Introduction
Financial statements and audits play a crucial role in ensuring the transparency, accountability, and financial health of a company. They provide stakeholders with critical financial information regarding the company’s performance, cash flows, and financial position. The Companies Act, 2013, along with accounting standards and regulatory frameworks, governs the preparation, presentation, and audit of financial statements in India.
This article comprehensively examines financial statements and audits, their legal framework, components, and judicial interpretations, ensuring a thorough understanding of their significance in corporate governance.
Legal Framework Governing Financial Statements and Audit
Relevant Provisions Under the Companies Act, 2013
The Companies Act, 2013, contains detailed provisions regarding financial statements and audits. Some of the key provisions include:
● Section 128: Books of accounts to be maintained.
● Section 129: Financial statements must give a true and fair view.
● Section 133: Compliance with accounting standards.
● Section 134: Board’s report and financial statements approval.
● Section 139-147: Audit and appointment of auditors.
● Section 143: Powers and duties of auditors.
● Section 148: Cost audit in specific cases.
The above provisions ensure that financial reporting is accurate, standardized, and compliant with the legal requirements, safeguarding investors’ and stakeholders’ interests.
Financial Statements: Definition and Components
Definition of Financial Statements
As per Section 2(40) of the Companies Act, 2013, a financial statement is a formal record of a company’s financial activities, providing insights into its financial health. It includes:
● Balance Sheet – Reflects the company’s financial position, listing assets, liabilities, and equity.
● Profit and Loss Account (Income Statement) – Shows the company’s financial performance over a period, detailing revenue, expenses, and net profit/loss.
● Cash Flow Statement – Reports cash inflows and outflows under operating, investing, and financing activities. (Not required for One Person Company, Small Company, and Dormant Company.)
● Statement of Changes in Equity – Displays movements in shareholders’ equity, including retained earnings and dividends.
● Explanatory Notes to Accounts – Provide additional details on accounting policies, contingent liabilities, and financial adjustments.
The primary objective of financial statements is to present a true and fair view of a company’s financial affairs, ensuring compliance with accounting standards and regulatory requirements. These statements assist investors, creditors, regulators, and other stakeholders in making informed financial decisions. Accurate financial reporting enhances corporate transparency, accountability, and governance, reinforcing investor confidence in the corporate sector.
Components of Financial Statements
Financial statements provide a structured representation of a company’s financial position and performance. They serve as critical tools for investors, regulators, and management in assessing a company’s financial health. The primary components of financial statements include the Balance Sheet, Profit and Loss Account, Cash Flow Statement, Statement of Changes in Equity, and Notes to Accounts.
Balance Sheet: The Balance Sheet reflects a company’s financial position at a specific date by listing its assets, liabilities, and equity. Assets represent economic resources controlled by the company, classified as fixed assets (such as property, plant, and equipment), current assets (such as cash, inventory, and receivables), and investments (such as shares in other companies). Liabilities include long-term obligations like loans and bonds, and short-term liabilities like trade payables and accrued expenses. Equity represents the shareholders’ claim on the company’s assets and includes share capital, reserves, and retained earnings. The balance sheet is prepared in accordance with Schedule III of the Companies Act, 2013.
Profit and Loss Account: The Profit and Loss Account (P&L Statement) details a company’s financial performance over a financial year. It records revenue from operations, other income, and various expenses, including cost of goods sold, administrative expenses, depreciation, and interest costs. The net result, either net profit or net loss, indicates the company’s profitability. As per Section 129 of the Companies Act, 2013, every company must prepare a profit and loss account that presents a true and fair view of its financial performance.
Cash Flow Statement: The Cash Flow Statement categorizes cash movements into three segments: operating activities (such as revenue and expenses), investing activities (such as purchase or sale of assets), and financing activities (such as raising capital or repaying loans). It helps stakeholders analyze a company’s liquidity position and its ability to generate cash.
Statement of Changes in Equity: This statement tracks changes in equity, such as issuance of shares, dividend distribution, and retained earnings adjustments. It provides insight into how a company utilizes its profits.
Notes to Accounts: Notes to Accounts supplement financial statements by explaining accounting policies, contingent liabilities, and major financial disclosures. These notes enhance transparency and compliance with Indian Accounting Standards (Ind AS) and the Companies Act, 2013.
Preparation and Presentation of Financial Statements
The preparation and presentation of financial statements in India are governed by the Companies Act, 2013, the Companies (Accounting Standards) Rules, 2021, and the Indian Accounting Standards (Ind AS). These regulations ensure that financial statements present a true and fair view of a company’s financial position and performance.
Requirements Under the Companies Act, 2013
Section 129(1) of the Companies Act, 2013, mandates that financial statements must be prepared in compliance with prescribed accounting standards to ensure consistency and transparency. They should present an accurate and fair assessment of the company’s financial status. Additionally, Section 134(1) requires that the Board of Directors approve the financial statements before they are presented to shareholders at the Annual General Meeting (AGM). The financial statements must also be signed by the Chairperson, Managing Director, or at least two directors, including a finance director, and the Chief Financial Officer (CFO), if applicable.
Furthermore, companies are required to adhere to Accounting Standards (AS) issued by the Institute of Chartered Accountants of India (ICAI). These standards ensure reliability and comparability in financial reporting across businesses.
Companies (Accounting Standards) Rules, 2021
Under these rules, companies are classified into two categories for the purpose of accounting standards compliance:
● Small and Medium Enterprises (SMEs) – Allowed to follow relaxed accounting norms due to their limited financial complexity.
● Non-SMEs – Must comply with detailed disclosure requirements and rigorous accounting norms.
Indian Accounting Standards (Ind AS)
For companies with a net worth of ₹250 crore or more, Ind AS (Indian Accounting Standards) are applicable. These standards align Indian financial reporting practices with International Financial Reporting Standards (IFRS), enhancing global comparability and credibility of Indian companies in international markets. Ind AS adoption is crucial for multinational corporations and listed companies to maintain transparency and investor confidence.
Audit of Financial Statements
Audit plays a crucial role in ensuring the accuracy, transparency, and compliance of a company’s financial statements. It serves as an independent verification mechanism that enhances corporate governance and investor confidence. The Companies Act, 2013 makes audits mandatory for all companies, reinforcing financial accountability.
Definition and Purpose of Audit
An audit is an independent examination of a company’s financial records and statements to verify their accuracy and fairness. The primary objectives of an audit include:
● Ensuring accuracy in financial records and reports.
● Verifying compliance with applicable laws, regulations, and accounting standards.
● Detecting and preventing fraud, errors, and financial misstatements.
● Enhancing credibility and transparency for investors, stakeholders, and regulatory bodies.
Under the Companies Act, 2013, statutory audits are mandatory for all companies, making the audit process a key element of corporate governance.
Types of Audits
1. Statutory Audit (Sections 139-147 of the Companies Act, 2013)
A statutory audit is legally required for all companies, ensuring compliance with financial regulations. Key features include:
● Conducted by a Chartered Accountant (CA) appointed by the Board and approved by shareholders.
● The auditor’s report must be presented at the company’s Annual General Meeting (AGM).
● Auditors must express an independent opinion on whether the financial statements present a true and fair view of the company’s financial position.
2. Internal Audit (Section 138 of the Companies Act, 2013)
An internal audit is conducted to assess a company’s operational efficiency, risk management, and internal controls. Key aspects include:
● Conducted by an internal auditor, who may be a CA, Cost Accountant, or another professional.
● Helps identify weaknesses in internal controls and suggests improvements.
3. Cost Audit (Section 148 of the Companies Act, 2013)
Cost audits are required for companies engaged in manufacturing, infrastructure, and other specified sectors. They ensure:
● Compliance with cost accounting standards.
● Transparent pricing and cost efficiency.
4. Tax Audit (Income Tax Act, 1961)
A tax audit is mandatory for companies with an annual turnover exceeding ₹10 crore. The objective is to:
● Verify tax compliance.
● Prevent tax evasion.
● Ensure accurate tax reporting under Section 44AB of the Income Tax Act, 1961.
Appointment, Duties, and Liabilities of Auditors
The Companies Act, 2013 lays down specific provisions regarding the appointment, responsibilities, and liabilities of auditors to ensure the credibility and transparency of financial statements.
Appointment of Auditors (Section 139 of the Companies Act, 2013)
The appointment of auditors follows a structured process to ensure independence and accountability.
● First Auditor:
o In the case of a company (excluding a government company), the Board of Directors must appoint the first auditor within 30 days of incorporation.
o If the Board fails, the members shall appoint the auditor within 90 days at an Extraordinary General Meeting (EGM).
● Subsequent Auditors:
o Appointed at the Annual General Meeting (AGM) for a term of five years.
o The appointment is subject to ratification by shareholders at each AGM.
o Listed companies and certain other classes of companies must rotate auditors after a specified period to prevent conflicts of interest.
Duties of Auditors (Section 143 of the Companies Act, 2013)
Auditors are responsible for ensuring the financial integrity of a company. Their primary duties include:
● Examining the company’s books of accounts, financial records, and compliance with accounting standards.
● Expressing an opinion on whether the financial statements present a true and fair view of the company’s financial position.
● Detecting fraud, misstatements, and non-compliance with financial laws and reporting them to the Board.
● Reporting irregularities to the government in case of suspected fraud exceeding ₹1 crore, as mandated under Section 143(12).
Liabilities of Auditors (Section 147 of the Companies Act, 2013)
Auditors are legally accountable for any misconduct, negligence, or false reporting.
● Civil Liability: Auditors can be held liable for damages if their actions cause financial loss to stakeholders.
● Criminal Liability:
o If an auditor knowingly provides a false audit report, they may face imprisonment of up to two years and fines.
o In cases of fraudulent conduct, stricter penalties, including higher fines and extended imprisonment, may be imposed.
Case Laws on Financial Statements and Audit
Judicial pronouncements play a crucial role in shaping corporate governance and financial accountability. Several landmark cases have reinforced the significance of accurate financial reporting and auditor responsibility under the Companies Act, 2013 and related laws.
Union of India v. Reliance Industries Ltd. (2010)
● Issue: The financial statements of Reliance Industries were challenged on the grounds that they did not accurately reflect the company’s financial position.
● Held: The Supreme Court ruled that financial statements must present a true and fair view of the company’s affairs, as mandated by Section 129 of the Companies Act, 2013.
● Significance: This case reinforced the principle of transparent financial reporting and emphasized the duty of companies to disclose complete and accurate financial information.
PNB Scam Case (2018) – Nirav Modi & Auditors’ Liability
● Issue: Punjab National Bank (PNB) suffered a massive fraud exceeding ₹11,000 crore due to fraudulent Letters of Undertaking (LoUs) issued by bank officials. The auditors failed to detect these fraudulent transactions.
● Outcome: The case led to increased accountability of auditors under Section 143 of the Companies Act, 2013. It also strengthened auditor reporting obligations for detecting fraud and non-compliance in financial statements.
● Significance: The case resulted in stricter banking and audit regulations to prevent similar scams in the future.
Satyam Scandal Case (2009)
● Issue: Satyam Computer Services manipulated its accounts by inflating profits and assets, misleading investors and regulators.
● Judgment: The fraud led to significant corporate governance reforms, including the introduction of mandatory auditor rotation and stricter penalties for false reporting under Sections 143 and 147 of the Companies Act, 2013.
● Significance: This case highlighted the importance of auditor independence and paved the way for regulatory reforms to improve financial transparency in India.
Reference
Taxmann’s Company Law And Practice
