device through which short term funds are loanedandborrowedthroughwhichalargepartofthefinancialtransactionsofaparticularcountryorworldaredegraded. A money market is distinct from but supplementary to the commercial banking system.”

Thesedefinitionshelpustoidentifythebasiccharacteristicsofamoneymarket.Amoneymarketcomprisesofawellorganisedbankingsystem.Variousfinancialinstrumentsareusedfortransactionsinamoneymarket.Thereisperfect mobility of funds in a money market. The transactions in a money market are of short term nature.

3.2 Characteristics of Money MarketThe important characteristics of money market are as follows:

Short Term Credit Market

No Definite Location

Funds Against Different Types of Instruments

Specific Institutions

Settlement of Financial Transactions

Composition of Sub-Markets

Purpose of Loans

Fig. 3.1 Characteristics of money market

37

Short term credit marketIn the money market funds are made available for a short period only. The funds are borrowed or lent for one day, a week or for three to six months or in exceptional cases for the period of more than six months but less than one year

Funds against different types of instrumentsThe funds are usually borrowed against different types of securities which are called as near-money. The important instruments against which funds are borrowed are trade bills or bills of exchange, promissory notes, banker’s acceptance, treasury bills or suitable commercial papers of maturity up to sic months.

Composition of sub-marketsIn the money market funds are borrowed against various securities,. The transactions of borrowing of funds against a particular security are carried out in a particular part which is called as a sub-part or a sub-market of the money market, i.e., transactions of borrowing against bills of exchange are carried out in a bill market, there are following important sub-markets in the money market, which are

Call money market•Acceptance market•Bill market•Treasury Bill market•Collateral Loans market•

No definite locationThemoneymarkethasnodefinitelocationwhereborrowersandlendersmeet,negotiationsbetweenborrowersandlenders may be carried on through telephone, telegraphs and through mails or any other arrangement. Thus, money market is an arrangement that brings about a direct or indirect contract between the borrower and the lender.

Specific institutionsSomefinancialinstitutionsdealinshorttermfinanceandlongtermfinanceatoneandthesametime.Buttherearecertain agencies which deal only in the short term credit. For example, discount houses and acceptance houses.

Purpose of loansThemoneymarketprovidesshorttermloansforvariouspurposessuchasloanformeetingshorttermsfinancialneeds of industry, commerce, trade, agriculture, government developmental activities and for meeting short term financialneedsofstockexchangebrokers,etc.

Settlement of financial transactionsFromthedefinitiongivenbyMaddenandNadleronecansaythatamoneymarketisanagencythroughwhichmanyfinancialtransactionsofthecountryaresettled.Incaseofdevelopedmoneymarketmanyfinancialtransactionsofthe world are settled. This conveys the importance of money markets in the world economy.

3.3 Functions of Money MarketMoneymarketisanimportantpartoftheeconomy.Itplaysverysignificantfunctions.Asmentionedaboveitisbasically a market for short term monetary transactions. Thus it has to provide facility for adjusting liquidity to the banks,businesscorporations,non-bankingfinancialinstitutions(NBFs)andotherfinancialinstitutionsalongwithinvestors.

The major functions of money market are given below:To maintain monetary equilibrium. It means to keep a balance between the demand for and supply of money •for short term monetary transactions.To promote economic growth. Money market can do this by making funds available to various units in the •economy such as agriculture, small scale industries, etc.


38

ToprovidehelptoTradeandIndustry.Moneymarketprovidesadequatefinancetotradeandindustry.Similarly•it also provides facility of discounting bills of exchange for trade and industry.To help in implementing Monetary Policy. It provides a mechanism for an effective implementation of the •monetary policy.To help in Capital Formation. Money market makes available investment avenues for short term period. It helps •in generating savings and investments in the economy.Moneymarketprovidesnon-inflationarysourcesoffinancetogovernment.Itispossiblebyissuingtreasury•bills in order to raise short loans. However this dose not leads to increases in the prices.

Apartfromthose,moneymarketisanarrangementwhichaccommodatesbanksandfinancialinstitutionsdealingin short term monetary activities such as the demand for and supply of money.

3.4 Importance of Money MarketAdevelopedmoneymarketplaysanimportantroleinthefinancialsystemofacountrybysupplyingshort-termfunds adequately and quickly to trade and industry. The money market is an integral part of a country’s economy. Therefore, a developed money market is highly indispensable for the rapid development of the economy. A developed moneymarkethelpsthesmoothfunctioningofthefinancialsysteminanyeconomyinthefollowingways:

Development of trade and industry:Moneymarketisanimportantsourceoffinancingtradeandindustry.Themoneymarket,throughdiscountingoperationsandcommercialpapers,financestheshort-termworkingcapitalrequirementsof trade and industry and facilities the development of industry and trade both – national and international.

Development of capital market: The short-term rates of interest and the conditions that prevail in the money market influencethelong-terminterestaswellastheresourcemobilisationincapitalmarket.Hence,thedevelopmentofcapital depends upon the existence of a development of capital money market.

Smooth functioning of commercial banks: The money market provides the commercial banks with facilities for temporarily employing their surplus funds in easily realisable assets. The banks can get back the funds quickly, in times of need, by resorting to the money market. The commercial banks gain immensely by economising on their cash balances in hand and at the same time meeting the demand for large withdrawal of their depositors. It also enables commercial banks to meet their statutory requirements of cash reserve ratio (CRR) and Statutory Liquidity Ratio (SLR) by utilishing the money market mechanism.

Effective central bank control: A developed money market helps the effective functioning of a central bank. It facilities effective implementation of the monetary policy of a central bank. The central bank, through the money market, pumps new money into the economy in slump and siphons if off in boom. The central bank, thus, regulates theflowofmoneysoastopromoteeconomicgrowthwithstability.

Formulation of suitable monetary policy: Conditions prevailing in a money market serve as a true indicator of the monetary state of an economy. Hence, it serves as a guide to the Government in formulating and revising the monetary policy then and there depending upon the monetary conditions prevailing in the market.

Non-inflationary source of finance to government: A developed money market helps the Government to raise short-termfundsthroughthetreasurybillsfloatedinthemarket.Intheabsenceofadevelopedmoneymarket,theGovernment would be forced to print and issue more money or borrow from the central bank. Both ways would leadtoanincreaseinpricesandtheconsequentinflationarytrendintheeconomy.

39

3.5 Difference between Capital and Money MarketDifference and demarcation between money market and capital market is made on the basis of maturity period of instruments and claims. Short-term instruments maturing within a period of one year are traded in money market whereasthecapitalmarketdealswithlongermaturityfinancialassetsandclaims.Thoughbothtypesofmarketsfacilitatethetransferoffundsfromsaverstodeficit-users,stillthedifferencebetweenthetwoismaintainedwithreference to the time-period covered by the transactions. Capital market includes trading in securities, mutual fund units,andgovernmentdebtinstruments.Ontheotherhand’moneymarketfacilitatesdealingsinshort-termfinancialinstrumentssuchasinter-corporatedeposits,certificateofdeposits,treasurybonds,commercialpapers,commercialbills, etc. Money market and capital market can be differentiated as follows:

Thesubjectmatterofcapitalmarketislong-termfinancialinstrumentshavingmaturityofmorethanoneyear.•On the other hand, the thrust of MM is on short-term instruments only.Money market is a wholesale market and the participants in money market are large institutional investors, •commercial banks, mutual funds, and corporate bodies. However, in case of capital market even a small individual investor can deal by sale/purchase of shares, debentures or mutual fund units.In capital market, the two common segments are primary market and secondary market. Both these segments •are interrelated. Securities emerge in primary segment and their subsequent dealings take place in secondary market.However,incaseofmoneymarket,thereisnosuchsub-divisioningeneral.Inefficientmoneymarket,secondary market transactions may also take place.Total volume of trade occurs per day in money market is many fold that of the volume per day taking place in •capital market.Incapitalmarket,thefinancialinstrumentsbeingdealtwithareshares(equityaswellaspreference),debentures•(a large variety), public sector bonds, and units of mutual funds. On the other hand, money market has different financialinstrumentssuchastreasurybills,commercialpapers,callmoney,certificateofdeposits,etc.

3.6 Indian Money Market InstrumentsInvestment in money market is done through money market instruments. Money market instrument meets short term requirements of the borrowers and provides liquidity to the lenders. Common money market instruments are as follows:

Treasury Bills

Repurchase Agreements

Commercial Paper

Certificate of Deposit

Banker’s Acceptance

Fig. 3.2 Indian money market instruments


40

Treasury bills (T-Bills)Treasury Bills, one of the safest money market instruments, are short term borrowing instruments of the Central Government of the Country issued through the Central Bank (RBI in India). They are zero risk instruments, and hence the returns are not so attractive. It is available both in primary market as well as secondary market. It is a promise topayasaidsumafteraspecifiedperiod.T-billsareshort-termsecuritiesthatmatureinoneyearorlessfromtheirissue date. They are issued with three-month, six-month and one-year maturity periods. The Central Government issues T- Bills at a price less than their face value (par value). They are issued with a promise to pay full face value on maturity. So, when the T-Bills mature, the government pays the holder its face value. The difference between the purchase price and the maturity value is the interest income earned by the purchaser of the instrument.

T-Bills are issued through a bidding process at auctions. The bid can be prepared either competitively or non-competitively.Inthesecondtypeofbidding,returnrequiredisnotspecifiedandtheonedeterminedattheauctionisreceivedonmaturity.Whereas,incaseofcompetitivebidding,thereturnrequiredonmaturityisspecifiedinthebid.IncasethereturnspecifiedistoohighthentheT-Billmightnotbeissuedtothebidder.Atpresent,theGovernmentof India issues three types of treasury bills through auctions, namely, 91-day, 182-day and 364-day. There are no treasury bills issued by State Governments. Treasury bills are available for a minimum amount of Rs.25K and in its multiples. While 91-day T-bills are auctioned every week on Wednesdays, 182-day and 364-day T-bills are auctioned every alternate week on Wednesdays.

The Reserve Bank of India issues a quarterly calendar of T-bill auctions which is available at the Banks’ website. It also announces the exact dates of auction, the amount to be auctioned and payment dates by issuing press releases prior to every auction. Payment by allottees at the auction is required to be made by debit to their/ custodian’s current account. T-bills auctions are held on the Negotiated Dealing System (NDS) and the members electronically submit their bids on the system. NDS is an electronic platform for facilitating dealing in Government Securities and Money Market Instruments. RBI issues these instruments to absorb liquidity from the market by contracting the money supply. In banking terms, this is called Reverse Repurchase (Reverse Repo). On the other hand, when RBIpurchasesbacktheseinstrumentsataspecifieddatementionedatthetimeoftransaction,liquidityisinfusedin the market. This is called Repo (Repurchase) transaction.

Repurchase agreementsRepurchase transactions, called Repo or Reverse Repo are transactions or short term loans in which two parties agree to sell and repurchase the same security. They are usually used for overnight borrowing. Repo/Reverse Repo transactions can be done only between the parties approved by RBI and in RBI approved securities, viz., GOI and State Govt Securities, T-Bills, PSU Bonds, FI Bonds, Corporate Bonds etc. Under repurchase agreement the seller sellsspecifiedsecuritieswithanagreementtorepurchasethesameatamutuallydecidedfuturedateandprice.Similarly, the buyer purchases the securities with an agreement to resell the same to the seller on an agreed date at a predetermined price. Such a transaction is called a Repo when viewed from the perspective of the seller of the securities and Reverse Repo when viewed from the perspective of the buyer of the securities.

Thus, whether a given agreement is termed as a Repo or Reverse Repo depends on which party initiated the transaction. The lender or buyer in a Repo is entitled to receive compensation for use of funds provided to the counterparty. Effectively the seller of the security borrows money for a period of time (Repo period) at a particular rate of interest mutually agreed with the buyer of the security who has lent the funds to the seller. The rate of interest agreed upon is called the Repo rate. The Repo rate is negotiated by the counterparties independently of the coupon rate or rates oftheunderlyingsecuritiesandisinfluencedbyoverallmoneymarketconditions.

Commercial paper (CP)Commercial paper is a low-cost alternative to bank loans. It is a short term unsecured promissory note issued by corporatesandfinancialinstitutionsatadiscountedvalueonfacevalue.Theyareusuallyissuedwithfixedmaturitybetweenoneto270daysandforfinancingofaccountsreceivables,inventories,andmeetingshorttermliabilities.Say,for example, a company has receivables of Rs 1 lakh with credit period 6 months. It will not be able to liquidate its receivables before 6 months. The company is in need of funds. It can issue commercial papers in form of unsecured promissory notes at discount of 10% on face value of Rs 1 lakh to be matured after 6 months. The company has

41

strongcreditratingandfindsbuyerseasily.Thecompanyisabletoliquidateitsreceivablesimmediatelyandthebuyer is able to earn interest of Rs 10K over a period of 6 months. They yield higher returns as compared to T-Bills astheyarelesssecureincomparisontothesebills;howeverchancesofdefaultarealmostnegligiblebutarenotzero risk instruments.

Commercialpaperbeinganinstrumentnotbackedbyanycollateral,onlyfirmswithhighqualitycreditratingswillfindbuyerseasilywithoutofferinganysubstantialdiscounts.Theyareissuedbycorporatestoimpartflexibilityinraising working capital resources at market determined rates. Commercial Papers are actively traded in the secondary market since they are issued in the form of promissory notes and are freely transferable in demat form.

Certificate of depositIt is a short term borrowing more like a bank term deposit account. It is a promissory note issued by a bank in form ofacertificateentitlingthebearertoreceiveinterest.Thecertificatebearsthematuritydate,thefixedrateofinterestand the value. It can be issued in any denomination. They are stamped and transferred by endorsement. Its term generallyrangesfromthreemonthstofiveyearsandrestrictstheholderstowithdrawfundsondemand.However,on payment of certain penalty the money can be withdrawn on demand also.

ThereturnsoncertificateofdepositsarehigherthanT-Billsbecauseitassumeshigherlevelofrisk.WhilebuyingCertificateofDeposit,returnmethodshouldbeseen.ReturnscanbebasedonAnnualPercentageYield(APY)orAnnual Percentage Rate (APR). In APY, interest earned is based on compounded interest calculation. However, in APR method, simple interest calculation is done to generate the return. Accordingly, if the interest is paid annually, equal return is generated by both APY and APR methods. However, if interest is paid more than once in a year, it isbeneficialtooptAPYoverAPR.

Banker’s acceptanceItisashorttermcreditinvestmentcreatedbyanonfinancialfirmandguaranteedbyabanktomakepayment.Itis simply a bill of exchange drawn by a person and accepted by a bank. It is a buyer’s promise to pay to the seller acertainspecifiedamountatcertaindate.Thesameisguaranteedbythebankerofthebuyerinexchangeforaclaim on the goods as collateral. The person drawing the bill must have a good credit rating otherwise the Banker’s Acceptance will not be tradable. The most common term for these instruments is 90 days. However, they can very from30daysto180days.Forcorporations,itactsasanegotiabletimedraftforfinancingimports,exportsandother transactions in goods and is highly useful when the credit worthiness of the foreign trade party is unknown. The seller need not hold it until maturity and can sell off the same in secondary market at discount from the face value to liquidate its receivables.

3.7 Drawbacks of Indian Money MarketThough the Indian money market is considered as the advanced money market among developing countries, it still suffersfrommanydrawbacksordefects.Thesedefectslimittheefficiencyofourmarket.Someoftheimportantdrawbacks Indian money market are:

Absence of integration• : The Indian money market is broadly divided into the Organised and Unorganised Sectors.TheformercomprisesthelegalfinancialinstitutionsbackedbytheRBI.Theunorganisedstatementofit includes various institutions such as indigenous bankers, village money lenders, traders, etc. There is lack of proper integration between these two segments.Multiple rate of interest• : In the Indian money market, especially the banks, there exists too many rates of interests. These rates vary for lending, borrowing, government activities, etc. Many rates of interests create confusion among the investors.Insufficient funds or resources• : The Indian economy with its seasonal structure faces frequent shortage of financialrecourse.Lowerincome,lowersavings,andlackofbankinghabitsamongpeoplearesomeofthereasons for it.Shortage of investment instruments• : In the Indian money market, various investment instruments such as TreasuryBills,CommercialBills,CertificateofDeposits,CommercialPapers,etc.areused.Buttakingintoaccount the size of the population and market these instruments are inadequate.


42

Shortage of commercial bill• : In India, as many banks keep large funds for liquidity purpose, the use of the commercial bills is very limited. Similarly since a large number of transactions are preferred in the cash form the scope for commercial bills are limited.Lack of organised banking system• : In India even through we have a big network of commercial banks, still the bankingsystemsuffersfrommajorweaknessessuchastheNPA,hugelosses,andpoorefficiency.Theabsenceof the organised banking system is major problem for Indian money market.Less number of dealers• : There are poor number of dealers in the short-term assets who can act as mediators between the government and the banking system. The less number of dealers leads to the slow contact between the end lender and end borrowers.

ThesearesomeofthemajordrawbacksoftheIndianmoneymarket;manyofthesearealsothefeaturesofourmoney market.

3.8 Reforms in Indian Money MarketIndian Government appointed a committee under the chairmanship of Sukhamoy Chakravarty in 1984 to review the Indian monetary system. Later Narayanan Vaghul working group and Narasimham Committee was also set up. As pertherecommendationsofthesestudygroupsandwiththefinancialsectorreformsinitiatedintheearly1990s,the government has adopted following major reforms in the Indian money market.

Deregulation of the interest rate• : In recent period the government has adopted an interest rate policy of liberal nature. It lifted the ceiling rates of the call money market, short-term deposits, bills rediscounting, etc. Commercial banks are advised to see the interest rate change that takes place within the limit. There was a further deregulation of interest rates during the economic reforms. Currently interest rates are determined by the working of market forces except for a few regulations.Money market mutual fund (MMMFs)• : In order to provide additional short-term investment revenue, the RBI encouraged and established the Money Market Mutual Funds (MMMFs) in April 1992. MMMFs are allowed to sell units to corporate and individuals. The upper limit of 50 crore investments has also been lifted. Financial institutions such as the IDBI and the UTI have set up such funds.Establishment of the• DFI: The Discount and Finance House of India (DFHI) was set up in April 1988 to impart liquidity in the money market. It was set up jointly by the RBI, Public sector Banks and Financial Institutions. DFHI has played an important role in stabilising the Indian money market.Liquidity Adjustment Facility (LAF)• : Through the LAF, the RBI remains in the money market on a continue basis through the repo transaction. LAF adjusts liquidity in the market through absorption and or injection of financialresources.Electronic transactions• :Inordertoimparttransparencyandefficiencyinthemoneymarkettransactiontheelectronic dealing system has been started. It covers all deals in the money market. Similarly it is useful for the RBI to watchdog the money market.Establishment of the CCIL• : The Clearing Corporation of India limited (CCIL) was set up in April 2001. The CCIL clears all transactions in government securities, and repose reported on the Negotiated Dealing System.Development of new market instruments• : The government has consistently tried to introduce new short-term investment instruments.Examples:TreasuryBillsofvariousdurations,Commercialpapers,CertificatesofDeposits, MMMFs, etc. have been introduced in the Indian Money Market.

ThesearemajorreformsundertakeninthemoneymarketinIndia.Apartfromthese,thestampdutyreforms,floatingrate bonds, etc. are some other prominent reforms in the money market in India. Thus, at the end we can conclude that the Indian money market is developing at a good speed.

43

3.9 Depository SystemIndia has adopted the Depository System for securities trading in which book entry is done electronically and no paper is involved. The physical form of securities is extinguished and shares or securities are held in an electronic form. Before the introduction of the depository system through the Depository Act, 1996, the process of sale, purchase and transfer of securities was a huge problem, and there was no safety at all.

Key features of the depository system in IndiaMulti-depository system: The depository model adopted in India provides for a competitive multi-depository •system. There can be various entities providing depository services. A depository should be a company formed undertheCompanyAct,1956andshouldhavebeengrantedacertificateofregistrationundertheSecuritiesandExchange Board of India Act, 1992. Presently, there are two depositories registered with SEBI, namely:

National Securities Depository Limited (NSDL), and �Central Depository Service Limited (CDSL) �

Depository services through depository participants: The depositories can provide their services to investors •through their agents called depository participants. These agents are appointed subject to the conditions prescribed under Securities and Exchange Board of India (Depositories and Participants) Regulations, 1996 and other applicable conditions.Dematerialisation:ThemodeladoptedinIndiaprovidesfordematerialisationofsecurities.Thisisasignificant•step in the direction of achieving a completely paper-free securities market. Dematerialisation is a process by whichphysicalcertificatesofaninvestorareconvertedintoelectronicformandcreditedtotheaccountofthedepository participant.Fungibility: The securities held in dematerialised form do not bear any notable feature like distinctive number, •folionumberorcertificatenumber.Oncesharesgetdematerialised,theylosetheiridentityintermsofsharecertificate distinctive numbers and folio numbers.Thus all securities in the same class are identical andinterchangeable. For example, all equity shares in the class of fully paid up shares are interchangeable.Registeredowner/Beneficialowner:Inthedepositorysystem,theownershipofsecuritiesdematerialisedis•bifurcatedbetweenRegisteredOwnerandBeneficialOwner.AccordingtotheDepositoriesAct,‘RegisteredOwner’meansadepositorywhosenameisenteredassuchintheregisteroftheissuer.A‘BeneficialOwner’means a person whose name is recorded as such with the depository. Though the securities are registered in thenameofthedepositoryactuallyholdingthem,therights,benefitsandliabilitiesinrespectofthesecuritiesheldbythedepositoryremainwiththebeneficialowner.Forthesecuritiesdematerialised,NSDL/CDSListheRegisteredOwnerinthebooksoftheissuer;butownershiprightsandliabilitiesrestwithBeneficialOwner.Alltherights,dutiesandliabilitiesunderlyingthesecurityareonthebeneficialownerofthesecurity.Free transferability of shares: Transfer of shares held in dematerialised form takes place freely through electronic •book-entry system.

3.10 Merchant BankingMerchant banking implies investment management, companies raise capital by issuing securities in the market, merchant bankers act as intermediaries between the issuers of capital and the investors who purchase these securities. Merchantbankingis thefinancial intermediationthatmatchestheentitiesthatneedcapitalandthosethathavecapital for investment.

Services of Merchant BankersThe services provided by merchant bankers includes management of mutual funds, public issues, trusts, securities and international fund. It involves dealing with the corporate clients and advising them on various issues like mergers, acquisitions, public issues, etc.


44

Functions of merchant bankersManagement of debt and equity offerings: this forms the main function of the merchant banker. He assists the •companies in raising funds from the market. The undergoing tasks include instrument designing, pricing the issue, registration of the offer document, underwriting support, marketing of the issue, allotment and refund and listing on stock exchange.Placement and distribution: The merchant banker helps in distributing various securities like equity shares, debt •instruments, mutual funds, insurance products and commercial papers, to name a few. The distribution network ofthemerchantbankercanbeclassifiedasinstitutionalandretailinnature.Theinstitutionalnetworkconsistsofmutualfunds,foreigninstitutionalinvestors,privateequityfunds,pensionfunds,financialinstitutions,etc.Corporateadvisoryservices:Merchantbankersoffercustomisedsolutionstotheirclient’sfinancialproblems.•Financial structuring includes determining the right debt-equity ratio and the framing of appropriate capital structure theory.Project advisory services: Merchant bankers help their clients in various stages of the project undertaken by the •clients. They assist them in conceptualising the project idea in the initial stage. Once the idea is formed, they conducted feasibility studies to examine the viability of the proposed project.Loan syndication: Merchant bankers arrange to tie up loans for their clients. This takes place in a series of •steps.First,theyanalysethepatternoftheclient’scashflows,basedonwhichthetermsoftheborrowingcanbedefined.Thenthemerchantbankerpreparesadetailedloanmemorandum,.Whichiscirculatedtovariousbanksandfinancialinstitutionsandtheyareinvitedtoparticipateinthesyndicate.Thebanksthennegotiatethetermsoflendingonthebasisofwhichthefinalallocationisdone.Providingventurecapitalfinancing:Merchantbankershelpcompaniesinobtainingventurecapitalfinancing•forfinancingtheirnewandinnovativestrategies.

Regulatory frameworkThe merchant banking activity in India is governed by SEBI (Merchant bankers) Regulations, 1992. Registration •with SEBI is mandatory to carry out the business of merchant banking in India, an application should comply with the following norms:The application should be a corporate body.•The application should not carry on any business other than those connected with the securities market.•Theapplicationshouldhavenecessaryinfrastructurelikeofficespace,equipment,manpower,etc.•The application must have at least two employees with prior experience in merchant banking.•Any associate company, group company, subsidiary or interconnected company of the application should not •have been a registered merchant banker.The application should not have been involved in any securities scam or proved guilty for any offence.•The application should have a minimum net worth Rs. 50 million.•

Scope of merchant banking in IndiaMerchantbankingactivitieshelpinchannelisingthefinancialsurplusofthegeneralpublicintoproductiveinvestmentavenues. They help to coordinate the activities of various intermediaries to the share issue such as the registrar, bankers, advertising agency, printers, underwriters, brokers, etc. and to ensure the compliance with rules and regulations governing the securities market. This being the era where mergers and acquisitions are hot, the scope of merchant banking has grown to a large extent.

45

3.11 SEBIIn 1988 the Securities and Exchange Board of India (SEBI) was established by the Government of India through an executive resolution, and was subsequently upgraded as a fully autonomous body (a statutory Board) in the year 1992 with the passing of the Securities and Exchange Board of India Act (SEBI Act) on 30th January 1992. In place ofGovernmentControl,astatutoryandautonomousregulatoryboardwithdefinedresponsibilities,tocoverbothdevelopment & regulation of the market, and independent powers have been set up. Paradoxically this is a positive outcome of the Securities Scam of 1990-91.

ThebasicobjectivesoftheBoardwereidentifiedas:toprotecttheinterestsofinvestorsinsecurities;•topromotethedevelopmentofSecuritiesMarket;•to regulate the securities market and•for matters connected therewith or incidental thereto.•

SinceitsinceptionSEBIhasbeenworkingtargetingthesecuritiesandisattendingtothefulfilmentofitsobjectiveswith commendable zeal and dexterity. The improvements in the securities markets like capitalisation requirements, margining, establishment of clearing corporations etc. reduced the risk of credit and also reduced the market.

SEBI has introduced the comprehensive regulatory measures, prescribed registration norms, the eligibility criteria, the code of obligations, and the code of conduct for different intermediaries like, bankers to issue, merchant bankers, brokers and sub-brokers, registrars, portfolio managers, credit rating agencies, underwriters and others. It has framed bye-laws,riskidentificationandriskmanagementsystemsforClearinghousesofstockexchanges,surveillancesystem etc. which has made dealing in securities both safe and transparent to the end investor.

Anothersignificanteventistheapprovaloftradinginstockindices(likeS&PCNXNifty&Sensex)in2000.Amarket Index is a convenient and effective product because of the following reasons:

Itactsasabarometerformarketbehaviour;•Itisusedtobenchmarkportfolioperformance;•Itisusedinderivativeinstrumentslikeindexfuturesandindexoptions;•It can be used for passive fund management as in case of Index Funds.•

Two broad approaches of SEBI is to integrate the securities market at the national level, and also to diversify the tradingproducts,sothatthereisanincreaseinnumberoftradersincludingbanks,financialinstitutions,insurancecompanies, mutual funds, primary dealers etc. to transact through the Exchanges. In this context the introduction of derivatives trading through Indian Stock Exchanges permitted by SEBI in 2000 AD is a real landmark.

SEBI appointed the L. C. Gupta Committee in 1998 to recommend the regulatory framework for derivatives trading and suggest bye-laws for Regulation and Control of Trading and Settlement of Derivatives Contracts. The Board of SEBI in its meeting held on May 11, 1998 accepted the recommendations of the committee and approved the phased introduction of derivatives trading in India beginning with Stock Index Futures. The Board also approved the “Suggestive Bye-laws” as recommended by the Dr LC Gupta Committee for Regulation and Control of Trading and Settlement of Derivatives Contracts.

SEBI then appointed the J. R. Verma Committee to recommend Risk Containment Measures (RCM) in the Indian Stock Index Futures Market. The report was submitted in November 1998.

However the Securities Contracts (Regulation) Act, 1956 (SCRA) required amendment to include “derivatives” in thedefinitionofsecuritiestoenableSEBItointroducetradinginderivatives.Thenecessaryamendmentwasthencarried out by the Government in 1999. The Securities Laws (Amendment) Bill, 1999 was introduced. In December 1999 the new framework was approved.


46

Derivatives have been accorded the status of ̀ Securities’. The ban imposed on trading in derivatives in 1969 under a notificationissuedbytheCentralGovernmentwasrevoked.ThereafterSEBIformulatedthenecessaryregulations/bye-laws and intimated the Stock Exchanges in the year 2000. The derivative trading started in India at NSE in 2000 and BSE started trading in the year 2001.

The major objective of the SEBI may be summarised as follows:To provide a degree of protection to the investors and safeguard their rights and to ensure that there is a steady •flowoffundsinthemarket.To promote fair dealings by the issuer of securities and ensure a market where they can raise funds at a relatively •low cost.Toregulateanddevelopacodeofconductforthefinancialintermediariesandtomakethemcompetitiveand•professional.To provide for the matters connecting with or incidental to the above.•

Section 11 of the SEBI Act deals with the powers and functions of the SEBI as follows:It shall be the duty of Board to protect the interests of the investors in securities and to promote the development of and to regulate the securities market by measures as deemed frt.

To achieve the above, the Board may undertake the following measures :Regulatingthebusinessinstockexchanges;•Registering and regulating the working of stock brokers, sub-brokers, share transfer agents, bankers to an issue, •merchantbankers,underwriters,portfoliomanagers;Registeringandregulatingtheworkingofthedepositories,participants,creditratingagencies;•Registering and regulating the working of venture capital funds and collective investment schemes, including •mutualfunds;Prohibitingfraudulentandunfairtradepracticesrelatingtosecuritiesmarkets;•Promotinginvestorseducationandtrainingofintermediariesofsecuritiesmarkets;•Prohibitinginsidertradinginsecurities;•Regulatingsubstantialacquisitionofsharesandtake-overofcompanies;and•Calling for information from undertaking, inspection, concluding inquiries, and audits of the stock exchanges, •mutual funds, other persons associated with the securities market intermediaries and self-regulatory organisations in the securities market.

In order to attain these objectives, SEBI has issued Guidelines, Rules and Regulations from time to time. The most importantoftheseisthe“SEBI(DisclosureandInvestorProtection)Guidelines,2000″.TheprovisionsoftheseGuidelines,2000 are aimed to protect the interest of the investors in securities.

3.12 Securities and Exchange Board of India Act, 1992Major part of the liberalisation process was the repeal of the Capital Issues (Control) Act, 1947, in May 1992. With this,Government’scontroloverissuesofcapital,pricingoftheissues,fixingofpremiaandratesofinterestondebenturesetc.ceased,andtheofficewhichadministeredtheActwasabolished:themarketwasallowedtoallocateresources to competing uses.

However, to ensure effective regulation of the market, Securities and Exchange Board of India Act, 1992 was enacted to establish SEBI with statutory powers for:

protecting the interests of investors in securities,•promoting the development of the securities market, and•regulating the securities market•

47

Its regulatory jurisdiction extends over companies listed on Stock Exchanges and companies intending to get their securities listed on any recognised stock exchange in the issuance of securities and transfer of securities, in addition to all intermediaries and persons associated with securities market. SEBI can specify the matters to be disclosed andthestandardsofdisclosurerequiredfortheprotectionofinvestorsinrespectofissues;canissuedirectionstoall intermediaries and other persons associated with the securities market in the interest of investors or of orderly developmentofthesecuritiesmarket;andcanconductenquiries,auditsandinspectionofallconcernedandadjudicateoffences under the Act.

In short, it has been given necessary autonomy and authority to regulate and develop an orderly securities market. All the intermediaries and persons associated with securities market, viz., brokers and sub-brokers, underwriters, merchant bankers, bankers to the issue, share transfer agents and registrars to the issue, depositories, Participants, portfolio managers, debentures trustees, foreign institutional investors, custodians, venture capital funds, mutual funds, collective investments schemes, credit rating agencies, etc., shall be registered with SEBI and shall be governed by the SEBI Regulations pertaining to respective market intermediary.

3.13 Functions of SEBISEBI has been obligated to protect the interests of the investors in securities and to promote and development of, andtoregulatethesecuritiesmarketbysuchmeasuresasitthinksfit.Themeasuresreferredtothereinmayprovidefor:

regulatingthebusinessinstockexchangesandanyothersecuritiesmarkets;•registering and regulating the working of stock brokers, sub-brokers, share transfer agents, bankers to an issue, •trustees of trust deeds, registrars to an issue, merchant bankers, underwriters, portfolio managers, investment advisersandsuchotherintermediarieswhomaybeassociatedwithsecuritiesmarketsinanymanner;registering and regulating the working of the depositories, participants, custodians of securities, foreign •institutionalinvestors,creditratingagenciesandsuchotherintermediariesasSEBImay,bynotification,specifyinthisbehalf;registering and regulating the working of venture capital funds and collective investment schemes including •mutualfunds;promotingandregulatingself-regulatoryorganisations;•prohibitingfraudulentandunfairtradepracticesrelatingtosecuritiesmarkets;•promotinginvestors’educationandtrainingofintermediariesofsecuritiesmarkets;•prohibitinginsidertradinginsecurities;•regulatingsubstantialacquisitionofsharesandtake-overofcompanies;•calling for information from, undertaking inspection, conducting inquiries and audits of the stock exchanges, •mutual funds, other persons associated with the securities market, intermediaries and self- regulatory organisations inthesecuritiesmarket;calling for information and record from any bank or any other authority or board or corporation established or •constituted by or under any Central, State or Provincial Act in respect of any transaction in securities which is underinvestigationorinquirybytheBoard;performing such functions and exercising according to Securities Contracts (Regulation) Act, 1956, as may be •delegatedtoitbytheCentralGovernment;levyingfeesorotherchargesforcarryingoutthepurposeofthissection;•conductingresearchfortheabovepurposes;•callingfromorfurnishingtoanysuchagencies,asmaybespecifiedbySEBI,suchinformationasmaybe•considerednecessarybyitfortheefficientdischargeofitsfunctions;performing such other functions as may be prescribed•


48

SEBI may, for the protection of investors, specify, by regulations for •

themattersrelatingtoissueofcapital,transferofsecuritiesandothermattersincidentalthereto;and �the manner in which such matters, shall be disclosed by the companies and �

by general or special orders : •prohibit any company from issuing of prospectus, any offer document, or advertisement soliciting money �from the public for the issue of securities, specify the conditions subject to which the prospectus, such offer document or advertisement, if not prohibited �may be issued. (Section 11A).

SEBI may issue directions to any person or class of persons referred to in section 12, or associated with the securities marketortoanycompanyinrespectofmattersspecifiedinsection11A.ifitisintheinterestofinvestors,ororderlydevelopment of securities market to prevent the affairs of any intermediary or other persons referred to in section 12 being conducted in a manner detrimental to the interests of investors or securities market to secure the proper management of any such intermediary or person (Section 11B).

3.14 Credit RatingThe removal of strict regulatory framework in recent years has led to a spurt in the number of companies borrowing directlyfromthecapitalmarkets.Therehavebeenseveralinstancesintherecentpastwherethe“fly-by-night”operatorshavecheatedunwaryinvestors.Insuchasituation,ithasbecomeincreasinglydifficultforanordinaryinvestor to distinguish between ‘safe and good investment opportunities’ and ‘unsafe and bad investments’. Investors findthataborrower’ssizeornameisnolongerasufficientguaranteeoftimelypaymentofinterestandprincipal.

Investors perceive the need of a n independent and credible agency, which judges impartially and in a professional manner, the credit quality of different companies and assist investors in making their investment decisions. Credit Rating Agencies, by providing a simple system of gradation of corporate debt instruments, assist lenders to form an opinion on the relative capacities of the borrowers to meet their obligations. These Credit Rating Agencies, thus, assistandformanintegralpartofabroaderprogrammeoffinancialdisintermediationandbroadeninganddeepeningof the debt market. Credit rating is used extensively for evaluating debt instruments. These include long-term instruments,likebondsanddebenturesaswillasshort-termobligations,likeCommercialPaper.Inaddition,fixeddeposits,certificatesofdeposits,inter-corporatedeposits,structuredobligationsincludingnon-convertibleportionof partly Convertible Debentures (PCDs) and preferences shares are also rated. The Securities and Exchange Board of India (SEBI), the regulator of Indian Capital Market, has now decided to enforce mandatory rating of all debt instruments irrespective of their maturity.

3.14.1 Meaning of Credit RatingCredit Rating Agencies rate the aforesaid debt instruments of companies. They do not rate the companies, but their individualdebtsecurities.Ratingisanopinionregardingthetimelyrepaymentofprincipalandinterestthereon;itisexpressedbyassigningsymbols,whichhavedefinitemeaning.

Aratingreflectsdefaultriskonly,notthepriceriskassociatedwithchangesinthelevelorshapeoftheyieldcurve.It is important to emphasis that credit ratings are not recommendations to invest. They do not take into account many aspects,whichinfluenceaninvestmentdecision.Theydonot,forexample,evaluatethereasonablenessoftheissueprice, possibilities of earning capital gains or take into account the liquidity in the secondary market. Ratings also do not take into account the risk of prepayment by the issuer, or interest rate risk or exchange rate risks. Although these are often related to the credit risk, the rating essential is an opinion on the relative quality of the credit risk. It has to be noted that there is no privity of contract between an investor and a rating agency and the investor is not protected by the opinion of the rating agency.

Ratings are not a guarantee against loss. They are simply opinions, based on analysis of the risk of default. They are helpful in making decisions based on particular preference of risk and return. A company, desirous of rating its debt instrument, needs to approach a credit rating agency and pay a fee for this service. There is no compulsion on the corporate sector to obtain or publicise the credit rating except for certain instruments. A company can use the

49

rating as another publicity exercise if it is a good one and obliterate it from its prospectus and publicity, if it is not good.TheCreditRatingAgenciesregularlyanalysethefinancialpositionofcorporationsandassignandrevisetheratings for their securities. The different rating agencies seldom give different ratings for the same security. If two ratingagenciesdogivethesamesecuritydifferentratings,itiscalledsplitrating;thefewdifferencesthatoccurarerarely more than one rating grade level apart. Accepted ratings are published in media, every week. In tune with the industrial practice in India, rating agencies do not publish ratings which are not accepted by issuers.

3.14.2 Credit Rating Agencies in IndiaIn India, at present, there are four Credit Rating Agencies:

Duff and Phelps Credit Rating of India (Pvt.) Ltd

Credit Analysis and Research Limited (CARE)

Investment Information and Credit Rating Agency of India Limited (ICRA)

Credit Rating and Information Services of India Limited (CRISIL)

Fig. 3.3 Credit rating agencies in India

CRISILThis was set-up by ICICI and UTI in 1988, and rates debt instruments. Nearly half of its ratings on the instruments are being used. CRISIL’s market share is around 75%. It has launched innovative products for credit risks assessment, viz., counter party ratings andbank loan ratings.CRISIL rates debentures,fixeddeposits, commercial papers,preference shares, and structured obligations. Of the total value of instruments, rated debentures accounted for 31.1%,fixeddepositsfor42.3%andcommercialpaper6.6%.CRISILpublishesCRISILratinginSCANthatisaquarterly publication in Hindi and Gujarati, besides English.

CRISILevaluationiscarriedoutbyprofessionallyqualifiedpersonsandincludesdatacollection,analysisandmeeting with key personnel in the company to discuss strategies, plans and other issues that may effect, evaluation ofthecompany.Therating,processensuresconfidentiality.Oncethecompanydecidestouserating,CRISILisobligated to monitor the rating over the life of the debt instrument.

ICRA ICRA was promoted by IFCI in 1991. During the year 1996-97, ICRA rated 261 debt instruments of manufacturing companies,financecompaniesandfinancialinstitutionsequivalenttoRs.12,850croreascomparedto293instrumentscovering debt volume of Rs. 75,742 crore in 1995-96. This showed a decline of 83.0% over the year in the volume of rated debt instruments. Of the total amount rated cumulatively until March-end 1997, the share in terms of number of instruments was 28.5% for debentures (including long term instruments), 49.4% for Fixed Deposit programme (including medium- term instruments), and 22.1% for Commercial Paper Programme (including short- term instruments).


50

Thecorrespondingfiguresofamountinvolvedforthesethreebroadratedcategorieswas23.8%fordebentures,52.2%forfixeddeposits,and24.0%forCommercialPaper.ThefactorsthatICRAtakesintoconsiderationforrating, depends on the nature of borrowing entity. The inherent protective factors, marketing strategies, competitive edge, competence and effectiveness of management, human resource development policies a n d practices, hedging ofrisks,trendsincashflowsandpotentialliquidity,financialflexibility,assetqualityandpastrecordofservicingof debt as well as government policies affecting the industry are examined.

Besides determining the credit risk associated with an instrument, ICRA has also formed a group under Earnings Prospects and Risk Analysis (EPRA). Its goal is to provide authentic information on the relative quality of the equity. This requires examination of almost all parameters pertaining to the fundamentals of the company including relevant sectoral perspectives. This quality analysis is reinforced and completed by way of the unbiased opinion and informed perspective of one analyst and wealth of judgement of committee members. ICRA opinions help the issuing company to broaden the market for their equity. As the name recognition is replaced by objective opinion, the lesser known companies are also able to access the equity market.

CARE CARE is a credit rating and information services company promoted by IDBI jointly with investment institutions, banks,andfinancecompanies.ThecompanycommenceditsoperationsinOctober1993.InJanuary1994,CAREcommenced publication of CAREVIEW, a quarterly journal of CARE ratings. In addition to the rationale of all accepted ratings, CAREVIEW often carries special features of interest to issuers of debt instruments, investors, and other market players.

3.14.3 Benefits of Credit Rating Rating serves as a useful tool for different constituents of the capital market. For different classes of persons, different benefitsaccruefromtheuseofratedinstruments.

Investors: Rating safeguards against bankruptcy through recognition of risk. It gives an idea of the risk involved in the investment. It gives a clue to the credibility of the issuer company. Rating symbols give information on the quality of instrument in a simpler way that can be understood by lay investor and help him in taking decision on investment without the help from broker. Both individuals and institutions can draw up their credit risk policies and assess the adequacy or otherwise of the risk premium offered by the market on the basis of credit ratings.

Issuers of debt instruments: A company whose instruments are highly rated has the opportunity to have a wider access to capital, at 0lower cost of borrowing. Rating also facilitates the best pricing and timing of issues and provides financingflexibility.Companieswithratedinstrumentscanusetheratingasamarketingtooltocreateabetterimage in dealing with its customers, lenders, and creditors. Ratings encourage the companies to come out with more disclosuresabouttheiraccountingsystems,financialreporting,andmanagementpattern.Italsomakesitpossiblefor some category of investors who require mandated rating from reputed rating agencies to make investments.

Financial intermediaries:Financial intermediaries likebanks,merchantbankers,andinvestmentadvisersfindrating as a very useful input in the decision relating to lending and investments. For instance, with high credit rating, the brokers can convince their clients to select a particular investment proposal more easily thereby saving on time, cost and manpower in convincing their clients.

Business counter-parties: The credit rating helps business counter-parties in establishing business relationships particularly for opening letters of credit, awarding contracts, entering into collaboration agreements, etc.

Regulators: Regulators can, with the help of credit ratings, determine eligibility criteria and entry barriers for new securities,monitorfinancial soundnessof organisations andpromote efficiency indebt securitiesmarket.Thisincreasestransparencyofthefinancialsystemleadingtoahealthydevelopmentofthemarket.

51

3.14.4 Factors for Successful Credit Rating Systems Factors for successful credit rating system are detailed below:

Credible and independently determined •Independence and unbiased opinion •Analytical research, consistency is crucial •Industry related expertise •Confidentiality•Timeliness of ratings and changes in ratings •Wide reach and coverage •

3.14.5 Process of RatingThe processing of credit rating is listed below.

Credit Rating Agency enters into an agreement with the client whose securities are to be rated •Rightsandliabilitiesofthepartiesaredefined �Feeschargedisspecified �Tenureforperiodicreviewoftheratingisspecified �The client shall disclose the credit rating received for its listed securities and disclosed the same in its offer �document whether or not it is accepted by him Ensureconfidentialityofalltheinformationdisseminatedbytheclient �The rating agency shall exercise due diligence to ensure that the rating assigned is fair and appropriate �

Rating agencies on the basis of several premises assign the credit rating and communicate to the client/ •issuer. Theissuercanmakeonerequestforreviewoftheratingbasedonfreshfactsandclarifications.•Thenthefinalratingisassignedandthesameispublishedalongwiththedefinitionoftheconcernedrating•along with the symbol. AcopyoftheratingisfiledwiththeBoardalongwithanymodificationsandadditionsmadethereafter•Theratingagencywillalsopublishtherationalebehindtheratingassignedandthejustificationtothepremises•considered, favourable assessment and factors constituting risk Once accepted, it is disclosed and put in the surveillance process thereafter •Surveillance: Continuous review of the ratings assigned to the rating agency. Frequency of the reviews may •vary from quarterly to annually as per the agreement Credit Watch: In case of any event taking place, that may result in major deviations from the expected trends •and which are likely to impact the credibility, rating of the entity, such instruments are put on credit watch, until the impact of the event is not evident or clear Investments in investment grade: Investors are advised to invest in securities up to investment grade level, which •is BBB (S&P) and Baa (Moody’s). Securities rated below the investment grade are referred to as speculative grade or junk bonds


52

SummaryMoneymarketispartoffinancialmarketwhereinstrumentswithhighliquidityandveryshorttermmaturities•are traded. AccordingtoCrowther,“Themoneymarketisanamegiventothevariousfirmsandinstitutionsthatdealin•the various grades of near money.”Adevelopedmoneymarketplaysanimportantroleinthefinancialsystemofacountrybysupplyingshort-•term funds adequately and quickly to trade and industry. The money market is an integral part of a country’s economy. Difference and demarcation between money market and capital market is made on the basis of maturity period •of instruments and claims. Money market instruments: Investment in money market is done through money market instruments. •India has adopted the Depository System for securities trading in which book entry is done electronically and •no paper is involved. Merchant banking implies investment management, companies raise capital by issuing securities in the market, •merchant bankers act as intermediaries between the issuers of capital and the investors who purchase these securities. In 1988 the Securities and Exchange Board of India (SEBI) was established by the Government of India through •an executive resolution, and was subsequently upgraded as a fully autonomous body (a statutory Board) in the year 1992 with the passing of the Securities and Exchange Board of India Act (SEBI Act) on 30th January 1992. Credit Rating Agencies, by providing a simple system of gradation of corporate debt instruments, assist lenders •to form an opinion on the relative capacities of the borrowers to meet their obligations.

ReferencesAppannaiah, H.R., Reddy, P.N. and Sharma, N.M, 2010. • Financial Markets and Services, Global Media.Desai, Vasant, 2009. • Financial Markets and Financial Services, Global Media.mbaknol, • Depository System in India [Online] Available at: <http://www.mbaknol.com/investment-management/depository-system-in-india/>. [Accessed 1 December 2011].Singh and Associates, 2008. • Merchant Banking, [Online] Available at: <http://www.asialaw.com/Article/1988860/Channel/16958/Merchant-Banking.html>. [Accessed 1 December 2011].Kotak Securities Ltd., 2011. • Indian Financial Market Review-2011 - Kotak Securities - Indian Economy [Video Online] Available at: <http://www.youtube.com/watch?v=basQcPXpu7E> [Accessed 13 December 2011].Anderssen, J., 2008. • Money Market Instruments [Video Online] Available at: <http://www.youtube.com/watch?v=gv-9VkRY5dI>. [Accessed 13 December 2011].

Recommended ReadingGordon, E. and Natarajan, K. 2010. • Financial Markets, Global Media.Howells, P. and Bain, K., 2007. • Financial markets and institutions, 5th ed., Prentice Hall/Financial Times, 2007Choudhary, C, M., 2006. • Financial market in India, Indus Valley Publications.

53

Self AssessmentWhich of the following is a synonym of liquidity?1.

Capitala. Moneyb. Marketc. Merchandisingd.

Accordingto__________,“Themoneymarketisanamegiventothevariousfirmsandinstitutionsthatdealin2. the various grades of near money.”

Crowthera. RBIb. Nadlerc. Shipmand.

Which of the following provides commercial banks with facilities for temporarily employing their surplus funds 3. in easily realisable assets?

Primary marketa. Forex marketb. Capital marketc. Money marketd.

Which of the following meets short term requirements of the borrowers and provides liquidity to the lenders?4. Functions of money marketa. Money market instrumentsb. Importance of money marketc. Objectives of money marketd.

Which of the following are zero risk instruments, and hence, the returns are not so attractive?5. Treasury billsa. Repurchase agreementsb. Commercial papersc. Certificateofdepositd.


T-Bills1. Repo or Reverse RepoA.

Repurchase agreement2. shorttermcreditinvestmentcreatedbyanonfinancialfirmB.

Commercial paper3. Central Government issues T- Bills at a price less than their C. face value

Banker’s acceptance4. low-cost alternative to bank loansD.



54

_____________isapromissorynoteissuedbyabankinformofacertificateentitlingthebearertoreceive7. interest.

Treasury billsa. Repurchase agreementsb. Commercial papersc. Certificateofdepositd.

India has adopted _________ for securities trading in which book entry is done electronically and no paper is 8. involved.

Capital marketa. Money marketb. Depository systemc. Merchant marketd.

Whichofthefollowingisthefinancialintermediationthatmatchestheentitiesthatneedcapitalandthosethat9. have capital for investment?

Capital marketa. Money marketb. Depository systemc. Merchant marketd.

________ appointed the L. C. Gupta Committee in 1998 to recommend the regulatory framework for derivatives 10. trading and suggest bye-laws for Regulation and Control of Trading and Settlement of Derivatives Contracts.

SEBIa. RBIb. NABARDc. IDBId.

55

Chapter IV

Capital Market

Aim


introduce capital market•

definestockexchange•

describe the functions and advantages of stock exchange•

Objectives


highlight the role of capital market in India•

explain the importance of capital market•

elucidatethecapitalmarketefficiency•

Learning outcome


understand the PESTEL analysis of Indian capital market•

state the characteristics of stock exchange•

differentiate between primary market and secondary market•


56

4.1 IntroductionIn the present day capital market scenario the merchant banks play as an encouraging and supporting force to the entrepreneurs,corporatesectorsandtheinvestors.TherecentmodificationsoftheIndiancapitalmarketenvironmenthaveemergedthevariousfinancialinstitutionsasthemajorsourcesoffinancefortheorganisations.Severalnewinstitutionshaveappeared in thefinancial spectrumandmerchantbankershave joined to expand the rangeoffinancialservices.

“CapitalMarketisamarketforfinancialinvestmentsthataredirectorindirectclaimstocapital”.Itcomprisesofthe institutions and mechanisms through which funds are pooled and made available to business, government and individuals.

With the expansion of commercial banking and unprecedented development of multinational corporations, the domesticfinancialmarketshasassumedglobaloutlook.TheintegrationofworldfinancialandcapitalmarketwiththatoftheIndianprovidesgreaterbenefitstoboththedemandersandsuppliersoffundsandopportunitytodiversifyrisk. This globalisation has added depth to the market with a large number of market participants.

Capital market is, generally, referred to the market for long-term funds. It includes institutions mechanism for the effective pooling of long-term funds form individuals and institutional investors and making them available to industrial and commercial undertakings. Capital market, in short, deals in shares, debentures, bonds and securities.

Capital market has the following features: It deals in long and medium term funds •It consists of primary market, secondary available to industrial and commercial undertakings market and special •financialinstitutionsIt covers both individual and institutional investors •It makes funds available to industrial and commercial undertaking•

Need and importance of capital market It helps in mobilising the savings on a large scale. •It helps in the capital formation in the country. •It helps in effective distribution of the mobilised funds for balanced economic development. •It provides continues market for long-term. •

4.2 Classification of Capital Market Capitalmarketcanbeclassifiedas:

Primary Market Secondary Market

Capital Market

Fig. 4.1 Classification of capital market

57

Primary marketPrimary market provides opportunity to issuers of securities, Government, as well as corporates, to raise resources to meet their requirements of investment and/or discharge some obligation. The issuers create and issue fresh securities in exchange of funds through public issues and/or as private placement. When securities are exclusively offered to the existing shareholders it is called ‘Rights Issue’ and when it is issued to selected mature and sophisticated institutional investors as opposed to general public it is called ‘Private Placement Issues’. Issuers may issue the securities at face value, or at a discount/premium and these securities may take a variety of forms such as equity, debt or some hybrid instruments. The issuers may issue securities in domestic market and /or international market through ADR/GDR/ECB route.

Secondary marketSecondary market refers to the network/system for the subsequent sale and purchase of securities. An investor can applyandgetallottedaspecifiednumberofsecuritiesbytheissuingcompanyintheprimarymarket.However,once allotted the securities can thereafter be sold and purchased in the secondary market only. An investor who wants to purchase the securities can buy these securities in the secondary market. The secondary market is market for subsequent sale/purchase and trading in the securities. A security emerges or takes birth in the primary market but its subsequent movements take place in secondary market. The secondary market consists of that portion of thecapitalmarketwherethepreviouslyissuedsecuritiesaretransacted.Thefirmsdonotobtainanynewfinancingfromsecondarymarket.Thesecondarymarketprovidesthelife-bloodtoanyfinancialsystemingeneral,andtothecapital market in particular.

The secondary market is represented by the stock exchanges in any capital market. The stock exchanges provide an organised market place for the investors to trade in the securities. This may be the most important function of stock exchanges. The stock exchange, theoretically speaking, is a perfectly competitive market, as a large number of sellers and buyers participate in it and the information regarding the securities is publicly available to all the investors. A stock exchange permits the security prices to be determined by the competitive forces. They are not set bynegotiationsoffthefloor,whereonepartymighthaveabargainingadvantage.Thebiddingprocessflowsfromthedemandandsupplyunderlyingeachsecurity.Thismeansthatthespecificpriceofasecurityisdetermined,more or less, in the manner of an auction. The stock exchanges provide market in which the members of the stock exchanges (the share brokers) and the investors participate to ensure liquidity to the latter.

Forthegeneralinvestor,thesecondarymarketprovidesanefficientplatformfortradingofhissecurities.Forthemanagement of the company, Secondary equity markets serve as a monitoring and control conduit—by facilitating value-enhancing control activities, enabling implementation of incentive-based management contracts, and aggregating information (via price discovery) that guides management decisions.

4.2.1 Distinction between Primary Market and Secondary MarketThe main points of distinction between the primary market and secondary market are as follows:

Function• : While the main function of primary market is to raise long-term funds through fresh issue of securities, the main function of secondary market is to provide continuous and ready market for the existing long-term securities.Participants• :Whilethemajorplayersintheprimarymarketarefinancialinstitutions,mutualfunds,underwritersand individual investors, the major players in secondary market are all of these and the stockbrokers who are members of the stock exchange.Listing requirement• : While only those securities can be dealt within the secondary market, which have been approved for the purpose (listed), there is no such requirement in case of primary market.Determination of prices• : In case of primary market, the prices are determined by the management with due compliance with SEBI requirement for new issue of securities. But in case of secondary market, the price of thesecuritiesisdeterminedbyforcesofdemandandsupplyofthemarketandkeepsonfluctuating.


58

4.3 Capital Market EfficiencyCapital market facilitates the buying and selling of securities, such as shares and bonds or debentures. They perform two valuable functions: liquidity and pricing securities.

Liquidity

Pricing Secirities

Fig. 4.2 Functions of capital market

LiquidityLiquidity means the convenience and speed of transforming assets into cash, or transferring assets from one person to another without any loss of value. Cash is the most liquid asset as it can be readily converted into any other asset, or transferred to another person without any decline in value.

Capital market makes securities liquid. They facilitate the buying and selling of securities by a large number of investorscontinuouslyandinstantaneouslywithoutincurringsignificantcosts.Theyhelptoreduce,ifnoteliminate,transaction costs. For ensuring the liquidity, capital markets do require certain investors who are always ready to buy or sell securities. These market makers enhance liquidity and reduce transaction costs.

Pricing securitiesHow are the prices of securities determined? Are these fair prices? In the capital markets hundred of investors make several deals a day. The screen-based trading makes these deals known to all in the capital market. Thus, a large number of buyers and sellers interact in the capital markets. The demand and supply forces help in determining theprices.Sinceallinformationispubliclyavailable,andsincenosingleinvestorislargeenoughtoinfluencethesecurity prices, the capital markets provide a measure of fair price of securities.

Afinancialmanagerborrowsandlends(invests)fundsonthecapitalmarket.Capitalmarkersfacilitatetheallocationoffundsbetweensaversandborrowers.Thisallocationwillbeoptimumifthecapitalmarketshaveefficientpricingmechanism.

59

4.3.1 Forms of Capital Market EfficiencyThefinancetheoryreferstothreeformsofcapitalmarketefficiency:

Strong-form of efficiency

Semi-strong form of efficiency

Weak-form of efficiency

Fig. 4.3 Forms of capital market efficiency

Weak-form of market efficiencyThesecuritypricesreflectallthepastinformationaboutthepricemovementsintheweak-formofefficiency,itis,therefore, not possible for any investor to predict future security price by analysing historical prices, and achieve a performance (return) better than the stock market index such as Bombay Stock Exchange Share Price Index or the Economic Times Share Price Index. It is so because the capital market has no money, and the stock market index has already incorporated past information about the security prices in the current market price.

Howdoesoneknowthatthecapitalmarketisefficientinitsweakform?Toanswerthisquestionitisnecessarytofindoutthecorrelationbetweenthe‘securitypricesovertime’inanefficientcapitalmarket,thereshouldnotexistasignificantcorrelationbetweenthesecuritypricesovertime.Mostempiricaltestshaveshownthatthereexistsserialindependencebetweenthesecuritypricesovertime.Hencetheweakformofefficiencyisreferredtoastherandomwalkhypothesis.Analternativemethodtotestingtheweaklyefficientmarkethypothesisistoformulatethetrading strategies using the security prices and compare their performance with the stock market performance.

Semi-strong form of market efficiencyInsemi-strongformofefficiencyassetpricesalreadyreflectallinformationthatispubliclyavailable,i.e.,earnings,dividends, analyst forecasts, expectations of the future, etc. Most tests show that material public announcements areaccompaniedbyanimmediatechangeinprice.Inasemi-strongefficientmarket,themarket’sreactiontonewand material information should be both instantaneous and unbiased, i.e., without any systematic pattern of over or under reaction. In addition, the market should only react to the extent that new information differs from what had beenexpected.Semi-strongefficiencyalsomeansthatmostfinancialanalysisworkorfundamentalanalysis,basedon using public information, should not work.

Opportunities may occasionally exist that produce above normal or excess returns. However, after the information orstrategiesbecomeknowntothepublic,theyshouldnolongerproduceexcessreturns;forexample,theJanuaryeffect in small stocks has vanished. Also, a talented investment analyst might still be able to beat the market, provided that he/she is able to consistently interpret information better than the competition can.


60

ImplicationsofSemi-strongformofmarketefficiencyStock prices are expected to increase over time, but future returns are expected to be consistent with the •systematic risk. InvestmentsinfinancialassetsareexpectedtobeZERONetPresentValue.Thismeansthatyoushouldexpect•to earn an average future return that is determined by the systematic risk of the investments. Whatifnooneperformedsecurityanalysis?Thenthefirstpersonthatbecomesananalystwillfindcountless•mispricedassetsandtradingrulesthatearnexcessorabnormalreturns.Suchprofitableopportunitieswouldcertainlyleadtomanymoreindividualsenteringtheanalystfield.Competitionwillquicklybegintoeliminatemost of the mispriced assets. Duetointensecompetition,itwillbecomedifficulttoearnabnormalreturns.Themarginalbenefitofanalysis•will just equal the marginal cost of analysis for the average analyst or investor. It thus follows that individuals should be exceedingly suspicious of anyone that advertises some investment •technique that earns abnormal returns. If the method really works, then any rational person would keep the techniqueundisclosed.Thisholdsfortheweak-formmarketefficiencyaswell,asmanyattempttosellmethodsfor technical analysis.

Strong-form of market efficiencyIn the strong-formof efficiency, the security prices reflect all published and unpublished, public and privateinformation,thisisasignificantlystrongassertion,andempiricalstudieshavenotborneoutthevalidityoftheefficientmarkethypothesisinthestrongformofefficiency,peoplewithprivateorinsideinformationhavebeenable to outperform the market.

4.4 Capital Market in IndiaIndian capital market is one of the oldest and largest capital markets of the world. Its history can be traced back to the19thcentury.ThefirstinstanceoforganisedtradingincorporatesecuritiesinIndiaisrelatedtothetradinginsecurities of East India Company.

Thereare22stockexchangesinIndia,thefirstbeingtheBombayStockExchange(BSE),whichbeganformaltrading in 1875, making it one of the oldest in Asia. Over the last few years, there has been a rapid change in the Indian securities market, especially in the secondary market. Advanced technology and online-based transactions have modernised the stock exchanges. In terms of the number of companies listed and total market capitalisation, the Indian equity market is considered large relative to the country’s stage of economic development.

61

Indian Capital Market

Market Instruments Intermediaries

Primary Secondary

Equity DebtHybrid

Regulator

•Brokers•Investment Bankers•Stock Exchanges•Underwriters

SEBI

Players

Corporate IntermediariesCRA Banks/FI FDI /FIIIndividual

Fig. 4.4 Indian capital market(Source: http://www.scribd.com)

The changes in economic scenario (after the liberalisation) and the economic growth have raised the interest of Indian as well as Foreign Institutional Investors (FII’s) in the Indian capital market. The recent massive structural reforms on the economic and industry front in the form of de-licensing rupee convertibility, tapping of foreign funds, allowing foreign investors to come to India, have resulted, on one hand, in the quantum leap in activities/volume in the Indian capital market, and on the other hand and more importantly, that the Indian capital market has undergone a metamorphosis in terms of institutions, instruments, etc. The capital market in India is rightly termed as an emerging and promising capital market. During last 20 years or so, the Indian capital market has witnessed growth in volume of funds raised as well as of. The buoyancy in the capital market has appeared as a result of increasing industrialisation, growingawarenessglobalisationofthecapitalmarket,etc.Severalfinancialinstitutions,financialinstruments,andfinancialserviceshaveemergedasaresultofeconomicliberalisationpolicyoftheGovernmentofIndia.

4.4.1 Structure of Indian Capital MarketBroadlyspeakingthecapitalmarketisclassifiedintotwocategories:Primarymarket(NewIssuesMarket)andtheSecondarymarket(Old(Existing)IssuesMarket).Thisclassificationisdoneonthebasisofthenatureoftheinstrument brought in the market. However on the basis of the types of institutions involved in capital market, it canbeclassifiedintovariouscategoriessuchastheGovernmentSecuritiesmarketorGilt-edgedmarket,IndustrialSecuritiesmarket,DevelopmentFinancialInstitutions(DFIs)andfinancialintermediaries.Allofthesecomponentshavespecificfeaturestomention.ThestructureoftheIndiancapitalmarkethasitsdistinctfeatures.Thesedifferentsegments of the capital market help to develop the institution of capital market in many dimensions. The primary market helps to raise fresh capital in the market. In the secondary market, the buying and selling (trading) of capital market instruments takes place. The following chart will help in understanding the organisational structure of the Indian capital market.

http://www.scribd.com/doc/14784493/Indian-Capital-Market


62

Capital Market in India

Government Securities

(Gilt-edged market)

Development Financial

Institutions (DFIs)

Individual Securitas Market

New Issues Market Old Issues Market (Stock Exchange)

Financial Intermediaries

IFCI ICICI

Merchant Banks

Mutual Funds

Leasing Companies

Venture Capital Companies

Other Financial Organisation

SFCs IDBI IIBI UTI

Fig. 4.5 Structure of capital market in India(Source: http://kalyan-city.blogspot.com)

Government securities market: This is also known as the Gilt-edged market. This refers to the market for government and semi-government securities backed by the Reserve Bank of India (RBI).

Industrial securities market: This is a market for industrial securities, i.e., market for shares and debentures of theexistingandnewcorporatefirms.Buyingandsellingofsuchinstrumentstakeplaceinthismarket.Thismarketisfurtherclassifiedintotwotypes;NewIssuesMarket(Primary)andOld(Existing)IssuesMarket(secondary).In primary market, fresh capital is raised by companies by issuing new shares, bonds, units of mutual funds and debentures. However, in the secondary market already existing, i.e., old shares and debentures are traded. This trading takes place through the registered stock exchanges. In India, there are three prominent stock exchanges which are Bombay Stock Exchange (BSE), National Stock Exchange (NSE) and Over The Counter Exchange of India (OTCEI).

Development Financial Institutions (DFIs): This is yet another important segment of Indian capital market. This comprisesvariousfinancialinstitutions.ThesecanbespecialpurposeinstitutionslikeIFCI,ICICI,SFCs,IDBI,IIBI,UTI,etc.Thesefinancialinstitutionsprovidelongtermfinanceforthosepurposesforwhichtheyaresetup.

Financial intermediaries: ThefourthimportantsegmentoftheIndiancapitalmarketisthefinancialintermediaries.Thiscomprisesvariousmerchantbankinginstitutions,mutualfunds,leasingfinancecompanies,venturecapitalcompaniesandotherfinancialinstitutions.

These are important institutions and segments in the Indian capital market.

4.4.2 Capital Market OperationsCapital market operations consist mainly of primary market operations and secondary market operations. Primary market or new issue market deals with the issue of new securities to the investors and facilitates the corporate sectorinraisingfunds.Theprimarymarketismadeupoftwocomponents:wherefirmsgopublicforthefirsttimethroughinitialpublicofferingsandwherefirmswhicharealreadytradedraiseadditionalcapitalthroughseasonedequity offerings. Initial capital is raised by issuing only ordinary and preference shares whereas further capital can be raised by selling debentures as well.

In order to effectively control the activities in the new issue market and to ensure that investments in the country are made in a planned manner and in accordance with the priorities laid down in the plans, the government has instituted the Controller of Capital Issues (CCI) under the Capital Issues (Control) Act, 1947. CCI laid stringent

63

controls on pubic and right issues and in their pricing. As a result, capital issues were generally underpriced. But when Capital Issues (Control) Act was repealed and free pricing was introduced by SEBI in 1992 the market saw a plethoraofissues.Heftypremiumswerechargedbytheissuingcompaniesastherewasnorestrictiononfixingofpremiums.Manyfly-by-nightcompaniesalsoaccessedcapitalmarket.Butinmanycasesinvestorslostheavilyasthe post issue listings were quoted far below issue prices. It is estimated that around 1000 companies which came out with issues and collected about Rs. 3000 crores in 1995 and 1996 have disappeared completely

With a view to protect the interest of investors Malegam Committee recommended the introduction of Book Building asanalternativedevicetotheexistingsystemoffixedpricinganditwasadoptedbySEBIin1996.BookBuildinghelpstofindabetterpriceforanissuetobemade.Underthismethod,theissuingcompanywillmentionanindicativeprice at which securities will be offered and gives the investors an opportunity to bid collectively. Then a consensus pricewillbearrivedatandallotmentwillbefinalisedattheagreedprice.

Buy-back of shares is a device which facilitates capital restructuring of a company. It helps in arresting wide fluctuationinsharepricesandpavesthewayforefficientallocationofresources.Earlier,buy-backofshareswasprohibited in India by the Companies Act, 1956. However, buy- back was allowed in India through an amendment ordinance in 1998. Now Indian companies are free to buy its own shares and other securities up to 25 per cent of their net worth out of its free reserves, or securities premium account, or proceeds of an earlier issue other than a freshissuemadespecificallyforbuy-backpurposes.Inanotherdevelopment,companiesaregiventheoptiontoissue shares of any denomination without a uniform par value.

4.5 Role of Capital Market in IndiaThe role of capital market in India is discussed below:Capital formationThe capital market encourages capital formation in the country. Rate of capital formation depends upon savings in thecountry.Thoughthebanksmobilisesavings,theyarenotsufficienttomatchtherequirementsoftheindustrialsector. The capital market mobilises savings of households and of the industrial concern. Such savings are then invested for productive purposes. Thus, saving and investment leads to capital formation in country.

Economic growthCapital market facilitates the growth of the industrial sector as well as other sectors of the economy. The main function of the capital market is to transfer resources (funds) from masses to the industrial sector. The capital market makes it possible to lend funds to various projects in public as well as private sector.

Development of backward areasThe capital markets provide funds for the projects in backward areas. This facilitates the economic development of the backward areas.

EmploymentCapital market generates employment in the country in two different ways:

Directemploymentinthecapitalmarketssuchasstockmarkets,financialinstitutions,etc.•Indirect employment in all sectors of the economy, because of the funds provided for developmental projects. •

Long term capital to the industrial sectorThe capital market provides a permanent long-term capital for the companies. Once, the funds are collected through issues, the money remains with the company. The company is left free with the funds while investors exchange securities among themselves.

Foreign capitalCapitalmarketmakespossibletogenerateforeigncapital.Indianfirmsareabletogeneratecapitalformoverseasmarkets though bonds and other securities. Such foreign exchange funds are vital for the economic growth of the nation.


64

Developing role of financial institutionsThe various agencies of capital market such as industrial Financial Corporation of India (IFCI), State Finance Corporations (SFC), industrial Development Bank of India (IDBI), Industrial Credit and Investment Corporation of India (ICICI), Unit Trust of India (UTI), life insurance Corporation of India (LIC), etc. have been rendering useful servicesforindustrialgrowth.Theyfinance,promote,andunderwritethefunctionsofthecapitalmarket.

Investment opportunitiesCapital markets provide excellent investment opportunities to the public members. The public can have alternative source of investment, i.e., bonds, shares and debentures, etc.

4.6 Importance of Capital MarketA well functioning stock market may help the development process in an economy through the following channels:

Growth of savings,•Efficientallocationofinvestmentresources,•Better utilisation of the existing resources.•

InmarketeconomylikeIndia,financialmarketinstitutionsprovidetheavenuebywhichlong-termsavingsaremobilisedandchannelledintoinvestments.Confidenceoftheinvestorsinthemarketisimperativeforthegrowthanddevelopmentofthemarket.Foranystockmarket,themarketIndicesisthebarometerofitsperformanceandreflectsthe prevailing sentiments of the entire economy. Stock index is created to provide investors with the information regarding the average share price in the stock market. The ups and downs in the index represent the movement of the equity market. These indices need to represent the return obtained by typical portfolios in the country.

Generally, the stock price of any company is vulnerable to three types of news:Companyspecific•Industryspecific•Economyspecific•

An all share index includes stocks from all the sectors of the economy and thus cancels out the stock and sector specificnewsandeventsthataffectstockprices,(lawofportfoliodiversification)andreflecttheoverallperformanceof the company/equity market and the news affecting it.

Themost importantuseof an equitymarket index is as abenchmark for aportfolioof stocks.All diversifiedportfolios, belonging either to retail investors or mutual funds, use the common stock index as a yardstick for their returns.Indicesareusefulinmodernfinancialapplicationofderivatives.

4.7 PESTEL Analysis of Indian Capital MarketThe PESTEL analysis of the Indian capital market is as follows.

PoliticalThe capital market of India is very vulnerable. India has been politically instable in the past but it is a little politically stable now-a-days. The political instability of the country has a very strong impact on the capital market. The share market of India changes as the political changes took place. The BSE Index, SENSEX goes up and down with any kind of small and big political news, like, if there is news that a particular political party has withdrawn its support from the ruling party, and then the capital market will go down with a bang. The political stability of the country is very important for the stability and growth of capital market in India. The political imbalance or balance of the country is the major factor in deciding the capital market of India. The political factors include:

employment laws•tax policy•

65

trade restrictions and tariffs•political stability•

EconomicalThe economical measures taken by the government of India has a very strong relationship with the capital market. Whenever the annual budget is announced the capital market goes up and down with the economical policies of the government .If the policies are supportive to the companies then the capital market takes it positively and if there is any other policy that is not supportive and it is not welcomed then the capital market goes down. Like, in the case of allocation of 3-G spectrum, those companies that got the license for 3-G, they witnessed sharp growth in their share values so the economic policies play a major part in the growth and decline of the capital market and again if there is relaxation on any kind of taxes on items of automobile industry then the share of automobile sector goes up and virtually strengthen the capital market .The economical factors include:

inflationrate•economic growth•exchange rates•interest rates•

SocialIndia is a country of unity in diversity .India is socially rich but the capital market is not very attached with the social factors .Yes, there is some relation between the social factors with the capital market. If there is any big social factor then to some extent it affects the capital market but small social factors don’t impact at all. Like, there was opposition of reliance fresh in many cities and many stores were closed. The share prices of the reliance fresh went downbuttheimpactwasonandindividualfirmtherewasnotmuchimpactonthecapitalmarketonawholethesocial factors have not much of impact on the capital market in India. The social factors include:

emphasis on safety•career attitudes•population growth rate•age distribution•health consciousness•

TechnologicalThe technological factors have not that much effect on the capital market. India is technological backward country. Same as social factors, technological factor can have an effect on an individual form but it cannot have a big impact on a whole of capital market. The Bajaj got a patent on its dts-i technology, and launched it in its new bike but it does not effect on capital market. The technological change in India is always on a lower basis and it doesn’t effect on country as a whole. The technological factors include:

R&D activity•technology incentives•rate of technological change•automation•

Environmental factorsInitially, the environmental factors don’t play a vital role in the capital market. But, in changing time, people are becomingmoreeco-friendly.Thisisreallybotheringthemthatifanyfirmorindustryisenvironmentfriendlyornot.Anincreasingnumberofpeople,investors,andcorporateexecutivesarepayingimportancetothesefacts;thecapitalmarkets still see the environment as a liability. They belie that it is of no use for their strategy. The environmental performance is even under-valued by the markets.


66

Legal factorsLegal factors play an important role in the development and sustain the capital market. Legal issues relating to any industryorfirmdecidesthefateofthecapitalmarket.Ifthegovt.ofIndiaortheparliamentintroducesanewlawthat can affect the running of the industry then the industry will be demotivated and this demonisation will lead to the demonisation of the investors and will result in the fall of capital market. Like after the Hardhat Mehta scam, new rules and regulations were introduced like PAN card was made necessary for trading, if any investor was investing toomuchmoneyinasmallfirm,thentheinvestorswerequestioned,etc.Theseregulationsweremeanttomaintaintransparency in the capital market, but at that time, investment was discouraged. Legal factors are necessary for the improvement and stability of the capital market.

4.8 Capital Market RegulationsConsidering the broad thrust of the ongoing programs of economic reform, the mechanism of administrative controls over capital issues has been dismantled and pricing of capital issues is now essentially market determined. Regulation of the capital markets and protection of investor’s interest is now primarily the responsibility of the Securities and Exchange Board of India (SEBI), which is located in Bombay. Accordingly, SEBI’s functions include:

Regulating the business in stock exchanges and any other securities markets•Registering and regulating the working of collective investment schemes, including mutual funds.•Prohibiting fraudulent and unfair trade practices relating to securities markets.•Promoting investor’s education and training of intermediaries of securities markets.•Prohibiting insider trading in securities, with the imposition of monetary penalties, on erring market •intermediaries.Regulating substantial acquisition of shares and takeover of companies.•Calling for information from, carrying out inspection, conducting inquiries and audits of the stock exchanges •and intermediaries and self regulatory organisations in the securities market.

Keeping this in view, SEBI has issued a new set of comprehensive guidelines governing issue of shares and other financial instruments, andhas laid downdetailednorms for stock-brokers and sub-brokers,merchant bankers,portfolio managers and mutual funds.

On the recommendations of the Patel Committee report, SEBI on 27 July 1995, permitted carry forward deals. Some of the major features of the revised carry-forward transactions as directed by SEBI are:

Carry forward deals permitted only on stock exchanges which have screen based trading system.•Transactions carried forward cannot exceed 25% of a broker’s total transactions on any one day.•90-day limit for carry forward and squaring off allowed only till the 75th day (or the end of the fifth•settlement).Dailymarginstoriseprogressivelyfrom20%inthefirstsettlementto50%inthefifth.•

On 26 January1995, the government promulgated an ordinance amending the SEBI Act, 1992, and the Securities Contracts (Regulation) Act, 1956.

In accordance with the amendment adjudicating mechanism will be created within SEBI and any appeal against this adjudicating authority will have to be made to the Securities Appellate Tribunal, which is to be separately constituted. These appeals will be heard only at the High Courts.

The main features of the amendment to the Securities Contract (Regulation) Act, 1956, are:The ban on the system of options in trading has been lifted.•The time limit of six months, by which stock exchanges could amend their bye-laws, has been reduced to two •months.AdditionaltradingfloorsonthestockexchangescanbeestablishedonlywithpriorpermissionfromSEBI.•

67

Any company seeking listing on stock exchanges would have to comply with the listing agreements of stock •exchanges, and the failure to comply with these, or their violation, is punishable.

Fraudulent and unfair trade practicesSEBI is vested with powers to take action against these practices relating to securities market manipulation and misleading statements to induce sale/purchase of securities.

Inspection and enforcementSEBI has the powers of a civil court in respect of discovery and production of books, documents, records, accounts, summoningandenforcingattendanceofcompany/personandexaminingthemunderoath.SEBIcanlevyfinesforviolations related to failure to submit information to SEBI / to enter into agreements with clients / to redress investor grievances, violations by mutual funds/stock brokers and violations related to insider trading, takeovers etc.

4.9 Reforms in the Capital MarketOver the last few years, SEBI has announced several far-reaching reforms to promote the capital market and protect investor interests. Reforms in the secondary market have focused on three main areas: structure and functioning of stock exchanges, automation of trading and post trade systems, and the introduction of surveillance and monitoring systems. Computerised online trading of securities, and setting up of clearing houses or settlement guarantee funds were made compulsory for stock exchanges. Stock exchanges were permitted to expand their trading to locations outside their jurisdiction through computer terminals. Thus, major stock exchanges in India have started locating computer terminals in far-flung areas,while smaller regional exchanges are planning to consolidate by usingcentralised trading under a federated structure. Online trading systems have been introduced in almost all stock exchanges. Trading is much more transparent and quicker than in the past.

Until the early 1990s, the trading and settlement infrastructure of the Indian capital market was poor. Trading on all stock exchanges was through open outcry, settlement systems were paper-based, and market intermediaries were largely unregulated. The regulatory structure was fragmented and there was neither comprehensive registration nor an apex body of regulation of the securities market. Stock exchanges were run as “brokers clubs” as their management was largely composed of brokers. There was no prohibition on insider trading, or fraudulent and unfair tradepractices.Since1992,therehasbeenintensifiedmarketreform,resultinginabigimprovementinsecuritiestrading, especially in the secondary market for equity.

Most stock exchanges have introduced online trading and set up clearing houses/corporations. A depository has become operational for scripless trading and the regulatory structure has been overhauled with most of the powers for regulating the capital market vested with SEBI. The Indian capital market has experienced a process of structural transformation with operations conducted to standards equivalent to those in the developed markets. It was opened up for investment by foreign institutional investors (FIIs) in 1992 and Indian companies were allowed to raise resources abroad through Global Depository Receipts (GDRs) and Foreign Currency Convertible Bonds (FCCBs). The primary and secondary segments of the capital market expanded rapidly, with greater institutionalisation and wider participation of individual investors accompanying this growth. However, many problems, including lack ofconfidenceinstockinvestments,institutionaloverlaps,andothergovernanceissues,remainasobstaclestotheimprovementofIndiancapitalmarketefficiency.

4.10 Introduction to Stock ExchangesStock exchange is a market in which securities are bought and sold and it is an essential market for developing a capital market.TheSecuritiesContracts(Regulation)Act1956definesStockExchangeas“anassociation,organisationorbody of individuals whether incorporated or not, established for the purpose of assisting, regulating and controlling business in buying and selling and dealing in securities’.

Thisdefinitionclearlyindicatesthatastockexchangeisacapitalmarketwherelongtermfinanceforthedevelopmentof companies can be obtained by selling the securities through authorised persons. This market facilitates marketability and liquidity of the corporate securities. Without this market, the corporate sector cannot grow. It is the economic barometerofthecountry.Itindicateseconomicgrowthofthecountry.Itfacilitatestheflowcapitalintoprofitable


68

enterprises.Ithasasignificantimpactonthebusinessactivitiesofthecountry.Thesecuritiesofgovernment,quasigovernmentandprivateenterpriseareboughtandsoldinthismarket.Itisthenervecentreofnationalfinance.Stockexchangeare,infactthefocalpointsofthebusiness,totheultimatebenefitandwell-beingofthenationaleconomyanditspeople.Enormouscapitalflowsthroughthenation’swell-connectednetworkoffinancialorganisationtoalltypes of companies operating in the country.

4.10.1 Characteristics of Stock ExchangeThe main characteristics of a stock exchange are:

It is an organised market.•It provides a place where existing and approved securities can be bought and sold easily.•In a stock exchange, transactions take place between its members or their authorised agents.•All transactions are regulated by rules and by laws of the concerned stock exchange.•It makes complete information available to public in regard to prices and volume of transactions taking place •every day.

It may be noted that all securities are not permitted to be traded on a recognised stock exchange. It is allowed only in those securities (called listed securities) that have been duly approved for the purpose by the stock exchange authorities. The method of trading now-a-days, however, is quite simple on account of the availability of on-line trading facility with the help of computers. It is also quite fast as it takes just a few minutes to strike a deal through the brokers who may be available close by. Similarly, on account of the system of scrip-less trading and rolling settlement, the delivery of securities and the payment of amount involved also take very little time.

4.10.2 Functions of a Stock ExchangeThe functions of stock exchange can be enumerated as follows:

Provides ready and continuous market: By providing a place where listed securities can be bought and sold •regularly and conveniently, a stock exchange ensures a ready and continuous market for various shares, debentures, bonds and government securities. This lends a high degree of liquidity to holdings in these securities as the investor can encash their holdings as and when they want.Provides information about prices and sales: A stock exchange maintains complete record of all transactions •taking place in different securities every day and supplies regular information on their prices and sales volumes to press and other media. In fact, now-a-days, you can get information about minute to minute movement in pricesofselectedsharesonTVchannelslikeCNBC,ZeeNews,NDTVandHeadlinesToday.Thisenablestheinvestors in taking quick decisions on purchase and sale of securities in which they are interested. Not only that, such information helps them in ascertaining the trend in prices and the worth of their holdings. This enables them to seek bank loans, if required.Provides safety to dealings and investment: Transactions on the stock exchange are conducted only amongst •its members with adequate transparency and in strict conformity to its rules and regulations which include the procedure and timings of delivery and payment to be followed. This provides a high degree of safety to dealings at the stock exchange. There is little risk of loss on account of non-payment or non-delivery. Securities and Exchange Board of India (SEBI) also regulates the business in stock exchanges in India and the working of the stock brokers. Not only that, a stock exchange allows trading only in securities that have been listed withit;andforlistinganysecurity,itsatisfiesitselfaboutthegenuinenessandsoundnessofthecompanyandprovides for disclosure of certain information on regular basis. Though this may not guarantee the soundness andprofitabilityofthecompany,itdoesprovidesomeassuranceontheirgenuinenessandenablesthemtokeeptrack of their progress.Helpsinmobilisationofsavingsandcapitalformation:Efficientfunctioningofstockmarketcreatesaconducive•climate for an active and growing primary market. Good performance and outlook for shares in the stock exchanges imparts buoyancy to the new issue market, which helps in mobilising savings for investment in industrialandcommercialestablishments.Notonlythat,thestockexchangeprovidesliquidityandprofitabilityto dealings and investments in shares and debentures. It also educates people on where and how to invest their

69

savings to get a fair return. This encourages the habit of saving, investment and risk-taking among the common people. Thus it helps mobilising surplus savings for investment in corporate and government securities and contributes to capital formation.Barometerofeconomicandbusinessconditions:Stockexchangesreflectthechangingconditionsofeconomic•health of a country, as the shares prices are highly sensitive to changing economic, social and political conditions. It is observed that during the periods of economic prosperity, the share prices tend to rise. Conversely, prices tend to fall when there is economic stagnation and the business activities slow down as a result of depressions. Thus, the intensity of trading at stock exchanges and the corresponding rise on fall in the prices of securities reflectstheinvestors’assessmentoftheeconomicandbusinessconditionsinacountry,andactsasthebarometerwhich indicates the general conditions of the atmosphere of business.BetterAllocationoffunds:Asaresultofstockmarkettransactions,fundsflowfromthelessprofitabletomore•profitableenterprisesandtheyavailofthegreaterpotentialforgrowth.Financialresourcesoftheeconomyarethus better allocated.

4.10.3 Advantages of Stock ExchangeThe advantages of stock exchange are outlined below:

To the companies•The companies whose securities have been listed on a stock exchange enjoy a better goodwill and credit- �standingthanothercompaniesbecausetheyaresupposedtobefinanciallysound.The market for their securities is enlarged as the investors all over the world become aware of such securities �and have an opportunity to investAs a result of enhanced goodwill and higher demand, the value of their securities increases and their �bargaining power in collective ventures, mergers, etc. is enhanced.The companies have the convenience to decide upon the size, price and timing of the issue. �

To the investors•The investors enjoy the ready availability of facility and convenience of buying and selling the securities �at will and at an opportune time.Because of the assured safety in dealings at the stock exchange the investors are free from any anxiety about �the delivery and payment problems.Availability of regular information on prices of securities traded at the stock exchanges helps them in �deciding on the timing of their purchase and sale.It becomes easier for them to raise loans from banks against their holdings in securities traded at the stock �exchange because banks prefer them as collateral on account of their liquidity and convenient valuation.

To the society•The availability of lucrative avenues of investment and the liquidity thereof induces people to save and �invest in long-term securities. This leads to increased capital formation in the country.The facility for convenient purchase and sale of securities at the stock exchange provides support to new �issue market. This helps in promotion and expansion of industrial activity, which in turn contributes, to increase in the rate of industrial growth.TheStockexchangesfacilitaterealisationoffinancialresourcestomoreprofitableandgrowingindustrial �units where investors can easily increase their investment substantially.Thevolumeof activity at the stock exchanges and themovement of share prices reflect the changing �economic health.Since government securities are also traded at the stock exchanges, the government borrowing is highly �facilitated. The bonds issued by governments, electricity boards, municipal corporations and public sector undertakings (PSUs) are found to be on offer quite frequently and are generally successful.


70

4.10.4 Limitations of Stock ExchangesLike any other institutions, the stock exchanges too have their limitations.

One of the common evils associated with stock exchange operations is the excessive speculation. You know that •speculation implies buying or selling securities to take advantage of price differential at different times. The speculators generally do not take or give delivery and pay or receive full payment. They settle their transactions just by paying the difference in prices. Normally, speculation is considered a healthy practice and is necessary forsuccessfuloperationofstockexchangeactivity.But,whenitbecomesexcessive,itleadstowidefluctuationsin prices and various malpractices by the vested interests. In the process, genuine investors suffer and are driven out of the market. Anothershortcomingofstockexchangeoperationsisthatsecuritypricesmayfluctuateduetounpredictable•political, social and economic factors as well as on account of rumours spread by interested parties. This makes itdifficulttoassessthemovementofpricesinfutureandbuildappropriatestrategiesforinvestmentinsecurities.However, these days good amount of vigilance is exercised by stock exchange authorities and SEBI to control activities at the stock exchange and ensure their healthy functioning.

4.10.5 National Stock Exchange of IndiaThe National Stock Exchange of India Limited (NSE) is a Mumbai-based stock Exchange. When we look in terms of volume of transaction, NSE is the largest stock exchange in India and the third largest in the world. It is mutually ownedbyasetofleadingfinancialinstitutionslikethebanks,insurancecompaniesandotherintermediariesinIndia,but its ownership and management operate as separate entities. In terms of market capitalisation it is the second largest market in South-Asia.

In November 1992 it was as a tax paying company. In April 1993, it was recognised as a stock exchange under the Securities Contracts (Regulation) Act, 1956. NSE includes many other functions which make it the best stock exchangeinIndia.Itstartedthefirstclearingcorporation“NationalSecuritiesClearingCorporationLtd”inIndiaandthefirstdepositoryinIndiacalledthe“NationalSecuritiesDepositoryLimited”.NSEwaspermittedtostarttradingequityderivativesthreedaysafterBombayStockExchangestartedittofunction.Itisthefirstexchangetotradeandexchangetradedfunds(ETFs)inIndia.NSEconductsanonlineexaminationandawardscertification,undertheprogrammesofNSE’sCertificationinFinancialMarkets(NCFM).Thesecertificatesarenowavailablein9modules,coveringdifferentsectorsoffinancialandcapitalmarkets.

71

SummaryTherecentmodificationsoftheIndiancapitalmarketenvironmenthaveemergedthevariousfinancialinstitutions•asthemajorsourcesoffinancefortheorganisations.Capital market comprises of the institutions and mechanisms through which funds are pooled and made available •to business, government and individuals.Capital market is, generally, referred to the market for long-term funds. It includes institutions mechanism for •the effective pooling of long-term funds form individuals and institutional investors and making them available to industrial and commercial undertakings.Primary market provides opportunity to issuers of securities, Government, as well as corporates, to raise resources •to meet their requirements of investment and/or discharge some obligation.When securities are exclusively offered to the existing shareholders it is called ‘Rights Issue’ and when it is •issued to selected mature and sophisticated institutional investors as opposed to general public it is called ‘Private Placement Issues’.A security emerges or takes birth in the primary market but its subsequent movements take place in secondary •market.Capital market facilitate the buying and selling of securities, such as shares and bonds or debentures. They •perform two valuable functions: liquidity and pricing securities.Indian capital market is one of the oldest and largest capital markets of the world. Its history can be traced back •tothe19thcentury.ThefirstinstanceoforganisedtradingincorporatesecuritiesinIndiaisrelatedtothetradingin securities of East India Company.InmarketeconomylikeIndia,financialmarketinstitutionsprovidetheavenuebywhichlong-termsavings•aremobilisedandchannelledintoinvestments.Confidenceoftheinvestorsinthemarketisimperativeforthegrowth and development of the market.Regulation of the capital markets and protection of investor’s interest is now primarily the responsibility of the •Securities and Exchange Board of India (SEBI), which is located in Bombay.Reforms in the secondary market have focused on three main areas: structure and functioning of stock exchanges, •automation of trading and post trade systems, and the introduction of surveillance and monitoring systems.Stock exchange is a market in which securities are bought and sold and it is an essential market for developing •a capital market.

ReferencesGopalsmay, N., 2005. • Capitalmarket:theIndianfinancialscene, India: Macmillan.Choudhry, M., 2002. • Capital market instruments: analysis and valuation, Volume 1, FT Press.Nos.org• . Indian Financial Market [PDF] Available at: <http://www.nos.org/srsec319new/319EL18.pdf>. [Accessed 6 December 2011].Indiastock.wikia.com. • National Stock Exchange of India An Overview [Online] Available at: <http://indianstocks.wikia.com/wiki/National_Stock_Exchange_of_India_An_Overview> [Accessed 6 December 2011].Anderssen, J., 2008. • Money Market Instruments [Video Online] Available at: <http://www.youtube.com/watch?v=gv-9VkRY5dI> [Accessed 13 December 2011].Money Control, 2011. • Capital market reforms important for India, says KKR India 1 [Video Online] Available at: <http://www.youtube.com/watch?v=JXQydBnqia0> [Accessed 13 December 2011].

Recommended ReadingKanuk A., R., 2002. • Capital markets of India: an investor’s guide, John Wiley and Sons.Rathore S., 2003. • Indian Capital Market: An Empirical Study, Anmol Publications PVT. LTD., Fabozzi, F., J., and Modigliani, F., 2003. • Capital Markets, 3rd ed., Prentice Hall.


72

Self Assessment_________isamarketforfinancialinvestmentsthathasdirectorindirectclaimstocapital.1.

Money marketa. Forex marketb. Capital marketc. Primary marketd.


Capital market1. market for long-term fundsA.

Features of capital market2. It deals in long and medium term fundsB.

Importance of capital market3. It helps in mobilising the savings on a large scaleC.

ClassificationofCapitalmarket4. Primary marketD. 1-D, 2-C, 3-B, 4-Aa. 1-A, 2-B, 3-C, 4-Db. 1-B, 2-D, 3-A, 4-Cc. 1-C, 2-A, 3-D, 4-Bd.

Which of the following provides an opportunity to issuers of securities, Government, as well as corporates, to 3. raise resources to meet their requirements of investment and/or discharge some obligation?

Money marketa. Secondary marketb. Capital marketc. Primary marketd.

________ refers to the network/system for the subsequent sale and purchase of securities.4. Money marketa. Secondary marketb. Capital marketc. Primary marketd.

Which of the following means the convenience and speed of transforming assets into cash, or transferring assets 5. from one person to another without any loss of value?

Liquiditya. Pricing securitiesb. Capitalmarketefficiencyc. Primary marketd.

73

Match the following:6.

Functionsofcapitalmarketefficiency1. assetpricesalreadyreflectallinformationthatisA. publicly available

Weak-formofefficiency2. Pricing securitiesB.

Semi-strongformofefficiency3. thesecuritypricesreflectallpublishedandC. unpublished, public and private information

Strong-formofefficiency4. securitypricesreflectallthepastinformationD. about the price movements


Which odf the following is true?7. Inastrongformofefficientmarket,themarket’sreactiontonewandmaterialinformationshouldbebotha. instantaneous and unbiased.Inasemi-strongefficientmarket,themarket’sreactiontonewandmaterialinformationshouldbebothb. instantaneous and unbiased.Inaweak-formofefficientmarket,themarket’sreactiontonewandmaterialinformationshouldbebothc. instantaneous and unbiased.Liquidityisnotavaluablefunctionofcapitalmarketefficiency.d.

__________ makes securities liquid.8. Money marketa. Secondary marketb. Capital marketc. Primary marketd.

____________ is also known as the Gilt-edged market.9. Government securities marketa. Industrial securities marketb. Developmentfinancialinstitutionsc. Financial intermediariesd.

The______________ismadeupoftwocomponents:wherefirmsgopublicforthefirsttimethroughinitial10. publicofferingsandfirmswhicharealreadytradedraiseadditionalcapitalthroughseasonedequityofferings.

Money marketa. Capital marketb. Primary marketc. Secondary marketd.


74

Chapter V

Auditing

Aim


introduce internal audit•

defineauditing•

describe different types of audits•

Objectives


elucidate internal control system•

explain auditing documentation•

explicate the auditing standards•

Learning outcome


understand the audit process•

comprehend the limitations of audit•

discuss the need for auditing•

75

5.1 IntroductionJudgement on recorded aspect was a practice prevalent in the ancient time itself as a means of checking. It has its own limitations and also in a grade form. The progress marked by the advent of double entry system of double entry system of book keeping. The pace got accelerated by the large scale production as a result of industrial revolution. The process of checks and counters check of public account popularised. Scope of auditing expands towards mercantile transaction also. Separation of ownership and management necessitates the need to uphold the authenticity of correctness of accounts. Modern business world adopts the auditing work with professionalism

The Indian companies Act of 1913 made it obligatory for registration of companies the annual audit of its accounts. Act rules laid down latest stipulates scope, duties and responsibilities of the auditor. Professional institutes like institute of chartered account, cost and works accountants, India came into existence. There factors provided a solid and healthy basis for the accounting and auditing profession in India.

AccountAuditinginIndiaisknownasanexaminationoffinancialstatements,i.e.,balancesheetandprofitandlossa/c,booksofaccountandrelatedvoucherssoastohelptheauditortoformanoptionastowhetherthefinancialstatements show true and fair view of the business affairs or not, and if not, then in what respect it is not showing the true picture of the business activities.

Auditingisdonebytheauditortofindoutwhetherthefinancialstatementsarepreparedbybusinessconcernstoknow the result of the business activity undertaken by them throughout the year, at the end of the business activity undertaken by them whole exercise of accounting.

Definition of auditingAccording to general guidelines on internal auditing issuedby ICAI, “auditing is defined as a systematic andindependent examinationof data, statements, records, operations andperformances (financial or otherwise) ofan enterprise for a stated purpose. In any auditing situation, the auditor perceives and recognises the propositions before him for examination, collects evidence, evaluated the same and on this basis formulates his judgment which is communicated through his audit report.”

The nature of the propositions which an auditor is called upon to review varies. Thus, an auditor may review the financialstatementsofanenterprisetoascertainwhethertheyreflectatrueandfairviewofitsstateofaffairsandof its working results. In another situation, he may analyse the operations of an enterprise to appraise their cost-effectiveness and in still another, he may seek evidence to review the managerial performances in an enterprise. In yet another type of audit, the auditor may examine whether the transactions of an enterprise have been executed withintheframeworkofcertainstandardsoffinancialpropriety.However,thevariationsinthepropositionsdonotchange the basic philosophy of auditing, though the process of collection and evaluation of evidence and that of formulatingajudgmentthereonmayhavetobesuitablymodified.

“Anauditisindependentexaminationoffinancialinformationofanyentity,whetherprofitorientedornot,andirrespective of its size or legal form, when such an examination is conducted with a view to expressing an opinion thereon.” The person conducting this process should perform his work with knowledge of the use of the accounting statements and should tale particular care to ensure that nothing contained in the statements will ordinarily mislead anybody. The auditor can do this honestly by satisfying himself that:

The accounts have been drawn up with reference to entries in the books of account•The entries in the books of account are adequately supported by underlying papers and documents and by other •evidenceNone of the entries in the books of account has been omitted in the process of compilation and nothing which •is not in the books of account has found place in the statementsThe information conveyed by the statements is clear and unambiguous•Thefinancialstatementamountsareproperlyclassified,describedanddisclosedinconformitywithaccounting•standards


76

The statement of accounts taken as an integrated whole, present a true and fair picture of the operational results •and of the assets and liabilities.

5.2 Types of AuditThebroadaimofauditistosafeguardthefinancialinterestsofthetaxpayerandtoassisttheParliament/State/Unionterritorylegislaturesinexercisingfinancialcontrolovertheexecutive.ItisthefunctionoftheComptrollerand Auditor General t o ensure that the various authorities set up by or under the Constitution, act in regard to all financialmatters,inaccordancewiththeConstitutionandthelawsofParliamentandappropriatelegislaturesandrules and orders issued thereunder. In order to discharge the auditorial duties entrusted by the Constitution t o him/ her, the Comptroller and Auditor General (CAG) conducts various types of audit, viz., Financial audit, Regularity audit, Receipts audit, Commercial audit, Audit of stores and stock, Performance audit etc. In the performance of this stupendous task, the C AG is assisted by the accounting authorities in various ministries and by the Principal AccountsOfficersfunctioninginvariousstates.

5.2.1 Regularity Audit Regularity audit consists mainly in checking that the payments have been duly authorised and are supported by proper vouchers in the prescribed form. Its main purpose has been to ensure conformity with the relevant administrative, financialbudgetaryandaccounting rulesand regulationsprovided for in theConstitutionor the lawsmadebyParliament.TheobjectivesofauditagainstregularityasspecifiedintheAuditcode,inter-aliaistoensure:

thatthereisprovisionoffundsfortheexpenditure,dulyauthorisedbycompetentauthority;•thattheexpenditureisinaccordancewithasanctionproperlyaccordedandisincurredbyanofficercompetent•toincurit;thattheclaimsaremadeinaccordancewiththerulesandinproperform;•that all prescribed preliminaries to expenditure are observed, such as proper estimated framed and approved by •competentauthorityforworksexpenditure,ahealthcertificateobtained,wherenecessarybeforedisbursementofpaytoagovernmentservant;that the expenditure sanctioned for a limited period is not admitted in audit beyond that period without further •sanction;thattherulesregulatingthemethodofpaymenthavebeendulyobservedbythedisbursingofficer;•that payment has been made to the person and that it has been acknowledged and recorded 50 that a second •claim against government on the same account, is not possiblethat the payments have been correctly brought into account in the original documents.•

Audit against provision of funds, aims at determining that the expenditure incurred has been on the purpose for which the grant and appropriation had been provided and that the amount of such expenditure does not exceed the appropriation made. Audit, in relation to audit of expenditure, is to ensure that each item of expenditure is covered by a sanction of the competent authority. Audit against rules and order is an important aspect of regularity audit. It ensures that the expenditure conforms to the relevant provisions of the Constitution and of the laws and rules made thereunder. Audit of expenditure against regularity is a quasi-judicial type of work, performed by the audit authorities. It involves interpretation of the Constitution rules and orders.

5.2.2 Financial AuditFinancialauditisonethatisconductedinordertoensurethattheaccountingandfinancialcontrolsystemsareefficientandcooperatingproperly;andthatfinancialtransactionshavebeencorrectlyauthorisedandaccountedfor.Inotherwords,itistoensurethatthefinancialstatementsandaccountshavebeenpreparedtopresentatrueandfairview of the state of affairs of the establishment concerned and in respect of the period covered by the audit. This is the type of audit conducted on the treasury accounts of the Federation from time to time.

77

Financial audit is the audit conducted by the Indian Audit and Accounts Department to see whether the administrative actionoftheexecutiveisnotonlyinconformitywithprescribedlaw,financialrulesandprocedures,butitisalsoproper and does not result in any extravagance. Financial audit does not concern itself with the audit of administrative organisations and procedures and is different from administrative audit. It is the duty or the function of the executive government to frame rules, regulations and orders, which are to be observed by its subordinate in waste, extravagance orimproperexpenditureitiscertainlythedutyofaudittocallspecificattentiontomattersofthatkindandtobringthe facts to the notice of Parliament. For instance, in a canal project construction, audit would not concern itself with the administrative set-up for the actual construction of the canal and whether it should pass through a particular part of the country or not. These are matters of administration and no scrutiny of these processes will be done by theaudit.Butifitisfoundthatthealignmentshadbeendrawnuponinsufficientdata,necessitatingasubsequentchangeinvolvingadditionalexpenditureorthatthefinancialresultswerelessthanwhathadbeenanticipated,thenit is the duty of audit to examine the circumstances which resulted in the wrong alignments resulting in loss or avoidable expenditure to the tax payer.

Auditinterferesonlywhenadministrativeactionhasseriousfinancialimplicationsandisnotinconformitywithprescribedlaw,financialrulesandprocedures.Financialauditalsoincludesauditagainstproprietyorbroadprinciplesoforthodoxfinance.Thus,financialauditsafeguardstheinterestsoftax-payerbybringingtothenoticeofParliament,wastage in government expenditure.

5.2.3 Receipt AuditIn receipts audit, the function of audit department is to ensure that adequate regulations and procedures have been framed and are being observed by the revenue department, to secure an effective check on assessment, collection and proper allocation of revenue. Since the assessments in a revenue department are of a quasi judicial nature, audit should ensure that the discretion used has been exercised in a judicious manner.

5.2.4 Performance AuditFinancial audit and Regularity audit generally involve scrutiny of individual transactions. They do not focus on the evaluation of a scheme or a programme to which these transactions relate. Therefore, both types of audits have been found inadequate for an evaluation of the performance of an organisation in terms of its goals or objectives.

Ever since the Government launched Five-Year Plans, investment on a large scale has been made on developmental activities for acceleration of socio-economic development of the country. In many cases, the investments did not give the expected returns. Therefore, public has a right to know whether the results achieved had been commensurate with the resources invested. The public concern has found expression in the introduction of performance budgeting in government. The change in the thinking of government, in recent tunes, about the need to relate expenditure to corresponding physical accomplishments made it also to think about the functions of audit. It has been accepted that Regularity audit/Propriety audit is essential for parliamentary control of expenditure. However, in view of the increasing developmental expenditure, under the successive Five Year Plans, audit should examine the achievements ofspecificprogrammes,activitiesandprojectsintermsoftheirgoalsorobjectives.Ithasbeenfeltthatauditshouldbring out those cases where utilisation of resources has been sub-optimal. This has resulted in a serious thought beinggiventotheneedforperformanceauditwhichisalsocalledefficiencyunit.

Performanceauditseekstofindoutwhethertheresourceshavebeenutilisedefficientlybydeployingtheminanoptimum manner. It highlights the extent to which resources are put to productive uses. It also highlights as to what extentquantifiedbenefitscouldbeexpectedfromsuchdeploymentofresources.

Although the technique of performance audit is sound and useful, there are many problems in conducting such an audit. Firstly, performance evaluation of an activity can be made only in the light of the objectives, which is expected to achieve.

Objectives spell out the results desired from an activity. Whereas inputs are easy to measure for an activity, •tremendous effort is required to quantify and measure the resulting output, particularly when this output has a social context.


78

Secondly, according to the concept of Net Welfare, the utilisation of resources has to be optimised not only at •the point where they are deployed but also at other points, where the effects of such investments are carried. In otherwords,investment,decisionsneedtobejustifiedbytheapplicationofthetechniqueofsocialcostbenefitanalysis.Thirdly,theobjectivesofinvestmentareoftenacombinationoffinancialandnonfinancialfactors.Theremay•be situations, when these objectives of public investment which are otherwise considered socially desirable, arefoundincompatiblewith.immediatefinancialobjectives.Forinstance,apublicundertakingengagedintheproductionof fertilisers,mayhave tosell itsoutputata lowpricefixedby thegovernment tosupportagricultural programmes. If the undertakingdoes not get adequate subsidy fromgovernment, itsfinancialresults may present a discouraging picture. The undertaking may have served a long-range national objective ofachievingself-sufficiencyinfoodproduction.Butintheprocess,itsprofitsgetreducedconsiderablyoritmayincurlosses.Insituations,wheretheobjectivesactagainstfinancialperformanceofapublicundertaking,it would not be proper toFourthly, performance audit presupposes a good information system. A good information system is necessary, •to furnish information about what has been actually achieved and at what cost, as against what was planned to be accomplished at a particular cost.Lastly, effectiveness of performance audit would depend on how best the yardsticks of performance have been •evolved. The technique of performance audit can be applied successfully in cases, where norms/standards are available for application. It is easier to apply in manufacturing organisations, than in the case of governmental organisations.

In India, the concept of performance audit is of recent origin. Its scope is unlimited. To conduct performance audit of public undertakings, Audit Boards have been set up. These Boards have been functioning, under the Comptroller and Auditor General, since April, 1969.

The utility of Performance audit can hardly be over-emphasised. It, however, requires expertise in identifying quantifiableobjectivesingovernment.Italsonecessitatesframingofpreciseyardsticksagainstwhichtheuseofresources can be evaluated. In view of these problems, the scope of performance audit in government appears to be at present limited.

5.3 Need for AuditingTheunderlyingobjectiveoftheauditoffinancialstatementistoaddcredibilitytomanagement’sfinancialstatements.Access to capital markets, mergers, acquisitions, and investments in an entity depend not only on the information thatmanagementprovidesinfinancialstatements,butalsoontheassurancethatthefinancialstatementsarefreeof material misstatements. This assurance is provided, to a considerable extent, by an audit. While an audit does notguaranteefinancialstatements’accuracy,itprovidesuserswithareasonableassurancethatanentity’sfinancialstatementsgiveatrueandfairviewinconformitywiththeapplicablefinancialreportingframework.

The need for an audit therefore originates from the following factors: Conflictofinterest•Unbiased and relevant information •Complexityoffinancialinformation•Remotenessoftheusersfromthefinancialinformationgeneratingsystemandprocesses•Economic consequences of using unreliable information •Appropriatefinancialdisclosures•

Inplainandsimpleterms,anauditenhancesusers’confidencethatfinancialstatementsdonotcontainmaterialmisstatement(s) (on account of a fraud or an error) because these have been examined by a person (the auditor) who is an independent and objective expert who is also knowledgeable about the entity’s business and the applicable financial reporting requirements. In otherwords, an auditor’s opinionprovides an assurance that thefinancialstatements have been prepared and presented fairly.

79

5.4 Limitations of Audit and Detection of FraudTheusersoftheauditedfinancialstatementsalsoneedtoappreciatetheinherentlimitationsofanaudit.

Thefirstlimitationofauditisthefactthatitisconductedonatestbasissinceexaminationofallthetransactions•of the auditee is neither possible nor practicable. The auditor examines the samples drawn from a population of a class of transactions, analyse its results to form an overall opinion about the entire population of a class of transactions. The second limitation of an audit is the fact that much of the audit evidence is persuasive rather than conclusive •in nature. Itismoredifficultfortheauditortodetectafraudthananerrorbecausefraudusuallyinvolvesactsdesignedto•conceal it, such as collusion, forgery, deliberate failure to record transactions, or intentional misrepresentations being made to the auditor. Unless the auditor’s examination reveals evidence to the contrary, he is entitled to accept representations as truthful and records and documents as genuine. An auditor, however, plans and performs his audit recognising that he may encounter conditions or events during his examination that would lead him to question whether fraud or error exists. Further, while the existence of an effective system of internal controlreducestheprobabilityofmisstatementoffinancialinformationresultingfromfraudorerror,therewillalways be some risk of internal controls failing to operate as designed on account of factors such as human error, erroneous design of the control, etc. Furthermore, any system of internal control may be ineffective against fraud involving collusion among employees or fraud committed by management.

5.5 Auditing StandardsThe Auditing Practices Committee (re-christened as Auditing and Assurance Standards Board) was constituted in September, 1982 as one the important technical committees of the ICAI on the lines of the standard setting procedure prevalent abroad. The composition of the Board had been broad based giving representations to RBI, SEBI, CII and Management Institute. The primary objective of the Board, as set out in the Preface to the Statements on Standard Auditing Practices (now renamed as Audit and Assurance Standards), is to review the existing Auditing Practices in India and to formulate the Statements on Standard Auditing Practices which turn are issued under the authority of the Council. While formulating the auditing standards the Board tries to integrate, to the extent possible, the provisions of the International Standards on Auditing issued by the International Federation of Accountants in the lightoftheconditionsandpracticesprevailinginIndia.TheBoardalsoissuesclarifications,GuidanceNotesetc.on matters relating to auditing.

Duringtheyearunderreport,theBoardissuedthreeindustriesspecificGuidanceNotesforthebenefitofthemembers,viz., Guidance Note on Audit of Companies Carrying on General Insurance Business (Revised), Guidance Note on Audit of Companies Carrying on Life Insurance Business and Guidance Note on Audit of Accounts of Members of Stock Exchanges (Revised). These Guidance Notes were issued in collaboration with the Committee on Insurance and the Committee on Financial Markets and Investor’s Protection respectively. The Guidance Note on Audit of Expenses and Guidance Note on Engagements to Perform Agreed upon Procedures were also released during the year.

The Statement on Standard Auditing Practices (SAP) 23 on related Parties and the Statement on Standard Auditing Practices (SAP) 24 ON Audit Considerations relating to Entities Using Service Organisations were also issued during the year.

During the year, the Board issued the format of the Auditor’s Report on Consolidated Financial Statements pursuant to the issuance of the Accounting Standard (AS) 21 on Consolidated Financial Statements.

As a major step towards bringing the reporting practices in India at par with the international practices and also as an attempttobridgethe“ExpectationGap”,theBoardrevisedtheformatoftheauditor’sreportonfinancialstatementsissued in 1958. The revised format clearly brings out, inter alia, the responsibility of the management vis-a-vis the auditorasregardsthefinancialstatements,thescopeofanaudit,thebasisoftheopinionexpressedbytheauditor.The revised former evoked positive response from all sections of the society. The Board is also in the process of formulation Statement on Standard Auditing Practices on Auditor’s Report on Financial Statements.


80

The Statement on Standard Auditing Practices on Risk Assessments and Internal Control has been issued as revised SAP 6.

The Board, pursuant to the issuance of the Accounting Standard (AS) 26 ON Impairment of Assets, is in the process revising the Guidance Note on Audit of Miscellaneous Expenditure shown in the Balance Sheet. The Statement on Standard Auditing Practices (SAP) 10 on Using the Work of another Auditor was published in the July, 2002 issue of the Journal. The Board also issued the Exposure Draft of the proposed SAP on Comparatives in July, 2002.

A ICAI Handbook 2002 on Auditing Pronouncements comprising of two volumes, as on July 1, 2002 - Volume of the Handbook containing the text of all the Guidance Notes on matters relating to auditing, which are generic in nature is in the process of release.

The Board is also working to bring out Statements on Standard Auditing Practices and Guidance Notes corresponding to the International Standards on Auditing and the International Auditing Practices Statements, issued by the International Federation of Accountants.

During the year, the Board also interacted with the Reserve Bank of India and other governmental and regulatory bodies.

In August, 2001, a crisp comparative position of the Indian Accounting Standards vis-a-vis International Accounting Standards and US GAAP was brought out by way of publication title “A comparative Study of Accounting Standards - Indian GAAP, IAS and US GAAP” for providing an up to date reference material to the various users ofthefinancialstatements.ThispublicationwasrevisedlatertakingintoaccountthesubsequentIndianAccountingStandards issued.

A sizeable number of background materials have been brought for the seminars and conferences held all over India relating to Accounting Standards and its implications, International Accounting Standards and US GAAP’S Accounting aspects of Disaster Management, etc.

5.6 Internal AuditInternal Auditing is an independent, objective assurance and consulting activity designed to add value and improve an organisation’s operations. It helps an organisation accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control and governance processes.

Roles and opportunitiesThe internal auditor is involved with

Evaluating Emerging Technologies•Analysing Opportunities•Examining Global Issues•AssessingRisks,Controls,Ethics,Quality,Economy,andEfficiency•Assuring that controls in place are adequate to mitigate the risks•Communicating information and opinions with clarity and accuracy. •Such diversity gives internal auditors a broad perspective on the organisation.•

Internal Auditors are well-disciplined in their skills and subscribe to a professional code of ethics. They are diverse andinnovative;committedtogrowingandenhancingtheirskills;continuallyonthelookoutforemergingrisksandtrendsintheprofession;goodthinkers.Toeffectivelyfulfilalltheirroles,internalauditorsmustbeexcellentcommunicators who listen attentively, speak effectively, and write clearly.

81

Sitting on the right side of the management, today’s internal auditors are consulted on all aspects of the organisation and must be prepared for just about anything. They are coaches, internal and external stakeholders’ advocates, facilitatorsofriskmanagement,controlexperts,efficiencyspecialistsandproblemsolvingpartners.

5.7 Professional Practices FrameworkThe Institute of Internal Auditors Inc. provides comprehensive guidance and information for the internal audit activity. Much of it is through the Professional Practices Framework (PPF), a blueprint for the profession that offers a full range of guidance to internal audit practitioners. The Institute’s Board of Directors approved the Professional Practice Framework (PPF) in June 1999. In general, a framework provides a structural blueprint of how a body of knowledgeandguidancefittogether.Asacoherentsystem,itfacilitatesconsistentdevelopment,interpretation,andapplicationofconcepts,methodologies,andtechniquesusefultoadisciplineorprofession.Specifically,theoverallpurpose of the PPF is to organise the full range of existing and developing practice guidance in a manner that is readily accessible on a timely basis to internal auditors. It also brings additional value to management, corporate governance entities, investors, and all other stakeholders by prescribing practices that access and ensures effectiveness throughout the organisation. In addition, it provides guidance for complying with new laws and regulations. The PPF basically contains:

Code of ethics: Ethics are inherent in the internal audit process, from operations to risk management to governance. •The code is established to promote an ethical culture throughout the profession and not only includes relevant principles and rules of conduct for internal auditors but also presents an enviable benchmark for ethics throughout the organisation.Standards: The purpose of the standards is to delineate basic principles that represent the practice as it should be, •provide a framework for performing and promoting a broad range of value added activities, establish the basis for measuring performance and foster improved organisational processes and operations. Standards comprise Attribute, Performance, and Implementation Standards. Attribute Standards and Performance Standards apply to allinternalauditservices.ImplementationStandardsapplytospecifictypesofengagements,suchas,assuranceandconsultingactivities.ThesearecontainedwithintheAttributeandPerformanceStandardsandareidentifiedby either assurance engagements or consulting engagements.Practice advisories: The advisories provide sound advice on interpreting and applying the standards. Although •they are not mandatory, the practice advisories represent best internal audit practice and are strongly recommended.Development and practice aids: It comprises a broad range of practical guidance in the form of professional •development conferences and seminars, IIA research foundation research reports, educational products and other select products and services related to the professional practice of internal auditing.

Corporate governanceCorporateGovernancemaybedefinedas“Asetofsystems,processesandprincipleswhichensurethatacompanyis governed in the best interest of all stakeholders.” It ensures Commitment to values and ethical conduct of business;Transparencyinbusinesstransactions;Statutoryandlegalcompliance;adequatedisclosuresandEffective decision-making to achieve corporate objectives.

In other words, Corporate Governance is about promoting corporate fairness, transparency and accountability. Good Corporate Governance is simply Good Business.

Clause 49 of the SEBI guidelines on Corporate Governance as amended on 29th October, 2004 has made major changesinthedefinitionofindependentdirectors,strengtheningtheresponsibilitiesofauditcommittees,improvingqualityoffinancialdisclosures,includingthoserelatingtorelatedpartytransactionsandproceedsfrompublic/rights/preferentialissues,requiringBoardstoadoptformalcodeofconduct,requiringCEO/CFOcertificationoffinancialstatements and for improving disclosures to shareholders. Certain non-mandatory clauses like whistle blower policy and restriction of the term of independent directors have also been included.

Besides the Listing Agreement of SEBI, certain provisions of the Companies Act 1956 also have an impact in the Corporate Governance process of the organisation. These provisions should be complied with in addition to clause 49 of the Listing Agreement and in no case supersedes the requirements of the said clause.


82

5.8 Audit ProcessAlthough every audit project is unique, the audit process is similar for most engagements and normally consists of four stages: Planning (sometimes called Survey or Preliminary Review), Fieldwork, Audit Report, and Follow-up Review. Client involvement is critical at each stage of the audit process. As in any special project, an audit results in a certain amount of time being diverted from your department’s usual routine. One of the key objectives is to minimise this time and avoid disrupting ongoing activities.

Planning Duringtheplanningportionoftheaudit,theauditornotifiestheclientoftheaudit,discussesthescopeandobjectivesof the examination in a formal meeting with organisation management, gathers information on important processes, evaluates existing controls, and plans the remaining audit steps.

Announcement letter The client is informed of the audit through an announcement or engagement letter from the Internal Audit Director. This letter communicates the scope and objectives of the audit, the auditors assigned to the project and other relevant information.

Initial meeting During this opening conference meeting, the client describes the unit or system to be reviewed, the organisation, available resources (personnel, facilities, equipment, funds), and other relevant information. The internal auditor meetswiththeseniorofficerdirectlyresponsiblefortheunitunderreviewandanystaffmemberss/hewishestoinclude. It is important that the client identify issues or areas of special concern that should be addressed.

Preliminary survey In this phase the auditor gathers relevant information about the unit in order to obtain a general overview of operations. S/Hetalkswithkeypersonnelandreviewsreports,files,andothersourcesofinformation.

Internal control review The auditor will review the unit’s internal control structure, a process which is usually time-consuming. In doing this, the auditor uses a variety of tools and techniques to gather and analyse information about the operation. The review of internal controls helps the auditor determine the areas of highest risk and design tests to be performed in thefieldworksection.Clickhereforanannualinternalcontrolreviewplan.

Audit program Preparationof theauditprogramconcludes thepreliminary reviewphase.Thisprogramoutlines thefieldworknecessary to achieve the audit objectives.

Fieldwork Thefieldworkconcentratesontransactiontestingandinformalcommunications.It isduringthisphasethattheauditordetermineswhetherthecontrolsidentifiedduringthepreliminaryreviewareoperatingproperlyandinthemannerdescribedbytheclient.Thefieldworkstageconcludeswithalistofsignificantfindingsfromwhichtheauditor will prepare a draft of the audit report.

Transaction testing After completing the preliminary review, the auditor performs the procedures in the audit program. These procedures usually test the major internal controls and the accuracy and propriety of the transactions. Various techniques includingsamplingareusedduringthefieldworkphase.

Advice and informal communications Asthefieldworkprogresses, theauditordiscussesanysignificantfindingswiththeclient.Hopefully, theclientcanofferinsightsandworkwiththeauditortodeterminethebestmethodofresolvingthefinding.Usuallythesecommunications are oral. However, in more complex situations, memos and/or e-mails are written in order to ensure full understanding by the client and the auditor. Our goal: No surprises.

83

Audit summary Uponcompletionofthefieldwork,theauditorsummarisestheauditfindings,conclusions,andrecommendationsnecessary for the audit report discussion draft.

Working papers Working papers are a vital tool of the audit profession. They are the support of the audit opinion. They connect theclient’saccountingrecordsandfinancialstotheauditor’sopinion.Theyarecomprehensiveandservemanyfunctions.

Audit report Ourprincipalproductisthefinalreportinwhichweexpressouropinions,presenttheauditfindings,anddiscussrecommendations for improvements. To facilitate communication and ensure that the recommendations presented in thefinalreportarepractical,InternalAuditdiscussestheroughdraftwiththeclientpriortoissuingthefinalreport.For an audit report template including an executive summary click here.

Discussion draft Attheconclusionoffieldwork,theauditordraftsthereport.Auditmanagementthoroughlyreviewstheauditworkingpapers and the discussion draft before it is presented to the client for comment. This discussion draft is prepared for the unit’s operating management and is submitted for the client’s review before the exit conference.

Exit conference When audit management has approved the discussion draft, Internal Audit meets with the unit’s management team todiscussthefindings,recommendations,andtextofthedraft.Atthismeeting,theclientcommentsonthedraftandthegroupworkstoreachanagreementontheauditfindings.

Formal draft The auditor then prepares a formal draft, taking into account any revisions resulting from the exit conference and otherdiscussions.Whenthechangeshavebeenreviewedbyauditmanagementandtheclient,thefinalreportisissued.

Final report InternalAuditprintsanddistributesthefinalreporttotheunit’soperatingmanagement,theunit’sreportingsupervisor,the Vice President for Administration, the University Chief Accountant, and other appropriate members of senior University management. This report is primarily for internal University management use. The approval of the Internal Audit Director is required for release of the report outside of the University.

Client response Theclienthastheopportunitytorespondtotheauditfindingspriortoissuanceofthefinalreportwhichcanbeincludedorattachedtoourfinalreport.However,iftheclientdecidestorespondafterweissuethereport,thefirstpageofthefinalreportisaletterrequestingtheclient’swrittenresponsetothereportrecommendations.

Intheresponse,theclientshouldexplainhowreportfindingswillberesolvedandincludeanimplementationtimetable.In some cases, managers may choose to respond with a decision not to implement an audit recommendation and to accepttherisksassociatedwithanauditfinding.Theclientshouldcopytheresponsetoallrecipientsofthefinalreportifs/hedecidesnottohavetheirresponseincluded/attachedtoInternalAudit’sfinalreport.

Client comments Finally, as part of Internal Audit’s self-evaluation program, we ask clients to comment on Internal Audit’s performance. Thisfeedbackhasproventobeverybeneficialtous,andwehavemadechangesinourproceduresasaresultofclients’ suggestions.


84

Audit follow-up Withinapproximatelyoneyearof thefinalreport,InternalAuditwillperformafollow-upreviewtoverifytheresolutionofthereportfindings.

Follow-up review Theclientresponseletterisreviewedandtheactionstakentoresolvetheauditreportfindingsmaybetestedtoensurethatthedesiredresultswereachieved.Allunresolvedfindingswillbediscussedinthefollow-upreport.

Follow-up report The review will conclude with a follow-up report which lists the actions taken by the client to resolve the original reportfindings.Unresolvedfindingswillalsoappearinthefollow-upreportandwillincludeabriefdescriptionofthefinding,theoriginalauditrecommendation,theclientresponse,thecurrentcondition,andthecontinuedexposuretoIndianaUniversity.Adiscussiondraftofeachreportwithunresolvedfindingsiscirculatedtotheclientbeforethereport is issued. The follow-up review results will be circulated to the original report recipients and other University officialsasdeemedappropriate.

Internal audit annual report to the board In addition to the distribution discussed earlier, the contents of the audit report, client response, and follow-up report may also communicated to the Audit Committee of the Board as part of the Internal Audit Annual Report.

The process: a collaborative effort Aspointedout,duringeachstageintheauditprocess--preliminaryreview,fieldwork,auditreports,andfollow-up--clients have the opportunity to participate. There is no doubt that the process works best when client management and Internal Audit have a solid working relationship based on clear and continuing communication.

Many clients extend this working relationship beyond the particular audit. Once the audit department has worked with management on a project, we have an understanding of the unique characteristics of your unit’s operations. As aresult,wecanhelpevaluatethefeasibilityofmakingfurtherchangesormodificationsinyouroperations.

5.9 Auditing DocumentationTheword“document”isusedtorefertoawrittenorprintedpaperthatbearstheoriginal,official,orlegalformofsomething and can be used to furnish decisive evidence or information. “Documentation” refers to the act or an instance of the supplying of documents or supporting references or records.

According to Auditing and Assurance standard 3 (AAS 3) issued by the Institute of Chartered Accountants of India “Documentation” refers to the working papers prepared or obtained by the auditor and retained by him , in connection with the performance of the audit.

ReviewIn contrast, a review provides a negative assurance report giving only a moderate level of assurance on the reliability ofthefinancialinformation.Thereportessentiallystatesthatnothinghascometothereviewer’sattentiontoindicatethatthefinancialinformationisnotpresentedfairlyinaccordancerelevantaccountingstandardsandprinciples.Reviewengagementsaredesignedasalimitedreviewoffinancialstatements;thereforetheriskofmistakes,omissionsor incorrect disclosures is considerably greater than with an audit.

Peer review The dictionary meaning of the word “Peer” is “A person who has equal standing with another or others”.

Theterm“Review”isdefinedas“subjecttoaformalinspectionorappraisalandreassessmentofthematterinquestion”.

Thus, peer review for chartered accountants would mean evaluation of a colleague’s work professionally. Peer review applies only to practicing Chartered Accountants as Audit and assurance work can be performed by practicing Chartered Accountants only.

85

Peer review is conducted with an idea to suggest improvements in the reporting services provided unlike auditing andinvestigationwhichareconductedwithafocustocommentonthetruthfulnessofthefinancialandaccountingrecords.

Other assurance servicesThe other types of assurance services usually provided by an auditor which are not related to Audit include due diligence report.

5.9.1 Form and Content of DocumentationThe form and content of audit documentation should be designed to meet the circumstances of the particular audit. The information contained in audit documentation constitutes the principal record of the work that the auditors have performed in accordance with standards and the conclusions that the auditors have reached. The quantity, type, and content of audit documentation are a matter of the auditors’ professional judgment. The Audit documentation therefore is not restricted to being only on papers, but can also be on electronic media

Generally the factors that determine the form and content of documentations for a particular engagement are:The nature of the engagement•The nature of the business activity of the client•The status of the client•Reporting format•Relevant legislations applicable to the client•Records maintained by the client•Internal controls in operation•Quality of audit assistants engaged in the particular assignment and the need to direct and supervise their •work

5.9.2 Permanent and Current Audit FilesIn thecaseof recurringaudits,someworkingpaperfilesmaybeclassifiedaspermanentauditfiles,whichareupdatedcurrentlywithinformationofcontinuingimportancetosucceedingaudits.Incontrastcurrentauditfilescontain information relating primarily to the audit of a single period.

Apermanentauditfilenormallyincludes:Copy of initial appointment letter if the engagement is of recurring nature•Record of communication with the retiring auditor, if any, before acceptance of the appointment as auditor•NOC from previous auditor•Information concerning the legal and organisational structure of the entity. In the case of a company, this includes •the Memorandum and Articles of Association. In the case of a statutory corporation, this includes the Act and Regulations under which the corporation functions .i.e.,

In case of partnerships- Partnership deed �In case of trusts- Trust deed �Incaseofsocieties-Certificateofregistration/RulesandBye-laws. �

Organisational structure of the client•List of governing body including Name, Address and contact details. For Instance, the List of Directors in case •of a company, List of partners in a partnership and list of Trustees in a Trust.Extracts or copies of important legal documents, agreements and minutes relevant to the audit.•A record of the study and evaluation of the internal controls related to the accounting system. This might be in •theformofnarrativedescriptions,questionnairesorflowcharts,orsomecombinationthereof.Copiesofauditedfinancialstatementsforpreviousyears•


86

Analysisofsignificantratiosandtrends•Copies of management letters issued by the auditor, if any.•Notesregardingsignificantaccountingpolicies.•Significantauditobservationsofearlieryears.•Assessment of risks and risk management•Major policies related to Purchases and Sales•Details of sister concerns•Details of Bankers, Registrars, Lawyers etc•Systems and Data Security policies•Business Continuity Plans•

Thecurrentfilenormallyincludes:

Correspondence relating to acceptance of annual reappointment.•Extracts of important matters in the minutes of Board Meetings and General Meetings, as are relevant to the •audit.Evidence of the planning process of the audit and audit programme•Analysis of transactions and balances.•A record of the nature, timing and extent of auditing procedures performed, and the results of such •proceduresEvidence that the work performed by assistants was supervised and reviewed.•Copies of communications with other auditors, experts and other third parties.•Copies of letters or notes concerning audit matters communicated to or discussed with the client, including the •terms of the engagement and material weaknesses in relevant internal controls.Lettersofrepresentationorconfirmationreceivedfromtheclient.•Conclusionsreachedbytheauditorconcerningsignificantaspectsoftheaudit,includingthemannerinwhich•exceptions and unusual matters, if any, disclosed by the auditor’s procedures were resolved or treated.Copiesofthefinancialinformationbeingreportedonandtherelatedauditreports.•Audit review points and highlight.•Major weakness in Internal control•

5.9.3 Need for Audit DocumentationDocuments believed to be related to Enron were destroyed, focusing the attention of regulators and lawmakers on the contents and retention of audit documentation.

Theauditworkingpapers(currentandpermanent)foraclientauditengagementshouldbesufficientlydetailedtoenable another appropriately experienced and competent auditor who is not familiar with the client to obtain an overall understanding of the engagement.

The need for Working papers can be listed as follows:Theyaidintheplanningandperformanceoftheaudit;•They aid in the supervision and review of the audit work and to review the quality of work performed, in •accordancewithAAS17“QualityControlforAuditWork”;They provide evidence of the audit work performed to support the auditor’s opinion•They document clearly and logically the schedule, results of test, etc.•The working papers should evidence compliance with technical standards•

87

TheydocumentthatInternalcontrolhasbeenappropriatelystudiedandevaluated;and•They document that the evidence obtained and procedures performed afford a reasonable basis for an •opinion.Theyretainarecordofmattersofcontinuingsignificancetofutureauditsoftheentity;•They enable an experienced auditor to conduct quality control reviews in accordance with Statement on Peer •ReviewissuedbytheInstituteofCharteredAccountantsofIndia;Theprocessofpreparingsufficientauditdocumentationcontributestothequalityofanaudit•Theyfulfil theneedtodocumentoraldiscussionsofsignificantmattersandcommunicate to thosecharged•with governance, as discussed in AAS 27, “Communication of Audit Matters with those Charged with Governance.

Guidance to staff on audit documentationProper guidance should be given to staff regarding the following:

Filing/keeping of working papers.•Checklist of documents to be obtained and maintained.•Indexing of documents/ working papers.•Proper numbering/ sequencing of working papers.•Summarisingofoverallfindings.•Writing of queries.•Discussing with seniors on matters of importance.•Disposing of Query -at staff level/ senior level/ partner level.•Importanceoftheworkingpaperstobesigned,datedandapprovedbyrelevantlevelofauditstaffwithsufficient•cross reference.Importanceofdepictingtheclient’sname,filenumber,accountingperiod,subjectofworkingpaperandreference•ofworkingpaperwithcurrentorpermanentfile.

5.9.4 Retention of Working Papers/ DocumentsTheauditorshouldretaintheworkingpapersforaperiodoftimesufficienttomeettheneedsofhispracticeandsatisfy any pertinent legal or professional requirements of record retention.

Working papers are the property of the auditor. The auditor may, at his discretion, make portions of or extracts from his working papers available to his client.

Theauditorshouldadoptreasonableproceduresforcustodyandconfidentialityofhisworkingpapers

Requests for access to working papersAAS1,BasicPrinciplesGoverningAnAudit,statesinpara6,“Theauditorshouldrespecttheconfidentiality•of information acquired in the course of his work and should not disclose any such information to a third party withoutspecificauthorityorunlessthereisalegalorprofessionaldutytodisclose.” (AAS) 3, Documentation (Paragraph 13), states, “Working papers are the property of the auditor. The auditor •may, at his discretion, make portions of or extracts from his working papers available to his client.” AAS 3 furtherrequiresinteralia,thatthe“auditorshouldadoptreasonableproceduresforcustodyandconfidentiallyof his working papers.”Part I of the Second Schedule to the Chartered Accountants Act, 1949 provides that “A Chartered Accountant •in practice shall be deemed to be guilty of professional misconduct, if he –“Discloses information acquired in the course of his professional engagement to any person other than his client •so engaging him, without the consent of his client or otherwise than as required by any law for the time being in force.”


88

Requests may be received by the members of the Institute, who have/had been performing the duties as the •auditors of an enterprise, to provide access to their audit working papers from the clients or other auditors of the enterprise or its related enterprise such as a parent enterprise.UnderthecircumstancesICAIhasclarifiedthatexcepttotheextentstatedinpara5below,anauditorisnot•required to provide the client or the other auditors of the same enterprise or its related enterprise such as a parent or a subsidiary, access to his audit working papers. The main auditors of an enterprise do not have right of access to the audit working papers of the branch auditors. In the case of a company, the statutory auditor hastoconsiderthereportofthebranchauditorandhasarighttoseekclarificationsand/ortovisitthebranchif he deems it necessary to do so for the performance of the duties as auditor. An auditor can rely on the work of another auditor, without having any right of access to the audit working papers of the other auditor. For this purpose, the term ‘auditor’ includes ‘internal auditor’.The client does not have a right to access the working papers of the auditor. However, the auditor may, at •his discretion, in cases considered appropriate by him, make portions of or extracts from his working papers available to the client.

5.9.5 Tips for Auditors on Documentation / Working PapersGeneral guidelines for the preparation of working papers are as follows.

Clarity and Understanding: As a preparer of audit documentation, step back and read your work objectively. •Would it be clear to another auditor?Working papers should be clear and understandable without supplementary oral explanations. With the •information the working papers reveal, a reviewer should be able to readily determine their purpose, the nature and scope of the work done and the preparer’s conclusions.Completeness and Accuracy: As a reviewer of documentation, if you have to ask the audit staff basic questions •about the audit, the documentation probably does not really serve the purpose.Work papers should be complete, accurate, and support observations, testing, conclusions, and recommendations. •They should also show the nature and scope of the work performed.Pertinence: Limit the Information in working papers to matters that are important and necessary to support the •objectives and scope established for the assignment.Logical Arrangement: File the Working papers in a logical order.•Legibility and Neatness: Be neat in your work. Working papers should be legible and as neat as practical. •Sloppy work papers may lose their worth as evidence. Crowding and writing between lines should be avoided by anticipating space needs and arranging the work papers before writing.Safety: Keep your work papers safe and retrievable•Initial and Date: Put your initials and date on every working paper•Summaryofconclusions:Summarisetheresultsofworkperformedandidentifytheoverallsignificanceofany•weaknesses or exceptions found.

5.10 Internal Control SystemInternalcontrolisacompany’ssystem,definedandimplementedunderitsresponsibility.

It comprises a set of resources, patterns of conduct, procedures and actions adapted to the individual characteristics of each company which:

contributestothecontroloveritsactivities,totheefficiencyofitsoperationsandtotheefficientutilisationof•its resources, and enablesittotakeintoconsideration,inanappropriatemanner,allmajorrisks,betheyoperational,financialor•compliance.

89

The system more particularly designed to ensure that: lawsandregulationsarecompliedwith;•the instructions anddirectional guidelinesfixedbyExecutiveManagement or theManagementBoard are•applied;the company’s internal processes are functioning correctly, particularly those implicating the security of its •assets;financialinformationisreliable.•

Internalcontrolisthereforenotlimitedtoasetofprocedures,norsimplytoaccountingandfinancialprocesses.Nordoesitembracealloftheinitiativestakenbytheexecutivebodiesorbymanagement,suchasdefiningcompanystrategy,fixingobjectives,managementdecisions,dealingwiththerisksormonitoringperformance.

5.10.1 Scope of Internal ControlIt is the responsibility of every company to design an internal control system which is suitably adapted to their situation. In the case of a group, the parent company ensures that internal control systems exist within its subsidiaries. These systems should be adapted in line with their own individual characteristics and to the relationship that exists between the parent company and the subsidiaries. In situations where a parent company has a substantial holding interest,overwhichithassignificantinfluence,thatparentshouldtakecaretoassessthepossibilityofacquaintingitselfwithandexaminingthemeasurestakenbyitsaffiliate,intermsofinternalcontrol.

5.10.2 Internal Control System ComponentsThe principal directional guidelines in terms of internal control are determined in line with the company’s objectives.

These objectives must be applicable to the various units of the entity and clearly communicated to staff so that they can understand and adhere to the organisation’s risk and control policy. Internal control will be that much more relevant if it is built on rules of conduct and integrity upheld by the governance bodies and communicated to all staff. In no way can it be reduced to a purely formal system with serious breaches in business ethics taking place on the sidelines. It is true that the internal control system can not, in itself, prevent company staff from committing fraud, contravening legal or regulatory provisions, or communicating misleading information outside the company about its situation.

Theinternalcontrolsystemconsistsoffivecloselyrelatedcomponents.

Although these components apply to all companies, the way they are implemented will vary depending on the size and the business sector of companies.

Thesefivecomponentsareasfollows:Anorganisationcomprisingacleardefinitionof responsibilities,with suitable resourcesandcompetencies•and supported by appropriate information systems, procedures or operating methods, tools and practices The implementation of an internal control system must be based on fundamental principles but also on:

a suitable organisation which provides the framework in which the activities implicit in meeting the objectives �areplanned,carriedout,followedupandcontrolled;clearlydefinedresponsibilitiesandpowerswhicharegrantedtotherightpeopledependingonthecompany’s �objectives. They can be formalised and communicated by means of task or job descriptions, operating and functional line organisation charts, delegation of powers, and should respect the principle of the segregation ofduties;a human resource management policy which should enable people to be recruited with the appropriate �knowledge and competencies required to carry out their responsibility and to meet the current and future objectivesofthecompany;


90

information systems which are adapted to the current objectives of the organisation and designed to be able �to respond to its future objectives. The IT systems on which these information systems depend must be effectively protected, both in terms of physical and logical security, thereby ensuring that there is no loss of the information stored. Their operational continuity is guaranteed by back-up procedures. The information ontheanalyses,theprogrammingandprocessingfunctionalitiesmustbedocumented;operating procedures or methods which specify the way in which an action or process should be carried �out(objectivestobeachievedwithinagiventime-frame,definitionsoffunctionsandoperating/reportinglines, policy framework, decision-making and assessment tools, control frequency, person responsible for the control, …), regardless of their format and type of support aid.toolsorworkfacilities(officeautomation,IT)whichareadaptedtoeveryone’sneedsandwhicheveryuser �shouldbesuitablytrainedin;practices which are commonly accepted within the company �

The in-house dissemination of relevant and reliable information, the awareness of which enables everyone to •exercise their responsibilities

The company should employ processes which ensure that all relevant and reliable information is �communicated in a timely manner to all relevant players within the company, thereby enabling them to exercise their responsibilities.

Asystemforidentifyingandanalysingthemainidentifiablerisksinrelationtothecompany’sobjectivesand•for ensuring that procedures exist for managing those risks

Given the ever-changing environment and regulatory context, companies implement methods to identify, analyse and manage the risks, both internal and external, with which they may be confronted and which could reduce the likelihood of them meeting their business objectives.

Risk identification Thecompanyidentifiesthemainidentifiablerisks,bothinternalandexternal,whichcouldhaveanimpactonthelikelihoodofitmeetingtheobjectivesithasfixedforitself.Thisidentificationprocess,whichison-going,shouldcoverthoseriskswhichcouldhaveasignificantimpactonitssituation.

Risk analysis This involves taking into consideration the likelihood of the risks occurring and their potential seriousness, as well as considering the environment and existing control measures. These different elements are not static, on the contrary, they form part of the risk management process.

Risk management procedures Executive Management or the Management Board, supported by a risk management function, if there is one, should defineriskmanagementprocedures.

Control activities proportionate to the implications of each individual process and designed to ensure that the •appropriate measures are taken in order to control the risks that could affect the company’s ability to achieve its objectives.Control activities can be found everywhere in the organisation, at every level, and in every function, be they •controls focusing on prevention or detection, manual or computerised controls, or controls by virtue of the reporting structure. In any event, control activities are determined in the light of the nature of the objectives with which they are associated and are proportionate to the implications of each process. In this context, particular attention should be paid to the controls over the processes involved in designing and running information systems.

91

On-going monitoring of the internal control system together with a regular review of the way it is operating. •As for any system, the internal control system requires on-going monitoring. The aim is to check its �relevance and appropriateness to the company’s objectives. Implemented by management and steered by the Executive Management or the Management Board, this monitoring principally comprises the analysis of the main incidents that have been recorded, the result of the controls performed, together with the work carried out by the internal audit team, when there is one. This monitoring also takes into consideration the observations made by the statutory auditors and by regulatory oversight bodies. Another useful complement to the monitoring tools can be to keep an active watch on internal control best �practices. Monitoring, together with the best practices watch, culminate, where required, in the implementation of �corrective actions and adjustments to the internal control system. Executive Management or the Management Board should assess the parameters for informing the Board �of the main results of the monitoring and reviews thus performed.

5.10.3 Limitations Inherent in Internal Control However well conceived and applied the internal control system might be, it cannot provide an absolute guarantee that the company’s objectives will be met. The likelihood of meeting these objectives does not depend solely on the will of the company.

There are in fact limitations which are inherent in any internal control system. These limitations are due to several factors, notably to the uncertainties in the outside world, to the exercise of people’s judgement or to problem areas that can arise as a result of human failure or of a simple error.

Inaddition,whenimplementingcontrols,itisimportanttobearinmindthecost/benefitrelationshipandnottodevelop internal control systems which are unnecessarily costly, even if it means accepting a certain degree of risk.


92

SummaryAnauditisindependentexaminationoffinancialinformationofanyentity,whetherprofitorientedornot,and•irrespective of its size or legal form, when such an examination is conducted with a view to expressing an opinion thereon.Auditingisdonebytheauditortofindoutwhetherthefinancialstatementsarepreparedbybusinessconcerns•to know the result of the business activity undertaken by them throughout the year. ThebroadaimofauditistosafeguardthefinancialinterestsofthetaxpayerandtoassisttheParliament/•State/Unionterritorylegislaturesinexercisingfinancialcontrolovertheexecutive.Regularity audit consists mainly in checking that the payments have been duly authorised and are supported by •proper vouchers in the prescribed form. Financialauditisonethatisconductedinordertoensurethattheaccountingandfinancialcontrolsystemsare•efficientandcooperatingproperly;andthatfinancialtransactionshavebeencorrectlyauthorisedandaccountedfor.In receipts audit, the function of audit department is to ensure that adequate regulations and procedures have •been framed and are being observed by the revenue department, to secure an effective check on assessment, collection and proper allocation of revenue. It has been accepted that Regularity audit/Propriety audit is essential for parliamentary control of •expenditure.The Auditing Practices Committee (re-christened as Auditing and Assurance Standards Board) was constituted •in September, 1982 as one the important technical committees of the ICAI on the lines of the standard setting procedure prevalent abroad. Internal Auditing is an independent, objective assurance and consulting activity designed to add value and •improve an organisation’s operations.According to Auditing and Assurance standard 3 (AAS 3) issued by the Institute of Chartered Accountants of •India “Documentation” refers to the working papers prepared or obtained by the auditor and retained by him , in connection with the performance of the audit.

ReferencesKumar, R. and Sharma, V., 2005. • Auditing: principles and practice, PHI Learning Pvt. Ltd.Gray,I and Manson, S., 1989. • The audit process: principles, practice and cases, Routledge.Egyankosh, • Auditing System in India [PDF] Available at: <http://www.egyankosh.ac.in/bitstream/123456789/ 25433/1/Unit-22.pdf>. [Accessed 10 December 2011].Institute of Internal Auditors, India, Introduction• [Online] Available at: <http://www.iiaindia.org/guidance.asp>. [Accessed 10 December 2011].Caclubindia.com, • Process of Conducting Internal Audit [Online] Available at: <http://www.caclubindia.com/articles/print_this_page.asp?article_id=69>. [Accessed 10 December 2011].Mbrozetti, 2010. • WhatisInternalAuditingandit’sDefinition? [Video Online] Available at: <http://www.youtube.com/watch?v=_nOe6rH6rq0>. [Accessed 13 December 2011].Nymigvideo, 2011. • Audits: Types and Preparation [Video Online] Available at: <http://www.youtube.com/watch?v=s-lI-bCZMw4>.[Accessed13December2011].

Recommended ReadingCosserat, G. W and Rodda, N., 2009. • Modern Auditing, 3rd ed., John Wiley and Sons.Dicksee, L. R., 1976., • Auditing: a practical manual for auditors: The History of accounting, Ayer Publishing.Rittenberg, L, E., Johnstone, K, Gramling, A. A. and Schweiger, B., 2009. • Auditing: A Business Risk Approach, 7th ed., Cengage Learning.

93

Self Assessment____________ consists mainly in checking that the payments have been duly authorised and are supported by 1. proper vouchers in the prescribed form.

Financial audita. Regularity auditb. Receipt auditc. Performance auditd.

In which of the following , the function of audit department is to ensure that adequate regulations and procedures 2. have been framed and are being observed by the revenue department, to secure an effective check on assessment, collection and proper allocation of revenue?


Financial audit and ___________ generally involve scrutiny of individual transactions.3. Regularity audit a. Accounts auditb. Performance auditc. Receipt auditd.

__________seekstofindoutwhethertheresourceshavebeenutilisedefficientlybydeployingtheminan4. optimum manner.


Which of the following does not concern itself with the audit of administrative organisations and procedures 5. and is different from administrative audit?

Regularity audita. Performance auditb. Financial auditc. Receipt auditd.

Which of the following is false?6. The utility of Performance audit can hardly be over-emphasised. It, however, requires expertise in identifying a. quantifiableobjectivesingovernment.An auditor plans and performs his audit recognising that he may encounter conditions or events during his b. examination that would lead him to question whether fraud or error exists.The utility of Regularity audit can hardly be over-emphasised.c. The Board is also in the process of formulation Statement on Standard Auditing Practices on Auditor’s d. Report on Financial Statements.


94

Which of the following helps an organisation accomplish its objectives by bringing a systematic, disciplined 7. approach to evaluate and improve the effectiveness of risk management, control and governance processes?

Regularity audita. Performance auditb. Internal auditc. Financial auditd.

In which phase of the audit process, the auditor gathers relevant information about the unit in order to obtain 8. a general overview of operations?

Initial meetinga. Preliminary surveyb. Audit programc. Fieldworkd.

Which of the following is conducted with an idea to suggest improvements in the reporting services provided 9. unlike auditing and investigation, which are conducted with a focus to comment on the truthfulness of the financialandaccountingrecords?

Financial auditinga. Internal auditb. Peer reviewc. Internal control systemd.

The internal control system consists of _____ closely related components.10. twoa. threeb. fourc. fived.

95

Chapter VI

Audit of Limited Companies

Aim


introduce the company auditor•

highlightthequalificationsanddisqualificationsofcompanyauditor•

describe appointment of an auditor•

Objectives


elucidate the process of reappointment of auditors•

explain the procedure of removal of auditor•

explicate special audit of banking companies•

Learning outcome


understand the rights and duties of a company auditor•

comprehend the audit of educational institutions•

discuss the audit report•


96

6.1 IntroductionAuditplaysapivotalroleinkeepingproperlegalcheckonthosewhocarryonthebusinessinafiduciarycapacity.Shareholders not being legal experts, the auditor acts as a link between the shareholders and the management.

Statutory auditing, mandatory for all companies, is one of the regulatory mechanism designed to check abuses and irregularitiesinthefinancialaspectsofthecompanies.TherearenumerousprovisionsincorporatedintheCompaniesAct, 1956 stipulating the norms and rules to be followed in maintaining the accounts of the company.

All companies are statutorily required to prepare and maintain accounts which are then scrutinised by the auditor who certify their correctness. For company accounts to be credible they must be true and fair and this is more likely to happen if someone competent and independent of the company has vetted the accounts.

Anauditorhasafiduciaryrelationshipwiththecompany.Thestatutoryauditorsareoftendescribedasthewatchdogsof the company. They have access to the book of accounts, vouchers and documents, which no member of the company has. At the same time a number of duties and responsibilities are cast upon them.

6.2 Need for a Company AuditorThe main purpose of appointing an auditor or auditors in a company is to safeguard the interests of the shareholders because, for every shareholder, it is neither possible to inspect the books of account of the company personally nor to participate in its management actively. An auditor, therefore, is a representative of the shareholders and he works on their behalf. He is to ensure that the directors have maintained proper books of account, the accounting records are correct and genuine, the company has complied with the provisions of the Companies Act, and that nothing has been done to jeopardise the interests of the shareholders deliberately.

When the auditor reports to the shareholders expressing satisfaction, his opinion serves as an assurance that everything relating to accounts is in order in the company. He is primarily to protect the rights of the shareholders. Those who are responsible for the management of its affairs must not work against the interests of the shareholders either in using the assets of the company or in distributing the dividend. An auditor, therefore, has to exercise reasonable amount of care and skill in his job because the shareholders rely primarily upon his opinion in this regard. If there is any irregularity in the books of account, or something is being done in the company which is illegal and improper, this will adversely affect the interests of the shareholders. Hence, the auditor should report all such cases of irregularity to the shareholders. The main responsibility of an auditor is to examine the books of account of the company as maintainedbyitsofficersandtoreporttotheshareholdersthatthefinancialpositionofthecompanyasrepresentedby its balance sheet gives a true and fair view of its state of affairs.

6.3 Qualification of a Company AuditorAccordingtoSection226(1)and(2)oftheCompaniesAct,1956,theprescribedqualificationsofacompanyauditorare as follows:

ApersonshallnotbequalifiedforappointmentasauditorofacompanyunlessheisaCharteredAccountant•within themeaningof theCharteredAccountant’sAct,1949.Provided thatafirmwhereofall thepartnerspractisinginIndiaarequalifiedforappointmentasaforesaidmaybeappointedbyitsfirmnametobeauditorofacompany,inwhichcaseanypartnersopractisingmayactinthenameofthefirm.ApersonwhoholdsacertificateundertheRestrictedAuditor’sCertificateRules,1956,isalsoqualifiedtoact•asanauditorofcompany.Suchpersonsarecalledcertifiedauditorsandarealwayssubjecttotherulesmadeinhis behalf by the Central Government.

97

6.4 Disqualification of a Company AuditorSection226(3) of theAct further provides that the following are not qualified for appointment as a companyauditor:

A body corporate•Anofficeroremployeeofthecompany•apersonwhoisapartner,orwhoisintheemployment,ofanofficeroremployeeofthecompany.•a person who is indebted to the company for an amount exceeding Rs. 1000, or who has given any guarantee or •provided any security in connection with the indebtedness of any third person to the company For an amount exceeding, RS. 1000.

Moreover,ifapersonisappointedascompanyauditorandsubsequentlybecomesdisqualified,heisdeemedtohaveautomaticallyvacatedhisofficeasauditorofthecompanyformthedateofhisdisqualification.

Rationale for restrictionsYou have noted here that some statutory restrictions have been imposed on the appointment of an auditor in a companyinrespectofhisqualifications.Thereasonsforsuchrestrictionsart:asfollows:

The process of auditing involves an independent examination of accounts to ensure that they are free from errors •or frauds. This is a professional responsibility expecting expertise as well as integrity.Anefficientperformanceofdutiesbyacompanyauditorisanequallyimportantaspectoflaw.Heis,therefore,•under the discipline or a recognised professional 6 accountancy body, is., Institute of Chartered Accountants of India.A company auditor needs legal protection as well as the support of an organised professional body in discharging •his duties in an independent manner.Unbiasedattitudeandimpartialjudgementarenecessaryforacompanyauditorbothinverificationofaccounts•andinexpressionofhisopiniononthefinancialstatementsofthecompany.Undueconnectionorassociationofacompanyauditorwiththedirectorsorofficersofthecompanyeitherasa•partner or as an employee defeats the very purpose of auditing and the concept of independence.

6.5 Appointment of an AuditorSection 224 of the Companies Act provides: “Every company shall, at each annual general meeting, appoint an auditororauditorstoholdofficefromtheconclusionofthatmeetinguntiltheconclusionofthenextannualgeneralmeeting and shall, within seven days of the appointment, give intimation thereof to every auditor so appointed”.

If you translate this provision into rules of appointment of a company auditor, these will be as follows:A company auditor is normally appointed at the annual general meeting of the company.•The tenure of appointment of a company auditor is from one annual general meeting to another.•That when an auditor is appointed in a company, he should be intimated about it within seven days of such •appointment.

Besides these three basic rules for the appointment of a company auditor, the supplementary considerations are:thatawrittencertificateandconsentshouldbeobtainedfromtheproposedauditorbefore-hisappointmentis•finalisedbythecompany;that in case a company is unable to appoint an auditor at its annual general meeting, the central government has •thepowerstomakesuchanappointmenttofillthevacancy;thatnooneisappointedasacompanyauditorwhoholdssuchappointmentintwentycompaniesatatime;•andthat the appointed auditor should communicate to the Registrar of Companies, within thirty days of the receipt •of intimation from the company, whether he I accepts or refuses to accept the appointment.


98

6.5.1 First Auditor of a CompanyA company may be registered any time during the year and, therefore, its date of registration may differ from the date of commencement of its normal accounting year. Hence, the company shall also need an auditor for that partial period of its operation which proceeds the normal accounting year. The auditor to be appointed for this initial and partialperiodofthecompanyisknownasthefirstauditor.Suchappointmentsaremadebytakingintoconsiderationthe following factors:

ThefirstauditororauditorsofncompanyareappointedbytheBoardofDirectorsofthecompany•Such appointment is to be made within one month of the date of registration of the company.•Thefirstauditorwillholdofficeuntiltheconclusionofthefirstannualgeneralmeetingofthecompany.•

6.5.2 Reappointment of AuditorsA statutory auditor is not appointed on a permanent basis. It is normally an annual assignment. It may, however, be renewed and extended for another term. When the previous auditor of the company is allowed to continue for the next year, it is considered as a reappointment. Under normal circumstances, a retiring auditor is reappointed as a company auditor. In some cases, however, this may not be so owing to the following reasons:

Theauditorisnownotqualifiedforreappointment;•The auditor has expressed his unwillingness to be reappointed by giving the company a notice in writing about •his intention to discontinue.The company has passed a resolution at the general meeting to appoint somebody else as the company auditor, •ornottoreappointtheretiringauditor;orNotice has been given of an intended resolution to appoint some person or persons in the place of a retiring •auditorandbyreasonofthedeath,incapacityordisqualificationofthat.personorofallthosepersons,theresolution cannot be proceeded with.

6.6 Removal of an AuditorAnAuditorofacompanycanberemovedfromofficebeforetheexpiryofhisterminthefollowingmanners:

When the company takes such decision at its general meeting•Byanordinaryresolutionofwhichspecialnoticehasbeengiven;and•After obtaining the previous approval of the central government.•

ThefirstauditorsofacompanyappointedbyitsBoardofDirectorscanberemovedatageneralmeetingbyanordinary resolution of which a special notice is given. Thus, you see that in all matters relating to appointment, reappointment, removal or retirement of an auditor, the shareholders of the company play an important role. This once again establishes the fact that the auditor is responsible to the shareholders. He acts on their behalf, and not on behalf of the directors. He is shareholders’ representative and his statutory duties are to safeguard their interest.

There is one more process of protection given to auditors against their undue removal. If an auditor other than the retiring auditor is to be appointed, special notice must be given to the company by a member before the annual general meeting. A copy of this notice must be sent to the retiring auditor as well as to all members prior to the general meeting. The retiring auditor, after getting a copy of the notice, may make a written representation to the company and ask the company to circulate it among the members of the company. Besides, the retiring auditor has the power to attend the annual general meeting at which the proposal for his removal is being considered and to address the members.

99

6.7 Status of an AuditorNow the question arises as to what is the real status of an auditor in a company. Obviously, an auditor enjoys a legal status. In other words, a company auditor is a statutory auditor, because he is appointed strictly in accordance with the provisions of the law. The status of an auditor in a company is governed by the following principles:

An agent: The auditor is an agent of the members of the company appointed to perform duties as laid down by •(a) the Companies Act, (b) the Articles of Association of the company, and (c) the audit agreement between the auditor and the client.Not an advisor: An auditor is not an advisor to the company. It is not a part of his duty to advise the directors •or shareholders.Not a detective: An auditor is neither a detective nor an employee of the company. He is a watchdog and not a •bloodhound. He need not be unduly suspicious in his job.Not to discover Frauds: it is not the responsibility of the auditor to discover frauds which have been carefully •perpetrated.Hecanrelyuponthehonestyoftheemployeesofthecompanywhoenjoyapositionofconfidencein the organisation.Notaguarantee:Anauditor’sopiniononthefinancialstatementsofthecompanydoesnotmeananautomatic•guarantee of correctness of books of account.Anofficer:Althoughanauditorisnotanemployeeofacompany,heistreatedasanofficerofthecompany•under various provisions of the Companies Act.

6.8 Rights and Duties of a Company AuditorFollowing are the rights and duties of a company auditor.

6.8.1 RightsThe Act provides for the following rights to the auditors of a company:

Rights of access to books of accounts: Every auditor of a company shall have a right of access at all times to •thebooksofaccountandvouchersofthecompany,whetherkeptattheheadofficeorelsewhere.Thebooksincludenotonlythefinancialbooksofthecompanybutalsothestatutoryandstatisticalbooks.Rightstoobtaininformationandexplanation:Theauditorisentitledtorequirefromtheofficersofthecompany•such information and explanations as he may think necessary for the performance of his duties as auditor. Right to receive notices and attend general meetings: According to Section 231 of the Act, the auditor has a •right(a)toreceiveallnoticesandothercommunicationsrelatingtoanygeneralmeetingofthecompany;(b)toattendanygeneralmeetingofthecompany;and(c)tobeheardonanypartofthebusinesswhichconcernshim as an auditor at any general meeting.Right tomake corrections in thefinancial statements:The auditor is requested to conduct an independent•examinationofthebooksofaccountofacompanyandreporttotheshareholderswhetherthefinancialstatementsshowatrueandfairviewofthestateofaffairsofthecompany.Hence,ifhefindssomefault,hehastherightto make the necessary corrections. If his suggestions are not carried out, he has the right to refer the matter in his report.Righttovisitbranches:Wherethebranchaccountsarenotauditedbyaqualifiedauditor,thecompanyauditor•has a right of access at all times to the books of accounts and vouchers of the company as maintained at the branchofficeandmyvisitthebranchofdeemsitnecessary.


100

6.8.2 DutiesThe duties of a company auditor can be divided into three categories (1) duties relating to audit report, (2) duties relating to enquiry, and (3) other statutory duties.

Duties relating to reportThe auditor shall make a report to the members of the company on the accounts examined by him, and on every balancesheetandprofitandlossaccountandoneveryotherdocumentdeclaredbythisActtobepartoforannexedtothebalancesheetorprofitandlossaccount,whicharelaidbeforethecompanyingeneralmeetingduringhistenureofoffice.Thereportshallstatewhether,inhisopinionandtothebestofhisinformationandaccordingtothe explanations given to him, the said accounts give the information required by the Act in the manner so required and give a true and fair view.

inthecaseoftheBalanceSheet,ofthestateofthecompany’saffairsasattheendofitsfinancialyears;and•inthecaseoftheProfitandLossAccount,oftheprofitorlossforitsfinancialyear.•

The auditor’s report shall also stateWhether he has obtained all the information and explanations which, to the best of his knowledge and belief, •werenecessaryforthepurposeofhisaudit;whether, in his opinion, proper books of account as required by law have been kept by the company so far as-•appears from his examination of those books, and proper returns adequate for the purposes of his audit has been receivedfrombranchesnotvisitedbyhim;andwhetherthecompany’sBalanceSheetandProfitandLossAccountdealtwithbythereportareinagreement•with the books of account and returns.

Duties relating to enquiryTheauditorshouldspecificallyenquireintothefollowingsixmatters:

Whether loans and advances made by the company on the basis of security have been properly secured and •whether the terms on which they have been made are not prejudicial to the interests of the company. Whether the transactions which are not supported by any facts or evidence, though recorded in the books, are •not prejudicial to the interests of the company.Where the company is not an investment company or a banking company, whether it has sold any shares, •debentures or other securities at a price which is lower than the price at which they were purchased by the company, Whether loans and advances made by the company have been shown as deposits.•Whether any personal expenses have been charged to revenue accounts of the company.•Where the books of the company show that shares have been issued for cash, whether cash has actually been •received in respect of such allotment, and if no cash has actually been received, whether the position as stated in the books and the Balance Sheet is correct, regular and not misleading.

Other statutory dutiesTheprospectusissuedbyanexistingcompanyshouldcontainanauditorsreportregarding(a)profitandlosses,•(b)assetsandliabilities.(c)rateofdividendspaidforeachofthefivefinancialyearsprecedingtheissueoftheprospectus. Hence it is the duty of auditor to submit such report.The auditor has to certify a statutory report.•The auditor has to sign his report.•Where an inspector is appointed by the Central Government to investigate the affairs of the company, it is the •duty of the auditor to give him all assistance in the investigation.When a company goes into voluntary winding up and a declaration of solvency is made by the directors, the •auditorshallsubmithisreportontheProfitandLossAccountandtheBalanceSheet.

101

It is important to note here that the rights and powers of auditors cannot be limited or abridged either by the Articles of Association or by the directors or shareholders of the company.

6.8.3 Some Legal Decisions The following legal decisions further highlight the role or the auditors in discharging their statutory responsibilities:

Itisthedutyoftheauditornottoconfinehimselfmerelytothetaskofascertainingthearithmeticalaccuracyof•the Balance Shed, but to see that it is a true and accurate representation of the company’s affairs. (Leeds Estate Building and Investment Co. vs. Shepherd, 1887)An auditor must be honest, that is, he must not certify what he does not believe to be true and he must take •reasonablecareandskillbeforehebelievethatwhathecertifiesistrue.(LondonandGeneralBank,1895).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 (Kingston Cotton Mills Co. Ltd., 1896).The auditor undoubtedly does undertake very considerable responsibilities, and is liable for the proper discharge •of his duties, and if by the neglect of his duties or by want of reasonable care he neglects his duty, and damage is caused to the company as such, he is responsible for that damage (London Oil Storage Co. Ltd. vs. Seear, Hasluck and Co., 1904).When the reports of the auditors are not communicated to the shareholders, directors are responsible for this •lapse. Auditor’s duties are discharged when their reports are delivered to the company. It is the duty of the directors to summon the shareholders’ meeting and to see that the report of the auditors is read at the meeting. (Allen. Craig & Co. Ltd. 1934).The vital task of the auditor is to ensure that errors are not made. He must carry out this task with an enquiring •mind and not with suspicion of honesty. He should proceed with his work suspecting that someone might have made a mistake somewhere and that a check must be made to ensure that there has been none. (Fomento Ltd, vs. Selsdon Fountain Pen Co. Ltd., 1958).

6.9 Auditing StandardsIt may be of interest to you that international standards also guide the role of auditors. Their approach to company audit is now based on the following professional guidelines:

Anauditistheindependentexaminationof,andexpressionofopinionon,thefinancialstatementsofacompanyby•an appointed auditor in pursuance of that appointment and in compliance with relevant statutory obligation.Theresponsibilityforthepreparationofthefinancialstatementsandthepresentationoftheinformationincluded•thereinrestswiththedirectorsofthecompany.Theauditor’sresponsibilityistoreportonthefinancialstatementsas presented by the management.The auditor should adequately plan, control and record his work.•The auditor should ascertain the company’s system of recording and processing transactions and assess its •adequacyasabasisforthepreparationoffinancialstatements.Theauditor shouldobtain relevantand reliableaudit evidencesufficient toenablehim todrawreasonable•conclusions therefrom.If the auditor wishes to place .reliance on any internal controls, he should ascertain and evaluate those controls •and perform compliance tests on their operation.Theauditorshouldcarryoutsuchareviewofthefinancialstatementsasissufficient,inconjunctionwiththe•conclusions drawn form the other audit evidence obtained, to give him a reasonable basis for his opinion on thefinancialstatements.

The normal expectation from the auditor, therefore, is to express an independent judgement on the results and financialpositionofthecompany,freefromanypressurewhichthemanagementorownersofthatcompanymightseek to exert.


102

6.10 Divisible Profits and DividendDividendmeansdividetheprofitofthecompany,attheendofyear,amongshareholderofthecompany.

Types of dividendFollowing are the types of dividend.

Proposeddividend:DividendrecommendedbytheBoardiscalledasproposeddividend.TheBoardspecifies•in its report, the amount it recommends for payment of dividend (Sec. 217), which is attached to the balance sheetfortherelevantfinancialyear.Final dividend: Proposed dividend, when consented to by the shareholders at the annual general meeting becomes •finaldividend.Thus,dividendisdeclaredbythemembersintheannualgeneralmeeting.Itisthediscretionoftheboardofdirectortorecommendornottorecommendthedeclarationoffinaldividend,whichhastobeexercisedingoodfaithintheinterestofthecompany.Theshareholdershavenopowertodeclarefinaldividendin the absence of a recommendation of the board of directors.Interimdividend:ThedividenddeclaredytheBoardforafinancialyearduringsuchfinancialyeariscalled•interimdividend.Thus,itisdeclaredinbetweentwoAGM.Nospecificpowerinthearticlesisrequiredfordeclaration of interim dividend.

Declaration of dividendFollowing are the ways of declaration of dividend.

Declarationofdividendoutofprofits•CalculationofDivisibleProfit �

CalculationofDivisibleProfit

Profits(Less): Current year depreciation (if not provided)a) (Less): Loss of PY OR Depreciation of PY - whichever is lessb) (Less): Amount to be transferred to reservesc)

xx(xx)(xx)(xx)

Divisibleprofits(Suchamountcanbedeclaredasdividend) xx

DistributableProfit–transferofprofittoreserve �

% of Dividend of paid-up capital % of C.Y. profit to be transferred to reserves

Upto 10 % Nil

More than 10% & upto 12.5% Minimum 2.5 %

More than 12.5% & upto 15% Minimum 5 %

More than 15% & upto 20% Minimum 7.5 %

Above 20% Maximum 10

Note–Ifcompanywantstotransfermorethan10%ofitsnetprofittoreserves,thenthecompanymustsatisfyfollowing two Conditions, which are as follows.

Condition 1– Dividend is Declared in Current YearSatisfy following two conditions –

Current year dividend • Avg.Dividendrateoflast3financialyearsIf Bonus share is declared in any of last 3 years, then•

Dividendamountiscurrentfinancialyear avg.dividendamountoflast3financialyears

103

Provided (i.e., No need to fulfil above 2 condition, if)Netprofitofcurrentyearofcompanyfallsbelow20%ormorethatofAveragenetprofitoflast2years

Condition2–DividendisNotDeclaredinC.Y.&co’wantstotransferitsprofittoreserveAmount transferred to reserve • Avg.dividendamountoflast3financialyears

Declaration of dividend out of reserveInterim dividend should not be declared out of reserves•Inayearinwhichtheprofitsofthecompanyisinadequateorthereisnoprofit,thecompanymaydeclareand•pay dividend out of free reserve

Conditions to be satisfied, if company pay dividend out of reserves Regarding rate of dividend •Dividend rate must be lower of –

Averagedividendrateoflast5years;or �10% �

Amount drawn from reserves shall not exceed 10% of sum of paid up capital + reserves.•Theamountsowithdrawnshouldbefirstutilisedtosetoffcurrentyearlosses.•Balance of reserves after such withdrawal should not fall below 15% of paid-up capital.•

6.11 Audit ReportAudit Report is the report is the report given by the Auditor after checking the accuracy of the particular data. The AuditreportcontainsthefindingsidentifiedbytheAuditorinthedatacheckedbyhimandhegiveshisopiniononthe quality of the data.

There are many types of Audits like Tax audit, Cost Audit, Company’s statutory audit, Bank Audit.

Need and importance of audit reportReporting is essential to the audit process because it explains what the auditor did and the conclusions reached. The need of auditor’s report is governed by the following provisions of the Companies Act, 1956.

That at every annual general meeting of a company, the Board of Directors of the company shall lay before the •company:

abalancesheetasattheendoftheperiod;and �aprofitandlossaccountfortheperiod[Sec.210]. �

That every balance sheet of a company shall give a true and fair view of the state of affairs of a company as at •theendofthefinancialyear.Similarly,everyprofitandlossaccountshallgiveatrueandfairviewoftheprofitandlossofthecompanyforthefinancialyear[Sec.211].Thattheprofitandlossaccountshallbeannexedtothebalancesheetandtheauditor’sreportincludingthe•auditor’s separate, special or supplementary report shall be attached thereto [Sec. 215].

The auditor of a joint stock company is appointed and entrusted to check the correctness and fairness of the financialstatements.Anauditoroccupiesafiduciaryposition,i.e.,apositionoftrustandconfidenceinacompany.The shareholders, who are in dark about the state of affairs of the company’s business, extend their trust, faith and confidencetothereportsubmittedbytheauditors.Auditreportenablestheauditorstoexplaintotheentirebodyofshareholderswhattheyconsiderrelevantandsignificantinformationrelatingtothefinancialstateofcompany’saffairs for the period under audit. It thus, serves the under mentioned purposes.

Itsubstantiatesthatthefinancialinformationofthecompanyreflectsatrueandfairpictureofthestateofaffairs•of company’s business.


104

It summarises the results of the audit work carried out by the auditor.•Apart form acquainting the shareholders with material facts about the affairs of company’s business, it offers •anopportunitytothereadersoffinancialstatements,viz.,creditors,bankers,financialinstitutionsandpotentialinvestorstogetreliableinsightintothefinancialpositionofthecompanyasreflectedbyitsprofitandlossaccount and the balance sheet.Auditor’sreportistheindicatorofcreditabilityoffinancialstatements.•

Thus, an auditor’s repost is a valuable document in which the auditor sets forth the scope and nature of the audit and alsogiveshisimpartialopinionasregardsthefinancialstateofcompany’sbusiness.Theauditormakesareporttothemembersonthefinancialstatementexaminedbyhimandtherefore,acquaintsthemwiththetrueandfairstateofthecompany’saffairs.Frequently,itistheonlypartoftheaudit,usersoffinancialstatementssee.Therefore,from the user’s point of view, the report is the product of an audit. However, the audit report does not guarantee that every detail of the company’s books of account is correct. It should be noted that an auditor is not a guarantor or an insurer. Even if he gives a clean report, it does not amount to complete accuracy of the accounts. His main dutyistoreporttothememberswhetherthebalancesheetandprofitandlossaccountexhibittrueandfairpositionof company’s affairs or not.

6.11.1 Responsibilities of an Auditor for making a ReportTo make a report on the accounts examined by him to the members of the company is one of the statutory duties of an auditor. The main duties and responsibilities of a company auditor with regard to the report are:

To safeguard the interest of the shareholders against any misuse of powers by the company directors in managing •the assets of the companyTo examine the books of account adequately in order to judge the genuineness and validity of the transactions •withultimateobjecttoacquainttheshareholderswiththetruefinancialpositionofthecompany.To highlight in the report any such activity of the management which in his opinion may endanger the interest •of the investors, viz., shareholders and or creditors who have contributed to its capital.To bring to the notice of the directors and shareholders the fact whether the accounts have been prepared and •presented in accordance with the accepted principles of accountancy. To see that the report reaches the members of the company by attending the annual general meeting. It must, •however, be noted that the ultimate responsibility to circulate the auditor’s report among the members or shareholders lies with the directors of the company.

6.11.2 Requisites of a Good Audit ReportThe auditor’s report should conform to the following criteria:

Based on factual information: The audit report should contain only factual information about the state of affairs •of the company. The auditor should base his opinion on the information ascertained by him and explanation given by the management, failing which the audit will not serve its purpose. Effective presentation: The presentation of the auditor’s report should be forceful and in a manner prescribed •by the Companies Act. An auditor should make it sure that the report is made available to the shareholders by attending the general meeting.Honest disclosure of discrepancies in the internal control: the audit report should contain an honest expression •of opinion. If the report does not highlight discrepancies or weaknesses in the internal control system, then the shareholders and the management will remain in dark as to the actual state of company’s affairs. Thus, auditor should highlight the weak areas of performance in the report.Impartial approach: The auditor should adopt independent and unbiased approach while writing and presenting •the report. An auditor of a company is appointed by shareholders, and his duty is to investigate the work of directors and ascertain all the information and explanations necessary for the purpose of his audit, and make a reportonthebasisofhisfindings.Ifauditreportdoesnotreflectanindependentandunbiasedopinionoftheauditor,therewillbenosanctityofsuchaudit.Thereportshouldreflectanimpartialattitudeoftheauditor.

105

Balanced criticism and logical suggestions: The auditor should present a report on the state of affairs of the •company after critical evaluation of the accounting system and policies of the company. The report should contain a balanced criticism of policies, procedures, accounting and internal control system followed by the company.Clear and unambiguous language: The audit report is the most important form of communication used by the •auditor. It must clearly and concisely communicate the nature of the auditor’s examination. Therefore, report should be written in an unambiguous language. Language of the audit report should be such that its readers could understand its subject matter clearly.Precise, brief and complete: The audit report should be brief and to the point. It should contain the relevant and •material particulars only. Any immaterial and irrelevant information in the report will contribute to nothing but creating confusion for the readers of the report. The report should be complete in all respects. The auditor shouldnotskipanymaterialfactwhiledraftinghisreportonthefinancialinformationexaminedbyhim.Theauditorshouldnotconfinehisauditreporttotheshareholdersandmanagementalone;itshouldalsocatertothe interest of the potential investors.

6.11.3 Types of Audit ReportAnauditreportisanappraisalofasmallbusiness’scompletefinancialstatus.Completedbyanindependentaccountingprofessional, this document covers a company’s assets and liabilities, and presents the auditor’s educated assessment ofthefirm’sfinancialpositionandfuture.Auditreportsarerequiredbylawifacompanyispubliclytradedorinanindustry regulated by the Securities and Exchange Commission (SEC). Companies seeking funding, as well as those lookingtoimproveinternalcontrols,alsofindthisinformationvaluable.Therearefourtypesofauditreports.

Unqualified opinionOftencalledacleanopinion,anunqualifiedopinionisanauditreportthatisissuedwhenanauditordeterminesthateachofthefinancialrecordsprovidedbythesmallbusinessisfreeofanymisrepresentations.Inaddition,anunqualifiedopinion indicates that thefinancial recordshavebeenmaintained inaccordancewith the standardsknown as Generally Accepted Accounting Principles (GAAP). This is the best type of report a business can receive. Typically,anunqualifiedreportconsistsofatitlethatincludestheword“independent.”Thisisdonetoillustratethat it was prepared by an unbiased third party. The title is followed by the main body. Made up of three paragraphs, themainbodyhighlightstheresponsibilitiesoftheauditor,thepurposeoftheauditandtheauditor’sfindings.Theauditor signs and dates the document, including his address.

Qualified opinionIn situationswhen a company’sfinancial records havenot beenmaintained in accordancewithGAAPbut nomisrepresentationsareidentified,anauditorwillissueaqualifiedopinion.Thewritingofaqualifiedopinionisextremelysimilartothatofanunqualifiedopinion.Aqualifiedopinion,however,willincludeanadditionalparagraphthathighlightsthereasonwhytheauditreportisnotunqualified.

Adverse opinionTheworsttypeoffinancialreportthatcanbeissuedtoabusinessisanadverseopinion.Thisindicatesthatthefirm’sfinancialrecordsdonotconformtoGAAP.Inaddition,thefinancialrecordsprovidedbythebusinesshavebeen grossly misrepresented. Although this may occur by error, it is often an indication of fraud. When this type ofreportisissued,acompanymustcorrectitsfinancialstatementandhaveitre-audited,asinvestors,lendersandother requesting parties will generally not accept it.

Disclaimer of opinionOn some occasions, an auditor is unable to complete an accurate audit report. This may occur for a variety of reasons, suchasanabsenceofappropriatefinancialrecords.Whenthishappens,theauditorissuesadisclaimerofopinion,statingthatanopinionofthefirm’sfinancialstatuscouldnotbedetermined.


106

6.12 Special Audit of Banking CompaniesThe audit of the banks should be well-acquainted with the relevant provision of the special enactment that govern differenttypesofbanks,particularlythosewhichaffectthevariousitemsofthefinancialimplicationsofthebusinesscarried on by banks and the types of the transaction that arise in the day-to-day operations.

6.12.1 Legislations Relevant to Audit of BanksThe provisions of many Acts relevant to audit of different types of banks are as follows.

AnauditorofthebanksshouldacquaintwiththespecificprovisionoftheActsapplicabletothetypeofbanks•under audit. Nationalised banks are governed by the provisions of the relevant Banking companies Act. Certain provision •of the Banking Regulation Act 1949 also applicable to nationalised banksThe non-nationalised banking companies are governed by the provision of the Banking Regulation Act 1949. •Co-operative banks are governed by the Co-operative Societies Act 1912 or the Co-operative Societies Act of •the state in which they are situated, as well as by Part- v of the Banking Regulation act 1949.CertainprovisionoftheBankingRegulationacthavebeenmodifiedwhilecertainothershavebeenomitted•in their allocation to co-operative banks. Regional rural banks are governed by the Regional rural banks Act 1976. The provisions of the State bank of India Act 1955, and the State bank of India (subsidiary banks) Act 1959, •applyStatebankofIndiaanditssubsidiariesrespectively.CertainspecifiedprovisionsoftheBankingRegulationact 1949, are applicable to regional rural banks as well as to the State bank of India and its subsidiaries.

6.12.2 Provision Relating to AuditAppointment of an auditor:The auditor of a banking company, a nationalised bank or a regional rural bank has to be a person who is duly qualifiedunderlawtobeanauditorofcompanies.Thus,theauditorofthecompaniesundersec226ofthecompaniesAct1956,andwhodoesnotattractanydisqualificationlaiddowntherein.Theauditorofanationalisedbankisappointed by the board of directors of the bank concerned, whereas the auditor of a banking company is appointed by the shareholder at the annual general meeting. Previous approval of RBI for appointment of the auditor is required in the both cases. The auditors of the state bank of India are appointed by RBI in consultation of the Central government. The auditors of the subsidiaries of the state bank of India are appointed by the state bank of India. It may be mentioned in the State bank of India Act 1955, specially provides for the appointment of the ‘two or more auditors’. The auditors of the regional rural banks concerned with the approval of the Central Government. The appointment of auditor of a co-operative bank is governed by the relevant Co- operative bank is governed by the relevant Co-operative Societies Act. Procedure for the appointment in case of nationalised banks:The statutory central auditors are appointed by the bank concerned on the basis of the names recommended by the RBI from out of panel of auditors. For this purpose, the RBI formulates detailed norms on the basis of which a panel is created by the Comptroller and Auditor General of India. Generally, each nationalised bank appoints 4-6 statutorycentralauditors.AsperthenormsprescribedbytheRBI,tobeeligibleforempanelment,afirmshould,asonJanuary1oftherelevantyear,meettheminimumeligibilitynormsrelatingto;

Number fulltime partners,•Numbers of FCA partners, •Numberofyearsthefirmhasbeenexistence,•Periodofminimumcontinuousassociationofpartnerswiththefirm,•Number of fulltime charted accountants,•Number of professional staff,•Experience of statutory audit of public sector banks having deposits of at least the prescribed sum.•Experienceofstatutoryauditofpublicsectorundertakings.Atleastonepartnershouldhavequalificationsin•computer audit.

107

6.12.3 Powers of the AuditorThe auditor of a bank has same powers as those of company auditor, except that the power the auditor of a co-operative is governed by the relevant Co-operative Societies Act.

6.12.4 Auditor’s ReportThe contents of the auditor report in case of different types of banks are somewhat different.

Banking companiesIn addition to the matters which he is required to state in his report under the companies Act, the auditor of banking company incorporated in India has also to state the following in his report to the shareholder:

Whetherornottheinformationandexplanationsrequiredbyhimhavebeenfoundtobesatisfactory;•Whether or not the transactions of the company which have come to his notice have been within the powers of •thecompany;Whetherornot thereturnsreceivedfrombranchofficesof thecompanyhavebeenfoundadequatefor the•purposesofhisaudit;Whether theprofit and loss account showsa truebalanceofprofitor loss for theperiod coveredby such•account;Any other matter which he considers should be brought to the notice of the shareholders of the company.•

Nationalised banksThe auditor of the nationalised bank, State bank of India or its subsidiary is required to report to the central government and has to state the full in his report:

Whether, in his opinion, the balance sheet is a full and fair balance sheet containing all the affairs of the bank, •and in the case he had called for any explanation or information, whether it has been given and whether it is satisfactory;Whether or not the transactions of the banks, which have come to notice, have been within the powers of the •banks;Whetherornotthereturnsreceivedfromtheofficesandbranchesofthebankhavebeenfoundadequatefor•thepurposeoftheaudit;Whethertheprofitorlossa/cshowsatruebalancesoftheprofitorlossfortheperiodcoveredbysuchaccount;•and Any other matter which he considers should be brought to the notice of the central government. •

Thereportoftheauditorofthenationalisedbankistobeverified,signed,andtransmittedtothecentralgovernment.The auditor has also to forward a copy of the audit report to the bank concerned and to the RBI.

Regional rural banksIn the case of regional rural banks, the auditor has to report directly to the bank. the content of the report are similar to those of an audit report in the case of a nationalised banks.

Apartfromtheauditreportonthefinancialstatements,theauditorofanationalisedbank,StatebankofIndia,anyof its subsidiary, or a banking company has also to prepare a longform audit report(LFAR).The auditor of the banks isalsocalledupontogivereportsandcertificatesoncertainotherspecifiedmatter.


108

6.12.5 Special AuditIn addition to the normal annual audit, a special of the banking company can be ordered by RBI under sec 30(1b) of the Banking Regulation Act. This power can be exercise by the RBI if it of the opinion that it is necessary to do so in public interest of the banks or in the of the bank or its depositors. The special audit is to cover the banks accounts,forthetransactionorclassoftransactionorforsuchperiodorperiodasmaybespecifiedbyRBI.Forconductingspecialaudit,RBImayeitherappointapersonwhoisqualifiedtoactasacompanyauditororthedirectthe statutory auditor of the bank to conduct a special audit. The section 223 of the Companies Act relates to the provisions of the special audit.

6.12.6 Approach to Banks' AuditsThe guidance note on the audit of banks issued by the ICAI, recognise that the general approach to audit of banks involves essentially the same stages as in any other audits. However at each stage, the auditor has to take into the accountthefollowingspecialcharacteristicsofbanks;

Custodyoflargevolumesofmonetaryitems,therebyrequiringformaloperatingprocedure,well-definedlimits•on the individual discretions and rigorous internal control.Large volume and variety of the transactions and continuing development of new products and services, many •of which may involve complex accounting. Widegeographicaldispersaloftheoperationswithconsequentdifficultiesinmaintaininguniformoperating•practices and accounting systems, particularly in the case of the overseas operations. Significantcommitmentswithouttransferfundsnotrequiringformalrecognitionsinthebooksofaccounts.•Special nature of risk with operations. •Astrictlegalandregulatoryframeworkthatinteralia,influencetheaccountingandauditing.•

6.13 Audit of Educational InstitutionsEducation has turned into a big business now. Apart from the Government controlled Schools, Colleges, Institutes and Universities, the entry of private sector into these areas have provided not only new opportunities to the Chartered Accountants who are in service, but have created an altogether new challenge to the Chartered Accountants who are in practice. Educational Institutions are very much different from the other business organisations and the process of audit of these Institutions is also very different.

ConstitutionStudy the Trust Deed or any other similar document to ascertain the constitution of the Educational •Institution.Make a note of the provisions contained in the regulations which may affect the accounts.•

Minutes book Peruse the minutes of the meeting of the Governing Body making a note of the Resolutions affecting •accounts.Ensure that the decisions taken have been duly complied with, for example, sanctioning of expenditure, operation •ofbankaccounts,rejectionofanyfinancialproposal,etc.

Fees from students Check the names entered in the Students Fee Register for each month on term, with the respective class registers, •showing names of students on rolls and testing amount of fees charged.See that the system of internal check ensures that demands against the students are properly raised.•Verify fees received by comparing counterfoils of receipts given with entries in the cast book.•Ascertain whether fees paid in advance have been duly considered under the sanction of an appropriate •authority.

109

Verifywhetherfines for late payment, absence, etc., have either been collected or remitted under proper•authority.VerifyadmissionfeeswithadmissionslipssignedbythePrincipaloftheInstitutionandconfirmingthatthe•amount has been credited to a capital fund or separate account if decided so by the Governing Body.Trace the totalcollections in theFeeRegister toconfirmthat therevenuefromthissourcehavebeenduly•accounted for.Ascertain whether hostel dues were recovered before students accounts were closed and their deposit of caution •money refunded.Report any old heavy arrears on account of fees, dormitory rent, etc., to the Governing Body or Management •Committee.

Other income Verify any Government or local body grant with the memo of grant. Ascertain the reasons if any expenses have •been disallowed for purpose of grant.Vouch the income from endowments and legacies, as well as interest and dividends from investment. Verify the •securities in respect of Investments held.Verify rental income from landed property with Rent receipt and Agreement.•

Expenditure Ascertain the operation of internal control system over various heads of expenditure.•Vouch various expenditure items, noting abnormal or heavy items, if any. Obtain suitable explanation for •significantitemsofexpenditure.

Taxation Verify whether the Institution enjoys tax exemption under Income-tax Act.•Examine whether the conditions subject to which exemption has been granted, have been followed.•In case of TDS from Rent, Interest, etc., see whether refund claim has been made.•

General Verifythefixedassetsandensuretheadequatedepreciationisprovided.•Verify the Capital Fund and other liabilities.•Note that the investments representing endowment funds for prizes are kept separate and any income in excess •of prizes has been accumulated and invested along with the corpus.Confirmthatcautionmoneyandotherdepositspaidbythestudentsonadmission,havebeenshownasliability•in the balance sheet and not transferred to revenue, unless they are not refundable.Ensure that separate statement of accounts have been prepared as regards Scholarships, Games Fund, Hostel •Fund, Library Fund and P.F., etc.VerifywhethertheformandmannerofpresentationoffinancialinformationconformstorelevantAccounting•Standard, if any and other applicable legal requirement.ObtainappropriaterepresentationandcertificatesfromtheCompetentpersonappointedbytheGoverningBody•or Management Committee in respect of various aspects covered during the course of audit.


110

6.14 Audit of Insurance CompaniesAn insurance audit is often conducted on behalf of insurance companies that issue worker’s compensation, general liability and risk insurance policies. If you are a business owner or independent contractor, you may be subject to an insurance audit to verify policy eligibility or to ensure you are paying the correct premiums for the type of policy you own. An insurance audit checklist is a number of potential items you should have handy during your audit.

Corporation paperworkInclude all documentation related to the formation and operation of your business, sole proprietorship, limited liability company or corporation as applicable. Documents may include the articles of incorporation, corporate bylaws,businessregistrationorbusinesslicense,partnershipagreementsorLLCfilingsandoperatingagreement.Provide a list of all partners, owners, directors and board members in addition to their contact information and the relevant ownership percentage held by all entities.

Business detailsPrepare a summary of the business operations such as the services that are provided by the business, what percentage of business operations could be considered foreign or domestic and the length of time business has been conducted. Create a list of all employees with their dates of employment, job titles and work responsibilities.

PayrollCreateapayrollsummarythatcorrespondstotheauditperiod.Youmaybeaskedtoadheretospecificrequirementsdepending on the insurance auditor’s preferences. Some auditors ask for copies of employee W-2 or contractor 1099 records, while others may prefer to see payroll ledgers or monthly or quarterly records generated by computerised accounting software.

Insurance certificatesIf your business worked with independent contractors during the audit period, include copies of their insurance certificatesinyourauditdocumentation.Acontractorconductingworkatyourplaceofbusinessoronbehalfofyourcompany may be included as a liability on your policy if he is found to be uninsured during an insurance audit.

Financial recordsInadditiontopayrollrecords,prepareacopyofyourcompany’sfinancialrecordssuchasthetotalsalesfiguresorinvoices for the audit period. Include tax records such as quarterly 941 forms or other relevant tax records. Provide a list of all company assets such as land, buildings, inventory and company vehicles. Notate the current market value of each asset in addition to any methods that are currently in place to protect those assets such as a building alarm system,securitycameras,fireprotectionandmonitoringsystemsorsecurityguardpatrol.

111

SummaryAuditplaysapivotal role inkeepingproper legalcheckon thosewhocarryon thebusiness inafiduciary•capacity.For company accounts to be credible they must be true and fair and this is more likely to happen if someone •competent and independent of the company has vetted the accounts.The statutory auditors are often described as the watchdogs of the company. They have access to the book of •accounts, vouchers and documents, which no member of the company has.When the auditor reports to the shareholders expressing satisfaction, his opinion serves as an assurance that •everything relating to accounts is in order in the company.A company may be registered any time during the year and, therefore, its date of registration may differ from •the date of commencement of its normal accounting year.A statutory auditor is not appointed on a permanent basis. It is normally an annual assignment.•ThefirstauditorsofacompanyappointedbyitsBoardofDirectorscanberemovedatageneralmeetingbyan•ordinary resolution of which a special notice is given.The normal expectation from the auditor, therefore, is to express an independent judgement on the results and •financialpositionofthecompany,freefromanypressurewhichthemanagementorownersofthatcompanymight seek to exert.TheAuditreportcontainsthefindingsidentifiedbytheAuditorinthedatacheckedbyhimandhegiveshis•opinion on the quality of the data.The audit of the banks should be well-acquainted with the relevant provision of the special enactment that govern •differenttypesofbanks,particularlythosewhichaffectthevariousitemsofthefinancialimplicationsofthebusiness carried on by banks and the types of the transaction that arise in the day-to-day operations.Educational Institutions are very much different from the other business organisations and the process of audit •of these Institutions is also very different.An insurance audit is often conducted on behalf of insurance companies that issue worker’s compensation, •general liability and risk insurance policies.

ReferencesHenderson, J. K., • WhatArethe4TypesofAuditReports? [Online] Available at: <http://smallbusiness.chron.com/4-types-audit-reports-3794.html>. [Accessed 11 December 2011].Scribd.com. • Audit of Banks [Online] Available at: <http://www.scribd.com/doc/19034757/Audit-of-Bank1>. [Accessed 11 December 2011].Ricchiute, D. N., 2006. • Auditing, 8th ed., Thomson/South-Western.Kumar, R. and Sharma, V., 2005. • Auditing: principles and practice, PHI Learning Pvt. Ltd.Kaplan Channel UK, 2011. • Types of audit reports [Video Online] Available at: <http://www.youtube.com/watch?v=Ffov8F2mNsI&feature=related>. [Accessed 13 December 2011].pitstop4performers, 2009. • Company auditor appointment should be made by the ICAI or the Government [Video Online] Available at: <http://www.youtube.com/watch?v=zBMTyT0_-9c>. [Accessed 13 December 2011].

Recommended ReadingBasu. • Auditing: Principles and Techniques, Pearson Education India.Gray,I and Manson, S., 1989. The audit process: principles, practice and cases, Routledge.•Millichamp, A. H., 2002. • Auditing, 8th ed., Cengage Learning EMEA.


112

Self Assessment____________, mandatory for all companies, is one of the regulatory mechanism designed to check abuses and 1. irregularitiesinthefinancialaspectsofthecompanies.

Internal auditinga. External auditingb. Statutory auditingc. Financial auditingd.

Section_________oftheCompaniesAct,1956describesthequalificationofacompanyauditor.2. 226 (1) and (2) a. 226 (1)b. 226 (2)c. 226 (3)d.

Section____________oftheCompaniesAct,1956describesthedisqualificationofacompanyauditor.3. 226 (1) and (2) a. 226 (1)b. 226 (2)c. 226 (3)d.

The auditor to be appointed for this initial and partial period of the company is known as the __________.4. firstauditora. second auditorb. third auditorc. forth auditord.

Who is not appointed on a permanent basis and normally works on an annual assignment?5. Internal auditora. Statutory auditorb. First auditorc. External auditord.

The duties of a company auditor can be divided into ______categories.6. twoa. threeb. fourc. fived.

Which of the following dividend is recommended by the board?7. Final dividenda. Proposed dividendb. Interim dividendc. Stock dividendd.

113

Proposed dividend, when consented to by the shareholders at the annual general meeting becomes 8. ____________.

finaldividenda. proposed dividendb. Interim dividendc. stock dividendd.

Which of the following dividend is declared in between two AGM?9. Final dividenda. Proposed dividendb. Interim dividendc. Special dividendd.


Unqualifiedopinion1. an auditor is unable to complete an accurate audit reportA.

Qualifiedopinion2. theworsttypeoffinancialreportthatcanbeissuedtoaB. business

Adverse opinion3. include an additional paragraph that highlights the reason C. whytheauditreportisnotunqualified

Disclaimer of opinion4. Often called a clean opinionD.



114

Chapter VII

Audit of Non-profit Companies and Fraud Detection

Aim


introducenon-profitorganisations•

highlightauditingofnon-profitcompanies•

describethelegalframeworkofauditingofnon-profitorganisation•

Objectives


elucidatenon-profitauditcommitteecharter•

explain the concept of fraud•

explicate the characteristics of fraud and error•

Learning outcome


enlist the types of fraud•

comprehendtheauditor’sresponsibilitiesinfindingfraud•

discusssomecriticalissuesrelatedtoauditingofnon-profitorganisation•

115

7.1 Audit of Non-profit OrganisationsAllovertheworld,Not-for-ProfitOrganisations(NPOs)playanimportantroleinthesocio-economicprocessofthe countries in which they operate. This is true not only in developing countries, but also in developed countries.

NPOs in the South Asian Region are no exception. These organisations are important players in both the social and political spheres.

In recent years there has been a substantial expansion of NPO presence in the Region. A considerable sum of funds, received from both national and international sources is handled by these NPOs. This situation has been further enhancedbytheTsunamiof26thDecember2004etc,whichresultedinanunprecedentedinflowoffinancialandother resources in to the Region with many more such organisations.

Legal framework The magnitude of the funds channelled through these organisations creates considerable responsibility in terms of follow up, monitoring and accountability. Transparency thus becomes an important issue. It is claimed that the statutory and regulatory environment is vague in the countries in this Region. Clear guidelines need to be provided to these organisations on how to conduct their affairs, including accounting and reporting. It is also acknowledged however, that extensive regulation is not necessarily fruitful, and that “too much” regulation might turn out to be equally as bad as “too little”, considering the important role that these organisations play within society at large.

7.2 Accounting and Auditing in not-for-profit Organisations — some Critical IssuesManyoftheaccountingstandardshavebeenmadeapplicabletoNot-for-ProfitOrganisations.ResearchCommitteeof the Institute of Chartered Accountants of India (ICAI) has recently brought out a research publication ‘Technical guideonAccountingandAuditinginNot-for-ProfitOrganisations’elaboratelyexplainingapplicabilityofvariousaccounting standards and other matters concerning accounting and auditing in such organisations. Though belated, it is indeed very praiseworthy on the part of the ICAI through its Research Committee to bring out this publication forthebenefit/guidanceofthemembers.TherearenotmanyauthoritativeguidelinesintheareaofaccountingforNPOsupuntilnowexceptforpiecemealeffortscoveringlimited/localproblems.Ascanbeexpectedinthefirstmajoreffortinthisdirection,thediscussionsinthetechnicalguide,however,appeartobeinsufficient/incompletein many areas and incorrect in some cases. Following are some of the important observations, calling for immediate review and improvement in the publication:

Registration under various central/state-level legislations:Manyoftheprovisionsofthecentralandstate-levellawsoverlapintheirapplicationtonot-for-profitorganisationsand registration of a charitable organisation under a particular enactment, central or state, does not necessarily make the organisation escape from other enactments. In States like Maharashtra and Gujarat, even if an organisation is registered under any enactment, say, S. 25 of the Companies Act, 1956, the provisions of the Bombay Public Trusts Act, 1950 are attracted if the organisation carries on public charitable or religious activities. [S. 2(13) of the Bombay Public Trusts Act, 1950].

NomentionisseenofacompanyincorporatedundertheCompaniesAct,1956inthedefinitionof‘publictrust’u/s.2(13) of the Bombay Public Trusts Act, 1950. In the case of Akhil Deshastha Rigvedi Brahmin Madhyawarti Mandal v. Joint Charity Commissioner, Bombay, (1971) 74 Bom. L.R. 337, 340 : A. 1972 313, 315, 316.), the Mandal was a company limited by guarantee incorporated under the Indian Companies Act, 1913, (and now under the Companies Act, 1956) under a licence from the Central Government u/s.26 of that Act, (corresponding to S. 25 of the Companies Act, 1956) and it was held that the Mandal, though incorporated as company, is also a trustee foritspropertyandbeneficiarywasthecommunity.Therefore,theMandalconstituteda‘publictrust’andrequiresregistration under the Bombay Public Trusts Act, 1950. Such overlapping applicability is to be kept in mind in formulationofaccountingandauditingnorms.Thisimportantissuedoesnotfinditsdiscussionormentioninthetechnical guide.


116

Applicability of accounting standards:There is a strong undercurrent of commercial considerations in all the accounting standards made applicable to different businesses or other entities. Detailed examination of each accounting standard from the point of view ofitsapplicabilitybytakingintoaccountthebasiccharitable/religiousnatureoftheobjectsoftheNot-for-ProfitOrganisations is necessarybeforemaking applicationof the accounting standardsmandatory toNot-for-ProfitOrganisations (NPOs). Application of accounting standards as they are, if at all they are to be applied, without appropriatemodifications/changestosuitNPOs,leadstomanydifficultiesofinterpretationanddefeatsthebasicobjective, as is illustrated in discussions below :

Accounting Standard 3 regarding cash flow statements:Themostimportantandprimesourceofcashflowincaseofanenterpriseisitsoperatingactivities.Thebasicobjectiveofthecashflowstatementis‘toassesstheabilityoftheenterprisetogeneratecashandcashequivalentsandtheneedsoftheenterprisetoutilisethosecashflows’.TheoperatingactivitiesoftheNot-for-ProfitOrganisations(NPO)do not, in most cases, generate cash nor are they meant to generate cash, as in case of any commercial enterprise. In casesofNPOinfact,thewholeprocessofcashflowmovesinthereversedirection.Cash/cashequivalentsflowinfirstandthereaftertheoperatingactivitiesaredecided,dependingupontheavailabilityofthefundswiththeNPO.The applicability of the accounting standard to NPO, therefore, loses its meaning and purpose. The recommendation in the technical guide to apply the standard needs a review.

AS 5 regarding net profit or loss for the period, prior period items and changes in accounting policies :Themainobjectiveofthefirstpartoftheaccountingstandardismeanttohelpdeterminationofcorrect‘netprofitorloss’ofanenterprisefortheperiodwhich‘enhancesthecomparabilityofthefinancialstatementsofanenterpriseovertimeandwiththefinancialstatementsofotherenterprises’.AnNPOdoesnotearnprofitsnorincurslosses.NPO utilises funds for its objects, whether on account of current year or prior period, which might result in surplus ordeficitfortheyear.Errorsandomissionsofearlieryear/smayhaveadirectbearingontheprofitsorlossesofacommercial enterprise for a particular year, but its impact on determination of utilisation of funds by an NPO during aparticularyearandconsequentlyonsurplusordeficitfortheyearisnotrelevant.Intheprocessofexecutionofprojects/activities by NPOs, the period covered may at times be more than a year and in some cases it may extend to several years. Accounting in such cases would be project-wise and not necessarily period-wise. The results, therefore, are to be viewed in a different perspective. NPOs generally operate in an independent environment of theirownandcomparingoftheirfinancialstatementsalsoisabsurd.Applicabilityofaccountingstandardlosesitsbasic objective and becomes irrelevant.

AS 10 regarding accounting for Fixed Assets :Assets held by NPOs are of many categories with different characteristics as to ownership tittles. Some such categories of assets are explained below:

Government land provided free of cost to NPO with or without conditions as to their use.•Non-monetary assets such as land, building and other assets acquired free of cost, or acquired at a concessional •rate with or without conditions, as to their use.Assets purchased out of own funds of NPO.•Assetspurchasedoutofrestrictedfundsforuseduringexecutionofspecificcharitableprojectsaspersponsor’s•directions, exclusively used for such purposes during the duration of the said project execution. Such assets, after the completion of the project could be attached with conditionality as to their ownership or could become absolute own assets of the NPO. It is also possible that such assets are of no use or of limited use to the NPO for its own purposes, after completion of the project though the asset per se is valuable and usable. Assets such as furniture, computer, vehicles, etc. are valuable and usable to the NPO even after the completion of the projects, ifnoconditionastoreturnoftheassettothesponsorisspecifiedinthesponsorshipagreement.The legal ownership of the assets, continues to remain with the sponsors in a long-duration agreement with the •NPO,butthebeneficialpossessionandusageremainswiththeNPO.Assets acquired, partly funded by donors and partly out of own funds.•

The technical guide does not cover various categories of assets discussed as above.

117

Technical guide prescribes two methods covering assets acquired free of cost and assets acquired at concessional rate/assets purchased. Reference is made in the technical guide to AS 12 regarding Accounting for Government Grants to specify that assets acquired as non-monetary grants free of cost should be accounted for at a nominal value (for example, Rupee one) with additions for incidental costs of acquisition, if any. As regards other assets, itisspecifiedthattheexpenditureincurredonacquisitionoftheassetsalongwithincidentalexpenses,ifany,istobe accounted for.

ApplicationofAS12toNPO,originallyintroducedforapplicationtoprofit-makingcommercialorganisations,willlead to many contradictions as highlighted below:

NPOs operate under totally different environment and their accounting requirements and norms will have to •suit that environment.ThemainsourcesoffundsforNPOsgenerallyaregrantsanddonationsandnotprofitsfromoperations,with•governmentgrantsmakingexception.Governmentgrants anddonationsare the ruleandearningprofits isexception for NPOs.Various endowment laws govern such grants and other receipts apart from the Companies Act, 1956 and •compliance of such laws with regard to accounting procedures and norms is unavoidable to NPOs.

AS12ismeantforcommercial,profit-earningenterprises,andtherefore,cannotbemadeapplicabletoNPOwithoutmodification.DonationscouldbeincashorinkindanditshouldmakenodifferencetoanNPOifitisoneortheother as far as accounting goes. Cost of donated asset to an NPO is the cost of such asset in the market, except that such asset is funded by a grant or donation and it is imperative to NPO to account for such grant as a grant in kind and the related asset as an asset. If a cash donation of, say, Rs.10 lakhs is given to an NPO for purchase of a building, the donation will be accounted for as donation and building purchased out of the said donation will be accounted for as building. If instead of cash donation, the donor buys a Rs.10 lakhs worth building and gives it free of cost to NPO, it will be accounted for at nominal value, say Re.1, if recommendation of technical guide is to be followed. This apparently is not what is intended.

Further, provisions of Bombay Public Trusts Act, 1950 read with Bombay Public Trusts Rules, 1951 also leave no option to an NPO in Maharashtra and Gujarat, but to account for both donations in cash or in kind at their correct/current value. The provisions of the Act as applicable to Maharashtra/Gujarat, prescribe disclosure of donations in kind,intheaccounts.TheformsofaccountsvideRule17(1)specificallyprovideforseparatedisclosureofsuchdonations. Contributions payable to the Charity Commissioner, as provided in the BPT, Act, 1950 u/s.58 and Rule 32 of the BPT Rules, 1951 do not exempt donations in kind and consequently, valuation of such assets at Re.1/- may be seen as under valuation for the purpose of avoiding BPT levy. There are, however, exemptions in case of Govt. grants and grants from other NPOs that can be availed to avoid the impact of BPT levy.

As regards assets described in items (iv), (v) and (vi) above, no clear-cut guidelines are prescribed in the technical guide. To value and account for such assets in the manner explained in accounting standard 10 will cause a lot of inaccuraciesandcontradictionsindisclosureoftheNPO’sfinalaccounts.

Incaseofproject-specificassetspurchasedoutofgrantsgivenforexecutionofaspecificprojectasstatedin(iv)above, the value of the asset will be an expenditure for the project during the duration of the project and thereafter, itmaybecomeNPO’sassetoracommunityassettobehandedovertothebeneficiariesofgrantforfutureuseoritmay revert back to the sponsor of the project, as per the condition of the grant. In case the asset becomes community assetforfutureuseofbeneficiariesorrevertsbacktothesponsor,thequestionofaccountingitinNPO’sbooksdoes not arise after the expenses are charged off as project expenses. In case the asset becomes part of NPO’s assets on completion of project, it is necessary to ascertain whether the said asset is useful to the NPO in its day-to-day operations and if so, what is its current value to be considered for accounting in the books. If the asset is not useful to the NPO, but the same is valuable, it may be recorded in the books at Re.1 and if on the other hand the asset is useful to the NPO, the same could be recorded on a technical evaluation and brought to books as addition of that year. Impliedly, this also could be considered as a non-monetary grant received free of cost in the year of completion of the project as per recommendation in AS 10, but due to reasons explained earlier, valuation at its current value would be more correct and proper.


118

Accounting Standard 6 regarding Depreciation Accounting:ThesignificanceofchargingdepreciationincaseofanNPOwilldifferfromNPOtoNPO,dependinguponthenatureof objects for which they are established. If activities are research oriented, wherein use of expensive equipment/tools is involved, the charging of depreciation thereon to ascertain correct utilisation of fund for research becomes unavoidable. Whereas, if an NPO exists for religious purposes or for famine and medical relief or for other services inwhichacquisitionandutilisationofassetsmaynotbeofsignificanceandactivitiesmaybeserviceorientedandmaynotinvolveuseofassets,insuchcases,one-timepurchaseofbuildingandrelatedfurnitureforofficeuseandpurchase of vehicles for day-to-day travel in pursuance of organisation’s objects do not call for mandatory charging of depreciation.

It may be noted that charging of depreciation is not made mandatory by various State laws, such as Bombay Public Trusts Act, 1950 or Societies Registration Act, 1860 and the rules prescribed therein as are applicable in several States and charging of depreciation in such cases is only optional. When the accounts are prepared as prescribed under those statutes, non-compliance of the mandatory accounting standard 6 regarding depreciation will have a place only in the auditor’s report, as was the case when accounting standards prescribed by the ICAI were not mandatory under the Companies Act, 1956 prior to its recent amendment. In fact, the prescribed audit report format under the Bombay Public Trusts Act, 1950 does not even have a place for disclosure of such non-compliance, unless onemakesmodificationstoprescribedformatatone’sownlibertyorinsertsitunder‘specialmatterstobebroughtto the notice of the charity commissioner’.

UndertheprovisionsofIncome-taxAct,1961also,thesignificantaspectoftheimportancegivento‘utilisationoffunds’ cannot be overlooked. Utilisation of funds in case of NPOs also includes cost of acquisition of assets, and depreciation is not separately considered.

Itisverysignificanttonotethatassetsplayamajorroleintheoperationsofacommercialorganisation,suchasplant and machinery in case of a manufacturing concern, and therefore, charging of depreciation to make up for costofuseofassets,isabsolutelyessentialindeterminingtheprofit,whereasinmostNPOsassetsplaynoroleorveryinsignificantroleinday-to-dayoperations.

Even if Accounting Standard 6 for charging of depreciation is to be made mandatory to NPOs, it is improper to overlook the salient features of the statutes under which the NPOs operate, the environment under which they work, different characteristics associated with each asset as a result of its unique mode of acquisition, etc. as discussed in detail above.

Accounting Standard 12, accounting for government grants:ThetechnicalguidespecifiesthatNPOsshouldfollowtherequirementsofAS12intheirentiretyforbothGovt.grants and grants from other donor agencies. The problem in applying AS 12 to NPOs, however, stems from the fact that the standard, which was originally prepared for application to a commercial organisation, is made applicable in toNPO.Variousaspectsofthegrants,theirspecial/distinctfeatures,alternativetreatmentspecifiedinotherapplicablelaws would all have to be ignored at NPO’s own risk, if the provisions of AS 12 are to be applied in toot. Treatment suggested in AS 12, may be summarised as under:

Grantgivenforacquisitionofspecificfixedassetshouldbeshowninthebalancesheetasadeductionfromthe•grossvalueoftherelevantfixedasset.Alternatively,thefixedassetshouldbedisclosedatitsgrossvalueandtherelatedgrant,ifreceivedfornon-•depreciable asset, should be credited to capital reserve.If the grant relates to a depreciable asset, it should be treated as deferred income, which should be recognised •inthe‘profitandlossaccount’byallocatingitovertheperiodsandinproportionsinwhichdepreciationontheasset concerned is charged.Govt. grants having the characteristics of promoters’ contribution should be credited to capital reserve.•Govt. grants in the form of non-monetary assets given at a concessional rate to be accounted for on the basis •of their acquisition cost.

119

Govt. grants in the form of non-monetary assets given free of cost should be recorded at a nominal value (for •example, Rupee 1).Govt. grants received with reference to ‘revenue’ of the enterprise to be recognised on a systematic basis in •the‘profitandlossaccount’overtheperiodsnecessarytomatchthemwiththerelatedcosts,whichtheyareintended to compensate.

Commercial considerations far outweigh other objectives in the norms prescribed as above to enable determination of correctprofitsofanenterprise.Itisthe‘revenue’and‘profits’,whichareofparamountimportancetoacommercialenterprise, which call for the treatments prescribed in the AS 12. The technical guide suggests the following treatment basedontreatmentspecifiedinAS12forGovernmentgrantsincaseofNPOs:

TheNPOshould recognisegrant/donation in itsfinancial statementsonlyat the stage it attains reasonable•assurance that the grant/donation will be received.Non-monetarygrants,whetherasfixedorcurrentasset,receivedfreeofcostorataconcessionalrateshould•be recognised at nominal value or actual cost to the NPO.Grants to meet revenue expenses should be accounted for to the extent utilised during the period and the relevant •expense should be disclosed separately in the Income and Expenditure Account. This, in other words, means thatthefundsremainingunutilisedbytheNPOoutofexpense,specificgrantandheldbyitattheyear-endshallbe disclosed as liability to the donor pending its utilisation by NPO.

While one may not have any difference of opinion regarding the applicability of suggestions as given in 1 and 3 above,themethodspecifiedin2aboverequirescompletereview.NPOssurvivemainlyongrantsanddonations,and all grants and donations, whether monetary or non-monetary, are required to be accounted for at their original value. Stress is on ‘receipt/income’ and not on ‘revenue’.

No accounting standard has been prescribed by ICAI or other authorities, for accounting of receipts for sponsored projects by NPO. Prescribing a standard, in fact, is not possible because in many cases, sponsorships have their owntermsandconditionsandunique/specialfeaturesapplicabletospecificprojects.Examplesare:onlypartialsponsorshipforacquisitionoftheasset(partshortfallofcostismetbyNPO);ownershipoftheassettoremainwithsponsor even after the completion of the project, return of the assets of the project to the sponsor after the completion of the project etc. Under such circumstances, the best-suited method is to be evolved taking into account the needs of the situation. Depending on the size and nature of operations, it may be different from NPO to NPO.

Funds provided by the sponsor for project assets acquired, are not covered by the type of grants (Government grants) explained in AS 12. These are the assets purchased primarily for use in the projects for which they are purchased. Grantsareproject-specificgrantsgivenunderasponsorshipagreementandnotasset-specificgrantsasenvisagedinthe AS 12. Grant is not received as grant for the NPO for its use. Until the project is completed as per the terms and conditions of the agreement, the asset is that of the project and cannot be treated as belonging to the NPO. Cost of the asset is treated as part of the project expenditure. It is only when the project is completed and the asset remains with the NPO without any pre-conditions in sponsorship agreement as to ownership of the NPO that the asset enters the books of the NPO. At that point in time, the said asset becomes a kind of ‘donation in kind’ and the same will have to be accounted for accordingly. Valuation of such an asset will have to be on an estimated basis, based on its condition and future use to the NPO.

Assetslikevehicles,landandbuildings,officeequipments,etc.,getgrosslyundervaluedinthebooksiftheyarevalued at Re.1/- and not at their correct value. The true and fair view of the balance sheet gets affected. An NPO may be holding substantial properties mostly donated or granted and if those are to be valued at Re 1 each as suggested, it will not only be contrary to the provisions of various local endowment laws, but also that the values at which they are disclosed will not be true and correct. The donations and grants, including those received in kind as well as at concessional rate, will have to be accounted for as such in the year of receipt in case of an NPO and the concerned asset will have to be recorded in the books of NPO at its correct and real value.


120

AS 17 segment reporting:This is another accounting standard, which does not by intent appear to be applicable to an NPO. At the most, this can only be applied to an NPO running a business. This cannot even be applied if business activity is only incidental in pursuing the main object of the NPO, which is charitable and not linked to such income. An NPO does not have a ‘business segment’ nor does it subject itself to ‘risks and returns’ that are linked to ‘products and services’.

The Institute of Chartered Accountants of India made segment reporting mandatory with effect from 1-4-2001 for disclosureinthefinalaccountsincaseofenterpriseswhoseequityordebtsecuritiesarelistedandenterprisesthatare in the process of issuing equity or debt securities that will be listed on a recognised stock exchange of India and to all other commercial, industrial and business reporting enterprises whose turnover for the accounting period exceeds Rs.50 crores.

It is obvious that an NPO does not fall in any of the categories mentioned above and, therefore, there is no statutory/ICAI compulsion for such disclosure in Final Accounts. Even otherwise, segmentising NPO activities either geographically or business- wise (activity-wise) as required under Accounting Standard 17 for Segment Reporting appears out of context.

Accounting standard 18, related party disclosures:Applicability of this accounting standard in an NPO environment is again an invalid proposition. NPO doesn’t operateforprofitsnordoesitoperateinabusinessenvironment,whereinrelationshipscouldleadtofinancialtiestothemutualbenefitofthepartiestobusiness.InthecaseofanNPO,arelatedpartytransactionwillnothaveanybearing on the working of the NPO. The technical guide states “. . . for the purposes of AS 18, trustees of an NPO would be considered as key management personnel and, accordingly, trustees and their relatives would, inter alia, betreatedasrelatedparties”.WhenthebasicprofitmotiveismissingintheworkingofanNPOandtheentireoperationiswithacharitymotive,therelatedpartytransactionsbetweenrelatedpartiesoftrustees/officebearersofNPOandtheNPOwillnothaveanyfinancialimplicationstotheNPO.Thedisclosures,ifmadeassuggested,will be just bland disclosures without any meaning or purpose. The trustee/manager of an NPO operates on trust forthebenefitofpublicatlarge.Hedoesnothave,norissupposedtohave,anypersonalinterestintrustpropertiesoritsfinancialtransactions.Heisnottheownerofthetrustproperty,butonlyatrusteeworkingundertheoverallsupervision/control of prescribed authority, say, Charity Commissioner/Registrar of Societies.

Without going into details and merits, perhaps one can say that ‘related party transactions’ as understood in commercial parlance is missing in NPO transaction and, therefore, need not apply in its existing form.

It may further be mentioned that as in case of AS 17 above, the applicability of the Accounting Standard 18 is restricted to enterprises whose equity or debt securities are listed and enterprises that are in the process of issuing equity or debt securities that will be listed on a recognised stock exchange of India and to all other commercial, industrial and business reporting enterprises whose turnover for the accounting period exceeds Rs.50 crores.

It is again apparent that an NPO does not fall in any of the categories mentioned above and, therefore, there is no statutory/ICAI compulsion for such disclosure in Final Accounts.

Accounting Standard 21, consolidated financial statements:While discussing the applicability of AS 21 to NGOs, the technical guide states that if an NPO controls another enterprise (organisation), either through ownership of more than one-half voting power or through control over governing body, the NPO would be considered as parent and the enterprise that is controlled by the NPO would be a subsidiary.ThetechnicalguidegoesontoprescribethattheNPOshouldprepareandpresentconsolidatedfinancialstatements in accordance with the requirements of AS 21.

121

It is apparent that the following important aspects of NPO environment are to be kept in mind before the accounting standardisspecifiedforapplicationbyNPOs:

AS21specifiesthatanenterprisethatpresentsconsolidatedfinancialstatementsshouldprepareandpresent•these statements in accordance with this standard. In case of different and independent NPOs, however, there isnoneedforpreparationofconsolidatedfinancialstatementseitherforstatutorypurposesorotherwise,evenif managing committee consists of common trustees/members. What is important to note is that AS 21 will be applicable if for any reason the Parent NPO, which controls other NPOs, voluntarily prepares consolidated financialstatement.AS21defines‘Control’betweentwoenterprisesas“(b)controlofthecompositionoftheboardofdirectors•in the case of a company or of the composition of the corresponding governing body in the case of any other enterprisesoastoobtaineconomicbenefitsfromitsactivities.”ItisveryapparentthatNPOsdonotoperatefortheirowneconomicbenefitsoreconomicbenefitsofotherNPOs.Thereis,therefore,noquestionofoneNPOderivingeconomicbenefitfromotherNPO(parentorotherwise)evenifgoverningbodyconsistsofcommontrustees/members making two institutions ‘related’ technically. The basic objective of the standard is defeated and as a result, the application of the standard to an NPO appears redundant/ absurd.

Accounting Standard 22 — Accounting for taxes on income :NPOs by nature of their activities and the objectives for which they exist are tax exempt, of course, subject to complianceofcertainconditionsspecifiedintheIncome-taxAct,1961.Butinnocaseonewouldexpectthemtopaytaxesoutofreceiptsfromdonationsandgrantsforcharitablepurposes.Theentirespecificationinthetechnicalguide that ‘The requirements of this standard should be followed by NPOs in their entirety. Normally, some kind of exemptions is allowed to the NPOs from payment of income tax due to the nature of their charitable objects andnon-profitmotives.SuchexemptionsallowedtotheNPOsunderIncome-taxAct,1961,couldbeconsideredas permanent differences for the purpose of AS 22.’ appear to be totally out of context. To say that some kinds of exemptions are available makes one feel that there is ignorance of the NPO set-up. By nature of their activities NPOs do not have ‘income’. It is by virtue of deeming provision under Income-tax Act, 1961 to encourage expenses on objects of NPOs, one is made to pay tax, provided expenses fall short of prescribed limits. The entire Para should be dropped and the standard should be made inapplicable.

Accounting Standard 23 — Accounting for investments in associates in consolidated financial statements :ItiswellknownthatNPOsarenotallowedto‘invest’inanyothermodesthanthosespecifiedinlocallaws,suchas Trust Acts or Societies Acts as well as Income-tax Act, 1961. The entire tax exemption will be lost if the tax provisions in this regard are contravened. The penal consequences from local authorities governing such institutions, such as Charity Commissioners or Registrar of Societies could also follow. The NPOs, therefore, can-not make investments in associates as envisaged in AS 23. The question of NPO accounting for investments in associates intheconsolidatedfinancialstatements,therefore,doesnotarise.ThestandardisnotapplicabletoNPOsandthetechnicalguideneedstobeappropriatelymodified.

AS 24 — Discontinuing operations :For the purpose of this Standard, each major programme/project carried on by the NPO may be considered as a separate major line of business.’ Considering activities/projects carried on by NPOs as ‘line of business’ is not comprehensible.Disclosureofthediscontinuingoperationsinabusinessenvironmentissignificant.IncaseofNPOs,there being no business activity pursued, application of AS 24 appears out of place. NPOs normally undertake two types of charitable activities/projects, viz., on their own and on behalf of others on a reimbursement/sponsorship basis. Even assuming application of AS 24, if own activities/projects are discontinued, identifying whether such activities aremajorfromthepointofviewofapplicationofAS24isgoingtocreatedifficultyintheabsenceofdefinitionof‘major programme’ in the technical guide. As regards activities carried on on behalf of others, the following practical aspects of project execution need to be kept in mind before AS 24 is made applicable to NPOs:


122

In the case of reasonably large NPOs, many projects, big and small, are taken up, executed and closed frequently •on a regular basis in a time-bound manner. Starting and closure of projects, both big and small, are far too manyandfrequentintheroutinecourseofworkingofanNPOtowarrantdisclosureasspecifiedinAS24.Accounting Standard 24 is not meant for application for such sponsored charitable projects. One may have to apply the standard to those activities the discontinuance of which may have a direct bearing on the working of the NPO as a ‘Going concern’.Thedefinitionof ‘majorprogramme’ isalsonecessarywithoutwhichapplicationofAS24wouldbevery•difficult.

AS 27 — Financial reporting of interests in joint ventures :The technical guide prescribes that ‘NPOs should report their interests in such joint ventures in separate as well as in theconsolidatedfinancialstatements(preparedasperAS21)inaccordancewiththerequirementsofthisstandard.’ThejointventureisdefinedinAS27as‘acontractualarrangement,where-bytwoormorepartiesundertakeaneconomic activity which is subject to joint control’. Provisions of various endowment laws under which the NPOs operate as well as provisions of Income-tax Act, 1961 under which the NPOs seek exemptions from tax, prevent NPOsfromundertakinganyeconomicactivitywherebytheNPOsderiveprofits.Investmentsinjointventuresforeconomicactivity/benefitswouldbecontrarytosuchexemptionprovisions.JointventureincaseofanNPOcouldonly be under the following circumstances:

Joint venture with another NPO to execute a common charitable activity, in which case the ‘interest’ as envisaged •in AS 27 is absent in the joint venture between two NPOs.A joint venture business which is incidental to the attainment of the objectives of the NPO as a charitable •institution allowed under Income-tax Act, 1961 and other endowment laws, provided separate books of account of such business are maintained and the income from such incidental business is used for the charitable objects of the NPO. AS 27 may be considered as applicable, though, even in such cases, treating joint venture as business activity as envisaged in AS 27 when the activity is only incidental to the charitable objects of the NPO, is not beyond doubt.

7.3 Non-profit Audit Committee CharterTheauditcommittee(“thecommittee”)oftheboardofdirectors(“theboard”)ofthenon-profitorganisation(“theorganisation”)willhavetheoversightresponsibility,authority,andspecificdutiesasdescribedbelow.

CompositionThe committee will comprise three or more directors, as determined by the board.

ResponsibilityThecommitteeispartoftheboard.Itsprimaryfunctionistoassisttheboardinfulfillingitsoversightresponsibilitieswith respect to (1) the audit of the organisation’s books and records and (2) the system of internal controls that the organisation has established. The committee should have a clear understanding with the outside auditors that they must maintain an open and transparent relationship with the committee, and that the ultimate accountability of the outside auditors is to the board and committee. The committee will make regular progress reports to the board.

AuthoritySubject to the prior approval of the board, the committee is granted the authority to investigate any matter or activity involvingfinancialaccountingandfinancialreporting,aswellastheorganisation’sinternalcontrols.Inthatregard,the committee will have access to the organisation’s external professionals to render advice and counsel in such matters.

MeetingsThe committee is to meet at least four times annually and as many additional times as the committee deems necessary. The committee chair should clear the content of the agenda for each meeting. The committee is to meet in separate executive sessions with the outside auditors at least once annually and at other times when considered appropriate.

123

AttendanceCommittee members will strive to be present at all meetings.

Specific dutiesIn carrying out its oversight responsibilities, the committee will

Review and reassess the adequacy of this charter annually and propose changes to the board for approval.•Reviewwiththeexecutivedirectorandoutsideauditorstheorganisation’saccountingandfinancialreporting•controls. Obtain annually in writing from outside auditors a letter regarding the adequacy of such controls.Reviewwiththeexecutivedirectorandoutsideauditorssignificantaccountingandreportingprinciples,practices,•andproceduresappliedbytheorganisationinpreparingitsfinancialstatements.Discusswiththeoutsideauditorstheir judgments about the quality--not just the acceptability--of the organisation’s accounting principles used infinancialreporting.Review the scope and general extent of the outside auditors’ annual audit. The committee’s review should include •an explanation from the outside auditors of the factors considered by the accountants in determining the audit scope,includingthemajorriskfactors.Theoutsideauditorsshouldconfirmtothecommitteethatnolimitationshave been placed on the scope or nature of their audit procedures. The committee will review annually with the executive director the fee arrangement with the outside auditors.Inquire as to the independence of the outside auditors and obtain from the outside auditors, at least annually, a •formal written statement delineating all relationships between the outside auditors and the organisation, including other consulting work being performed by the outside auditors for the organisation.

At the completion of the annual audit, review with the executive director and the outside auditors the following:Resultsof theauditof thefinancialstatementsandtherelatedreport thereinand, ifapplicable,areporton•changes during the year in accounting principles and their application.Significantchangestotheauditplan,ifany,andseriousdisputesordifficultiestheexecutivedirectorencountered•during the audit. Inquire about the cooperation received by the outside auditors during their audit, including access to all requested records, data, and information. Ask the outside auditors about any disagreements with the executive director that, if left unresolved, could have caused them to issue a nonstandard report on the organisation’sfinancialstatements.Other communications as required to be conveyed by the outside auditors by Statement of Auditing Standards 61, •as amended by SAS 90, relating to the conduct of the audit. Further, receive a written communication provided by the outside auditors concerning their judgment about the quality of the organisation’s accounting principles asoutlinedinSAS61andamendedbySAS90,andconfirmthattheyconcurwiththeexecutivedirector’srepresentation regarding audit adjustments.

7.4 FraudIn simple terms fraud is a mistake with a reason. To explain more Fraud is an activity by a person who does his duty inawrongwayorrefrainsfromdoinghisdutyforsomefavours,i.e.,financial,tangible,oranythingelsewhichis not due to him or them in the normal course. In simple words fraud is an intentional abnormal activity for undue gains. Or Fraud as the name suggests refers to the intentional misrepresentation by employees or other persons related to business, it can be both for monetary or non monetary gains.

As a human being everybody has some immediate goal. For example for a hungry person global worming has nothingtodo,heneedsfoodashisfirstpriority.Eitherhecanstealitordosomethingtomakeitavailable.Givena free will he will just eat and go. If there is a person sitting there he may force and eat or work and it. Assuming that there is no law, based on his personal power he will force and eat. That is the jungle rule.


124

Today we all live in some or other society and we want to live happily. However, the jungle rule mentality of the people is not gone. It is there deep inside us. It is forced to sleep under the fear of, god, society, law and order. It wakes up when ever the fear elements are reduced or zero. With modernisation the human being has understood that same jungle rule can be played even now with the polish of knowledge. But as always it remains shot lived since somewhere or other it will be disclosed by another human having the same style and same mentality.

It is as if, it is the only thing known to the maximum of the man kind and all those people do it with the same intention, i.e., to gain something. Of course that is the reason they do it.

7.4.1 Characteristics of Fraud and ErrorMisstatementsinthefinancialstatementscanarisefromfraudorerror.Theterm“error”referstoanunintentionalmisstatementinthefinancialstatements,includingtheomissionofanamountoradisclosure,suchas:

Amistakeingatheringorprocessingdatafromwhichfinancialstatementsareprepared.•An incorrect accounting estimate arising from oversight or misinterpretation of facts.•Amistake in the application of accountingprinciples relating tomeasurement, recognition, classification,•presentation, or disclosure.

The term “fraud” refers to an intentional act by on or more individuals among management, those charged with governance, employees, or third parties, involving the use of deception to obtain an unjust or illegal advantage. Although fraud is a broad legal concept, the auditor is concerned with fraudulent acts that cause a material misstatementinthefinancialstatements.Misstatementofthefinancialstatementsmaynotbetheobjectiveofsomefrauds. Auditors do not make legal determinations of whether fraud has actually occurred. Fraud involving one ormoremembersofmanagementorthosechargedwithgovernanceisreferredtoas“managementfraud”;fraudinvolving only employees of the entity is referred to as “employee fraud.” In either case, there may be collusion with third parties outside the entity.

Two types of intentional misstatements are relevant to the auditor’s consideration of fraud-misstatements resulting fromfraudulentfinancialreportingandmisstatementsresultingfrommisappropriationofassets.

Fraudulentfinancialreportinginvolvesintentionalmisstatementsoromissionsofamountsordisclosuresinfinancialstatementstodeceivefinancialstatementusers.Fraudulentfinancialreportingmayinvolve:

Deceptionsuchasmanipulation,falsification,oralterationofaccountingrecordsorsupportingdocumentsfrom•whichthefinancialstatementsareprepared.Misrepresentation in,or intentionalomissionfrom, thefinancialstatementsofevents, transactionsorother•significantinformation.Intentionalmisapplication of accounting principles relating tomeasurement, recognition, classification,•presentation, or disclosure

Misappropriation of assets involves the theft of an entity’s assets. Misappropriation of assets can be accomplished in a variety of ways (including embezzling receipts, stealing physical or intangible assets, or causing an entity to payforgoodsandservicesnotreceived);itisoftenaccompaniedbyfalseormisleadingrecordsordocumentsinorder to conceal the fact that the assets are missing.

Fraud involves motivation to commit fraud and a perceived opportunity to do so. Individuals might be motivated tomisappropriateassets,forexample,becausetheindividualsarelivingbeyondtheirmeans.Fraudulentfinancialreporting may be committed because management is under pressure, from sources outside or inside the entity, to achieve an expected (and perhaps unrealistic) earnings target particularly when the consequences to management of failing tomeetfinancialgoals canbe significant.Aperceivedopportunity for fraudulentfinancial reportingor misappropriation of assets may exist when an individual believes internal control could be circumvented, for example,becausetheindividualisinapositionoftrustorhasknowledgeofspecificweaknessesintheinternalcontrol system.

125

The distinguishing factor between fraud and error is whether the underlying action that results in the misstatement inthefinancialstatementsisintentionalorunintentional.Unlikeerror,fraudisintentionalandusuallyinvolvesdeliberate concealment of the facts. While the auditor may be able to identify potential opportunities for fraud to beperpetrated,itisdifficult,ifnotimpossible,fortheauditortodetermineintent,particularlyinmattersinvolvingmanagement judgment, such as accounting estimates and the appropriate application of accounting principles.

7.5 Types of FraudThere are various trigger points for fraud:Accidental Unintentional: Toerrishuman.Ifyouworkthenyouwilldefinitelydosomemistakes.Thisisanormalprocedureforhumanbeings.Ifthesameisnotedandrectifiedwithorwithoutdeclaringthesamethenthemistakebecomesanerroranda learning point. If the error is caught by another person and brought to the table, than again it will depend whether the person committing the mistake has gained anything due to this mistake and if yes, then whether the immediate employersoranyotherpersoninthisplanethasincurredanylossinstantlyorremotely.Ifbothareconfirmedaspositive,thenitcanbetermedasfraudirrespectiveoftheperson’sintentionsinceitwillbeverydifficultforhimto prove otherwise. In such a case, it becomes very hard for a person to explain and prove that it was not fraud and he is honest.

But if unintentional mistake committed by one person is not caught by any other person and if the person committing theerrorslearnstousethesamemistakeformakingmoneyorotherfavours,thentheclassificationchangesandthe same error becomes a fraud.

Planned Fraud: Planned fraud is again divided in to two categories

Asinglepersonplanningandexecutingthewholefraudthiscanbecontrolledtosomewhatextent,byefficient•internal controls where every transaction goes through multiple levels and authorities. However due to saving on employees cost we become very much susceptible to such fraud.A Group of People: This category is famous for even killing all the internal controls. Where an outsider only can •do something may be a private investigator. But all the organisations cannot really afford to put some undercover agentintheworkingfloorduetothecostfactor.Eventhoughitisseenthatsomecompaniesdothis,wherethe promoters interest is very high. Further these type of frauds never comes out unless otherwise an outsider or perpetrators themselves disclose the same. Proper Record keeping and monitoring of employees by some trustworthy outside agency can help to some extent. Whether done or not the employment letter should get their legal permission just to make them aware of the fact that this is being regularly done by the employer. Forced Fraud: Some good people also get involved with the fraudsters innocently and then of course get punished •too. Blackmailed people are such instances. They committed an innocent or illegal act and got caught by these famous fraudsters and then get used by them. Fear is one of the most driving agents, since some people get involved for the sake of saving their job, family, friends etc. Usually these people are the weakest links in the whole chain and often disclose the whole chain of fraudulent activities.

7.6 Preventing FraudFraud in any form affects somebody or other, instantly or remotely and is one of the biggest problems that are faced by the mankind. It is, as if the only thing known to the maximum number of people in some form or other and all those people do it with the same intention, i.e., to gain something. Of course that is the reason they do it. Fear can be of any type, but the fraudsters should know that they will be caught irrespective of their position and power. Normally we try to prevent fraud by implementing internal control systems in our business and our surrounding, but everything is breakable since it is operated through human beings, and most people’s ethics are sold or bought attherightprice.Internalcontrolstoworkefficientlyneedstobeupdatedregularlybasedonthenewdevelopmentsfor which again it should be monitored on a continuous basis. There is no one formula which may suit all business, since the fraud detection techniques also need a continuous update. However, some are listed:


126

Evaluationofallinternalcontrol:Thereshouldberegularevaluationofallinternalcontrolswhicharespecifically•prone to fraud risk. A responsible person should be nominated to keep and eye on the controls where it is easy for someone to commit a fraud. Area where cash handling is involved is particularly prone to frauds.Check on business assets: A good business man is one who keeps a control on his assets and liabilities. It is •necessary to keep an inventory of all business assets at regular intervals, so that no misappropriation like theft, pilferageetccantakeplace.Regularstocktakeandphysicalverificationoftheassetswilldeteremployeesfrom theft.Keep check on the code of ethics or conduct of your employees: Businessmen should keep a check on their •employees conduct and from time to time they should keep a note of their behaviours especially if they are relatedtofinancialtransactionsarea.Thebestpracticeisdefinitelytrainingandsettingexamples.Employeesinvolved in accounts payable functions or purchasing functions and any employee who submits expense reports are the most susceptible to fraud. Training these individuals, as well as all employees, on company policies, procedures and code of conduct is imperative. Accountability plays a large role in deterrence. When employees realise the company will take a hard stance on fraudsters, they will think twice about committing an abnormal act, i.e., fraud.Check on illegal acts: Every act of an organisation matters, a single illegal act can affect the business and may •destroy its reputation and goodwill in the market. Therefore, it is imperative for the owners to be sure that no illegal acts are taking place in their organisation. Especially in wide spread business houses it should be ensured thattheresponsibilityisfixedonthechief-in-chargefortheplace,toensurethatnoviolationofthelocalstatuteis being done at his place.Auditors recommendations: Both statutory as well as internal auditors are third party person who are independent •fromyourbusinessandhencedonothaveanyvestedinterestinthebusiness,henceanyfindingbythemshouldbe taken very seriously as these are professional people who have in depth knowledge of their subject and can add substantial value to your business. However this is applicable when management other than top management is committing the fraud.Review of audit committee: Audit committee is one key source which outlines the major issues of your business. •Management should seriously take the recommendations and reviews made by the audit committee.Maintain adequate business procedures for handling complains: most of the times frauds are brought to the notice •by employees who do not want to appear in public. So it is necessary that there should be some mechanism in the organisation for the employees to anonymously report any complains or information that they may have. A complain box or hotline can effectively serve this purpose.Now days there are so many software companies who have designed products that perform fraud tests on real-•time, daily transactions. They can also conduct tests on company’s last one or two year’s data just by attaching the same.

7.7 Auditor’s Responsibility in Finding FraudInternal auditors support management’s efforts to establish a culture that embraces ethics, honesty, and integrity. They assist management with the evaluation of internal controls used to detect or mitigate fraud, evaluate the organisation’s assessment of fraud risk, and are involved in any fraud investigations.

Although it is management’s responsibility to design internal controls to prevent, detect, and mitigate fraud, the internal auditors are the appropriate resource for assessing the effectiveness of what management has implemented. Therefore, depending on directives from management, the board, audit committee, or other governing body, the internal auditors might play a variety of consulting, assurance, collaborative, advisory, oversight, and investigative roles in an organisation’s fraud management process.

Competentprofessionalinternalauditorsarehighlyproficientintechniquesusedtoevaluateinternalcontrols.Thatproficiency,coupledwiththeirunderstandingoftheindicatorsoffraud,enablesthemtoassessanorganisation’sfraud risks and advise management of the necessary steps to take when indicators are present.

127

PreventionEstablishing a culture of integrity is a critical component of fraud control. Executive management must set the tone at the top and model the highest level of integrity. The internal auditors may advise management on methods to ensure integrity and may become involved in communicating or interpreting those methods. They also may help develop training related to integrity policies and fraud.

As a part of their assurance activities, internal auditors watch for potential fraud risks, assess the adequacy of related controls, and make recommendations for improvement. They also can help benchmark statistics related to the probability of occurrence and consequences of fraud.

DetectionBecause the internal auditors are exposed to key processes throughout the organisation and have open lines of communication with the executive board and staff, they are able to play an important role in fraud detection. In many organisations, the chief audit executive (CAE) is responsible for responding to issues raised on the ethics hotline or through another process that may lead to detection of fraud.

When developing their annual audit plan, the internal auditors consider the organisation’s assessment of fraud risk, and periodically might make assessments of management’s fraud detection capabilities. They design tests that use audit techniques like data mining to ensure the controls in place are effective.

InvestigationInternal audit skills relate to gathering evidence, analysing the breakdown in controls that could enable a fraud, and making recommendations for improvement. And reporting directly to the board or governing body provides the internal auditors with a level of independence and objectivity necessary for them to undertake investigations of a sensitive nature.

Although the internal auditors may either have a direct role in investigating fraud incidents, or act as a resource to those responsible, they generally are not expected to have the expertise of those whose primary responsibility is detecting and investigating fraud.

When the internal auditors have the primary responsibility for fraud they must have the key competencies for this work-typicallyobtainedthroughspecialisedtrainingandrelatedexperiences.Theyalsomaybecertifiedasfraudor forensic investigators.

7.8 Clauses of Fraud in Auditing in IndiaConcerns of audit effectiveness were raised in India too, and the auditor’s role and CARO and ICAI’s auditing standards have been revised. The relevant clauses of these pronouncements have been examined below:Auditing Assurance Standard — AAS 4:ThisisaspecificauditingandassurancestandardpronouncedbytheICAI(effectivefromApril1,2003),relatingtoanauditor’sdutyasregards‘fraudanderror’infinancialstatements.Thisstandardstatethattheprimaryresponsibilityfor the prevention and detection of fraud and error rests with both: (1) those charged with governance, and (2) the management of an entity. The standard also spelt out the auditor’s enhanced responsibility and laid down expectations of a far more penetrative audit than ever before in the past. The salient features of this AAS 4 are:

An attitude of professional skepticism. No longer can an auditor rely merely on any management representation. •In effect, he must obtain evidence that either agrees with, or, brings into question the reliability of management representations. An auditor must adopt, necessarily, an attitude of professional skepticism that will enable him to identifyandproperlyevaluatemattersthatincreasetheriskofamaterialmisstatementinthefinancialstatementsresultingfromfraudorerror.Henowhastoexamineandquestionthemanagement’sinfluenceoverthecontrolenvironment,industryconditions,andoperatingcharacteristicsandfinancialstability.Importance of teamwork in conducting an audit. The standard also expresses the importance of teamwork. In •planning the audit, the auditor should discuss with other members of the audit team, the susceptibility of the entitytomaterialmisstatementsinthefinancialstatementsresultingfromfraudorerror.


128

Perform additional, extended or commensurate audit procedures where fraud is suspected. When the auditor •encounterscircumstancesthatmayindicatethatthereisamaterialmisstatementinthefinancialstatementsresultingfromfraudorerror,theauditorshouldperformprocedurestodeterminewhetherthefinancialstatementsare materially misstated.Reportingobligations.Whentheauditoridentifiesamisstatementresultingfromfraud,orasuspectedfraud,or•error, the auditor should consider the auditor’s responsibility to communicate that information to management, those charged with governance and, in some circumstances, when so required by the laws and regulations, to regulatory and enforcement authorities also.Where an auditor has obtained evidence that fraud exists, even materiality is not a point for consideration for •communicating this matter to the appropriate level of the management timely.

Thus, as per AAS 4, an auditor has to virtually move heaven and earth to satisfy himself while carrying out an audit, thatnoseriousredflagsexist.Iftheydoexist,hehastonecessarilyapplyappropriateprocedurestoconfirmhissuspicions or dispel his doubts, about the existence of fraud. In case there is evidence of fraud, then, even materiality is not a factor for consideration — the matter of fraud has to be communicated to the appropriate level of management on a timely basis and he has to even consider reporting it to those charged with corporate governance.

CAROalsocastsasignificantresponsibilityontheauditorwhichhasbeenconsiderednext.

Clauses of CARO relating to reporting of fraud by auditors:Clauses 4(iv) and 4(xxi) of CARO are very important for auditors, especially with regard to their duty towards fraud. 4(iv) requires an auditor to report whether there are adequate internal control procedures commensurate with thesizeofthecompanyandthenatureofitsbusiness,forthepurchaseofinventoryandfixedassetsandforthesaleofgoods.Whatissignificantisthattheauditorisexpectedtoreportwhetherthereisacontinuingfailuretocorrect major weaknesses in internal control. The key phrase is ‘continuing failure’. The continuing failure could stem from incompetence or fraud, but either way the auditor cannot ignore the possibility of existence of fraud. If he reportssuchacontinuingfailurebutnotafraud,andiffraudisdiscoveredlater,theauditormayfindhimselfinanunenviable situation to escape the responsibility for not carrying out appropriate audit procedures and also perhaps for not reporting the fraud. Clause 4(xxi) is even more serious, in that, it actually casts a direct responsibility on theauditortoreportwhetheranyfraudonorbythecompanyhasbeennoticedorreportedduringtheyear;iftheanswerisaffirmative,thenatureofthefraudandtheamountinvolvedhavetobeindicated.Heretoo,itispertinentto note that materiality is not a factor for consideration by the auditor. If a fraud has been noticed or even reported, he has no choice but to report its nature and the amount involved. Furthermore, by virtue of being an auditor, and theverydefinitionofauditasexplainedlater,hisdutydoesnotendmerelyinmentioningthatafraudwasnoticedorreported;asanauditorhisroleautomaticallyrequireshimtocarryoutaninvestigationandapplysuchotherchecksandverificationssoastoenablehimtobesatisfiedthatthefraudisnotisolatedandthatitdoesnothaveanyotherimplicationsonthefinancialinformationheisexpressinganopinionon.

Thus, CARO clearly spells out the duty of the auditor towards fraud detection and reporting.

Sales Tax Practitioners’ Association (STPA) of Maharashtra v. the State of Maharashtra (Note 3) :Thiscaseisalsoveryrelevanttothisarticlebecauseitexaminesthedefinitionofauditandconcludesthatdetectionof fraud is of primary importance in an audit. While considering the petition of the STP (refer note 3 for details) theHighCourtexaminedtheverydefinitionofaudit.Afterconsideringcertaindefinitions,itconcludedthatthewordaudithasaspecificconnotationinthematterofexamination,investigationandauditingofaccounts,wheredetectionoffraudisofprimaryimportance.OneofthedefinitionsofauditreferredtoisthatofRAIrishinhisbook ‘Practical Auditing’. It says that an audit may be said to be a skilled examination of such books, accounts and vouchers as will enable the auditor to verify the balance sheet. The main objects of an audit are: (a) to certify thecorrectnessofthefinancialpositionasshowninthebalancesheetandtheaccompanyingrevenuestatements,(b) the detection of errors and (c) the detection of fraud — the detection of fraud is generally regarded as being of primary importance. The High Court also observed ‘The object and purpose of compulsory audit is to facilitate the prevention of evasion of taxes, administrative convenience. It is a specialised job which can be undertaken only by a person professionally competent and trained to audit. Thus, auditors are expected to possess skills which could

129

act as even a deterrent for tax evasion fraud. However, the High Court, also accentuated the risks accompanying the privileges: “The Chartered Accountant, by his very privileged status exposes himself to the consequences of civil liability for negligence, liability for professional misconduct in disciplinary proceedings under the Chartered Accountants Act, 1949, and sometimes to criminal liability under the Penal Code.”

Thus the above judgment clearly emphasises that an auditor’s role includes fraud and error detection and detection of fraud is of primary importance and that the auditor is exposed to severe penal consequences for non-performance of his duty.

Insights from the O’Malley Report:Thus far, this article has reviewed the auditor’s role within the domain of the Indian legislation and the ICAI’s pronouncements. The Panel made some important revelations about the auditor’s role towards fraud. The Panel recommended that auditors should perform some ‘forensic-type’ procedures on every audit to enhance the prospects ofdetectingmaterialfinancial statement fraud.Auditworkwouldbebasedanddirected todetectandfind thepossibilityofdishonestyandcollusion,overridingofcontrolsandfalsificationofdocuments.

Auditors would be required, during this phase, in some cases on a surprise basis, to perform substantive tests directed at the possibility of fraud. The Panel recommendation also calls for auditors to examine non-standard entries, and to analysecertainopeningfinancialstatementbalancestoassess,withthebenefitofhindsight,howcertainaccountingestimates and judgments or other matters were resolved.

The intent of this recommendation is twofold: to enhance the likelihood that auditors will be able to detect material fraud, and to establish implicitly a deterrent to fraud. This can be achieved by greater audit effectiveness which would pose a threat to perpetrators in successful concealment of fraud. The Panel also advocated stronger standard setting for auditors. It observed that the Auditing Standards Board should make auditing and quality control standards more specificanddefinitivetohelpauditorsenhancetheirprofessionaljudgment.ThePanelrecommendedthatauditfirmsshouldreview,andwhereappropriate,enhancetheirauditmethodologies,guidance,andtrainingmaterials;andpeer reviewers should ‘close the loop’ by reviewing those materials and their implementation on audit engagements andthenreportingtheirfindings.

Auditfirms shouldputmoreemphasison theperformanceofhigh-qualityaudits incommunications from topmanagement, performance evaluations, training, and compensation and promotion decisions.


130

SummaryAllovertheworld,Not-for-ProfitOrganisations(NPOs)playanimportantroleinthesocio-economicprocess•of the countries in which they operate.The magnitude of the funds channelled through these organisations creates considerable responsibility in terms •of follow up, monitoring and accountability.Research Committee of the Institute of Chartered Accountants of India (ICAI) has recently brought out a •researchpublication‘TechnicalguideonAccountingandAuditinginNot-for-ProfitOrganisations’elaboratelyexplaining applicability of various accounting standards and other matters concerning accounting and auditing in such organisations.Manyoftheprovisionsofthecentralandstate-levellawsoverlapintheirapplicationtonot-for-profitorganisations•and registration of a charitable organisation under a particular enactment, central or state, does not necessarily make the organisation escape from other enactments.Fraud is an activity by a person who does his duty in a wrong way or refrains from doing his duty for some •favours,i.e.,financial,tangible,oranythingelsewhichisnotduetohimortheminthenormalcourse.Two types of intentional misstatements are relevant to the auditor’s consideration of fraud-misstatements resulting •fromfraudulentfinancialreportingandmisstatementsresultingfrommisappropriationofassets.Fraudulentfinancialreportinginvolvesintentionalmisstatementsoromissionsofamountsordisclosuresin•financialstatementstodeceivefinancialstatementusers.Fraud involves motivation to commit fraud and a perceived opportunity to do so.•Internal auditors support management’s efforts to establish a culture that embraces ethics, honesty, and integrity. •They assist management with the evaluation of internal controls used to detect or mitigate fraud, evaluate the organisation’s assessment of fraud risk, and are involved in any fraud investigations.

ReferencesDalal, C., 2008. • Auditing, [Online] Available at: <http://www.bcasonline.org/articles/artin.asp?819>. [Accessed 11 December 2011].Choudhary, S., 2010. • Audit and Fraud [Online] Available at: <http://www.caclubindia.com/articles/audit-and-fraud-6835.asp>. [Accessed 11 December 2011].Rezaee,Z.,2002.• Financial statement fraud: prevention and detection, John Wiley and Sons.Kumar, R. and Sharma, V., 2005. • Auditing: principles and practice, PHI Learning Pvt. Ltd.NDTV, 2009. • Satyamscam:Auditorsinthelineoffire[Video Online] Available at: <http://www.youtube.com/watch?v=EU0wYQW1SMs&feature=fvsr>. [Accessed 13 December 2011].Brozzeti, M., 2010. • Internal Auditing & Fraud Interview (1 of 2) [Video Online] Available at: <http://www.youtube.com/watch?v=i4R_a9GZP58>.[Accessed13December2011].

Recommended ReadingDicksee, L. R., 1976., • Auditing: a practical manual for auditors: The History of accounting, Ayer Publishing.Rittenberg, L., E., Johnstone, K, Gramling, A. A. and Schweiger, B., 2009. • Auditing: A Business Risk Approach, 7th ed., Cengage Learning.Ricchiute, D. N., 2006. • Auditing, 8th ed., Thomson/South-Western.

131

Self AssessmentWhichofthefollowingisaspecificauditingandassurancestandardpronouncedbytheICAI(effectivefrom1. April1,2003),relatingtoanauditor’sdutyasregards‘fraudanderror’infinancialstatements?

AAS 3a. AAS 4b. AAS 5c. AAS 6d.

___________ skills relate to gathering evidence, analysing the breakdown in controls that could enable a fraud, 2. and making recommendations for improvement.

Frauda. Internal auditb. Cost auditc. External auditd.

When the _________ have the primary responsibility for fraud they must have the key competencies for this 3. work - typically obtained through specialised training and related experiences.

external auditora. tax auditorb. cost auditorc. internal auditorsd.


Evaluation of all internal control1. ThebestpracticeisdefinitelytrainingandsettingA. examples.

Check on business assets2. A responsible person should be nominated to keep and B. eye on the controls where it is easy for someone to commit a fraud.

Keep check on the code of ethics or 3. conduct of your employees

Every act of an organisation matters, a single illegal act C. can affect the business and may destroy its reputation and goodwill in the market.

Check on illegal acts4. A good business man is one who keeps a control on his D. assets and liabilities.


Both, _________ as well as internal auditors are third party person.5. externala. costb. taxc. statutoryd.


132

Which of the following is one key source which outlines the major issues of a business?6. Audit committeea. Auditors recommendationb. Illegal actsc. Internal controld.

Area where cash handling is involved is particularly prone to__________.7. auditinga. accountingb. fraudc. prevent fraudd.

Planned fraud is again divided into _____ categories.8. twoa. threeb. fourc. fived.

Which of the following category is famous for even killing all the internal controls?9. A group of peoplea. Forced fraudb. Accidental c. Unintentionald.

Fraud involving one or more members of management or those charged with governance is referred to 10. as_______.

employee frauda. management fraudb. unintentional fraudc. planned fraudd.

133

Chapter VIII

Audit of Limited Companies

Aim


introduce recent trends in auditing•

highlight the role of supreme audit institutions•

describe cost audit•

Objectives


elucidate tax audit•

explain management audit•

explicate objectives of cost audit•

Learning outcome


understand the requirements of tax audit•

comprehend the process of management audit•

discuss the purpose of tax audit•


134

8.1 Recent Trends in AuditingThe decade of eighties is known for the spread of privatisation all over the world. There is a global development and expansion of this concept and there is no longer any doubt that it continues to be popular with all forms of Governments.ThedeterioratingprofitabilityandincreaseinsubsidiesofStateenterpriseshavefurtherstrengthenedthebeliefthatprivatisationremainstheonlyremedytoinjectefficiencyintopublicsectormanagement.

Privatisation essentially means transfer of ownership from the State into the hands of non-state entities. There are, however, many transient forms of this process, for example, partial disinvestment, dilution of State ownership, contracting out certain functions, management buy outs etc. In every case however, the State decides to part with its assetsoritsrighttomanagethemforaspecificreturn.Sincetheseassetswereacquiredoutofthepublicfundsandhave grown in value over the years, it is in the public interest to ensure that the process of privatising them should be such as to get the best return for the exchequer.

It is here that the SAIs steps in. As independent institutions with constitutional mandate to guard the interests of the State exchequer, they are naturally involved in examining the process of privatisation at various stages not only to ensure that the State receives the best return out of the enterprise or the assets being privatised, but also to ascertain that the ultimate objectives of the privatisation are realised.

Role of supreme audit institutionsTheimprovement in thepublicfinancesof thecountry isnowdependent,amongotherfactorson theprogressmade in reforms of public sector management in general and State enterprises in particular. Privatisation is one of the important measures in this direction and the public has already come to bestow a good deal of faith on this approach. As an extension of this faith, they expect that independent institutions, such as the SAI, which have come to be viewed as a kind of trustee, would, while facilitating the transition, also provide from time to time, not only a report on the progress made, but also its opinion on whether the privatisation has achieved its objectives. More significantly,itisalsoexpectedthattheSAIwouldidentifythesystemicandotherbottlenecksthatarehinderingthe implementation of these measures and suggest ways as to how they could be overcome.

This perception has driven almost all SAIs to undertake the audit of privatisations by accommodating such audits withintheirmandateandbyapplyingbothtraditionalaudit techniquesaswellasnewlyacquiredskills; inthisprocess, they have contributed substantially to making the process of privatisation more transparent and accountable. Indoingso,theSAIshavegenerallyconfinedthemselvestothefollowingmajorareasofexamination:

Legalityoftransaction,whereaspecificlawhasbeenenactedoraspecificmandatehasbeengivenbythe•legislatureorclearguidelineshavebeenlaiddown;EconomyandEfficiencyofthetransaction,byexaminingwhetherthetransferorsaleofpublicenterpriseor•assetshasbeendoneinsuchawayastomaximisethesaleproceedsandminimisecosts;andEffectiveness of the privatisation process, by ascertaining whether the objectives of the privatisation have been •achieved.

The objectives of audit as well as the methods, techniques and focus of audit efforts however differ from country to country,sincethemethodsofprivatisation,theextentofdevelopmentoffinancialmarkets,thelevelofcompetitionandthe resources deployed in this area differ widely. The State objectives in privatisation and the historical background aswellasthelegalmandateoftheSAIineachcountrywillalsoinfluenceitsapproachineachcase.

The audit of privatisation is yet to acquire deep roots in Asia, Africa and other developing countries. Most of the countries in this region have not initiated privatisation in a big way. Even where it has started, many SAIs have not got involved in its audit, although in most cases they do have statutory powers to do so. However, in some countries, SAIs have started assuming an important consultative role in the process.

135

In Egypt, the Central Auditing Organisation conducts as a part of its duties, the evaluation of privatisation programmes by studying and analysing the draft laws submitted by the Government to ascertain whether it contains the conditions ofsuccessandadequateprecautionstowardoffnegativeeffectsandexpressesanopinionthereon.Italsoverifiesthe execution of programme as per the time schedule, contracting, sale and other transactions. The SAI continues to retain its audit jurisdiction, till the Government shareholding falls below 25%.

In Bahrain, public sector restructuring is in its early stages. As restructuring projects come to fruition, the role of SAIisexpectedtobecomemoredirectinthespecificareasofsystemdevelopmentauditandpostimplementationreviews. It expects to provide technical accounting support and peer advice through its membership of project review committees.Onthesamelines,theSAIsofMauritius,ThailandandZambiaareintheprocessofgettinginvolvedin the audit of privatisation. In Indonesia, Brazil and Lesotho, the SAIs have yet to get involved in privatisation audit.

SAI-Indiahasfirmlyestablisheditsjurisdictionwithintheexistinglegalframeworkandhassuccessfullyconductedthe audit of partial disinvestment of the shares of Government companies conducted in 1992. This disinvestment programme, which yielded a sum of Rs. 30.38 billion ( US $ 868 m.) to the Indian Government, aimed at disinvesting a part of the equity capital in respect of 30 public enterprises. The SAI’s Audit Report highlighted a number of interesting points. It observed that the sale was not conducted in a competitive environment and was restricted only tothehandfuloffinancialinstitutionsinthepublicsector.Italsobroughtoutthatsincethesharesweresoldbelowthe reserve prices originally computed on the basis of valuation, there was a loss of Rs. 344 bn. ( US $ 10 bn.) to the Exchequer. Since there was no ‘claw back’ provision in the terms and conditions of the sale, the buyers made considerableprofitassoonastheshareswereoffloadedinthemarket,fromwhichGovernmentderivednobenefit.The report made considerable impact both in the Parliament and the media and the Government has initiated a number of corrective measures to streamline the procedures.

Apart from the fact that the privatisation process has not fully taken off in this region, one of the reasons for low key activity of SAIs in the audit of privatisation is that many SAIs are still in the process of equipping themselves for this task. Training and know-how for auditing in this complex area is one of the important inputs needed in this region. However as the process of privatisation gathers momentum, SAIs will also gear themselves to tackle this crucial area.

Audit of privatisation is one of the most complex issues faced by SAIs in their long and chequered history. It acquires new dimensions with the changing socio-economic and political situations. There are several areas which haveproveddifficultandelusive,oneofthembeingtheuncertaintyaboutthevalueofbusinessbeingsoldandtheconsequentdeterminationofthesaleprice.TherecanbenofixedformulaetosolvetheseproblemsandeverySAIhas to make judgements to arrive at the best possible solution. Lack of experience of privatisation audit within the SAI, inadequacies in the existing market structure and inadequacies of legal provisions are some of the other major problems, but these are likely to get resolved with the passage of time.

The most encouraging feature in the recent trends in the audit of privatisation is the emerging strength of the SAIs and their role as independent advisors to streamline the systems to achieve better value for money. The proactive, positiveandassertiveroleplayedbySAIsinthefieldofprivatisationauditisalandmarkintheevolutionofstateaudit.Ithasexplodedthemyththatauditismerelyafaultfindingandnegativefunction,andhasunderlineditscrucialroleinsecuringimprovementsinadministrativesystemstoachievegreatereconomy,efficiencyandeffectivenessin governmental operations.


136

8.2 Cost AuditCost audit is the audit of cost records. According to Chartered Institute of Management Accountants, London (CIMA), costauditis“theverificationofthecorrectnessofcostaccountsandoftheadherencetothecostaccountingplan”.Inotherwords,costauditistheverificationofthecostofproductionofanyproduct,serviceoractivityonthebasisofaccountsmaintainedbyanenterpriseinaccordancewiththeacceptedprinciplesofcostaccounting.Thisdefinitionsof Cost Audit is relevant to the voluntary Cost Audit without any statutory backing

TheInstituteofCostandWorksAccountantsofIndiaontheotherhand,definescostauditas“asystemofauditintroduced by the Government of India for the review, examination and appraisal of the cost accounting records andattendantinformation,requiredtobemaintainedbyspecifiedindustries.”ThustheconceptandscopeofcostauditasdefinedinIndiaismorespecificandlaysemphasisontheevaluationoftheefficiencyofoperationsandtheproprietyofmanagementactionsasintroducedbytheGovernmentofIndiaforspecifiedindustries.Inthissense,costauditinIndiaappearstobesynonymouswithefficiencyauditmainlyasaguideformanagementpolicyanddecision making besides being a barometer of actual performance.

ThejustificationformandatoryCostAccountingandCostAuditprovisionshasbeenverywellexplainedintheParliamentary Debate that led to the adoption of Companies Amendment Bill, 1965 incorporating the provisions related to Sections 209 (1) (d) and 233B. Smt. Tara Ramchandra Sathe (MP for Maharashtra) stated during the relevant Rajya Sabha Debate as under: What is Cost Audit? The Cost Audit is quite different from the Financial Audit. It is to see whether the labour is Efficientornot,whethertheindustryhasprovidedefficientlabourorthelabourwhichisrequiredbythatindustryisless than what is required, whether every material and every part of the machinery is used to the optimum, whether any material is wasted, etc.

Thus Cost Audit in India refers to the statutory Cost Audit of the selected companies covered under the relevant provisions of the Companies Act, 1956. These requirements are mandatory and non-compliance may invite penal provisions also.

8.2.1 Features of Cost AuditThe cost audit of the companies under the relevant provisions of the Companies Act, 1956 has the following features:

Assessingcomplianceoftherelevantcostaccountingrecordsrulesasapplicabletotheproductunderreview;•Study of the costing system to assess whether it is adequate for the cost ascertainment of the product under •review;Evaluationoftheoperatingandotherefficienciesoftheorganisationunderauditwithspecialreferencetothe•productunderreview;toensurethesubmissionofnecessarydetailsrequiredundertheCostAuditReportRules,2001 as amended from time to time.Submission of Cost Audit Report in the format prescribed.•

Since cost audit is carried out under the various provisions of the Companies Act, 1956, a thorough and comprehensive knowledge of the Indian Companies Act including various rules prescribed thereunder and the circulars issued by the Ministry of Corporate Affairs is essential for conducting an effective Cost Audit.

8.2.2 Objectives of Cost AuditCost Audit has both general and social objectives. The general objectives can be described to include the following:

Verificationofcostaccountswithaviewtoascertainingthatthesehavebeenproperlymaintainedandcompiled•according to the cost accounting system followed by the enterprise.Ensuring that the prescribed procedures of cost accounting records rules are duly adhered to.•Detection of errors and fraud.•

137

Verification of the cost of each “cost unit” and “cost centre” to ensure that these have been properly•ascertained.Determination of inventory valuation.•Facilitatingthefixationofpricesofgoodsandservices.•Periodicalreconciliationbetweencostaccountsandfinancialaccounts.•Ensuringoptimumutilisationofhuman,physicalandfinancialresourcesoftheenterprise.•Detection and correction of abnormal loss of material and time.•Inculcation of cost consciousness.•Advisingmanagement, on the basis of inter-firm comparison of cost records, as regards the areaswhere•performance calls for improvement.Promoting corporate governance through various operational disclosures to the directors.•

Among the social objectives of cost audit, the following deserve special mention:Facilitationinfixationofreasonablepricesofgoodsandservicesproducedbytheenterprise.•Improvementinproductivityofhuman,physicalandfinancialresourcesoftheenterprise.•Channelisingoftheenterpriseresourcestomostoptimum,productiveandprofitableareas.•Availability of audited cost data as regards contracts containing escalation clauses.•Facilitation in settlement of bills in the case of cost-plus contracts entered into by the Government.•Pinpointingareasofinefficiencyandmismanagement,ifanyforthebenefitofshareholders,consumers,etc.,•such that necessary corrective action could be taken in time.

8.2.3 Scope of Cost AuditSection 227(2) of the Companies Act, 1956, requires the auditor of a company to state whether the accounts in his opinion give a true and fair view of the state of the company’s affairs in the case of the balance sheet and of the profitorlossforitsfinancialyearinthecaseoftheprofitandlossaccount.Therefore,statutoryfinancialauditofa company conducted by the Chartered Accountant is an essential annual feature of all the companies registered under the provisions of Companies Act, 1956. The Board of Directors of every company has a statutory obligation toplaceitsauditedannualaccounts,viz.,ProfitandLossAccountandBalanceSheetbeforetheshareholdersintheAnnualGeneralMeeting,dulycertifiedbyaCharteredAccountantappointedasan‘Auditor’undertheprovisionsofSection 224 of the Act. However, there is no corresponding statutory provision for compulsory annual audit of cost accounts of a company covered under Section 209(1)(d) of the Companies Act or under relevant Cost Accounting Records Rules.

One of the pre-requisites of cost audit is the maintenance of cost accounting records by the company. Section 209(1)(d) makes it obligatory for a company pertaining to any class of companies engaged in production, processing, manufacturing or mining to maintain such particulars relating to utilisation of material or labour or to other items of cost as may be prescribed, if such class of companies is required by the Central Government to include such particulars in the books of accounts. The rules provide that only those companies, which are covered under Section 209(1)(d)of theCompaniesActandaspecificCostAuditOrderhasbeen issuedwith reference toa specifiedproduct by the Cost Audit Branch of Ministry of Corporate Affairs are required to get their cost accounts audited withrespecttothatspecificproduct.Moreover,CostAuditReportisnotplacedbeforetheshareholdersduringtheAnnual General Meeting.

The Central Government prescribes the separate cost accounting records for each class of companies, i.e., companies manufacturing a particular class of product or activity like Cement, Steel, Chemicals and Electricity etc. and these arecalledtheCostAccountingRecordsRulesforthatspecificindustryorclassofcompanies.Whencostaccountingrecords/formats are prescribed, they apply to those companies engaged in the manufacture of a particular product or activity. In the case of companies engaged in production or processing of other products or activities also in addition toproduction,processingormanufactureofthespecifiedproduct,therecordswillhavetobemaintainedonlyforthe manufacture of particular product for which rules are issued and not necessary for other products.


138

A company manufacturing bulk drugs, formulation and watches need not necessarily maintain cost accounting records in respect of watch making activity if no statutory rules are prescribed for watch making activity. The detailed provisions relating to the manner of prescription of cost accounting records, selection of the product, the contents of the rules and the list of products/industries covered by the statutory rules under Section 209(1)(d) of the Companies Act have also been explained in Study Notes 2 and 3. Thus Cost Audit u/s 233B does not embrace a particularactivityofthecompanyunlessaseparatecostaccountingrecordruleisalreadynotifiedforthatparticularactivity under Section 209(1)(d) detailing the nature of cost accounting records to be maintained.The legal provisions relating to statutory cost audit are applicable only to companies registered under the provisions of Companies Act, 1956. Therefore, cost audit is not applicable to other enterprises like partnership, cooperative societies, etc. The Cost Audit is conducted by a Cost Accountant in practice within the meaning of the Cost and Works Accountants Act, 1959. The cost auditor is appointed by the Board of Directors of the company with the previous approval of the Central Government. The report of cost auditor is to rendered to the Central Government with a copy to the Company.

8.2.4 Cost AuditorIssueofCostAuditOrderisthefirststepinCostAuditofanycompany.TheCentralGovernmentissuesaspecificorder under Section 233(B)(1) of the Companies Act, 1956 on a particular company directing it to get its cost records audited by a practicing Cost Accountant indicating the product for which the order is issued and the period for which it is ordered. Therefore, the starting point for the cost audit exercise is the receipt of cost audit order by the company, specifying the year and the product for which such cost audit is to be conducted. However, the Cost Audit Branch has now been issuing Cost Audit Orders on regular basis to all the companies covered (i.e., every financialyearthereaftercontinuouslyuntilfurtherorders.)Thisamountstosayingthatonceanorderisissued,thecostauditisrequiredtobedoneeveryyearunlessitisspecificallywithdrawn.ItmaybeclarifiedherethatsincethecostauditorderissuedbytheCostAuditBranchspecifiestheproduct,theCompanyneednothaveacostauditfortheproductnotspecifiedinthatorder.Thus,ifthecompanyproducingSugar,CementandSteelreceivesanorderrelating to Sugar for the year ending 31st March, 2009, then it need not get the cost records for products Cement and Steel audited under Sec. 233B for the year ending 31st March, 2009. Similarly for subsequent years also, it needs togetitscostrecordsforSugaronlycostauditedunlessitgetsaspecificorderonotherproductsalso.

8.2.5 Qualification of Cost AuditorSection 233(B) of the Companies Act, 1956 provides that the Central Government may, if it considers necessary, direct thattheauditofcostaccountskeptbyacompanyforaspecifiedproductoractivityunderSection209(1)(d)shallbeconducted by an auditor who shall be a cost accountant within the meaning of the Cost and Works Accountants Act, 1959.Inotherwords,theSec.233B(1),insofarasitrelatestoqualificationofcostauditorprovidesthatapersonholdingcertificateofpracticefromtheInstituteofCostandWorksAccountantsofIndiaonlycanbeappointedasacostauditor.Thecostauditormaybeanindividualcostaccountantorafirmofcostaccountantswithatleasttwopartners.AfirmofcostaccountantscanbeconstitutedwiththepreviousapprovaloftheCentralGovernment/Institute as required under the regulation 113 of the Cost and Works Accountants Act, 1959 as amended from time totimeandinwhichallthepartnersarecostaccountantsholdingcertificateofpracticeissuedbytheInstituteofCost and Works Accountants of India. Section 224 (1-B) of the Companies Act, 1956 further provides that a person can be appointed as a cost auditor only if he is not in full time employment elsewhere.

AprovisiontoSection233B(1)laysdownthatiftheCentralGovernmentisofopinionthatsufficientnumberofcost accountants within the meaning of the Cost and Works Accountants Act, 1959 are not available for conducting theauditofthecostaccountsofcompaniesgenerally,theGovernmentmay,bynotificationintheOfficialGazette,direct that, for suchperiod asmaybe specified in the saidnotification, suchCharteredAccountantwithin themeaningoftheCharteredAccountantsAct,1949,aspossessestheprescribedqualification,mayalsoconducttheauditofthecostaccountsofcompanies.ItmaybeclarifiedherethattheCentralGovernmenthasnotsofarissuedanynotificationundertheaboveprovision.

139

ThereareseveralmembersoftheInstituteofCostandWorksAccountantsofIndia(ICWAI),whohavequalifiedtheexamination of both the Institutes namely ICWAI and the Institute of Chartered Accountants of India and thus are eligibleformembershipaswellascertificateofpracticefromboththeInstitutes.However,noneofthememberscanhold“certificateofpractice”inmorethanoneInstituteundertheprovisionsofboththeInstitutes.Therefore,practicallythereisnopossibilityofanyfinancialauditortopracticeascostauditororviceversa.

However, it is only in the background of the aforesaid proviso that Section 233B(5)(b) provides that a person appointedunderSection224asanauditorofthecompany(financialauditor)shallnotbeappointedorre-appointedfor conducting the audit of the cost accounts of a company (cost auditor of the same company).

8.2.6 Powers of a Cost AuditorSection233B(4)oftheCompaniesAct,1956givesthecostauditorsamepowersasthefinancialauditorhasunderSection227(1).Inaddition,Rule6oftheCostAuditReportRulesalsorequiresthecompanyandeveryofficerthereof, including the persons referred to in sub-Section (6) of Section 209 of the Act to make available to the costauditor,within135daysfromthecloseofthefinancialyearofthecompany,suchcostaccountingrecords,cost statements, other books and documents, Annexure and proforma to the Report, duly completed as would be required for conducting the cost audit, and shall render necessary assistance to the Cost Auditor so as to enable him tocompletethecostauditandsubmithisreportwithinthetimelimitspecifiedinrule5.Section233B(6)furtherprovides that it shall be the duty of the company to give all facilities and assistance to the cost auditor so as to enable him to complete the audit and send the report within the prescribed time limit.

The powers of the cost auditor under sub-Section (1) of Section 227 are as under:Right to access at all times to the books and accounts and vouchers of the company, whether kept at the head •officeofthecompanyorelsewhere.Entitledtorequirefromtheofficersofthecompanysuchinformationandexplanationsashemaythinknecessary•for the performance of his duties as an auditor.

8.2.7 Duties of a Cost AuditorThedutiesofthecostauditorarealsosimilartothoseofthe(financial)auditorofthecompanyhasundersub-Section(1) of Section 227 (Section 223B(4)).The duties of the cost auditor inter-alia include:

To ensure that the proper books of accounts as required by Cost Accounting Records Rules have been kept by •the company so far as it appears from the examination of those books and proper returns for the purpose of his audithavebeenreceivedfrombranchesnotvisitedbyhim;To ensure that the Cost Audit Report and the detailed cost statements are in the form prescribed by the Cost •AuditReportRulesbyfollowingsoundprofessionalpractices,i.e.,thereportshouldbebasedonverifieddataandobservationsmaybeframedafterthecompanyhasbeenaffordedanopportunitytocommentonthem;The underline assumptions and basis for allocation and absorption of indirect expenses are reasonable and are •aspertheestablishedaccountingprinciples;Iftheauditorisnotsatisfiedinanyoftheaforesaidmatters,hemaygiveaqualifiedreportalongwiththereasons•forthesame;SendingtheReporttotheCostAuditBranchwithin180daysfromtheendofthefinancialyearwithonecopy•tothecompany;Sendinghisrepliestoanyclarification,thatmaybesoughtbytheCostAuditBranchonhisreport.Sendingsuch•replieswithin30daysfromthedateofreceiptofcommunicationcallingforsuchclarification.


140

8.3 Tax AuditSeptember month is a Tax audit month. Tax audit is popularly known 44AB audit. This audit has to be completed on or before due date, i.e., 30th Sept.

The tax audit was introduced by insertion of a new section 44AB to the Income Tax Act, 1961 w.e.f 1st April, 1985. This section creates an obligation on a person carrying on business to get his accounts audited by a chartered accountantandtofurnishbythespecifieddate,thereportinprescribedformofsuchaudit,ifthetotalsales,turnoveror gross receipts in business in the relevant previous year exceed or exceeds Rs. 40 lakhs (increased to Rs. 60 lakhs fromfinancialyear2010-11)44ABcomprisesof2forms–Form3CA/CBandForm3CD.Every44ABassessseeneedtofileeitherForm3CAor3CB.ButForm3CDismust.

8.3.1 Purpose of Tax AuditThe purpose of tax audit as per CBDT circular no. 387, dated July 6, 1984 as under.“Compulsory audit of accounts of certain persons carrying on business or profession

Accounts maintained by companies are required to be audited under the Companies Act, 1956. Accounts •maintained by co-operative societies are also required to be audited under the Co-operative Societies Act, 1912. There is, however, no obligation on other categories of taxpayers to get their accounts audited.A proper audit for tax purposes would ensure that the books of account and other records are properly maintained, •thattheyfaithfullyreflecttheincomeofthetaxpayerandclaimsfordeductionarecorrectlymadebyhim.Suchaudit would also help in checking fraudulent practices. It can also facilitate the administration of tax laws by a proper presentation of the accounts before the tax authorities and considerably saving the time of Assessing Officersincarryingoutroutineverifications,likecheckingcorrectnessoftotalsandverifyingwhetherpurchasesandsalesareproperlyvouchedornot.The timeof theAssessingOfficers thussavedcouldbeutilised forattending to more important investigational aspects of a case.”

8.3.2 Books of Accounts and List of Documents/Papers Required for Tax Audit PurposeFollowing are the books of accounts required

Cash Book •Bank Book •Journal •All Ledgers •Purchase Register •Sales Register •Stock Registers•

Need to maintain supporting documents and vouchers for above accounts

The necessary documentation for tax audit is listed below.All above books of accounts with supporting •Bank Passbook •Balance Sheet •Profitandlossaccount.•

141

8.3.3 Standard Procedures or Steps for Tax Audit

Sendanappointment letter toCharteredAccountant inyourofficial letter appointinghimas auditor.Your•appointment should have Ca Firm registration as per recent change. Please note that only CA has legal right to doTaxauditandhecansignonly45taxauditinayear.Pleaseconfirmwithhimonthis.Ask for Engagement Letter from Chartered Accountant for accepting your appointment. Please make sure that •you maintain a copy of this letter as permanent record at least for 6 years. Get this engagement letter on his CA letter head with duly signed by him and date. Before sending engagement letter to you for your sign, CA needs to get “No objection letter” to previous tax auditor. This is mandatory as per ICAI guidelines and Professional code of ethics.During audit, CA may ask you to provide management representations – For closing stock valuation etc. Please •provide the same to auditorFinally CA will give audit report in above mentioned forms – Form 3CA/Form 3CB and Form 3CD. Audit •report should contain date, seal and sign of CAMentionCAname,PAN,Firmregistration#,ICAImembership#withauditsigneddatewhilefilingITR4.•Thisneedstobedoneonorbefore30thSepttofileRegularReturn.PYBalanceSheet,PYProfitandLossaccountandPYTaxAuditReportFormsneededforcomparisonstudy•and reporting purpose

8.3.4 Requirements of Tax AuditThepurposeofTaxauditistoensurepropermaintenanceofbooksofaccountsandotherrecords,inordertoreflectthetrueincomeoftheassesseeandtofacilitatetheassessingofficertocarryouttheverification.

While conducting a tax audit, the following points need to be kept in mind:Itistheprimaryresponsibilityoftheassesseetogiveclassifiedinformationforthepurposeoftaxaudit.This•isintheinterestofanefficientconductoftaxaudit.TheTaxauditorhastoensurethatthedataheauditsusingTally.ERP9isthefinalone.•Audit Programme and the extent of Audit Procedures have to be planned according to the nature of business •and operations of the client.Particulars given in Form 3CD have to be true and correct. The emphasis is on the accuracy of data extracted.•Thedataextractedhastobefurtherfilteredtocertainquantity/valuelimitsasjudgedbytheCA.TheConcept•of Materiality – AAS 13 has to be referred to while preparing the particulars to be reported. Print outs of particulars reported in Form 3CD should be duly signed by the authorised signatory, and be kept •as working papers. AAS 3 - Documentation - Working PapersMany of the particulars require exercise of judgment by the tax auditor.•Tally.ERP 9 is used only to generate various reports and required information, reporting of such information or •not is subject to tax auditor’s judgment.The tax audit report is for an assessee. Details/ information should be consolidated where the enterprise has •more than one division/ unit/ branch and accounts are maintained separately for each division/ unit/ branch. Where an auditor is required to furnish tax audit report only in respect of a division/ unit/ branch, details of the same should be mentioned in the Report.

8.3.5 Tax AuditorTheterm“accountant”hasbeendefinedinsub-clause(i)ofExplanationtosection44ABasunder:-“Explanation, - For the purposes of this section, -(i) “accountant” shall have the same meaning as in the Explanation below sub-section (2) of section 288”.

The above-mentioned Explanation reads as under:“Accountant’ means a chartered accountant within the meaning of Chartered Accountants Act, 1949 (38 of 1949) and includes, in relation to any State, any person, who by virtue of the provisions of sub-section (2) of section 226 of the Companies Act, 1956 (1 of 1956), is entitled to be appointed to act as an tax auditor of companies registered in that State.”


142

The proviso to section 44AB also lays down that where the accounts of an assessee are required to be audited by orunderanyotherlaw,itshallbesufficientcompliancewiththeprovisionsofthissection,ifsuchpersongetstheaccountsofsuchbusinessorprofessionauditedundersuchotherlawbeforethespecifieddateandfurnishesbythatdate the report of the audit as required under section 44AB. It may be noted that with the deletion of the words “by an accountant” in the proviso to section 44AB by the Finance Act, 1985 with effect from 1st April, 1985, in the case of any assessee like a co-operative society where the accounts under the relevant law are allowed to be audited by a person other than a chartered accountant, the tax audit may also be conducted by the statutory auditor who may not be a chartered accountant.

Though the section refers to the accounts being audited by an accountant, which means a chartered accountant as definedabove,theauditcanalsobedonebyafirmofcharteredaccountants.Thishasbeenarecognisedpracticeunder the Act. In such a case, it would be necessary to state the name of the partner who has signed the audit report onbehalfofthefirm.Themembersigningthereportasapartnerofafirmorinhisindividualcapacityshouldgivehis membership number below his name.

Section 44AB does not stipulate that only the statutory auditor appointed under the Companies Act or other similar statute should perform the tax audit. The tax audit can, therefore, be conducted either by the statutory auditor or by any other chartered accountant in practice.

Taxauditundersection44ABbeingarecurringauditassignment,forexpressingprofessionalopiniononthefinancialstatements and the particulars, the member accepting the assignment should communicate with the member who had done tax audit in the earlier year as provided in the Chartered Accountants Act. In the case of a person whose accounts of the business or profession have been audited under any other law (i.e., a company, a co-operative society, etc. which is required to get the accounts audited under a Statute) it is not necessary to communicate with the statutory auditor if he had not done tax audit in the earlier year. Attention of the members is invited to the detailed discussion in the publication of ICAI, “Code of Conduct” under clause (8) of Part I of the First Schedule to the Chartered Accountants Act, 1949 vide Appendix II.

The tax auditor should obtain from the assessee a letter of appointment for conducting the audit as mentioned in section 44AB. It is advisable that such an appointment letter should be signed by the person competent to sign the return of income in terms of the provisions of section 140. The tax auditor should get the statement of particulars, as required in the annexure to the audit report, authenticated by the assessee before he proceeds to verify the same.The tax auditor is required to submit his report to the person appointing him, viz., the assessee.

The appointment of the auditor for tax audit in the case of a company need not be made at the general meeting of themembers.ItcanbemadebytheBoardofDirectorsorevenbyanyofficer,ifsoauthorisedbytheBoardinthisbehalf.Theappointmentinthecaseofafirmoraproprietaryconcerncanbemadebyapartnerortheproprietorora person authorised by the assessee. It is possible for the assessee to appoint two or more chartered accountants as joint auditors for carrying out the tax audit, in which case, the audit report will have to be signed by all the chartered accountants. In case of disagreement, they can give their reports separately. In this regard, attention is invited to paragraph 15 of the Statement on the Responsibility of Joint Auditors reproduced below: “No problem arises if the joint auditors are able to arrive at an agreed report. But, where joint auditors are in disagreement with regard to the report,eachoneofthemwouldbejustifiedinexpressinghisownopinionthroughaseparatereport.Evenwheremore than two joint auditors are appointed, there is no question of majority or minority with regard to the joint audit report. Each auditor is entitled to express his own separate opinion and, in fact, it is his duty to do so.”

The responsibility of joint tax auditors will be the same as in the case of other audits, for example, audit under the Companies Act. For details relating to such responsibility, in the case of joint tax audit, reference may be made to “Statement on the Responsibility of Joint Auditors” issued by ICAI. The same is reproduced in Appendix III.

Thepositionofataxauditorforconductingauditundersection44ABwillbeconsideredasanofficeofprofit.Therefore, the provisions of section 314 of the Companies Act, 1956 will be attracted when a relative of a director is appointed as a tax auditor of the company, if the remuneration thereof exceeds the limits prescribed in the aforesaid section. The necessary formalities will be required to be complied with as required under section 314.

143

8.4 Management AuditManagement audit or process audit is the audit of the management, i.e., evaluation of the mangers’ ability to manage. Itmaybedefinedas“thesystematic independentappraisalactivity,withinanorganisation,forareviewof themanagement’sefficiency,initsdecisionmakingfunction.

It is concerned with appraising:Management’s accomplishment of organisational goals•Management functions of planning, organising, directing and controlling.•Adequacy of management’s decisions and action in attaining its objectives.•

The management audit is a more recent concept. It focuses on results, evaluating the effectiveness and suitability of controls by challenging underlying rules, procedures and methods. Management audits, which are generally performed internally, are compliance audits plus cause-and-effect analysis. When performed correctly, they are potentially the most useful of the evaluation methods, because they result in change.

8.4.1 Process of Management AuditManagement audit is a key internal control tool for managements and company boards to ensure that daily business operations are being carried out as per laid down rules and procedures. Thus, risk based Process Audit involves ahostofactivitieslikecollectionandanalysisofdata,physicalverificationandreconciliationofdatagenerated,based on agreed standards. Thus, Process Audits also ensure that data collected by analysis of the entire or selected processofacompanyisusedforfurtherenhancingtheefficiencyandusabilityoftheprocess.

The cornerstone of CRP team’s end-to-end solutions approach is obtaining a good understanding of the client’s business process and objectives including organisational structure, systems & processes, applications and data input and output. Key processes which are risk prone and are critical to meeting the business’s objectives are evaluated by using qualitative and quantitative information.

8.4.2 Advantages of Management AuditProcess Audit is one of the key measures in ensuring the smooth and risk free running of any enterprise - business, government or social organisations. With corporations having multi-country, multi-location and multi-divisions, non-compliance becomes a high probability and human control and physical checks for each and every process becomes an unviable, cumbersome and a costly affair.

A Process Audit on regular interval helps an organisation ensure process compliance and monitoring. Also, a Process Audit helps in identifying areas of non-compliance, purposeful fraud or ignorance at an early stage and suggests means and ways to plug the same. Lastly, with changing business environment, Process Audits help in bettering existingprocesses,improvingefficiencyandaddingquantifiableprofitstothecompany.

8.4.3 Management Audit ReportThe written report uses the medium by which the comments, criticism and recommendations of a management audit department are conveyed to the Board, to functional directors and to management in general. It follows, therefore, that audit reports crystallise the work of the management auditor and merit the closest consideration of all audit staff engaged in their preparation. Reports must be written with very great care after full consideration of the subject matter and with full regard to the fact that it is imperative that the report conveys exactly the right impressionsonthereader.Managementauditreportswillinevitablycoverawidevarietyofsubjects,reflectingastheydothemanyandeverincreasingramificationsofmanagementauditdepartments.Reportscanbedividedintofour main categories.

Reports prepared by the management audit staff after their visits to a unit.•Periodical reports prepared by senior members of management audit department which summarise the main •auditfindingsandrecommendationsfortheperiodunderconsiderationandwhichaffordaconcisereviewofthe department’s activities for that period.


144

Reports in the results of special investigation and inquiries.•An annual audit report.•

The right of the management auditor to report to the highest level is now well established in many organisations butinallcasesresponsibleofficialsofthedifferentunitswhichhavebeensubjectedtoaudit,shouldbeaffordedtheopportunityofdiscussingmattersinthereportconcerningtheirdepartmentsbeforethisispassedinfinalformto a higher level.

145

SummaryTheimprovementinthepublicfinancesofthecountryisnowdependent,amongotherfactorsontheprogress•made in reforms of public sector management in general and State enterprises in particular.The audit of privatisation is yet to acquire deep roots in Asia, Africa and other developing countries. Most of •the countries in this region have not initiated privatisation in a big way.SAI-India hasfirmly established its jurisdictionwithin the existing legal framework andhas successfully•conducted the audit of partial disinvestment of the shares of Government companies conducted in 1992.TheInstituteofCostandWorksAccountantsofIndiaontheotherhand,definescostauditas“asystemofaudit•introduced by the Government of India for the review, examination and appraisal of the cost accounting records andattendantinformation,requiredtobemaintainedbyspecifiedindustries.”Cost Audit in India refers to the statutory Cost Audit of the selected companies covered under the relevant •provisions of the Companies Act, 1956.Cost Audit has both general and social objectives.•BoardofDirectorsofeverycompanyhasastatutoryobligationtoplaceitsauditedannualaccounts,viz.,Profit•andLossAccountandBalanceSheetbeforetheshareholdersintheAnnualGeneralMeeting,dulycertifiedbya Chartered Accountant appointed as an ‘Auditor’ under the provisions of Section 224 of the Act.One of the pre-requisites of cost audit is the maintenance of cost accounting records by the company.•TheCentralGovernment issuesaspecificorderunderSection233(B)(1)of theCompaniesAct,1956ona•particular company directing it to get its cost records audited by a practicing Cost Accountant indicating the product for which the order is issued and the period for which it is ordered.Thecostauditormaybeanindividualcostaccountantorafirmofcostaccountantswithatleasttwopartners.•The tax audit was introduced by insertion of a new section 44AB to the Income Tax Act, 1961 w.e.f 1st April, •1985.The purpose of Tax audit is to ensure proper maintenance of books of accounts and other records, in order to •reflectthetrueincomeoftheassesseeandtofacilitatetheassessingofficertocarryouttheverification.Management audit or process audit is the audit of the management, i.e., evaluation of the mangers’ ability to •manage.The written report uses the medium by which the comments, criticism and recommendations of a management •audit department are conveyed to the Board, to functional directors and to management in general.

ReferencesICAI, 2005. • Guidance Note on Tax Audit under Section 44AB of the Income-tax Act, 1961, [PDF] Available at: <http://220.227.161.86/21025guide_44AB_dtc.pdf>. [Accessed 11 December 2011].Oza, B. M., • Recent Trends in the Audit of Privatisation -A Comparative Analysis [Online] Available at: <http://asosai.org/journal1997/recent_trends_in_the_audit.htm>. [Accessed 11 December 2011].Cosserat, G. W and Rodda, N., 2009. • Modern Auditing, 3rd ed., John Wiley and Sons.Turley, S., 1997. • Current issues in auditing, Sage.ONTS9, 2011. Tax Audit Representation [Video Online] Available at: <http://www.youtube.com/watch?v=-•vuTI5L2zRk>. [Accessed 13 December 2011].pitstop4performers, 2009. Cost audit is a tool of enterprise governance [Video Online] Available at: <http://•www.youtube.com/watch?v=s44vVxCA-3U>. [Accessed 13 December 2011].

Recommended ReadingDicksee, L. R., 1976., • Auditing: a practical manual for auditors: The History of accounting, Ayer Publishing.Rittenberg, L, E., Johnstone, K, Gramling, A. A. and Schweiger, B., 2009. • Auditing: A Business Risk Approach, 7th ed., Cengage Learning.Rezaee,Z.,2002.• Financial statement fraud: prevention and detection, John Wiley and Sons.


146

Self Assessment____________ essentially means transfer of ownership from the State into the hands of non-state entities.1.

Publica. Privatisationb. Autonomousc. Government aidedd.

Which of the following is false?2. ThedeterioratingprofitabilityandincreaseinsubsidiesofStateenterpriseshavefurtherstrengthenedthea. beliefthatprivatisationremainstheonlyremedytoinjectefficiencyintopublicsectormanagement.The State objectives in privatisation and the historical background as well as the legal mandate of the SAI b. ineachcountrywillalsoinfluenceitsapproachineachcase.The audit of privatisation is yet to acquire deep roots in Asia, Africa and other developing countries.c. Audit of industrialisation is one of the most complex issues faced by SAIs in their long and chequered d. history.

Which of the following is the audit of cost records?3. Internal audita. External auditb. Cost auditc. Management auditd.

According to ____________, cost audit is “the verificationof the correctness of cost accounts andof the4. adherence to the cost accounting plan”.

CIMAa. ICAIb. ICWAIc. IIAId.

__________definescostauditas“asystemofauditintroducedbytheGovernmentofIndiaforthereview,5. examination and appraisal of the cost accounting records and attendant information, required to be maintained byspecifiedindustries.”

CIMAa. ICAIb. ICWAIc. IIAId.

Which of the following is the Tax audit month?6. Aprila. Decemberb. Marchc. Septemberd.

The tax audit was introduced by insertion of a new section 44AB to the __________.7. Income Tax Act, 1961 a. Companies Act, 1956b. Co-operative Societies Act, 1912c. Chartered Accountants Act, 194d.

147

The purpose of ________ is to ensure proper maintenance of books of accounts and other records, in order to 8. reflectthetrueincomeoftheassessee.

Internal audita. Tax auditb. Management auditc. Cost auditd.

The _________should obtain from the assessee a letter of appointment for conducting the audit as mentioned 9. in section 44AB.

internal auditora. cost auditorb. tax auditorc. statutory auditord.

_____________ or process audit is the audit of the management, i.e., evaluation of the mangers’ ability to 10. manage.

Internal audita. Tax auditb. Management auditc. Cost auditd.


148

Case Study I

How a private investment manager utilised a comprehensive team to successfully raise capital

The issue: Alargeprivatealternativeinvestmentmanageridentifiedamarketopportunitytoraisecapitalandregistershares with the SEC. Unfortunately, neither the manager nor a majority of its funds had ever maintained US GAAP compliantfinancialinformationinthepast.Inordertocompletethedesiredcapitalraising,managementneededto produce audited historical US GAAP information, make strides toward developing a Sarbanes-Oxley-compliant controlenvironment,andprepareacompleteregistrationstatementforfilingwiththeSEC.

Our approach: PwCidentifiedateamoftransactionspecialiststoadvisetheclientthroughoutthemultipleprocessesof data gathering, data conversion, financial statement preparation, audit coordination, registration statementpreparation and responding to SEC questions and comments. The company encountered an enormous number of complex accounting issues and we worked beside them, advising them based on our experiences and insights to enable the client to arrive at its own well-considered conclusions. When it came time to convert the data, and preparethefinancialstatements,ourteamstayedwiththem,continuingtoadviseandcounselthecompanyanditsteam of consultants throughout the process. Finally, our transaction specialists drew upon their extensive capital markets experience to counsel the company throughout the preparation of the registration statement, and responding to inquiries from the SEC.

The outcome: Thanks to a team effort of the company, its consultants, PwC Transaction Services specialists and others, the company was able to achieve its desired capital raising objectives. Many long hours were invested by all partiesworkingandadvisingtoprepareauditedfinancialstatements,togetherwithacompleteregistrationstatementproviding investors with clear, transparent descriptions of the company’s performance over its track record period so they could make informed investment decisions.

(Source: Pwc.com. Capital Markets case study [Online] Available at: <http://www.pwc.com/us/en/transaction-services/case-studies/capital-markets.jhtml> [Accessed 13 December 2011].)

QuestionsWhich issue is prescribed in the above case study?1. Answer Alargeprivatealternativeinvestmentmanageridentifiedamarketopportunitytoraisecapitalandregistershareswith the SEC. Unfortunately, neither the manager nor a majority of its funds had ever maintained US GAAP compliantfinancialinformationinthepast.Inordertocompletethedesiredcapitalraising,managementneededto produce audited historical US GAAP information, make strides toward developing a Sarbanes-Oxley-compliant controlenvironment,andprepareacompleteregistrationstatementforfilingwiththeSEC.

State the approach to the issue mentioned in the above case study by PwC.2. AnswerPwCidentifiedateamoftransactionspecialiststoadvisetheclientthroughoutthemultipleprocessesofdatagathering,dataconversion,financialstatementpreparation,auditcoordination,registrationstatementpreparationand responding to SEC questions and comments. The company encountered an enormous number of complex accounting issues and we worked beside them, advising them based on our experiences and insights to enable the client to arrive at its own well-considered conclusions. When it came time to convert the data, and prepare the financialstatements,ourteamstayedwiththem,continuingtoadviseandcounselthecompanyanditsteamofconsultants throughout the process. Finally, our transaction specialists drew upon their extensive capital markets experience to counsel the company throughout the preparation of the registration statement, and responding to inquiries from the SEC.

149

Specify the outcome of the solution provided by PwC.3. AnswerManylonghourswereinvestedbyallpartiesworkingandadvisingtoprepareauditedfinancialstatements,together with a complete registration statement providing investors with clear, transparent descriptions of the company’s performance over its track record period so they could make informed investment decisions.


150

Case Study II

Implementation of a local internal audit function with a financial services company

Afinancialservicescompany(subsidiaryofaninternationalgroup)wasconsideringtheimplementationofalocalinternalauditfunctioninLuxembourg.Theobjectivewastodefinewhichorganisationwouldbecosteffective(externalising the audit, appointment of an internal auditor or assigning the role to a member of the group).

Our approachReviewtheexistingorganisation(processes,humanresourcesandsystems)andidentifykeyrisks;•EvaluatetherequirementsandexpectationsoftheBoardofDirectorsandexecutivecommitteemembers;•Create an internal audit report template that includes specific reporting topics required by theBoard of•Directors;Assistindesigningtheauditplanandauditprograms;•Defineanddescribethescopeoftheinternalauditor’sjob;•Managetheinternalauditor’srecruitmentprocess;•Traintheinternalauditor;•Provide quality review of audit reports.•

The outcomeCreation of a cost effective internal audit department in Luxembourg•Significantimprovementstothecompany’organisation•Improvement of reporting process to the Board of Directors•

(Source: Pwc.lu. Internal Audit Services: Case Study [Online] Available at: <http://www.pwc.lu/en/internal-audit/case.jhtml> [Accessed 13 December 2011].)

QuestionsStatetheissuefacedbythefinancialservicescompany.1. Mention the measures taken for the issue in the above case study.2. What is the outcome of the approach?3.

151

Case Study III

ICAI seeks jail in audit fraud cases

The Institute of Chartered Accountants of India (ICAI) has recommended strict penal action, including imprisonment, for auditors who are found associated with serious accounting frauds.

ItalsowantstheMinistryofCorporateAffairstoframeacodeofconductforfinancialanalystsandinvestmentbankersforbetterscrutinyoffirmsthatmayindulgeinsuchillegalaffairs.

TherecommendationsarepartofICAI’sfinalreportonSatyamscamandtheroleofSatyam’sformerstatutoryauditorsfromglobalauditingfirmPriceWaterhouseCoopers.Thereport,finalisedbyICAI’shighestdecision-makingcouncil a few days ago, would be submitted to the ministry this week.

According to sources, ICAI has recommended strict action against auditors known to have collided with Satyam’s former promoter Ramalinga Raju in committing fraud. The committee has also recommended fresh scrutiny of the accountbooksofallassociatefirmsandsubsidiarycompaniesoftheRajufamily.ICAIofficialsconfirmedthatitsapexcouncilhadfinalisedthereportonMay13,butdeclinedtoprovidedetails.

An ICAI sub-committee, which carried out extensive inquiry into the scam in January this year, submitted its report to the institute’s council. The sub-committee report prima facie found fault with PriceWaterhouse auditors S Gopalakrishnan and S Talluri, and recommended disciplinary action, including a professional ban on the two individuals.

ThecentralcouncilofICAItooktimetofirmupitsviewsonthereportasitwantedtheaccusedauditorstobegivena fair chance to present their case.

(Source: Mathew, J. C., ICAI seeks jail in audit fraud cases [Online] Available at: <http://www.business-standard.com/india/news/icai-seeks-jail-in-audit-fraud-cases/395159/> [Accessed 13 December 2011].)

QuestionsThe Institute of Chartered Accountants of India (ICAI) has recommended strict penal action, including 1. imprisonment, for auditors who are found associated with whom?State the recommendations of the ICAI cub-committee report mentioned in the above case study.2. The above case study is related to which fraud case?3.


152

Bibliography

ReferencesAnderssen, J., 2008. • Money Market Instruments [Video Online] Available at: <http://www.youtube.com/watch?v=gv-9VkRY5dI>. [Accessed 13 December 2011].Appannaiah, H.R., Reddy, P.N. and Sharma, N.M, 2010. • Financial Markets and Services, Global Media.Brozzeti, M., 2010. Internal Auditing & Fraud Interview (1 of 2) [Video Online] Available at: <http://www.•youtube.com/watch?v=i4R_a9GZP58>.[Accessed13December2011].Caclubindia.com, • Process of Conducting Internal Audit [Online] Available at: <http://www.caclubindia.com/articles/print_this_page.asp?article_id=69>. [Accessed 10 December 2011].Choudhary, S., 2010. • Audit and Fraud [Online] Available at: <http://www.caclubindia.com/articles/audit-and-fraud-6835.asp>. [Accessed 11 December 2011].Choudhry, M., 2002. • Capital market instruments: analysis and valuation, Volume 1, FT Press.Cosserat, G. W and Rodda, N., 2009. • Modern Auditing, 3rd ed., John Wiley and Sons.Dalal, C., 2008. • Auditing, [Online] Available at: <http://www.bcasonline.org/articles/artin.asp?819>. [Accessed 11 December 2011].Desai, Vasant, 2009. • Financial Markets and Financial Services, Global Media.Egyankosh, All India Financial Institutions [PDF] Available at: <http://www.egyankosh.ac.in/•bitstream/123456789/25900/1/Unit11.pdf>. [Accessed 5 December 2011].Egyankosh, • Auditing System in India [PDF] Available at: <http:/ /www.egyankosh.ac.in/bitstream/123456789/25433/1/Unit-22.pdf>. [Accessed 10 December 2011].Financial Institutions, Lecture 01 • [Video Online] Available at: <http://www.youtube.com/watch?v=btdTkebcwSs> [Accessed 9 December 2011].Financial Institutions, Lecture 02 • [Video Online] Available at: <http://www.youtube.com/watch?v=btdTkebcwSs> [Accessed 9 December 2011].Gopalsmay, N., 2005. • Capitalmarket:theIndianfinancialscene, India: Macmillan.Gray,I and Manson, S., 1989. • The audit process: principles, practice and cases, Routledge.Henderson, J. K., • WhatArethe4TypesofAuditReports? [Online] Available at: <http://smallbusiness.chron.com/4-types-audit-reports-3794.html>. [Accessed 11 December 2011].ICAI, 2005. • Guidance Note on Tax Audit under Section 44AB of the Income-tax Act, 1961, [PDF] Available at: <http://220.227.161.86/21025guide_44AB_dtc.pdf>. [Accessed 11 December 2011].Indiastock.wikia.com. National Stock Exchange of India An Overview [Online] Available at: <http://indianstocks.•wikia.com/wiki/National_Stock_Exchange_of_India_An_Overview>. [Accessed 6 December 2011].Institute of Internal Auditors, India, Introduction [Online] Available at: <http://www.iiaindia.org/guidance.asp>. •[Accessed 10 December 2011].Joshi, I., 2010. • RBI Monetary Policy [Video Online] Available at: <http://www.youtube.com/watch?v=jqb2DoWKL9I&feature=related>. [Accessed 13 December 2011].Kalyancity. • Functions of Reserve Bank of India RBI - RBI Credit Policy [Online] Available at: <http://kalyan-city.blogspot.com/2010/09/functions-of-reserve-bank-of-india-rbi.html> [Accessed 9 December 2011].Kaplan Channel UK, 2011. • Types of audit reports [Video Online] Available at: <http://www.youtube.com/watch?v=Ffov8F2mNsI&feature=related>. [Accessed 13 December 2011].Kapoor, G. P., 2004. Commercial Banking, APH Publishing.•Kotak Securities Ltd., 2011. • Indian Financial Market Review-2011 - Kotak Securities - Indian Economy [Video Online] Available at: <http://www.youtube.com/watch?v=basQcPXpu7E> [Accessed 13 December 2011].Kumar, R. and Sharma, V., 2005. • Auditing: principles and practice, PHI Learning Pvt. Ltd.Machiraju, H.R., 2008. • Modern Commercial Banking, New Age International.

153

Madura, J., 2010• . Financial Institutions and Markets, Cengage South-Western, p.250.mbaknol, • Depository System in India [Online] Available at: <http://www.mbaknol.com/investment-management/depository-system-in-india/>. [Accessed 1 December 2011].Mbrozetti, 2010. • WhatisInternalAuditingandit’sDefinition? [Video Online] Available at: <http://www.youtube.com/watch?v=_nOe6rH6rq0>. [Accessed 13 December 2011].Money Control, 2011. • Capital market reforms important for India, says KKR India 1 [Video Online] Available at: <http://www.youtube.com/watch?v=JXQydBnqia0>. [Accessed 13 December 2011].Moneycontrol, 2003. • IFCIfinancialstrengthstrong;CARat20% [Video Online] Available at: <http://www.youtube.com/watch?v=Yprr-EDO-mw>. [Accessed 13 December 2011].Murthy, D. K. & Venugopal, K. R• ., Indian Financial System, I. K. International Pvt. Ltd, p.152.NABARD, 2007. • Introduction to NABARD [Online] Available at: <http://www.nabard.org/introduction.asp>. [Accessed 5 December 2011].NDTV, 2009. • Satyamscam:Auditorsinthelineoffire [Video Online] Available at: <http://www.youtube.com/watch?v=EU0wYQW1SMs&feature=fvsr>. [Accessed 13 December 2011].NDTVProfit,2011.• BankingLawsAmendmentBilltobenefitcommercialbanks [Video Online] Available at: <http://www.youtube.com/watch?v=Aim-XDYCm4Q>. [Accessed 13 December 2011].Nos.org. • Functions of Commercial Banks [PDF] Available at: <http://www.nos.org/srsec319/319-33.pdf>. [Accessed 5 December 2011].Nos.org• . Indian Financial Market [PDF] Available at: <http://www.nos.org/srsec319new/319EL18.pdf>. [Accessed 6 December 2011].Nymigvideo, 2011. • Audits: Types and Preparation [Video Online] Available at: <http://www.youtube.com/watch?v=s-lI-bCZMw4>.[Accessed13December2011].ONTS9, 2011. Tax Audit Representation [Video Online] Available at: <http://www.youtube.com/watch?v=-•vuTI5L2zRk>. [Accessed 13 December 2011].Oza, B. M., • Recent Trends in the Audit of Privatisation -A Comparative Analysis [Online] Available at: <http://asosai.org/journal1997/recent_trends_in_the_audit.htm>. [Accessed 11 December 2011].pitstop4performers, 2009. • Company auditor appointment should be made by the ICAI or the Government [Video Online] Available at: <http://www.youtube.com/watch?v=zBMTyT0_-9c>. [Accessed 13 December 2011].pitstop4performers, 2009. • Cost audit is a tool of enterprise governance [Video Online] Available at: <http://www.youtube.com/watch?v=s44vVxCA-3U>. [Accessed 13 December 2011].Reserve Bank of India. • Reserve Bank of India: Functions and Working [pdf] Available at: <http://rbidocs.rbi.org.in/rdocs/Content/PDFs/FUNCWWE080910.pdf> [Accessed 9 December 2011].Reservebankindia, 2010. • The Reserve Bank of India: Making a Difference [Video Online] Available at: <http://www.youtube.com/watch?v=YwTxuRMXjg0>. [Accessed 13 December 2011].Rezaee,Z.,2002.• Financial statement fraud: prevention and detection, John Wiley and Sons.Ricchiute, D. N., 2006. • Auditing, 8th ed., Thomson/South-Western.Scribd.com. • Audit of Banks [Online] Available at: <http://www.scribd.com/doc/19034757/Audit-of-Bank1>. [Accessed 11 December 2011].Singh and Associates, 2008. • Merchant Banking, [Online] Available at: <http://www.asialaw.com/Article/1988860/Channel/16958/Merchant-Banking.html>. [Accessed 1 December 2011].Turley, S., 1997. • Current issues in auditing, Sage.


154

Recommended ReadingBarger, T., International Finance Corporation, World Bank, 1998. • Financial institutions, World Bank Publications, p.135.Basu, C. R. • Commercial Banking in the Planned Economy of India, Mittal Publication.Basu. • Auditing: Principles and Techniques, Pearson Education India.Choudhary, C, M., 2006. • Financial market in India, Indus Valley Publications.Cosserat, G. W and Rodda, N., 2009. • Modern Auditing, 3rd ed., John Wiley and Sons.Dicksee, L. R., 1976., • Auditing: a practical manual for auditors: The History of accounting, Ayer Publishing.Fabozzi, F., J., and Modigliani, F., 2003. • Capital Markets, 3rd ed., Prentice Hall. Gordon, E. and Natarajan, K. 2010. • Financial Markets, Global Media.Gray,I and Manson, S., 1989. The audit process: principles, practice and cases, Routledge.•Gup, B. E., Kolari, J. W. and Fraser, D. R., 2005. • Commercial banking: the management of risk, J. Wiley.Howells, P. and Bain, K., 2007. • Financial markets and institutions, 5th ed., Prentice Hall/Financial Times, 2007Kanuk A., R., 2002. • Capital markets of India: an investor’s guide, John Wiley and Sons.Khan, 2006. • Indian Financial System 5E, Tata McGraw-Hill Education.Millichamp, A. H., 2002. • Auditing, 8th ed., Cengage Learning EMEA.Pathak, 2007. • The Indian Financial System: Markets, Institutions and Services, 2nd ed., Pearson Education India, p.752.Rathore S., 2003. • Indian Capital Market: An Empirical Study, Anmol Publications PVT. LTD., Ray, P., Academic Foundation, 2008. • Commercial Banks and monetary policy in India, Volume 2, Academic Foundation. Rezaee,Z.,2002.• Financial statement fraud: prevention and detection, John Wiley and Sons.Ricchiute, D. N., 2006. • Auditing, 8th ed., Thomson/South-Western.Rittenberg, L, E., Johnstone, K, Gramling, A. A. and Schweiger, B., 2009. • Auditing: A Business Risk Approach, 7th ed., Cengage Learning.

155

Self Assessment Answers

Chapter Ib1. c2. d3. c4. b5. a6. c7. d8. a9. c10.

Chapter IIa1. c2. d3. b4. c5. b6. a7. b8. a9. d10.

Chapter IIIb1. a2. d3. b4. a5. d6. d7. c8. d9. a10.

Chapter IVc1. b2. d3. b4. a5. c6. b7. c8. a9. c10.


156

Chapter Vb1. c2. a3. d4. c5. c6. c7. b8. c9. d10.

Chapter VIc1. a2. d3. a4. b5. b6. b7. a8. c9. a10.

Chapter VIIb1. b2. d3. c4. d5. a6. c7. a8. a9. b10.

Chapter VIIIb1. d2. c3. a4. c5. d6. a7. b8. c9. c10.