Bombay High Court
Tri-Sure India Ltd. vs A.F. Ferguson And Co. And Others on 24 October, 1985
Equivalent citations: [1987]61COMPCAS548(BOM)
JUDGMENT M.L. Pendse, J.
1. The plaintiffs, Tri-Sure India Ltd., have instituted this suit on September 20, 1978, for recovery of sum of Rs. 63,84,792 with interest thereon at the rate of 16.25% per annum from the date of the suit till recovery and costs of the suit from the defendants.
2. The plaintiffs were incorporated as a private limited company in West Bengal under the name of Indian Flange Mfg. Co. Ltd. on February 10, 1960. The name was changed to Tri-Sure India (Pvt.) Ltd. on April 22, 1960, and the registered office was transferred to Bombay in the middle of the year 1962. The company was a wholly-owned subsidiary of American Flange Mfg. Co., United States of America. On February 24, 1975, the plaintiffs became a public limited company. The financial year of the plaintiffs is from September 1, to August 31.
3. Defendant No. 1 is a partnership firm of chartered accountants and is carrying on business for last over 85 years and has acquired reputation all over the country. Defendants Nos. 2 to 13 were the partners of defendant No. 1 at the relevant time. Defendant No. 1 was appointed as auditors of the plaintiffs right from the year 1960. Defendant No. 1 was also attending to the income-tax assessment of the plaintiff company.
4. The defendants audited the accounts of the plaintiffs for the year ended August 31, 1974, and the audit work was over by about October, 1974, and defendant No. 1 forwarded the long-form report to the plaintiffs, and the copy thereof to the holding company in the United States of America. The audit showed steep increase in sales and gross profit, taxes payable and net profits compared to the relevant figures for the previous year. The corresponding figures were as follows :
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Figures submitted Figures submitted
for the year for the year
ended 31-8-1973 ended 31-8-1974
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Rs. Rs. Sales 1,10,33,512 1,85,02,761 Gross profit 24,48,563 82,42,226 Income-tax 11,38,807 44,45,557 Surtax 34,091 9,41,216 Net profit 7,42,909 22,42,522
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5. On February 19, 1975, the accounts were reported by defendant No. 1 to the plaintiffs as required under section 227 of the Companies Act and the said accounts were approved by the shareholders at the annual general meeting held on February 20, 1975. Prior to this date, on December 9, 1974, the Controller of Capital Issues had passed an order for diluting the foreign equity holding with a view to comply with the Foreign Exchange Regulation Act, 1973, and thereupon the plaintiffs had decided to issue to the public 2,63,680 equity shares of the face value of Rs. 10 each at a premium of Rs. 7.50 per share. After the accounts for the year 1973-74 were approved by the shareholders in the annual general meeting, the plaintiffs issued the prospectus on February 26, 1975, inviting public to subscribe to the shares. As required by the provisions of the Companies Act, the report dated February 19, 1975, made by defendant No. 1 was annexed to the prospectus. The report, inter alia, states that the auditors had examined the accounts for the financial period ended April 30, 1970, and the subsequent four financial years, and the figures of profits after adjustments were set out. A perusal of this report indicates that there was generally a consistent pattern of an upward trend for the financial years 1970 to 1973, but the figures of the year ending with August 31, 1974, showed a remarkably steep increase and abnormal rise in the rate of profits. The public issue was heavily over-subscribed and the plaintiffs received an aggregate sum of Rs. 22,96,000 at the rate of Rs. 5 per share and the premium amount of Rs. 19,77,600. The shares were then allotted in pursuance of the prospectus.
6. The accounts for the next financial year ending with August 31, 1975, also indicated a steep increase in the rate of profits and large volume of sales were effected in the last three months of the financial year. On October 3, 1975, Singaravelu, head of the purchase department of the plaintiffs, informed Mr. C.J. E. Grundy, one of the directors of the plaintiffs and a partner of Little and Co. that the accounts of the financial year 1974-75 were manipulated by the staff to show large sales in the months of June, July and August, 1975. Mr. Grundy, in his turn, communicated the fact to Mr. Richard L. Parish who was also one of directors of the plaintiffs and residing at New York and who was also a director of the holding company. The disclosure by Singaravelu created a stir and Mr. Parish directed Mr. Wheaton to proceed to Bombay to ascertain the magnitude of fraud committed by the staff of the plaintiff company. At the same time, Mr. Parish also advised defendant No. 1 on October 6, 1975, to undertake confidential investigative audit to ascertain the true nature of the transactions alleged to have been effected by the plaintiffs. Defendant No. 1 was informed that there was reason to believe that finished goods were shipped to various godowns in Bombay in order to avoid their being recorded in the year in the inventories and consequently being treated as sold in the financial year. Mr. Wheaton arrived in Bombay on October 10, 1975, and immediately proceeded to the factory of the plaintiffs situate at Mahul, Chembur, and noticed that finished goods were indeed removed to the private godowns and erroneous record was prepared to show increase in sales in the last three months. Mr. Wheaton carried out the inspection in the presence of K. Shankar Hegde who was the managing director at the relevant time.
7. During the investigative audit undertaken by defendant No. 1 in respect of the accounts of the financial year 1974-75, several irregularities were noticed and thereupon defendant No. 1 extended the investigative audit in respect of the accounts of the previous year, that is financial year 1973-74 ending on August 31, 1974, and which accounts were already finalised.
8. During the course of the investigation, it was noted by defendant No. 1 that in respect of 35 sales invoices and 38 delivery challans prepared in the names of the customers for sales aggregating to Rs. 55.20 lakhs, various records of the subsequent year indicated a date of delivery subsequent to the end of the accounting year, except in one case where the delivery does not appear to have been made till the date of completion of the investigative audit. Defendant No. 1 also noted that as in the case of the year ended August 31, 1975, preprinted and serially numbered delivery challans have been issued on a date prior to August 31, 1974. In respect of 20 delivery challans for sales aggregating to Rs. 19.13 lakhs, there were carriers' bills, both dated August 31, 1974 from the company's main transport carrier, that is, M/s. Sonavane Transport Service for having booked these items to various destinations/customers on varying dates within the accounting year ended August 31, 1974. The investigation, however, revealed that in respect of at least 16 of these delivery challans for sales aggregating to Rs. 17.21 lakhs, there were further bills in the subsequent year from the carriers for booking these same items to the same destinations/customers on subsequent dates. It was also noticed by defendant No. 1 that out of the 38 delivery challans, 6 related to the Directorate-General of Supplies and Disposals and in respect of two invoices of this customer, the goods were put up for inspection prior to August 31, 1974, while in respect of one invoice, though the goods were put up for inspection on September 9, 1974, the company had written a letter addressed to the General Manager,, Ordnance Factory, Bhusawal, dated August 9, 1974, that arrangement should be made for inspection of the goods at the company's premises at the earliest convenience. It was further noted that all the inspection notes indicated that after the goods had been inspected, the relevant number of cases were stamped or stencilled with certain identification markings. The inspection, therefore, revealed that though the goods were delivered to the customer subsequent to August 31, 1974, the sales were shown in the earlier financial year with a view to boost the profits. There were several other irregularities noted by defendant No. 1 while undertaking the investigative audit for the financial year 1974-75 and, accordingly, a detailed report was submitted by defendant No. 1 to the plaintiffs on April 20, 1976. During the investigative audit, it came to notice that the accounts were manipulated by K. Shankar Hedge with the active co-operation of heads of various departments of the company.
9. K. Shankar Hedge was working with the plaintiffs since its inception, that is the year 1960, and in January, 1972, was appointed as wholetime director. Hedge was then appointed as managing director on January 21, 1975, but tendered his resignation on October 17, 1975, when manipulations of the accounts came to light and Hegde could not give satisfactory explanation to Mr. Wheaton and Mr. Parish, the two American directors of the holding company as well as the plaintiff company. Ultimately, on April 27, 1976, the plaintiffs filed a private criminal complaint against Hegde and two other officers in the Court of the Metropolitan Magistrate Bombay.
10. The special investigative report submitted by defendant No. 1 was included as part of the statutory report of directors to shareholders and was presented on May 24, 1976, that is at the fifteenth annual general meeting. It is the claim of the plaintiffs that the market value of the shares tumbled down after the report became public. The plaintiffs realised that the shares were offered to the general public on misrepresentation of the true state of accounts of the company, as existed on August 31, 1974, and, therefore, offered to refund all moneys which were subscribed by the allottees of the shares together with interest at the rate of 6%. In pursuance of this offer, 637 shareholders holding 68,574 shares opted to take back the amount. The remaining shareholders merely demanded repayment of the premium amount and the plaintiffs decided to refund the premium in respect of 2,63,680 shares. According to the plaintiffs, in all, an amount of Rs. 19,77,600 was refunded to the various allottees. In pursuance of the financial results for the year ending August 31, 1974, income-tax returns were filed by defendant No. 1 and the assessment orders were passed by the Income-tax Officer on October 26, 1975. It is the claim of the plaintiffs that due to the inflated figures, the plaintiffs were required to pay higher amount of income-tax and surcharge and the defendants did not request the Income-tax Authorities to withhold passing of the assessment orders inspite of being aware of the inaccuracy of the accounts for the period in question.
11. The plaintiffs claim that the defendants, as auditors, failed to examine and ascertain (i) whether there was satisfactory explanation for steep increase in the rate of gross and net profits; (ii) whether the consumption of raw material was commensurate with the sharp increase in sales/production; (iii) the reasons for the disproportionate ratio of the total debts due by trade debtors to turnover as compared to the previous years; (iv) the reason for the material variations in the ratio between the value of stock on hand with the cost of turnover for the year ended August 31, 1973, and for the year ended August 3, 1974; (v) whether there was any change in the prices of prime raw material; (vi) whether there was any improvement/deterioration in the usage of material; (vii) whether the plaintiffs had got new customers and/or there was any change in the terms of credit to customers; and (viii) whether the production for the year was adequate claim that the defendants were guilty of negligence and breach of their duty as auditors, as the audit work was carried out by ignoring the accepted principles of auditing and certification of the same. The plaintiffs' claim that the defendants failed to obtain relevant information and explanation for the inflated production, sales and profits. This being achieved by manipulation of accounts. The plaintiffs' complain that the defendants did not inquire or seek explanation for the abnormal increase in the turnover and in the sales and profits and made no efforts to reconcile the final production figures with the store transfer slips. The defendants failed to notice that the sales to the tune of Rs. 55 lakhs were not covered by the production records and there was no corresponding consumption of raw materials for sales/production appearing in the accounts. According to the plaintiffs, as a result of the negligence of the defendants, the plaintiffs suffered damages and the claim has been set out in paragraph 22 of the plaint as follows :
(i) Excess income-tax paid by the plaintiffs Rs.
for the year ended August 31, 1974, as per the
particulars annexed and marked exhibit "D" 28,98,869
(ii) Excess surtax paid for the year ended
August 31, 1974 as per the particulars annexed and
marked exhibit "E" 6,80,923
(iii) Excess sales tax paid for the year ended
August 31, 1974, as per the particulars annexed and
marked exhibit "F" 2,80,000
(iv) Loss of excise rebate under Tariff 68 of
the Central Excise and Salt Act 25,000
(v) For the loss of reputation, goodwill, dis-
location of business and extra expenditure
incurred as a result thereof as per the particulars
annexed and marked exhibit "C" 25,00,000
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63,84,792
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12. The break-up in respect of item (v) is, Rs. 20 lakhs are claimed for loss of interest and extra expenditure incurred; while an amount of Rs. 5 lakhs for loss of reputation, goodwill and dislocation of business. The plaintiffs served notice dated October 14, 1977, on the defendants calling upon them to pay the amount of damages, but the defendants by their reply dated November 20, 1977, declined to submit to the requisition and that has given rise to filing of this suit.
13. Prior to institution of the suit, on April 25, 1977, Mr. Wheaton, Mr. Parish, Mr. Parker and Mr. Grundy, the four directors of the plaintiff company filed Company Petition No. 308 of 1977 under section 633 of the Companies Act in this court on April 25, 1977. Section 633 enables the court to relieve any director of proceedings for negligence or breach of trust, if it appears to the court that the director has acted honestly and reasonably. The petition was filed by the four directors as the Registrar of Companies was threatening to initiate proceedings for issuing prospectus inviting public to the shares and as the prospectus had contained inaccurate figures of profits. The learned single judge granted relief to Mr. Parker and Mr. Grundy who were the attorneys and were not directly concerned with the day-to-day working but declined to do so in respect of Mr. Parish and Mr. Wheaton. In an appeal preferred before the Division Bench of this court, by a judgment dated March 3, 1981, the relief was granted also in favour of Mr. Parish and Mr. Wheaton.
14. The defendants filed their written statement declared on November 15, 1979, and it was pointed out that defendant No. 4 has retired with effect from October 31, 1978, and is no longer a partner. The defendants asserted that the audit work was carried out in accordance with the well-established practice of accountancy and the allegation of the plaintiffs that the defendants were negligent is totally false. The defendants pleaded that the board of directors of the plaintiffs and the officers of the holding company never doubted the figures which were accepted by the auditors or the explanations which were offered by the staff of the plaintiff company from time to time and the charge of negligence against the defendants is levied only to find a scapegoat to cover the failures of the plaintiffs themselves. The defendants further pleaded that the auditors cannot be held responsible for failure of the plaintiffs to detect the fraud committed by their managing director, K. Shankar Hegde, and other officers and the staff. The defendants denied that the plaintiffs suffered any set-back in their credibility, prestige or goodwill and are entitled to any damages. As regards the assessment order passed by the Income-tax Officer, the defendants pointed out that the order was passed on September 25, 1975, that is long prior to the date when defendants were informed by Mr. Parish to undertake the confidential investigative audit and, therefore, there was no occasion for the defendants to advise the Income-tax Officer to defer passing of the order. The defendants denied that they were negligent in carrying out their work and that such negligence has caused damage to the plaintiffs.
15. With these rival pleadings, the issues were settled by consent of parties and the said issues and my findings thereon are as follows :
Issues Findings 1. Whether the defendants failed or neglected to No. apply their minds to or enquire into or ascertain the true facts as alleged in paras. 5 and 6 of the plaint ? 2. Whether the correct figures of sales, etc., Yes. have been set out in para. 11 of the plaint ? 3. Whether the publication of the report for No. the year ended August 31, 1974, caused any set-back to the credibility, prestige or goodwill of the plaintiffs as alleged in para 12 of the plaint ? 4. Whether the said alleged manipulations, No. frauds, etc., could have been discovered by the defendants had they carried out their duties as auditors with reasonable diligence as in para. 19 of the plaint ? 5. Whether the defendants failed and neglected No. to carry out their audit in accordance with accepted principles of accounting as alleged in para. 21 of the plaint ? 6. Whether the plaintiffs have suffered damages No. as set out in para. 22 of the plaint ? 7. Whether the defendants are liable to compen- Does not arise. sate the plaintiffs for the said alleged damages ? 8. What reliefs, if any ? Suit dismissed.
16. In support of the claim, the plaintiffs examined Mr. Narayanaswami Chella Krishnan, a chartered accountant, practising from the year 1950, and the witness deposed about the practice of auditing and various steps required to be taken by the auditor in the discharge of his duties. The plaintiffs also examined Mohan Narayan Menon who is a plant manager and who was working with the plaintiffs from the year 1972. The next witness examined by the plaintiffs is Arun Madan Kelkar, the accountant, who was working as accounts assistant from July, 1970, and the last witness is Satish Mahadeo Pradhan, a chartered accountant, attending to the income-tax assessment proceedings of the plaintiff company after the year 1976. On behalf of the defendants, Mr. Kaiki Rustom Alpaiwalla, defendant No. 3 entered the witness box and Mr. Mahindra, who had carried out the audit work for the year 1973-74, under the supervision of Mr. Alpaiwalla, was also examined. Mr. Vasant Raiji, a chartered accountant practising from the year 1945, was examined by the defendants and the witness deposed about the practices followed by the auditors in undertaking audit work. The parties by consent filed compilations containing various documents and in addition some documents were produced during the trial and were duly exhibited.
17. From a perusal of the issues, it is obvious that the principal issue required to be determined is whether the defendants failed and neglected to carry out their audit in accordance with the accepted principles of accounting and whether such failure or neglect has caused damages to the plaintiffs. Before consideration of this issue, it is necessary to set out certain undisputed facts which were either disclosed in the evidence or are stated by counsel at the Bar.
18. The plaintiff company was a wholly owned subsidiary of American Flange Mfg. Co. incorporated in the United States of America till the end of the financial year August 31, 1974, and all the shares of the plaintiff company were held by the American Company. Mr. Parish and Mr. H. F. Wheaton, the directors of the plaintiff company, were also directors of the American company. The registered office and factory of the plaintiffs is situate at Mahul, Chembur, and the principal products manufactured by the plaintiffs are flanges and bungs (barrel stoppers). The operation of the plaintiffs is particularly carried out by five departments headed by different officers. The departments are sales, accounts, purchases, stores and production, and in the financial year 1973-74, these departments were in the charge of Banerjee, Ramamurthi, Singaravelu, Sudhir and Satish Kumar, respectively. Banerjee was in employment of the company from the year 1965, Ramamurthi from 1963 and Singaravelu from 1969. K. Shankar Hegde was associated with the company right from its inception, that is from the year 1960, and was appointed as a wholetime director in 1972 and as managing director in the year 1975. Hegde was a man of confidence of the American directors and though the Americans found that Hegde was acting on some occasions contrary to the settled principles and policies of the holding company, it was felt that it would not be possible to dispense with his services. The American company had absolute control over the working of the plaintiffs and information was furnished regularly to New York even in respect of minor issues. The monthly balance-sheet and profit and loss account were regularly sent by the plaintiffs to New York and the holding company had appointed Mr. Yien as a financial controller in respect of several subsidiary companies spread over the world. Kelkar deposed in paragraph 20 of his evidence that the plaintiff company used to prepare monthly balance-sheets and profit and loss accounts and these statements were sent to America every month. Kelkar was shown a specimen letter accompanying the profit and loss statement and balance sheet forwarded to the United States and the letter is dated August 29, 1974, and the copy of which is at page 23 of volume 16 of the compilation of the defendants. The letter was signed by Ramamurthi, the accountant in-charge of the accounts department, and also by K. Shankar Hegde. Kelkar at the relevant time was working as a subordinate of Mr. Ramamurthi. Copy of the letter dated August 31, 1974, at page 10 of volume 16 of the compilation of the defendants, indicates that K. Shankar Hegde had issued instructions that the practice of overtime in the factory should be completely stopped and even a copy of this letter was forwarded to America. At page 5 of volume 16 is a copy of a note dated June 4, 1973, from Singaravelu to Hegde in respect of an inspection carried out by the factory inspector on the previous day. A copy of this note was also forwarded to New York. On page 16 of volume 16 is a copy of the letter dated February 12, 1974, from Mr. Ramamurthi to Mr. Yien stationed at New York, and is in reply to the memo received from America in respect of the expenditure of gasoline for the month of November, 1973, and processing charges paid to Gannon Dunkerley in 1974. These letters and the note unmistakably establish that the holding company was exercising absolute control over the functioning of the plaintiff company. The fact that copies of notes in respect of internal control were forwarded to America and even in respect of minor items, like visit of a factory inspector or the instructions not to permit working overtime or the excessive user of the petrol, are tell-tale circumstances to establish the extent of control exercised by the American Company.
19. The American company was also giving instructions about various practices introduced from time to time and various systems of maintenance of record to the plaintiffs and in this connection, reference can be usefully made to the copy of letter dated August 7, 1973, from Mr. Parish to Mr. Hegde. The directors of the holding company were fully conscious of the operations of the plaintiffs and on May 13, 1974, a telex message was sent by Mr. Parish complaining that the plaintiffs are accepting payments against pro forma invoices even though the goods were not produced. The telex message demands that the proper accounting of the funds should be forwarded to New York to enable the holding company to know the obligations of the plaintiffs. Mr. Hegde sent a reply on June 7, 1974, promising that the system adopted by the plaintiffs would not be repeated in future, and cash would be collected from the customers only when the company is in a position to despatch the goods right from the shelf. The copy of the telex and the reply of Hegde are at pages 90 and 91 volume 10 of the compilation of the defendants.
20. There are two letters dated July 5, 1974, and August 8, 1974, at pages 17 and 18, respectively, of volume 16 of the compilation of the defendants to which a reference is necessary. The letter dated July 5, 1974, is addressed to Mr. Yien by Ramamurthi and, inter alia, recites that the tempo of production is picking up since the workmen returned to duty. The letter then recites that the sales up to the end of June, 1974, were of Rs. 114 lakhs and the sales expected for the remaining two months of the year, that is July and August, 1974, would be around Rs. 46 lakhs. Mr. Ramamurthi stated that the normal activities commenced from the last week of May and the plaintiffs expect to come back to a healthy cash position. The letter further recites that due to the efforts of the supervisory staff, it is possible to make delivery of the sales effected in the year, and the deliveries which were delayed due to the railway strike would be completed in the months of May and June, 1974, and full collection would be recovered. The second letter dated August 8, 1974, is also from Ramamurthi to Mr. Yien and sets out the cash position for the period August, 1974, to January, 1975. The letter recites that the sales for the month of August, 1974, has been taken at Rs. 25 lakhs, but the actuals may turn out to be much higher if the tempo of working was maintained and report would be made during the first week of September. These three letters unmistakably indicate that the fact that the sales were mounting up in the last three months of the financial year ending with August 31, 1974, was known to the directors of the holding company, even before the year was over. The correspondence to which reference is made hereinabove further indicates that Mr. Parish was conscious that Mr. Hegde was sometimes acting contrary to the settled practice of the company and instructions were given to ensure that the plaintiff company does not depart from settled principles. This correspondence coupled with the evidence of Kelkar establishes that the information supplied by the plaintiffs to the holding company was extensive in nature and the directors, including Mr. Parish and Mr. Wheaton, and the financial controller, Mr. Yien, were aware that the sales of the plaintiff company during the last three months of the year 1973-74 were large in nature. It is also required to be stated that true copies of every invoice and credit notes were sent to the United States of America and this fact could be gathered from the affidavit dated November 30, 1977, filed by Mr. Parish in Company Petition No. 308 of 1977. The affidavit recites :
"The periodic statements which were sent by the Indian company to American Flange chiefly comprised the balance-sheets, the income statements, cash flow statement, occasional budget projections and also copies of invoices and purchase orders. Such of these as were submitted by departmental heads of the Indian company were initialled by Mr. Hegde in accordance with the practices mentioned above. If American Flange had any comment or instructions in respect of any such periodic statements, etc., such comments and instructions were communicated directly to Tri-Sure (I.) Ltd. normally by a letter addressed to Mr. Ramamurthi with a copy to Mr. Hegde. On urgent matters and for convenience, telexes to Tri-Sure (I.) Ltd. were sent through Little and Company's telex station."
21. It is not in dispute that the accounts and records for the years ending August 31, 1974, and August 31, 1975, and particularly those relating to sales, debtors, creditors, production, stocks, consumption of material, and excise and customs were fabricated and this fact came to the notice at the time of special investigative audit undertaken by defendant No. 1 in pursuance of instructions received from Mr. Parish on October 6, 1975. It is essential to remember that the instructions were issued for carrying out investigative audit in respect of financial records of the year 1974-75, but defendant No. 1 on their own extended the special investigative audit for the earlier year, that is, financial year 1973-74, on realisation that the accounts were not properly written. The result of fabrication of the accounts was that inflated figures of sales and profits were shown in the balance-sheets which were handed over by the management of the plaintiffs to the auditors. Now, it is necessary to set out the modus operandi of the staff of the plaintiffs in manipulating the accounts. The auditors were informed by the officers of the company that booking of sales invoices before the actual date of delivery of the goods was mainly done as indicated hereinbelow subject to variations in the method in some cases :
(A) Sales invoices and delivery challans (referred to as "mother" documents) were initially prepared for the purpose of booking the sales in the books of account and in the company's inventory records. These sales invoices were prepared by the company before the actual date of delivery of the goods in order to record the sales in the books of account. In order to make the booking of these sales appear genuine, the procedure that was evolved was to require the transport carriers to sign these delivery challans. These sales invoices and pre-numbered delivery challans receipted by the company's transport carriers formed the basis of the accounting entries in the sales journal, debtors' ledger, finished goods cardex and finished goods ledgers.
(B) When the finished goods relating to the sales invoices booked before the actual date of delivery of the goods were actually sold/delivered to customers on subsequent dates, the procedure adopted was :
(i) in cases where the deliveries took place in the same lot as indicated in the "mother" documents, the dates on the customers' copies of the "mother" documents were altered by inserting the dates of actual shipment, whereas in the company's copies of the "mother" documents, no such alterations were made. Such of the customers' copies of the altered "mother" delivery challans which may have been received back by the company were destroyed. In case where the delivery took place subsequent to the year but within a short period, no alterations were made in the "mother" documents;
(ii) in cases where the deliveries took place in different lots, another set of documents (referred to as "real" documents) were prepared for each lot delivered, as follows :
(a) Supplementary sales invoices were prepared with the same serial numbers as the "mother" sales invoices which were prepared originally for booking the sales in the books of account. The dates indicated on the real sales invoices were the actual dates of delivery. The real sales invoices were sent to the customers and all extra copies thereof were destroyed once the entire quantity indicated in the "mother" documents had been supplied to the customers.
(b) Supplementary delivery challans were prepared from a book of unnumbered delivery challans and given the same serial numbers as the "mother" delivery challans prepared originally for purposes of booking the sales in the books of account. The sequence of deliveries was indicated by adding numbers after the relevant serial number of the challan, that is from "mother" delivery challan numbered 100, the real delivery challans would be numbered 100/1, 100/2 and so on. The dates indicated on the real delivery challans were the dates of actual delivery.
22. The real delivery challans were sent to the customers and all copies thereof were destroyed once the entire quantity had been supplied to the customers.
23. The modus operandi reveals that the documents fabricated were invoices, delivery challans, store transfer slips, costs record and gate passes. The fabrication of invoice was by the staff in the sales and accounts departments; while in respect of delivery challans, it was stores and accounts departments, and in respect of store transfer slips, it was production and stores departments. The cost record was maintained by production and accounts departments; while gate passes were in charge of stores and security departments. The system of gate passes was introduced on September 23, 1974, for the first time. It is obvious that all the five main departments of the plaintiff company and the heads of those departments, that is, Banerjee, Singaravelu, Ramamurthi, Sudhir and Satishkumar, had joined hands in manipulating the accounts and with the full connivance or at the instance of the managing director, Hegde. In this connection, it would not be inappropriate if reference is made to contents of paragraph 3 of the affidavit filed by Mr. Parish in Company Petition No. 308 of 1977. Mr. Parish claims that he considered the heads of various departments and Hegde as guilty of a conspiracy to falsify the books and records. Mr. Parish told the conspirators that he would fire the whole lot, but for the fact that the business could not be run without the people they had trained for many years. Mr. Parish further claimed that each one of the conspirators admitted his part in the complicity and Mr. Ramamurthi agreed to work the investigative auditors. Mr. Parish stated that Ramamurthi showed to the auditors in his presence a number of entries made while the 1974 audit was being carried out in order to cover up his tracks. Mr. Parish claims that Mr. Ramamurthi admitted to falsifying the auditors' initials or marks which would have indicated that the entry had been checked by the auditors. It is true that what was claimed by Mr. Parish to have been admitted by Ramamurthi and the other conspirators cannot be used as admission of the staff involved in the manipulation of accounts, but it cannot be overlooked that each and every head of the department along with the managing director were deeply involved in the conspiracy to inflate the figures of sales and profits. It is necessary to state at this juncture that though the accounts were manipulated to show the inflated figures of sales and profits for the year ending August 31, 1974, it is not in dispute that none of the conspirators made any personal gain out of the manipulations. In fact, by manipulation, the sales which were really effected in the subsequent year were antedated to show higher figures of sales and profits. The plaintiff company has instituted Criminal Case No. 1026/S of 1976 on April 27, 1976, against Hegde, Banerjee and Satish Kumar, and these accused were charged of having committed offences under sections 420, 477A, 467, 468, 471 read with sections 120B and 34 of the Indian Penal Code. The private prosecution launched by the company against these accused is still pending hearing in the Court of Metropolitan Magistrate. As mentioned hereinabove, the managing director, Hegde, resigned on October 17, 1975, while Ramamurthi left the company on June 2, 1976, and Satish Kumar and Banerjee on April 27, 1976. The officers and all the concerned staff involved in manipulation of accounts left the company save and except Kelkar, who was working as assistant of Ramamurthi at the relevant time and who was examined at the trial. These facts are not disputed and with this back ground, it is now necessary to consider whether the auditors were negligent in the discharge of their duties.
24. The word "audit" has been defined in the Oxford English Dictionary as "an official examination of accounts with verification by reference to witnesses and vouchers". Audit is concerned with the verification of accounting data with determining the accuracy and reliability of accounting statements and reports. Auditing primarily involves testing the reliability, competency and adequacy of evidence in support of monetary transactions. The main objective of the company audit is to conduct an independent review of the financial statements and offer an opinion about their reliability in representing the organisation's financial condition and working results. The main function of the auditor is to ascertain whether the financial statements fairly represent the actual financial position and the working results of an organisation. The International Auditing Guideline No. 1 published in January, 1980, prescribes that while the auditor is responsible for forming and expressing his opinion on the financial statements, the responsibility for their preparation is that of the management of the entity. The management's responsibilities include the maintenance of adequate accounting records and internal controls, the selection and application of accounting policies, and the safeguarding of the assets of the entity. The audit of the financial statements does not relieve the management of its responsibilities. The auditor assesses the reliability and sufficiency of the information contained in the underlying accounting records and other source data by making a study and evaluation of accounting systems and internal controls on which he wishes to rely and testing those internal controls to determine the nature, extent and timing of other auditing procedures.
25. In "Statement on Auditing Practices" published by the Institute of Chartered Accountants of India in the year 1968, it is pointed out that it is the directors of a company who are primarily responsible for the preparation of the annual accounts and for the information contained in it. The duty of safeguarding the assets of a company is primarily that of the management and the auditor is entitled to rely upon the safeguards and internal controls instituted by the management, although he will of course take into account any deficiencies he may note therein while drafting the audit programme. The auditor does not conduct the audit with the objective of discovering all frauds, because in the first place it would take a considerable amount of time and it would not be possible to complete the audit within the time-limit prescribed by law for the presentation of accounts to the shareholders. Further, such an audit would have to involve a detailed and minute examination of all the books, records and other documents of the company, and the cost of doing so would be prohibitive and disproportionate to the benefits which may be derived by the shareholders. Finally, even if such examinations were to be conducted, there will be no assurance that all types of frauds, omissions and forgery, etc., would be discovered. The auditor, while conducting the audit, bears in mind the possibility of existence of fraud and irregularities in the accounts of the company.
26. R. K. Mautz and Hussein A. Sharaf in their book "The Philosophy of Auditing" published in the year 1961 set out the tentative postulates of auditing on page 42, and the following three of them are relevant :
(1) The financial statements and other information submitted for verification are free from collusive and other unusual irregularities;
(2) The existence of a satisfactory system of internal control eliminates the probability of irregularities; and (3) In the absence of clear evidence to the contrary, what has held true in the past for the enterprise under examination will hold true in the future.
27. On page 110, the authors state that in view of the limitations of audit evidence in the establishment of incontrovertible truth and the influence of time and other conditions under which an auditor works, truth in auditing may be defined as conformity with reality as the auditor can determine reality at the time of his examination and with the evidence available.
28. Mr. Ronald Irish in his book "Practical Auditing" states that an audit may be said to be a skill and examination of such books, accounts and vouchers as will enable the auditor to verify the balance-sheets. The main objectives of audit are : (a) to certify the correctness of the financial position as shown in the balance-sheet and accompanying statements; (b) detection of error, and (c) detection of fraud. The author states that detection of fraud is generally regarded as being of primary importance. Section 227 of the Companies Act defines the powers and duties of auditors and sub-section (2) prescribes that the auditor shall make a report to the members of the company on the accounts examined by him, and on every balance-sheet and profit and loss account and on every other document declared by the Act to be part of or annexed to the balance-sheet or profit and loss account, which are laid before the company in general meeting, and the report shall state whether in the opinion of the auditor and to the best of his information and according to the explanations given to him, the said accounts give the information required by the Act so as to give full and fair view of the company's affairs at the end of the financial year. It is obvious that the statutory duty cast upon the auditor is to certify whether the accounts give a true and fair view of the balance-sheet and the state of the company's affairs at the end of the financial year.
29. From a perusal of the International Auditing Guidelines, published by the International Federation of Accountants, and Statement on Auditing Practices, published by the Institute of Chartered Accountants of India, it is possible to ascertain the process of auditing. The first step is planning and the auditor should plan his work to enable him to conduct and effective audit in an efficient and timely manner. The plan should be based on a knowledge of the client's business and should cover, among other things, (a) acquiring knowledge of the client's accounting system, policies and internal control procedures; (b) establishing the expected degree of reliance on internal control; (c) determining and programming the nature, timing and extent of the audit procedures to be performed; and (d) co-ordinating the work to be performed. The auditor should consider several matters in developing his overall plan, including possibility of material error or fraud or the involvement of related parties.
30. The second step is to ascertain the accounting system and internal controls provided by the management. The management is responsible for maintaining an adequate accounting system incorporating various internal controls to the extent appropriate to the size and nature of the business. The auditor should gain an understanding of the accounting system and related internal controls and where the auditor concludes that he can rely on certain internal controls, the substantive procedures would normally be less extensive than would otherwise be required and may have also to differ as to the nature and timing. An accounting system can be defined as a series of tasks in an entity by which transactions are processed as a means of maintaining financial records, and such a system should recognise, calculate, classify, post, summarise and report transactions. The system of internal control is the plan of organisation and all the methods and procedures adopted by the management to assist in achieving the management's objective of ensuring the orderly and efficient conduct of the business. An effective internal control system provides for the communication of the delegation of authority and the scope of responsibilities. It should be so designed as to preclude an individual from overriding the control system and should provide for segregation of incompatible functions. Of course, the proper function of any system depends upon the competence and honesty of those operating it, and the auditor should review the accounting system and related internal controls to gain an understanding of the flow of transactions and make a preliminary evaluation and identification of those internal controls on which it might be effective and efficient to rely in conducting the audit.
31. The next stage is known as selective verification or compliance procedure. After being satisfied that the internal controls are adequate and function effectively throughout the period, the auditor selects certain transactions for verification. This procedure is known as "in-depth audit". It is now generally accepted that in the case of business where an adequate system of internal control is in force, the auditor is entitled to apply appropriate test checks. By selecting some representative transaction and examining them in-depth, an auditor can form a better opinion on the financial statements than by mechanically ticking off all the entries. The selective verification enables the auditor to complete his work within a reasonable time and costs. The auditor is finally recalled to carry out the overall assessment of the audit work undertaken by him and prepare ratio analysis. The auditor uses ratio analysis to identify anything abnormal or anything which deviates from the expected and the known. It highlights the dual nature of transactions which arises from the interconnection between the variables of business, and, therefore, ratio analysis is a valuable tool of overall assessment.
32. The plaintiffs have led the evidence of Mr. Krishnan to establish the various steps required to be undertaken by the auditors, while carrying out the audit work, and those steps are referred in paragraph 4 of the evidence of Krishnan. There is no dispute about the various steps suggested by Mr. Krishnan, save and except on one or two points. Mr. Raiji who was examined as an expert by the defendants to state about the procedure followed by auditors, generally supports what has been stated by Mr. Krishnan, but highlighted that the basic function of auditing is examination of financial records.
33. In paragraph 10 under the heading "GENERAL PRINCIPLES OF THE LAW OF NEGLIGENCE" in Halsbury's Law of England, fourth edition, volume 34, it is stated that it is a question of fact whether the defendant has failed to show reasonable care in the particular circumstances. The law lays down the general rule which determines the standard of care which has to be attained. The legal standard is not that of the defendant, but is that of a person of ordinary prudence or a person using ordinary care and skill. Doctors and members of other professions and calling must exercise the standard of skill which is usual in the profession and calling. Justice McNair in his address to the Jury reported in Bolam v. Friern Hospital Management Committee [1957] 2 All ER 118, referred to the statement of law contained in a Scottish case dealing with negligence of a medical practitioner with approval and the statement reads as under :
"In the realm of diagnosis and treatment, there is ample scope for genuine difference of opinion, and one man clearly is not negligent merely because his conclusion differs from that of other professional men, nor because he has displayed less skill or knowledge than others would have shown. The true test for establishing negligence in diagnosis or treatment on the part of a doctor is whether he has been proved to be guilty of such failure as no doctor of ordinary skill would be guilty of it acting with ordinary care."
34. The test is the standard of the ordinary skilled man exercising and professing to have that special skill, but one need not possess the highest expertise or skill at the risk of being found negligent. It is well established that it is sufficient if one exercises the ordinary skill of an ordinary competent man exercising that particular art. It hardly requires to be stated that burden to prove any action of negligence rests primarily on the plaintiffs, who, to maintain action, must show that he was injured by a negligent act or omission for which the defendant in law is responsible. This was to prove some duty owed by the defendant to the plaintiff, some breach of duty, and an injury to the plaintiff between which and the breach of duty, a causal connection must be established. In order to establish contributory negligence, the defendant has to prove that the plaintiff's negligence was a cause of harm which he has suffered in consequence of the defendant's negligence. Knowledge by the plaintiff of an existing danger or of the defendant's negligence may be an important element in determining whether or not he has been guilty of negligence. The question is not whether the plaintiff realised the danger but whether the plaintiff had knowledge which would have caused the reasonable person in his position to realise the danger. It is also essential for the plaintiff in an action for damages on the ground of negligence to establish that on the balance of probabilities the defendant's negligence was an essential pre-condition of the damage suffered and which is normally done by reference to the "but for" test. The test demands that the negligence was a factual cause of damage. A reference can be made in support of this aspect on "Factual causation" in Dugdale and Santon's 'Professional Negligence', Chapter 28, Paragraph 28.01. A reference can be usefully made in this connection to the short passage from the speech of Lord Reid in the case of McWilliams v. Sir William Arrol and Co. Ltd. [1962] 1 WLR 295 (HL) and which has been quoted with approval in Karak Rubber Co. Ltd. v. Burden (No. 2) [1972] 1 WLR 602, 631 (Ch D) :
"If I prove that my breach of duty in now way caused or contributed to the accident, I cannot be liable in damages. And if the accident would have happened in just the same way whether or not I fulfilled my duty, it is obvious that my failure to fulfil my duty cannot have caused or contributed to it. No reason has ever been suggested why a defendant should be barred from proving that his fault, whether common law negligence or breach of statutory duty, had nothing to do with the accident."
35. It would be appropriate at this juncture to refer to certain decisions, cited at the Bar, dealing with the subject of liabilities of auditors.
36. The earliest decision is reported in [1895] 2 Ch 673 (London and General Bank, In re (No. 2). In this case, an auditor presented a confidential report to the directors calling their attention to the insufficiency of the securities on which the capital of the company was invested, and the difficulty of realizing them, but in his report to the shareholders merely stated that the value of the assets was dependent on realization, and in the result the shareholders were deceived as to the condition of the company, and a dividend was declared out of capital and not out of income. Subsequently, a petition was presented for winding up of the company and the auditor was held guilty of misfeasance under section 10 of the Companies (Winding-up) Act, 1890, and was liable to make good the amount of the dividend paid. In an appeal, Lord Justice Lindley observed (at pages 682-683) :
"It is no part of an auditor's duty to give advice, either to directors or shareholders, as to what they ought to do ..... His business is to ascertain and state the true financial position of the company at the time of the audit, and his duty is confined to that ..... An auditor, however, is not bound to do more than exercise reasonable care and skill in making inquiries and investigations. He is not an insurer; he does not guarantee that the books do correctly show the true position of the company's affairs; he does not even guarantee that his balance-sheet is accurate according to the books of the company. If he did, he would be responsible for error on his part, even if he were himself deceived without any want of reasonable care on his part, say, by the fraudulent concealment of a book from him. His obligation is not so onerous as this. Such I take to be the duty of the auditor : he must be honest - i.e., he must not certify what he does not believe to be true, and he must take reasonable care and skill before he believes that what he certifies is true. What is reasonable care in any particular case must depend upon the circumstances of that case. Where there is nothing to excite suspicion very little inquiry will be reasonably sufficient, and in practice I believe business men select a few cases at haphazard, see that they are right, and assume that others like them are correct also. Where suspicion is aroused more care is obviously necessary; but; still, and auditor is not bound to exercise more than reasonable care and skill, even in a case of suspicion, and he is perfectly justified in acting on the opinion of an expert where special knowledge is required."
37. The decision was approved in the next case reported in [1896] 2 Ch 279 (Kingston Cotton Mill Co., In re (No. 2) where an order under section 10 of the Companies (Winding-up) Act, 1890, was passed against the auditors of the company ordering them to pay to the liquidator certain sums of money being the amounts of dividends improperly declared and paid out of the assets of the company on the faith of certain balance-sheets prepared and signed by the auditors. In appeal, one of the questions considered was "what was the duty of auditors" and Lord Justice Lindley reiterated the view taken in the earlier case of London and General Bank, In re (No. 2) [1895] 2 Ch 673. Lord Justice Lindley made it clear that the auditors should not be suspicious but only reasonably careful. The learned judge further noted that the auditors relied on the manager who was a man of high character and of unquestioned competence and who was trusted by every one who knew him, and observed that it is not sufficient to say that the frauds must have been detected if the entries in the books had been put together in a way which never occurred to any one before suspicion was aroused. Lord Justice Lopes, in a concurring judgment, observed (at page 288) :
"But in determining whether any misfeasance or breach of duty has been committed, it is essential to consider what the duties of an auditor are. They are very fully described in In re London and General Bank [1895] 2 Ch 673 to which judgment I was a party. Shortly they may be stated thus : It is the duty of an auditor to bring to bear on the work he has to perform that skill, care and caution which is reasonably competent, careful and cautious auditor would use. What is reasonable skill, care and caution must depend on the particular circumstances of each case. An auditor is not bound to be a detective, or, as was said, to approach his work with suspicion or with a foregone conclusion that there is something wrong. He is a watch-dog, but not a bloodhound. He is justified in believing tried servants of the company in whom confidence is placed by the company. He is entitled to assume that they are honest, and to rely upon their representations, provided he takes reasonable care. If there is anything calculated to excite suspicion he should probe it to the bottom; but in the absence of anything of that kind he is only bound to be reasonably cautious and careful."
38. The learned judge further observed : (at page 290) "The duties of auditors must not be rendered too onerous. Their work is responsible and laborious, and the remuneration moderate ....... auditors must not be made liable for not tracking out ingenious and carefully laid schemes of fraud when there is nothing to arouse their suspicion, and when those frauds are perpetrated by tried servants of the company and are undetected for years by the directors. So to hold would make the position of an auditor intolerable."
39. Lord Alverstone, Chief Justice, in his address to the Jury in the case reported at [1904] 31 Accntt. LR 1 London Oil Storage Co. Ltd. v. Seear, Hasluck and Co., while dealing with an action for damages for alleged negligence in auditing the plaintiff company's accounts, observed :
"The auditor is an officer contemplated by law to protect the interest of the company and its shareholders as such; he is there having certain duties prescribed by the Act ...... The auditor has got to bring to bear upon those duties reasonable and watchful care, he has got to discharge those duties remembering that the company look to him to protect their interests. He is not, however, supposed to be a man constantly going about suspecting other people of doing wrong ....... If circumstances of suspicion arise, it is the duty of the auditor, in so far as those circumstances relate to the financial position of the company, to probe them to the bottom ..... The conduct of the director is no answer to any breach of duty by the defendant, but it is a circumstance you must take into consideration because if you are of opinion that the loss was occasioned by a man stealing the money in consequence of there being want of proper control over him, then the fact of there being a breach of duty by the auditor is what we lawyers call a causa causans, which contributed to, but would not be the cause of the loss."
40. In the case reported in [1925] 1 Ch 407 (City Equitable Fire Insurance Co. Ltd. In re), Sir Pollock, Master of the Rolls, observed, at page 503, that it is of the first importance to remember that, in an action against the auditor, one is looking into facts which have been subjected to the scrutiny and have been explained by the ability of the accountants who have come in to look at all the books, and not only the documents which were presented to the auditors at the time of the original audit. It is the duty of the court to endeavour to ascertain what was the problem presented to the auditors, and what was the knowledge available to them at the time of audit. It is not fair to consider the case with hindsight and hold that the auditors were negligent in discharge of their duties. The court must bear in mind the facts available at the time of alleged negligence by the auditors, and it is not fair to determine the fact of negligence by taking into consideration what has come to light after true scrutiny carried out in the special audit.
41. The next decision is of the Supreme Court of Canada and reported in [1941] SCR of Canada 164 Guardian Insurance Co. of Canada v. F. W. Sharp, which approves the earlier decisions of the English Court.
42. Mr. Cooper, learned counsel appearing on behalf of the plaintiffs, submitted that though the principles laid down by the English Court in the later part of the 19th century are sound, such principles are required to be revised as the standards of reasonable care and skill required from the auditors are more exacting in modern times. Learned counsel relied upon the decision of the House of Lords reported in [1958] 1 WLR 45 (Fomento (Sterling Area) Ltd. v. Selsdon Fountain Pen Co. Ltd.), and the part of speech of Lord Denning, which reads as under (at page 61) :
"The first point raises the question : What is the proper function of and auditor ? It is said that he is bound only to verify the sum, the arithmetical conclusion, by reference to the books and all necessary vouching material and oral explanations : and that it is no part of his function to inquire whether an article is covered by patents or not. I think this is too narrow a view. An auditor is not to be confined to the mechanics of checking vouchers and making arithmetical computations. He is not to be written off as a professional 'adder-upper and subtractor'. His vital task is to take care to see that errors are not made, be they errors of computation, or errors of omission or commission, or downright untruths. To perform this task properly, he must come to it with an inquiry mind - not suspicious of dishonesty, I agree - but suspecting that someone may have made a mistake somewhere and that a check must be made to ensure that there has been none. I would not have it thought that the Kingston Mill's case [1896] 2 Ch 279, relieved an auditor of his responsibility for making a proper check. But the check to be effective may require some legal knowledge, or some knowledge of patents or other speciality. What is he then to do ? Take, for instance, a point of law arising in the course of auditing a company's accounts. He may come upon a payment which, it appears to him, may be unlawful in that it may not be within the powers of the corporation, or improper in that it may have no warrant or justification. He is then not only entitled but bound to inquire into it and, if need be, to disallow it, see Roberts v. Hopwood [1925] AC 578, and In re Ridsdel : Ridsdel v. Rawlinson [1947] 1 Ch 597. It may be, of course that he has sufficient legal knowledge to deal with it himself, as many accountants have, but if it is beyond him, he is entitled to take legal advice on the principles stated in Bevan v. Webb [1901] 2 Ch 59, that 'permission to a man to do an act, which he cannot do effectually without the held of an agent, carries with it the right to employ an agent.' So also with an auditor who is employed for the purpose of checking the royalties payable. It is part of his duty to use reasonable care to see that none have been omitted which ought to be included. He is not bound to accept the ipse dixit of the licensee that there are no other articles which attract royalty. He is entitled to check the accuracy of that assertion by inquiring the nature of any other articles which, it appears to him, may come within the patented field. If he cannot be sure, of his own knowledge, whether they attract royalty or not, he can take the advice of a patent agent, just as, within the legal sphere, he can take the advice of a lawyer."
43. Reliance is also placed on the decision of Justice Pennycuick reported in [1968] 1 Ch 455 (In re Thomas Gerrard and Son Ltd.), where the managing director of a company falsified the company's books by three methods : (i) causing half-yearly stock valuation to be inflated; (ii) causing the price payable on purchases of stock made at the end of each half-yearly period to be included in the outgoings of the succeeding period by altering the invoices in a manner immediately apparent to anyone looking at the invoices; and (iii) causing the price payable for sales made after the end of the relevant period to be included in the preceding period. The company's auditors obtained the information about the various matters and accepted the explanation of the alterations believing that the managing director was a person of highest integrity. Frauds were subsequently discovered and the company went into liquidation. On the summons by the liquidator against the auditors claiming that they were guilty of or are liable for negligence or breach of duty in respect of the audit of the accounts, it was held that the auditor must use reasonable skill and care in carrying out his statutory duty. Justice Pennycuick, after citing the earlier decision, In re Kingston Cotton Mill Co. (No. 2) [1896] 2 Ch 279, observed (at page 475) :
"The real ground on which In re Kingston Cotton Mill Co. (No. 2) [1896] 2 Ch 279, is, I think, capable of being distinguished is that the standards of reasonable care and skill are, upon the expert evidence, more exacting today than those which prevailed in 1896. I see considerable force in this contention .....
On the other hand, if this breach of duty stood alone and the facts were more or less the same as those in In re Kingston Cotton Mill Co. (No. 2) [1896] 2 Ch 279, this court would, I think, be very chary indeed of reaching a conclusion different from that reached by the Court of Appeal in In re Kingston Cotton Mill Co. (No. 2) [1896] 2 Ch 279."
44. Another decision of the Supreme Court of New South Wales reported in [1970] 92 WN 29 Pacific Acceptance Corporation Ltd. v. Forsyth was cited, where the learned judge considered various decision dealing with the subject of auditors' liability, and observed that the reasonable care and skill expected of the auditor in modern times is more stringent than expected in the later part of the 19th century.
45. Mr. Cooper urged that originally an auditor was required merely to check whether the accounts examined were correct; while today the statute, both in India and in England, places high requirement on the auditor and expects the auditor to check the books, to see whether the directors' report and the summary of the account correctly reflects the account of the company, and whether the balance-sheet and profit and loss account gives a true and fair view of the state of affairs of the company. Mr. Cooper submits that the obligation has been augmented by the requirements of the Companies Act and the amendment of the Schedule in the year 1973. The real thrust, says Mr. Cooper, is not on adding, subtracting and multiplication but on verification by reference to the books, vouchers, papers and by also asking questions to witnesses wherever necessary for the purposes of such verification. It was also claimed that whilst originally it was felt that detection of fraud was a very remote incident of auditing, today, the possibility of fraud is considered, at least by some writers, to be the main objective of such verification. It is undoubtedly true that the complexity of corporate business, interlinking various sister corporations and other changes in modern times, makes the possibility of fraud or error larger and the deception can also be of a varied nature. It is also undoubtedly true that an auditor should not merely rely upon the oral explanation furnished by the management, but by in-depth checking must ascertain whether there is adequate internal control and whether the affairs of the company are in order. The auditor's duty is internal verification with a watchful eye, to detect an error or to detect a fraud and to see whether the accounts and the summary in the balance-sheet and the profit and loss account present a reasonably fair and true picture of the affairs of the company; the verification, of course, has to be in consonance with the requirements of the Companies Act, the requirement of standard guidelines issued by the institutional authorities, both in India and international, and in consonance with the complexities of modern business carried out by the corporate sectors. But one thing which should not be overlooked is that the basic concept that the reasonable care and skill expected from the auditor is one which is expected from the average professional has remained unchanged. It is also not fair to hold the auditor negligent after more facts which were not available at the time of audit have come to light.
46. On consideration of the authorities cited at the Bar, the principles which can be carved out are as follows :
The auditor is required to employ reasonable skill and care, but he is not required to begin with suspicion and to proceed in the manner of trying to detect a fraud or a lie, unless some information has reached which excites suspicion or ought to excite suspicion in a professional man of reasonable competence. An auditor's duty is to see what the state of the company's affairs actually is, and whether it is reflected truly in the accounts of the company, upon which the balance-sheet and the profit and loss accounts are based, but he is not required to perform the functions of a detective. What is reasonable care and skill must depend upon the circumstances of each case. Where there is nothing to excite suspicion and there is an atmosphere of complete confidence, based on the record of continued success in financial matters, less care and less severity of scrutiny may be considered reasonable. Whereas reasonable care and skill may be regarded as not exercised when, in spite of the presence of unusual features in the accounts or other prima facie reasons for believing that the affairs of the company may not be in order, the examination is perfunctory and not sufficiently detailed. One major aspect while determining the question of reasonable care and skill is whether the auditor was justified in relying upon the statements of the director or the managing director, and that again must depend on the circumstances of each case and on the nature of the subject-matter which requires explanation. Whether the subject is one which requires explanation. Whether the subject is one which is not capable of direct verification and when to verify properly the result presented in the balance-sheet, it would require investigation rather than checking and where there is nothing at all to excite suspicion and in relying upon the statement of the management, the auditor himself is deceived, then he will not held to have failed in the discharge of his duties. In judging whether an auditor exercises reasonable care and skill, it would not appropriate to proceed on matters which have subsequently transpired, but one must place oneself in the position of the auditor as when the accounts were audited and find out how the matters appeared for ought to have appeared to a man of reasonable care and skill. Bearing in mind these principles, it would now be appropriate to ascertain whether the defendants were guilty of negligence or have failed to discharge their duties properly.
47. Issues Nos. 1, 4 and 5. - These are the principal issues dealing with the claim of the plaintiffs that the defendants were negligent in the discharge of their duties. The averments in this respect are to be found in paragraphs 5 and 21 of the plaint. Paragraph 5 of the plaint sets out eight areas which, according to the plaintiffs, the defendants were bound to and should have examined and ascertained. It may be stated at the outset that in respect of items (ii), (iii), (iv), (vi) and (vii), the plaintiffs have led no evidence whatsoever. In paragraph 21 of the plaint, the plaintiffs have set out the grounds of alleged negligence of the defendants, and in respect of grounds (j), (k) and (l), there is no evidence. The undisputed facts which are required to be reiterated are that the staff employed by the plaintiffs had fabricated virtually the entire record for the financial year 1973-74 in collusion with K. Shankar Hegde, the whole-time director, who was subsequently promoted as managing director. The fabrication or manipulation of accounts could not be detected by the board of directors even after exercising reasonable care and the fraud was detected only when the same modus operandi was adopted for the next financial year 1974-75. The manipulation of accounts was resorted to for showing inflated sales and profits in the profit and loss accounts and the sharp increase in sales was shown in the last quarter of the financial year 1973-74. The management was desirous of showing the sale transactions effected in the year 1974-75 in the previous year and thereby inflated higher sales and higher profits in the financial year 1973-74. The grievance of the plaintiffs on this aspect is two-fold; one is that the procedure followed by defendant No. 1 was erroneous and defective; and, secondly, even execution of that procedure was entirely faulty. Before examining these grounds, it is necessary to state that defendant No. 3 was in charge of the audit work of the relevant year, that is, 1973-74. One Mr. Mahindra was second in command and was assisted by the audit team consisting of senior clerks and junior clerks. It is also required to be stated that defendant No. 1 was attending to the audit work of the plaintiffs from the year 1960 onwards and there were two major alterations in respect of the audit programme of the year 1973-74. The major alterations were : (i) to reduce the scope of checking from cent per cent. to one month in each quarter; and (ii) the introduction of in-depth checks or selective verification.
48. The plaintiffs complain that the defendants followed erroneous procedure by resorting to the selective verification for the financial year 1973-74, and the departure from the earlier practice of checking of all transactions was uncalled for. It is not possible to accept the contention of the plaintiffs on this count. In paragraph 1.5 of the Statement on Auditing Practices published by the Institute of Chartered Accountants of India in the year 1968, it is observed :
"It is now generally accepted that in the case of business where an adequate system of internal control is in force, the auditor is entitled to apply appropriate test checks. This statement does not attempt to prescribe either the maximum or the minimum amount of work to be performed in an audit. The facts and circumstances of each case have to be taken into account in deciding upon the extent of the checking to be done."
49. The plaintiffs examined Mr. Krishnan as an expert to depose about the practices followed by auditors in undertaking the audit work and the witness deposed in paragraph 7 of his evidence that after examining the internal control system, he would determine whether there should be a sample audit or audit in extenso depending upon the satisfaction about the effectiveness of the internal control. The witness also deposed that the compliance test which, inter alia, means selective verification is well recognised in the audit work and is resorted to when the auditor is satisfied about the existence of the internal control system and its effectiveness. The defendants examined Mr. Raiji, a practicing auditor as an expert witness and Mr. Raiji deposed in paragraph 6 of his evidence that to satisfy about the sales transactions, the system which the auditor is expected to follow is popularly known as "compliance test". Mr. Raiji further deposed that the auditor should examine the specimen sales transaction during the cut off period to ensure that the goods sold are not included in the stock. In cross-examination Mr. Raiji stated that the compliance system is more or less equivalent to audit of sample transactions in depth. Mr. Krishnan deposed in paragraph 24 of his evidence that the essential feature of the internal control system is to give information of different functions, whether accounting records are properly maintained and whether the system is tailored in such a way that the assets are protected. The witness further deposed that the "segregation of function" means that the documents are not prepared, seen and checked by the same person, and stated that he would attach more importance to the fact that there is requisite supervision by an outside agency over the affairs of the company. Mr. Krishnan deposed that if the internal control system is effective, then the auditor can very well resort to selective verification. Mr. Raiji also stated in paragraph 5 of his evidence that the internal control system means various systems prevailing in the organisation to prevent loss of its assets and to ensure that accurate statements of the working are prepared and maintained. The important feature, according to Mr. Raiji, is segregation of duty and that control should not be left in the hand of an individual, but must be checked or cross-checked by different authorities. Mr. Raiji stated that the system of internal control is made of people and procedures, procedures in which people are expected to perform and report in the normal fashion and this is an important facet of the system. Mr. Alpaiwalla stated in paragraph 5 of his evidence that internal control system followed by the plaintiffs was one introduced by the holding company in America for all its subsidiaries. Mr. Alpaiwalla further deposed that there was dual control on each function and the plaintiffs were regularly reporting each and every aspect of the matter to the parent company. The expression "dual control", says Mr. Alpaiwalla, implies that every function of the company would pass through the hands of at least two officers of two different departments. Mr. Mahindra in paragraph 3 of his evidence deposed that a departure was made from the earlier practice and the system of selective verification was introduced as he found that the internal control system was functioning smoothly. In my judgment, in view of the evidence of Mr. Krishnan and Mr. Raiji, well supported by the Statement on Auditing Practices, that the system of selective verification is well recognised in audit procedure and in view of the evidence of Mr. Alpaiwalla and Mr. Mahindra that the internal control system was functioning smoothly and was introduced by the holding company and one which was as common for its all subsidiaries, it may be well concluded that defendant No. 1 was justified in resorting to the practice of selective verification or an in depth check or the compliance test while carrying out the audit work of the relevant year.
50. The plaintiffs then complain that even assuming that the introduction of selective verification was not erroneous, still defendant No. 1 was guilty of negligence, as the auditors failed to check the procedure from the beginning to the end in respect of production of goods. In support of the submission, heavy reliance is placed on the evidence of Mr. Krishnan who deposed in paragraph 4(1) of his evidence that in the case of a manufacturing company, one of the essential areas is to check the procedure from the beginning to the end in respect of production of goods. In paragraph 5, Mr. Krishnan deposed that where he is not satisfied with the entire process right from the receipt of raw materials till the disposal of the end products, he would try to supply the missing link, if possible, and in case the missing link is vital and he is unable to supply it, then he would not place any reliance on the internal control system. It was contended that as one of the essential areas is to check the procedure from the beginning to end and as that was not carried out by the auditors, it was impossible to come to the conclusion that the internal control system was effective and could be relied upon. Mr. Krishnan was closely cross-examined on this aspect and in paragraph 24, the witness had to concede that he is not in a position to place his finger on any authoritative publication in support of the claim that one of the essential areas of internal control system is to check the procedure from the beginning to the end in respect of production of goods. In paragraph 25 of his evidence, Mr. Krishnan conceded that the Institute of Chartered Accountants have published Internal Control System questionnaire in the year 1976, and this publication nowhere sets out that while checking the internal control system, it is necessary to check the procedure from the beginning to the end in respect of production of goods of a manufacturing concern. The witness tried to explain by suggesting that the questionnaire is merely illustrative and not exhaustive. The attention of Mr. Krishnan was also invited to International Auditing Guidelines No. 6, published in July, 1981, on the subject of "Study and Evaluation of the Accounting System and related Internal Control in connection with an audit", and Mr. Krishnan had to concede that even these guidelines do not demand that the auditor should check the procedure from the beginning to the end in respect of the production. The attention of the witness was also invited to Chapter VII on page 142 of R. J. Anderson's The External Audit, volume I, and Mr. Krishnan conceded that there is no specific reference in the Chapter or any other part of the book to the requirement of the auditor to check the procedure from the beginning to the end. Mr. Raiji, on the other hand, in paragraph 5 of his evidence stated that it is outside the ambit of the auditor's work to check specimen production from beginning to end and the auditor is really concerned with examining the financial account. In cross-examination, Mr. Raiji stated that it would be dangerous to rely upon some passage in some book written by a foreigner to ascertain duties cast upon the auditors. It must be held that the evidence of Mr. Krishnan on this aspect is not acceptable, as not supported by any authoritative publication and the evidence on record is wholly unsatisfactory to come to the conclusion that is the duty of the auditor to check the procedure of production from beginning to end to ascertain the effectiveness of the internal control system.
51. There is one more aspect of the matter which must be noted. Mr. Krishnan stated in paragraph 26 of his evidence that the method suggested by him is possible where the production is on batch basis. Kelkar, who was examined on behalf of the plaintiffs and who was working as assistant of Ramamurthi in the accounts department at the relevant time, deposed in paragraph 41 of his evidence that the production of the company was on continuous basis in the year 1973-74 and not on batch basis. In view of this clear-cut admission by Mr. Kelkar, the claim made by Mr. Krishnan that it was necessary to ascertain the procedure from the beginning to the end in respect of production of goods must fall to the ground. Such a requirement, even according to Mr. Krishnan, was necessary in case of batch production and not in the case of continuous production.
52. There is one more aspect which also cannot be overlooked, and that is that the system suggested by Mr. Krishnan, even assuming to be applicable to the case in hand, is not required to be carried out by the auditor who was checking the internal control system of the plaintiff company for over several years. Defendant No. 1 company was carrying out the audit work of the plaintiffs from the year 1960 onwards and it was futile to suggest that defendant No. 1 were not familiar with the internal control system of the plaintiffs. In my judgment, the grievance of the plaintiffs on this count is misconceived.
53. The plaintiffs then contended that defendant No. 1 should have taken additional care and steps in view of some of glaring features of the case and failure to do so amounts to negligence. Broadly, three glaring features of the case were pointed out by the plaintiffs, and they are : (1) the fact that the company was going public by issuing shares by the beginning of financial year 1974-75; (2) heavy increase in sales of the plaintiffs in the last quarter of the financial year 1973-74; and (3) there was high gross profit to sales ratio in respect of the relevant year and compared to the previous year. It is necessary to examine each of these facts to determine whether any one of the circumstances was so suspicious as to raise an apprehension in the mind of the auditors that there may be certain frauds in the affairs of the company.
54. The first circumstance pointed out is that the plaintiffs had decided to issue to the public equity shares of the face value of Rs. 10 each at a premium of Rs. 7.50 per share with a view to dilute the foreign equity holding and with a view to comply with the Foreign Exchange Regulation Act, 1973. Reliance was placed on paragraph 11 of the International Auditing Guideline No. 4, published in February, 1981, which, inter alia, prescribes that the auditor, while developing his overall plan for the expected scope and conduct of the audit should consider conditions requiring special attention, such as the possibility of material error or fraud or the involvement of related parties. Paragraph 11 of International Auditing Guideline No. 11 published in October, 1982, recites that in planning and performing his examination, the auditor should take into consideration the risk of material misstatement of the financial information caused by fraud or error. Paragraph 12 recites that in addition to weaknesses in the design of the internal control system and non-compliance with identified control procedures, conditions or events which increase the risk of fraud or error include unusual pressure within an entity. One of the unusual pressures within an entity is that the entity needs a rising profit trend to support the market price of its shares due to a contemplated public offering, as set out in appendix B (4) of these guidelines. Mr. Krishnan in paragraph 15 of his evidence deposed that it is customary for a company while going public to inflate its profits and show a rosy picture to the proposed investor and therefore it is necessary for the auditor at that juncture to have an in-depth audit of the company to ascertain the true facts. Mr. Krishnan further deposed that the auditor is required to take more care to determine the comparative ratio when the company is going public. Mr. Krishnan relied upon the guidelines issued by the International Federation of Accountants to which reference is made hereinabove. In cross-examination, Mr. Krishnan stated in paragraph 41 of his evidence that his statement that it is customary for the company while going public to inflate its profits and show a rosy picture to the proposed investor does not accurately reflect what he wished to convey. Mr. Krishnan clarified by stating that what he meant was that a few companies are prone to inflate their profits while going public and paint a rosy picture to the proposed investor. Mr. Krishnan further stated that to inflate the profit means to manoeuvre books and show larger profit when there are no profits. In paragraph 42 of his evidence, Mr. Krishnan conceded that he had no authority in support of his claim except the guidelines to which reference is made hereinabove. In my judgment, from this evidence, it is impossible to conclude that the fact that the company is going public is enough to warrant a suspicion in the mind of the auditor. It is not unusual for the companies to offer the shareholdings to the public to comply with the requirement of the Foreign Exchange Regulation Act, and it cannot be assumed that every company would manipulate the accounts to present a rosy picture to the proposed investor. Indeed, in the year 1973-74, it was hardly necessary for any company diluting its foreign exchange to paint a rosy picture as investors were obsessed with the purchase of shares of a foreign company. In my judgment, this circumstance could not have made the auditors suspicious about the maintenance of the accounts of the relevant financial year.
55. The next circumstance relied upon is the high increase in sales of the company's products in the last quarter of the financial year 1973-74, Mahindra admitted in paragraph 53 of his evidence that he did notice during the regular audit that there was unusual rise in sales in the last two months of the relevant year. The witness claimed that he could not recollect whether the audit team reported to his that 51 per cent. of the total sales of the relevant year were effected in the last three months of the year. Mr. Mahindra deposed in paragraph 15 of his evidence that on calculation, the quantity increase in sales during the relevant year compared to the previous year was in the region of 2.5% to 10%. Mr. Setalvad, learned counsel appearing on behalf of the defendants, did not dispute that 51% of the total sales were effected in the last three months of the relevant year, but submitted that mere increase in sales during the closing months of the financial year cannot lead to any suspicion in the mind of the auditors as it is not an unusual feature. The claim that rise in sales in the last quarter of the year is not an unusual feature is accepted by Mr. Krishnan by stating in paragraph 47 of the evidence :
"I would not say that increase in sales in last three months of an accounting year is an unusual feature."
56. Mr. Raiji has also stated in paragraph 8 of his evidence that an auditor need not suspect merely because there are large sales in the last month of the accounting year, unless there are reasons to suspect. Raiji further stated that the auditor should bear in mind the experience of the client in respect of the working of the previous year before determining whether there is any irregularity because of the large sales in the last month. In this connection, it would not be out of place to make reference to a note dated October 8, 1975, prepared by Mr. Yien and addressed to Mr. Wheaton at New York, and the copy of which was forwarded to Mr. Parish. Copy of this note is at page 7 of volume 6 of the compilation of the defendants, and the note, inter alia, states that although there is no significant seasonal variation for the company's products in India, the sales, as reported, are always heavy in the last quarter for the past three years. Then he sets out the summary of last three years as follows :
----------------------------------------------------------------------
9 months Last quarter Total for % of last
to May 31 to Aug.31 Yr. 8/31 quarter
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( Rs. in lakhs) 1973 72 38 110 34.5% 1974 88 97 185 52.4% 1975 136 82 218 37.6%
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57. The note further raised a question about the genuineness of the transactions, but it is necessary to point out that though the holding company and Mr. Wheaton, Mr. Parish and Mr. Yien were familiar with the heavy increase in sales in the last quarter for the years 1973 and 1974, there was not any suspicion in their minds about the working of the plaintiff company. The note was prepared by Mr. Yien only after Singaravelu communicated to the directors about the manipulation of accounts. But for that disclosure by one of the conspirators, the holding company would not have felt anything suspicious even in respect of heavy sales in the last quarter of the year 1975. In these circumstances, in my judgment, it is nothing but a hindsight to suggest that the auditor should have suspected some irregularity after noticing heavy sales in the last quarter of the relevant year 1973-74. A reference was made to A Guide to Company Audit, published in the year 1982, and it was contended that one of the points set out at page 22 of this booklet is whether the auditor paid any particular attention to sales recorded at the close of the accounting year to ascertain that they are genuine. The submission is that this is one of the requirements which the auditor must attend to and the failure to do so amounts to negligence. It is not possible to accept the submission as this guide was published for the first time in the year 1980 and was not available to the auditors during the audit of the relevant year. In my judgment, the circumstance that there was increase in sales in the last quarter of the relevant year could not have rung a bell of suspicion in the mind of the auditors.
58. In this connection, Mr. Setalvad placed reliance upon the decision of the Division Bench of this court reported in [1983] 54 Comp Cas 197 Richard Laurence Parish (Jr.) v. Registrar of Companies in a proceeding adopted by Mr. Parish and Mr. Wheaton under section 633 of the Companies Act. The Division Bench, while dealing with the circumstances relied upon by the trial judge about the phenomenal increase shown in the sales from June, 1974, onwards month by month, observed that though, according to Mr. Parish, he was struck by looking at the sales figures, it is not possible to hold that it should have aroused any suspicion in the mind of directors for doubting the correctness of the figures. Mr. Setalvad contended that if the increase in figures of sales would not have created any suspicion in the mind of the directors, then equally it could not create suspicion in the mind of the auditors. Mr. Cooper controverted the submission by urging that Mr. Parish was not in possession of the entire record of the plaintiffs, while the auditors were appointed to inspect the same and could have easily detected the irregularity. In my judgment, without referring to the findings recorded by the Division Bench, the conclusion is inescapable that the mere fact that there was increase in the sales in the last three months of the financial year is not sufficient to conclude that the auditors should have suspected foulplay.
59. The third circumstance on which heavy reliance was placed by Mr. Cooper is the fact that there was abnormal rise of gross profit to sales ratio between the relevant year and the previous year. In A. A. Arens and J. K. Loebbecke's book Auditing : an Integrated Approach, 2nd edition, at page 192, it is stated that the computation of ratios and percentage relationship for comparison with previous years is another way to obtain an indication of whether an account is materially misstated. One of the most important percentage ratios is gross margin percentage. A significant change in this amount could be due to an error either in sales or in cost of goods sold. An error in the cost of goods sold could be caused by errors in the quantities or pricing of physical inventory, inadequate cut-off of accounts payable or other factors. A major change in the gross margin percentage cannot be as a result of the change in production or selling price and it is an auditor's responsibility to determine the cause of the change so that he can be sure that it did not result from misstated financial statements. Paragraph 10.5 under the heading COMPARATIVE STUDY of Statement on Auditing Practices, published in 1968, recites :
The figures for the previous year should not only be disclosed but should serve as a guide to the general scrutiny of the current year's item. Comparisons with previous year's figures are very important. A proper scrutiny of comparative figures would indicate important changes in the business of the company. Not only should each item appearing in the profit and loss account be compared with that of the previous year, but important ratios like the gross profit to sales ratio must also be compared. Enquiries may be made into the reason for any material change in the ratios, or for ratios remaining constant where it is believed that there should have been a change. Clients should be asked to explain on each expenditure schedule any material variations from last year's figures and also the major reasons for any material changes in the gross profit ratio (with figures if possible)".
60. International Auditing Guideline No. 12, published in July, 1983, also prescribes that the auditor should obtain analysis of significant ratios and trends including the resulting investigation of unusual fluctuations and items. Paragraph 15 of this publication recites that when analytical review procedures identify unusual fluctuations and items, that is, relationships that are unexpected or inconsistent with evidence obtained from other sources, the auditor should investigate them. The investigation begins with the inquiries of management and includes the evaluation or adequacy of replies and then it is for the auditor to determine whether there is need to apply other audit procedures based upon the result of such inquiries. In case the management is unable to provide on explanation or if the explanation is not considered adequate, then further investigation is necessary, Now, before turning to the evidence on this aspect, it is required to be stated how exactly the ratio of profit to sale is determined in a financial year compared to the previous year. For illustration, in a given year the sales effected are of value of Rs. 1,000, while the profits made are of Rs. 100, and the ratio becomes 1 : 10. In the next year, the sales may be of an identical value, but the profit may jump up to Rs. 200 and the ratio would be 1 : 5. By comparison of the ratios of the two years, it would be abundantly clear whether there is an abnormal growth or fall in the ratio of profits.
61. Mr. Cooper vehemently submitted that defendant No. 1 failed to make comparison of ratio of profits to sale of the relevant year with the previous year and that is a serious dereliction. It was urged by the learned counsel that there was an abnormal rise in the gross profit to sales ratio in the relevant year; and still the audit team ignored that fact and failed to notice that it was a suspicious circumstance warranting further detailed investigation.
62. Mr. Krishnan deposed in paragraph 16 of his evidence that while evaluating the profit and loss account of a particular financial year, he would examine the comparative ratio analysis with reference to the earlier financial year, both in respect of the income and expenditure. Mr. Krishnan further stated that in case he finds abnormal departure from the earlier year, then he would investigate the matter in greater depth. Mr. Krishnan was shown the profit and loss account of the plaintiffs for the year ending August 31, 1974, and thereupon stated that the gross profit for the year ending August 31, 1973, is approximately 22%, while in the next financial year it is approximately 43% and that is an abnormal variation; and it was necessary to ascertain the cause of this percentage rise to find out whether the sale prices have gone up or the value of the raw material had decreased. Mr. Krishnan stated that he would consider whether the fluctuation in sale prices or purchase prices of raw material would justify the variation of the gross profit ratio. According to Mr. Krishnan, to ascertain the effect of increase in the sale price, he would compare the average price in the earlier financial year with the prices prevailing in the current year and number of units sold and then would determine the quantum of increase and conclude whether the rise in gross profit ratio was because of increase of sale price. Mr. Raiji in paragraph 10 of his evidence stated that in a case where an auditor finds an abnormal rise in the ratio of gross profits to sales, then the auditor should find out the reasons for the same, and the auditor should seek explanation is reasonable. Mr. Raiji further stated that the satisfaction would depend upon the assessment of the auditor about the working of the company and the credibility of the management. Alpaiwalla in paragraph 6 of his evidence stated that before finalisation of the audit work for the relevant year, Mahindra reported to him that there was unusual spurt in the profits of the plaintiffs and also there was unusual variance. Alpaiwalla thereupon advised Mahindra to ask Mr. Hegde, the Director and the General Manager of the plaintiffs, to come and see him. Alpaiwalla deposed that Hegde met him on October 11, 1974, and informed him that there was favourable variance due to increase of the prices of the goods and availability of raw materials to secure higher production. Alpaiwalla advised Mahindra to check this variance, and claims that the fact was reported to the board of directors, a claim which was not sustained and very rightly given up by Mr. Setalvad, learned counsel for the defendants. Alpaiwalla admitted in cross-examination in paragraph 12 that the unusual spurt can be for a number of reasons, and one of them can be that the selling price vis-a-vis the production cost has risen. Mr. Alpaiwalla conceded that it was possible to find out what price was paid for procuring raw materials, including steel, which was the main ingredient for the manufacture of the company's products. Alpaiwalla stated that he advised Mahindra to check the prices. Mahindra deposed that during the original audit work for the year 1973-74, a note was prepared by senior in-charge and the copy of which is at page 48 of volume 14 of the compilation of the defendants. Mahindra had initialled this paper and had made an endorsement to the following effect :
"Substantial increase in prices during the year-main reason given by the company."
63. The note reads as under :
Gross profit percentage
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1973-74 1972-73
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Sales 1,85,02,990 1,10,33,512
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Opening stocks 6,28,833 9,07,764
Consumption 78,45,602 56,70,928
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84,74,435 65,78,692
Closing stock 14,25,042 6,28,833
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70,49,393 59,49,859
------------ -------------
Profit 1,14,53,597 50,83,653
Ratio 61.90% 46.07%
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64. Mahindra deposed that on noticing the large increase in the profits of the company by comparison with the profits of the earlier year, he advised his staff to prepare a working of the gross profit ratio for the two years, and to find out the reasons for the increase. On realising that the increase was substantial, Mahindra advised his senior in-charge Mr. Rajadhyaksha to inquire from the plaintiffs the reason for the same. Mr. Rajadhyaksha made the inquiry and reported to Mahindra that it was mainly on account of substantial increase in the selling price of the finished goods. Mahindra then instructed Rajadhyaksha to verify the explanation given by checking the invoices and the price lists and Rajadhyaksha on verification confirmed the accuracy of the explanation. Mahindra claimed that he made the endorsement on the note thereafter and he had kept his superior Mr. Alpaiwalla posted with this development., Mahindra was cross examined at length on this aspect and deposed in paragraph 29 of his evidence that he took steps to check the sharp increase in the percentage of gross profit by verification of the price list and the relevant sales invoices and also the average cost of purchase of raw material. The work was not carried out by Mr. Mahindra himself, but was entrusted to his team. Mahindra deposed that his audit team checked up the average purchase price of the steel in the previous year, that is year 1972-73, but subsequently changed his version and stated that the average purchase price of flange steel was checked and not that of steel. The witness deposed that the average purchase price of flange steel was approximately Rs. 3.30 per kilogram and the actual average purchase price of flange steel was determined by taking into consideration the standard. The witness conceded that the main ingredient for the manufacture of the products of the plaintiffs is steel; and flange steel is only a part of it and he did not work out the average purchase price of steel. The witness further admitted that the actual price of steel consumed in the year 1973-74 was higher than the average price at Rs. 4.32 per Kilogram, and the purchase price came to about Rs. 6 per kilogram. The witness stated that in spite of being aware that the price paid for the steel was more than the standard fixed, still he did not feel it necessary to investigate the increase in the price of the steel. The witness was cross-examined with reference to the variance arrived at by reference to the actuals and the standards and had to accept that in case the standards for the two years are same, then it is necessary to examine whether favourable quantity variance has any interplay with the increase in the profit. The witness at one stage claimed that the standards fixed for the relevant year and the previous year were the same, but ultimately had to give up that claim.
65. Mr. Cooper urged that defendant No. 1 did notice an abnormal rise of gross profits in the relevant year compared to previous year and such rise could be caused by high quantity of sale or by rise in price or by better utilisation of the available raw material. It was contended that the audit team did not bother to ascertain whether any of these factors was in existence to make an analysis of the rise in gross profit ratio. Mr. Setalvad on the other hand urged that the auditors did make the analysis and applied their mind to the rise in gross profit ratio and that could be demonstrated with reference to the note prepared by Rajadhyaksha on which an endorsement was made by Mahindra, and to which reference has been made hereinabove. Mr. Setalvad submitted that rise in gross profit ratio was not inconsistent with what was revealed in the account books of the plaintiffs and, therefore, there was no occasion for the defendants to suspect that something was wrong in the affairs of the company. Learned counsel relied upon the fact that there was sharp increase in price by reference to exhibit 4, which was the price list of the relevant year and which undoubtedly shows that the prices were rising. The accounts maintained by the plaintiffs also clearly indicated that there was a sharp rise in sales effected in the relevant year. If this was the situation existing at the relevant time, then it cannot be concluded that the circumstance of rise of profit ratio should have raised suspicion in the mind of the auditors. Both Mahindra and Alpaiwalla noticed the rise in the gross profit ratio and did contact the managing director. Hegde, to give explanation. There was no reason to discard the explanation offered by Hegde, who was in charge of the management of the plaintiffs and was working with the plaintiffs right from the inception of the company in the year 1960. It is true that the material which has come to light subsequent to the investigative audit and which is now highlighted at the trial, would certainly make one wonder why the explanation of the management and of Hegde was accepted by the auditors, but it is well said that it is easier to be wise after the event. One should put oneself back to the situation existing at the time of original audit and it is necessary to keep out of mind all the facts which have come to light subsequently. In my judgment, the fact that internal control system of the plaintiffs was functioning efficiently for over several years, the fact that the defendants carried out the audit work of the plaintiffs for over 12 years, and without finding any irregularity, the fact that an independent outside agency, like the holding company was in the full know of the working of the plaintiffs and the directors of that company never suspected any irregularity in the affairs of the company, and the board of directors of the plaintiffs even after taking reasonable care were unable to detect the manipulation of accounts by the staff with the connivance of Hegde, are tell-tale circumstances to indicate that a reasonable or prudent auditor would not have suspected foul play after seeking an explanation from the management. In these circumstances, in my judgment, it was not necessary for the auditors to carry out the detailed analysis in the absence of any suspicion. In my judgment, the circumstance relied upon by Mr. Cooper was not sufficient to rouse suspicion in the mind of the auditors on the facts and circumstances of the case.
66. Mr. Cooper then submitted that even the audit programme settled by the auditors, a copy of which is to be found in volume 9 of the compilation of the defendants, was not carried out. About eight factors were pointed out to indicate that the proper procedure was not carried out by the defendants as required by the audit programme. The first contention urged on behalf of the plaintiffs is that the auditors were negligent in selecting 20 invoices and the measure adopted for selection of these invoices was entirely defective. Item 6 in the audit programme prescribes selection of 20 invoices for in-depth checking regarding the orders received from the customers, acceptances by the company, receipted delivery challans, posting to stores-card, raising of invoices, checking the prices from published price-lists, calculations and additions of invoices and subsequent receipts etc. It is not in dispute that the auditors selected 20 invoices in respect of transactions effected in the month of August, 1974. It is required to be stated at this juncture that during the investigative audit undertaken by the defendants in October, 1975, 35 suspected transactions were noticed in respect of the last three months of the financial year, that is, June, July and August, 1974, and out of which 29 transactions were effected in the month of August, 1974. It must be made very clear that it is not the claim that the transactions were fictitious or unreal, but what was done was that the transactions which were really effected in the next financial year were ante-dated to show high sales and profits in the year ending with August 31, 1974. Out of the 20 invoices of August, 1974, checked by the auditors, 9 invoices formed part of the 35 suspected bills noticed by the auditors during the investigative audit. With this background, it is now necessary to consider the contention that the auditors were in error in selecting 20 invoices only and that too out of the invoices prepared in the month of August, 1974.
67. Mr. Krishnan in paragraph 7 of his evidence deposed that an audit programme necessarily contains examination of cut-off transactions, and the expression "cut-off" means "the transactions effected in the first month and the last month of the given financial year". In paragraph 20 of the evidence, Mr. Krishnan stated that it is not necessary to take into account each and every transaction and it is sufficient if representative high value transactions spread over throughout the year, with emphasis on cut-off transactions, are taken into consideration. Alpaiwalla in paragraph 8 of his deposition, stated that he did not suggest to Mahindra or the audit team as to how the invoices should be selected, but normally the invoices are selected at random and the selection is left to the discretion of the person undertaking the audit work. Alpaiwalla deposed that the spectrum of selection must cover a wide range and both high value and low value invoices should be normally selected, though weightage should be given to high value invoices. Alpaiwalla further stated that though it is open for the auditor to make the selection of invoices spread over the year, usually the selection is made from invoices of one or two months and importance is given to cut-off months, with further priority to the last month of the accounting year. Mr. Raiji also deposed in paragraph 6 of his evidence that the auditor should examine the specimen sales transaction during the cut-off period to ensure that the goods sold are not included in the stock. In cross-examination in paragraph 15, Raiji deposed that there is no fixed test as to how the selection of invoices should be made and sometimes it is selected at random and in some cases the invoices selected are for the particular month. But what is necessary is that such selection should not be biased and must be representative. Reading the evidence of Krishnan, Alpaiwalla and Raiji, in my judgment, there could be hardly any doubt that no fault can be found with the selection of 20 invoices made by the auditors. What should be the number of invoices and what is the range of selection should be left to the discretion of the auditor. Moreover, the gravamen of the complaint of the plaintiffs is that the accounts were manipulated to show that sales transactions took place in the last three months, when in fact the transactions were carried out in the subsequent year, and when according to the plaintiffs the highest sales were effected in the last three months of the financial year, the plaintiffs could have no complaint if 20 invoices were selected from the month of August, 1974, for in-depth checking. The expression "in-depth check" has been described by the witness as "from cradle to grave" and means that the transaction should be checked exhaustively right from the inception to the end.
68. The next ground of challenge to the work of auditors is that the delivery challans in respect of 20 invoices checked were not receipted by the customers. Kelkar in paragraph 4 of his evidence deposed about the system of delivery challans adopted by the plaintiffs, and prevalent in the relevant year. Kelkar deposed that after receipt of the order from the customer, the sales department used to enter the order in the company's form known as "sales order form". The stores department thereafter prepared a challan for dispatch of goods to the customer and the challan was prepared in quadruplicate. The copies of the challan were to different colours; white, yellow, pink and green. The white, yellow and green copies were forwarded to the customers or their agents along with the goods, and the customer was expected to retain the white copy and return the yellow and green to the company after being duly acknowledged. The pink copy was retained with the stores department till the receipt of the two copies from the customer, and the pink copy was thereafter forwarded to the accounts section, the yellow copy to the sales section and the green copy to the stores department. Kelkar further deposed in paragraph 6 of his evidence that goods to be despatched to the customer at outstation by railway were taken to Wadibunder station by the company's transport agent and subsequently the agent used to produce the railway receipt to establish the fact of dispatch of goods. In respect of export transactions, the goods were sent to the forwarding and clearing agent and the agent used to send the requisite documents, like bill of lading, port trust receipts, etc., to the company and the said documents were then retained in the sales department. In cross-examination, Kelkar deposed in paragraph 22 that M/s. Sonawane Transport Service used to carry the goods from the company's gate to Wadibunder Railway Station, and the charges were paid to that transport agent on piece-work basis. M/s. Sonawane Transport was not in the employment of the plaintiffs, but were merely public carriers. Kelkar accepted in paragraph 23 of the cross-examination that the invoices were not prepared till after the yellow and green copies are received from the customers. Kelkar admitted that in the relevant year on numerous occasions, invoices were prepared even before the delivery was effected, and pretended ignorance as to whether on several occasions, the copies of challans were not received back from the customers. During the investigative audit undertaken by the defendants in October, 1975, a note was prepared and initialed by Mahindra in respect of maintenance of delivery challans, and the copy of which is at page 69 of volume 4 of the compilation of the defendants. The perusal of this note indicates that the testimony of Kelkar about maintenance of delivery challans is correct.
69. Mr. Krishnan in paragraph 6 of his evidence deposed that while checking the invoices, it is necessary to ascertain whether there is receipt of the customer or receipt of the independent carrier or bill of lading to establish delivery of goods. Krishnan further deposed in paragraph 9 of his evidence that while closely examining substantial items in the sales register, it is necessary to look into the sale vouchers, invoices and mode of transport, etc. The witness further deposed that he would call for the railway receipts in order to ensure that the goods are in fact despatched by train, and the railway receipt must indicate that it was drawn in favour of the customer and that the goods were despatched within the financial year. Mr. Krishnan stated that the production of delivery challans receipted by the lorry driver employed by the company would not sufficient proof to establish delivery to customer. The witness stated that he would make several inquiries by probing into the correspondence, by writing to the customer and by other modes to ascertain whether the goods have been delivered to the customer, and whether payment has been received, and in case he is not satisfied, he would make a point in that regard while submitting the audit report. In cross-examination, Mr. Krishnan stated that in support of the claim that the auditor should satisfy that the goods sold are in fact received by the customer, he placed reliance upon the contents on page 80 of B. N. Tondon's Practical Auditing. In paragraph 30, the witness conceded that there is no authority in support of the claim that it is necessary for the auditor to look into the mode of transport. The witness, also conceded that his claim in examination-in-chief that the railway receipt should be called for to ensure that the goods are in fact despatched is not just because the railway receipt would not be with the company. The witness added that he would call for the register in which the railway receipt numbers are entered. In paragraph 38 of the evidence, Krishnan deposed that the delivery challan would not include the number of the bill of lading as that document is prepared when the goods are loaded on the ship, and his statement in examination-in-chief that the delivery challan is an unsatisfactory document because it does not indicate the number of the bill of lading is not correct. Raiji in paragraph 8 of his evidence deposed that it is not necessary for the auditor to ascertain whether the goods are actually delivered to the customer by the company, but what is important is the recovery of the price. Raiji further stated that the auditor is not expected to check whether goods were transferred by any mode referred to in the delivery note. Mr. Raiji stated in cross-examination that in case the receipted delivery challans are not available, he would not jump to the conclusion that there is something wrong in the internal control system. Mahindra admitted in cross-examination in paragraph 16 of his evidence that a manufacturing concern normally maintains a copy of the delivery challan with the endorsement from the customer, but claimed that the internal control would not be defective in case such challans with endorsements are not maintained. Mahindra further deposed in paragraph 17 of the evidence that he was not aware as to what method the plaintiffs were following in respect of maintenance of delivery challans. The witness further deposed that receipted delivery challans means acknowledgment on the challans when the goods leave the factory gate.
70. With this evidence on the point, it is now necessary to examine the complaint of the plaintiffs about the delivery challans being not receipted by the customer. Out of the 20 delivery challans examined by the auditors, 17 were receipted by M/s. Sonawane Transport Service, while the remaining three challans are not receipted. Mr. Cooper contended that during the investigative audit, Mr. Mahindra prepared a note in regard to checking of the delivery challans and the following endorsement in the hands of Mahindra speaks volumes :
"No query was raised regarding the non-receipt of delivery challans why ?" Learned counsel urged that if Mr. Mahindra was careful and not negligent during the regular audit, the deficiency which was noticed at the time of investigative audit would not have escaped and would have been seen and examined. It was contended that Mahindra had no explanation why such query was not raised at the time of original audit. Mr. Setalvad, on the other hand, urged that it was not necessary to suspect the delivery challans receipted by M/s. Sonawane Transport Service because M/s. Sonawane Transport Service was not in the employment of the plaintiffs but was an outside agent appointed by the plaintiffs. Learned counsel pointed out that M/s. Sonawane Transport Service had tendered bills for transport of various goods from the factory of the plaintiffs and the copies of the bills which are at pages 75 to 79 of Volume 'C' of the compilation of the plaintiffs, show quantities of various goods handed over to M/s. Sonawane Transport Service for being transported. The bills also set out the number of invoices of the delivery challans. The amount due to M/s. Sonawane Transport Service under these bills was included in the amount of expenses and accruals - other than petty cash - of August 31, 1974. Kelkar conceded that the liability of M/s. Sonawane Transport Service in respect of the goods carried under these bills was not disputed. Mr. Setalvad is right in his submission that the auditors could not have suspected that something was amiss only because the delivery challans were receipted by M/s. Sonawane Transport Service and not by customers. Learned counsel is right in claiming that the bills tendered by M/s Sonawane Transport Service were on the record of the company and the accounts clearly indicate that the plaintiffs were liable to pay the amount of the bill to M/s. Sonawane Transport Service. There was no occasion for the auditors to suspect that M/s. Sonawane Transport Service was also hand-in-glove with the staff of the company and the managing director Hegde, in manipulating the accounts. The auditor could not have imagined that M/s. Sonawane Transport Service would prepare fake bills although the goods were not handed over to them and would also to submit bills and the liability under the bills would be entered in the company's accounts. Mr. Cooper contended that it was not sufficient that the delivery challans should be receipted by the customer, but it was necessary for the auditors to examine the railway receipts or bill of lading. The submission was countered by Mr. Setalvad by pointing out that in the absence of any suspicion, the auditors need not have examined the railway receipts or bills of lading and more so when there are other supporting documents to indicate that the transactions were genuine. The other documents to which reference was made by learned counsel are the sales journal, customers ledger and stores cardex, copies of which are at page 108, 109, and 111, respectively of Volume 'C' of the compilation of the plaintiffs. In my judgment, when the auditors were satisfied with the existence of these documents, coupled with the fact that M/s. Sonawane Transport Service had signed 17 delivery challans, then it is not possible to hold that the auditors should have come to the conclusion or at least suspected that there was a breakdown of the internal control system. It must be remembered that the auditors even in an in-depth check could not have started with the presumption that something was irregular in the working of the company, and not only the staff and the managing director, but even an outside agent, like M/s. Sonawane Transport Service, were out to manipulate the accounts.
71. It is necessary in this connection to make reference to one of the submissions urged by Mr. Setalvad claiming that the property in goods stands transferred to the customer as soon as the company handed over the goods for delivery to M/s. Sonawane Transport Service. Learned counsel relied upon sections 4, 23(2) and 39 of the Sale of Goods Act, 1930, in support of the submission. In my judgment, the submission is not correct. Sub-section (2) of section 23 merely prescribes that where the seller delivers the goods to the buyer or to a carrier or other bailee for the purpose of transmission to the buyer, and does not reserve the right of disposal, then it would be deemed to have unconditionally appropriated the goods to the contract. Sub-section (2) of section 39 prescribes that unless otherwise authorised by the buyer, the seller shall make such contract with the carrier on behalf of the buyer as may be reasonable having regard to the nature of the goods, and if the seller omits to do so and the goods are lost or damaged in course of transit, the buyer may decline to treat the delivery to the carrier as a delivery to himself and hold the seller responsible in damages. A plain reading of these sections indicates that the property in goods does not stand transferred from the seller to the buyer by mere delivery of the goods to a carrier. In the present case, the goods were handed over to M/s. Sonavane Transport Service for being removed from the factory to Wadibunder Railway Station for further despatch by railway, or from the factory to the warehouse of the shipping agent for further export. The handing over of the goods to M/s. Sonavane Transport Service can by no stretch of imagination be held to be transferring of the property in goods in favour of the customer. The customer could not be held to have received the goods merely because the plaintiffs handed over the goods to the transport agent for being carried to the Railway Station or the warehouse. The reliance by Mr. Cooper in this connection on the decision of the Supreme Court in Morvi Mercantile Bank Ltd. v. Union of India and Mahabir Commercial Co. Ltd. v. CIT is very appropriate. It is not possible to accept the submission of Mr. Setalvad that the auditors could have assumed that the goods were transferred to the customers and received by the customer merely because M/s. Sonavane Transport Service signed the delivery challans.
72. It is not in dispute that three delivery challans were not receipted at all and the attention of Mahindra was invited in cross-examination to two delivery challans out of three. Mahindra admitted in paragraph 21 of his evidence that if he was personally to carry out in-depth checking and noticed that a delivery challan was not receipted, either by the driver or the receiver, then he would have looked into other documents to find out whether the challan was a genuine document. Mr. Cooper submitted that the defendants did not examine any member of the audit team who had actually carried out the in-depth checking and Mahindra was taking shield by stating that he did not personally carry out the in-depth checking. It is true that Mahindra did not personally carry out the in-depth checking but the explanation that in case a delivery challan is noticed during in-depth checking as not being receipted, then that explanation would be sought from other documents cannot be ruled out. In the present case, the other documents in the shape of store cards, sales journal and customers ledger corroborate the delivery challans and the mere fact that three delivery challans were not receipted could not have led any reasonable auditor to come to the conclusion that there was something suspicious about the dealings of the plaintiffs. The submission of Mr. Cooper that Mahindra during the investigative audit noticed that the explanation was necessary for non-receipted delivery challans but that fact, could have been noticed during the regular audit and the failure to do so amounts to negligence cannot be accepted, because even though that fact was noticed during the regular audit, the auditing team would not have suspected any foul play in view of the other documents. In my judgment, the auditors could not be held to have been negligent in the in-depth check in respect of 20 delivery challans.
73. The next grievance urged by Mr. Cooper is that the auditors failed to notice that the plaintiffs prepared invoices without receipt of orders from the customers. Out of the suspected 35 transactions which are set out in Appendix IV in Volume 15 of the compilation of the defendants, only in respect of seven cases, there were no orders and the total value in respect of those seven transactions was approximately 2.5 lakhs. Mr. Setalvad submitted that the complaint of the plaintiffs on this ground is misconceived, and though it is true that there were no written orders in respect of the seven transactions, there was ample evidence available to the auditors at the time of regular audit to hold that the transactions were genuine. The submission of learned counsel is correct and deserves acceptance. In respect of two transactions with Standard Drum & Barrel Manufacturing Co., dated August 29, 1974, and August 22, 1974, of a value of about Rs. 2 lakhs, there was documentation available on the file of the company to hold that the order was in fact received from the customers. On page 13 of volume 16 is a copy of the bill of exchange drawn in favour of the plaintiffs by the customer and accepted by the Union Bank of India. The bill of exchange is dated August 27, 1974, and copy of the letter dated October 14, 1974 at page 14 in volume 16 clearly indicates that the bill of exchange was forwarded by the plaintiffs to the bank after effecting the amendment. These documents are more than enough to conclude that the orders were indeed received from the Standard Drum & Barrel Mfg. Co., and the grievance of the plaintiffs in this connection is unfounded. There are two transactions, one with Steel Containers Ltd., and another with Tide Water Oil Co. (India) Ltd., where, though a written order was not received from the customer, the amount due in respect of the goods supplied was received by the plaintiff company before September, 1974, that is before the end of the relevant year. The fact that payment was received is a clear indication that the customer did book the order, though not in writing. There is one more transaction with Hindustan Petroleum Corporation Ltd., where though there is no written order from the customer, the invoice prepared by the plaintiff is marked with the endorsement "pre-payment" and that is also sufficient evidence to indicate that the customer did in fact book the order. If this material was available to the auditors at the time of the regular audit, then it is difficult to accept the submission of Mr. Cooper that the fact that invoices were prepared without written orders should have aroused the suspicion of the auditors while carrying out the in-depth check.
74. The next contention urged by Mr. Cooper is that the auditors failed to scrutinise three invoices which were marked as "pre-paid', but in respect of which the amounts were not received till completion audit work.
75. Mr. Cooper submitted that the in-depth check demands that the auditors should be satisfied to the hilt that each and every transaction selected for examination is genuine in every respect and it is wholly immaterial whether the amount due under the invoice is petty or large. The three invoices with the endorsement "pre-paid" are invoice No. 954/73 of National organic Chemical Industries Ltd., invoice No. 944/73 of Rallis India Limited, and invoice No. 961/73 of Hindustan Petroleum Corporation. All these invoices were prepared by the plaintiffs on August 29, 1974. The amounts due under these three invoices are Rs. 16,037.39, Rs. 15,978.60 and Rs. 23,363.03, respectively. Mahindra deposed in paragraph 20 of his evidence that he is not aware as to what inquiries were made by his assistant for non-receipt of the amounts in respect of these invoices, but he would not find anything irregular because the balance amount was not received till the completion of the audit work, as the amount covered by these three invoices is very small compared to the amount due from various debtors of the company, and set out in the debtors' schedule, copy of which is at page 1 of volume 2 of the compilation of the defendants.
76. Mahindra also stated that he would not be perturbed by non-recovery of amount till the completion of the audit work as the amounts were not due for a long duration. Now, turning to the debtors' schedule of the company, it is clear that the debtors' dues were to the tune of Rs. 61,72,400.47 and out of that amount, and amount of Rs. 79,245 was due for a period over six months. Mahindra is right in his claim that compared to the total dues receivable by the plaintiffs, the amount covered by the three invoices was negligible, and in any event the amounts were not due for a period of over six months. Mr. Cooper urges that it is wholly immaterial that the amount was a small amount and it was the duty of the auditors to seek an explanation as to why the amount was not received till the completion of the audit work. In my judgment, the auditors could not be held negligent when the amounts covered by the three invoices were not large and were not due for a period over six months, and there was nothing to arouse the suspicion of the auditors at the relevant time.
77. The next grievance is in respect of the four invoices of Directorate General of Supplies and Disposals, Bombay. In respect of two invoices, there were no delivery challans and in respect of the remaining two payment was not received. Mr. Cooper submitted that the Directorate General of Supplies and Disposals was one of the main customers of the plaintiffs and still the auditors did not bother to get familiar with the terms of contract with that customer. The amount not received from this customer till the completion of the audit was to the tune of Rs. 1,92,433.87. Now, before considering the evidence on this point, it must be stated that it is not in dispute that there were orders received from this customer and the goods were in fact supplied and payments received by the plaintiffs. The only grievance is that the sales were predated with a view to inflate the figure of sales and profits of the relevant year. Mahindra admitted that he was not familiar with the procedure of sales to the Directorate General of Supplies and Disposals at the time of the original audit, and he could not state whether his audit team was familiar with that procedure. Mahindra admitted that he became aware of the procedure of sales to the Directorate General of Supplies and Disposals only during the investigative audit, and a note was prepared in that connection by his assistant. The note is at page 73 of volume 4 of the compilation of the defendants, and sets out that the plaintiff company writes to the Directorate General of Supplies and Disposals offering the goods for inspection, and thereafter the customer deputes a representative to inspect the goods. The representative of the customer draws random sample and the samples are tested and thereafter the particulars of quantities accepted are entered in the inspection certificate, which is part of the inspection note prepared by the representative. The inspection note along with the other documents is forwarded to the plaintiffs implying instructions to despatch the goods. The plaintiffs then despatch the goods along with the inspection note, and then payment is obtained on the basis of the receipt of the inspection note. The grievance of Mr. Cooper is that the auditors did not bother to get familiar with this procedure, and, therefore, overlooked the fact that there could not have been any transaction in favour of this customer without the existence of the inspection note. Learned counsel also urged that if the auditors had carried out the in-depth check in respect of these transactions, it would have been noticed that the payment was not received till the completion of the audit and an explanation would have been sought. Mahindra in his evidence gave two reasons for not seeking an explanation for non-receipt of payment till completion of the audit and those are, (i) that the account of the customer was of a long standing and was operated regularly; and (ii) the amount due was not for a period over six months. In my judgment, the explanation given by Mahindra, in the facts and circumstances of the case, cannot be said to be imaginary or stated for covering any failure at the time of regular audit. The auditors had no occasion to suspect that the transactions were not genuine or that the management was out to pre-date the sales transactions with a view to show inflated figures of sales and profits.
78. The next item is of export sales and there the complaint is that in the alleged in-depth check undertaken by the auditors, no effort was made to ascertain whether the export is related to sales during the relevant year. There are three transactions of export sales in the last three months of the relevant year and one of them was in the month of August, 1974. It is an admitted position that an export sales transaction was not included in the 20 invoices selected by the auditors, and Mr. Cooper complains that not selecting an export invoice of the month of August, 1974, itself amounts to negligence, but it is not possible to accept the submission. The selection was made at random and was left to the discretion of the member of the audit team dealing with the same and it is not possible to find fault with that selection with a hindsight. Out of three transactions of export sales, two were in favour of Myanma Oil Corporation, Burma, and the delivery challans were prepared on June 29, and July 30, 1974, respectively. The delivery challans are signed by M/s. Sonavane Transport Service. Each of these transactions was of a value of over Rs. 4 lakhs and through the date in respect of these transactions was circularised, no confirmatory letter was received from the customer. Mahindra admitted in his evidence that item 11 in the audit programme requires checking of various journals. The witness further stated in paragraph 25 of his evidence that during the review carried out by him as part of the audit work he examined the account of Myanma Oil Corporation. Mahindra admitted that on most occasions, the payment in respect of export transactions would be by letter of credit and the payment would be received within 10 to 15 days on presentation of the bill of lading by the bankers. Mahindra deposed that he did not inquire why payment was not received and whether the bill of lading was presented. In cross-examination, Mahindra admitted that page 63 of exhibit "H", which is the sales journal for the year 1973-74, pertains to export transactions. The witness admitted that under the audit programme, full checking of posting from sales journal to general ledger was necessary but on perusal of exhibit "H" and entries in Freight on Export Shipments, Account No. 19A, it is clear that the entries were not fully checked. Mahindra further admitted that in respect of three entries in the sales journal, the corresponding entries in the general ledger were not posted, and the three entries included the export items of Myanma Oil Corporation and Oil Refineries Administration, Iraq. Mahindra further admitted that the auditor is required to ascertain the export earning of the company on the basis of FOB value. On the strength of these admission, Mr. Cooper submitted that the auditors were negligent in not ascertaining whether the amount was received in respect of the export sales and in not seeking an explanation for the same. Learned counsel urged that Schedule VI, item 4D(e), of the Companies Act demands that the auditor should inquire into several aspects and certify that the information is correct, and to enable the auditor to do so, it was necessary to look into several documents. Section 211 of the Companies Act prescribes that every balance-sheet of a company shall give a true and fair view of the state of affairs of the company as at the end of the financial year and shall be in the form set out in Part I of Schedule VI or as circumstances admit. In Schedule VI, the relevant item is 4D, which prescribes that the profit and loss account shall also contain by way of note, the following information, namely :-
"(e) earning in foreign exchange classified under the following heads, namely :-
(i) Export of goods calculated on FOB basis;"
79. Mr. Setalvad urged that what Schedule VI demands is only the information to be given and it is not necessary for the auditors to certify the accuracy of the same. In this connection, it would be appropriate to make reference to paragraph 14.2 of "Statement on the Amendments to Schedule VI to the Companies Act, 1956". The paragraph sets out that as in the case of a disclosure relating to foreign currency expenditure, the question arises as to whether foreign currency earnings have to be disclosed on cash basis or on mercantile basis. Both the bases are acknowledged as accepted, but it is necessary to remember that once a particular basis is selected, such basis should be consistently applied from year to year. Contents of paragraph 21.1 of this publication deals with the auditor's duties and functions and, inter alia, prescribes that since the additional information in terms of the new requirements of Schedule VII would be the integral parts of the profit and loss account and the balance-sheet, it would be covered by the normal statutory affirmations in the auditor's report rather than by any separate certification of such information by the auditor. If further recites that the test of the responsibility of the auditor with reference to the additional information is precisely the same as the test of responsibility with reference to the company's accounts taken as a whole. In other words, the auditor must perform his duties diligently and honestly with reasonable care and skill and without any negligence. Reading the contents of this paragraph, it is obvious that the submission of Mr. Setalvad that the auditor is not required to certify the information demanded by Schedule VI, item 4D (e), of the Companies Act is erroneous and cannot be accepted. Even though the submission is not acceptable, that would not lead to the conclusion that the auditors were negligent in the discharge of their duties for not ascertaining the receipt of payments in respect of the export sales. It has come to light during the investigative audit and that fact is set out in paragraph 4.6 of the auditor's report, part of the 15th annual report of the company that out of export shipment of 472 cases, 450 cases were removed to a godown belonging to a warehousing agent prior to August 31, 1974. These cases were removed to the godown of Madhavdas Khetan and subsequently shipped in October, 1974. These facts became clear from the correspondence entered into with the clearing agents. Now, the invoices selected by the auditors do not include any transaction in respect of export sales and, therefore, no fault could be found with the auditors for not ascertaining whether the goods were in fact shipped during the relevant year. The complaint is in respect of non-receipt of the payment and here it should be remembered that the debt was not due for a period over six months. The auditors had no occasion to suspect that the management was manipulating the accounts to show inflated figures of sales and profits and the reliance on the representation of the management, including that of Hegde, who was the man of confidence of the holding company, could not be said to be unreasonable. The auditors could not be faulted for assuming that the plaintiffs indeed earned the foreign exchange by export of goods during the relevant year. There is one more circumstance in this connection which must be mentioned and that is that even after the investigative audit, the plaintiff company treated the sales covered by export invoices as the sales effected in the relevant year. The note in this connection, forming part of Schedule of the notes annexed to the accounts in the 15th annual report is relevant. It reads as under :
"The FOB value of exports for the year ended August 31, 1975, includes Rs. 10,44,245 in respect of an adjustment for sales taken into account for the year ended August 31, 1974, but for which no deliveries of finished goods had taken place up to that date. However, this sum has not been deducted from the comparative figure for the year ended August 31, 1974."
80. In my judgment, the plaintiffs have failed to establish that the auditors were negligent in the discharge of their duties because of the failure is not selecting the export invoices for in-depth checking and the failure is not seeking an explanation for non-receipt of the payment and the failure to ascertain whether the foreign exchange in respect of export sales in fact accrued in the relevant financial year.
81. The next complaint is in respect of improper procedure adopted by the auditors in regard to confirmation of debts. Mr. Krishnan deposed in paragraph 18 of his evidence that it is customary to ascertain the confirmation of debtors' balances at the end of the financial year and normally the auditors make queries with the debtors but in some cases, the company of its own, sends letters to the debtors prior to closing of the accounting year. Mr. Krishnan claims that where the inquiry is made directly by the company about the existence of the debt, then it is necessary for the auditor to further inquire whether such debts continue to remain in existence till the end of the accounting year. Mr. Krishnan further stated that it is necessary for the auditor to ascertain whether any further debts are created between the dates mentioned in the confirmation of the queries and the end of the accounting year. Mr. Krishnan suggested that it is desirable to apply the Roll Forward Method, if there are high value items shown in the column of "debts" which are due for a period of more than six months. In support of the claim, reliance was placed on the contents of paragraph 7.10 of the Statement of Auditing Practices published by the Institute of Chartered Accountants of India. In cross-examination, Krishnan admitted in paragraph 30 that the confirmation of balance from the debtors need not be on a date ending with the financial year. The witness further stated that it would be difficult to obtain confirmatory letters from the customers, in case the audit work is required to be completed within a period of two months from the end of the financial year. Krishnan further stated that the auditor should ascertain how many debtors have responded to the circularisation of the debts and then find out whether the payments have been received till the completion of the audit work bearing in mind the terms of credit agreed between the company and the customer. In respect of debts created in the interregnum, says Mr. Krishnan, the auditor should inquire as to whether any payment has been received and whether the goods have been delivered against the invoices. Mr. Krishnan stated that the object of a confirmatory letter is to ensure whether the transactions were completed before the cut-off period or carried over to the next accounting year. The witness conceded that the fact that a customer is of a long standing and has several transactions with the company is a relevant factor and in such cases, the auditor must examine the debts very closely because of the likelihood of some concessions given to such customer. Mr. Krishnan deposed in paragraph 31 of the evidence that the Roll Forward Method is a safer method in respect of sales transactions in the interregnum, but had to concede that this method is not referred either in Statement of Auditing Practices or International Auditing Guidelines. Mr. Krishnan further conceded that there is no authority for the proposition that the auditor must ascertain from the customer that the goods have in fact been received and payments made in respect of the sales transactions during the interregnum. Mr. Raiji in paragraph 7 of his evidence deposed that the object of securing confirmation of debts is to ensure about the accuracy of the existence of the debt from an outside agency and also to prevent what is known as "Teeming and lading". Mr. Raiji stated that outside confirmation of existence of debt confirms whether the staff of the company had misappropriated any amount and manoeuvred the account. According to Mr. Raiji, normally the auditor fixed up a date which is earlier than the date of closing of the year for confirmation of the debt as that would enable the auditor to receive back the letters before the dead-line for completion of the audit work. The response to the enquiries would depend upon the nature of the customer and the products supplied to him. Mr. Raiji then stated that it is not necessary for the auditor to take any steps for ascertaining the debts in interregnum unless the auditor suspects some irregularities. In the present case, the auditors had selected July 31, 1974, as the date for confirmation of debts. The debt was circularised and the confirmation letters were sent to the customers by the company under the supervision of the auditors. The confirmation letters were sent to 97.3 per cent. of the total debtors and confirmation was received from 31.9% of the debtors. Mr. Alpaiwalla in paragraph 31 of his evidence admitted that they had applied the Roll Forward Method to ascertain the realisation of debts subsequent to August 31, 1974 and for such ascertainment had checked the actual realisations. Mr. Cooper made two grievances in respect of the system adopted by the auditors, and those are, (i) that it was wrong to select July 31, 1974, as the date for confirmation of debts; and (ii) the auditors failed to ascertain the debts created in the month of August, 1974, when the sales in that month were highest compared to the sales for the remaining months of the financial year. There is no merit in the submission of learned counsel in respect of both the grievances. It is not in dispute that the auditors were advised by the management to complete the audit work within two months of the year ending and in fact the work was completed by October, 1974. Taking into consideration the evidence of Krishnan and Raiji, it is obvious that the auditors faced with the demand that the audit work should be completed within two months of the end of the financial year, could not have selected the last date of the financial year for the purpose of confirmation of debts. The auditors had to give sufficient time to the customers to answer and confirm the debt and, therefore, it is futile to claim that the auditors were in error in selecting July 31, 1974, as the relevant date for confirmation of debt. The second grievance made is that Roll Forward Method should have been applied for the debts created during the month of August, 1974, but Mr. Alpaiwalla deposed that in fact that method was applied. Even though the sales were highest in the month of August, 1974, it was difficult for the auditors to secure confirmation of debts created in that month due to paucity of time and the mere fact that the payment was not received in respect of these debts could not have aroused the suspicion of the auditors, as the debt was very fresh and non-receipt of payment within two months was not a matter of serious concern.
82. In this connection, it is necessary to make reference to one crucial fact which would highlight how the system of confirmation of debt is proved futile or can be misleading. Out of the suspect 35 sales transactions found out by the auditors during the investigative audit, two are with Steel Containers Ltd., and the invoices in respect of these transactions were prepared on June 29, 1974, and July 30, 1974. The delivery challans were also prepared on the same dates. The confirmatory letters were sent to this customer, Steel Containers Ltd., which was run by Balmer Lawrie & Co. Ltd. The copy of the confirmatory letter is at page 8 of volume 4 of the compilation of the defendants and the customer confirmed the indebtedness by letter dated September 13, 1974, addressed to defendant No. 1. The letter recites that the customer had received the attached statement from the plaintiffs for confirmation of balance of Rs. 13,17,920.70 due as on July 31, 1974. The letter confirms that the balance due is Rs. 13,16,606.40 only according to the accounts of the customer. Now this confirmation raises several issues. According to the plaintiffs, the delivery of the goods was made to the customer only in the months of October and November, 1974, and the bogus invoice and delivery challans were prepared to pre-date the sales, and if this contention is correct, then it is difficult to believe how the customer acknowledged the indebtedness as on July 31, 1974, on the basis that the goods have been received. It indicates that either the record produced by the plaintiffs during the investigative audit is fabricated or the customer, Steel Containers Ltd. and Balmer Lawrie & Co. Ltd., are also hand-in-glove with the management of the plaintiffs, including Hegde, the managing director, in manipulating the accounts. In this state of affairs, it would be highly unjust to hold that the auditors were negligent in employing the procedure regarding confirmation of debts.
83. The last ground urged by Mr. Cooper is that the auditors were negligent in not checking the control account at the time of audit. Item 9 of the audit programme refers to costing journal and costing ledger and demands, checking of vouching journal entries and posting to cost ledgers. In both the cases, checking was to be carried out in respect of the entries of one month out of six months. The first grievance of Mr. Cooper is that though the audit programme specifically refers to checking of entries of one month in six months, the auditor carried out the checking of entries in respect of one month out of the entire year. Mahindra admitted in paragraph 44 of his evidence that the entries were checked only for the month of September, 1973, for the period covering from September, 1973, to August, 1974. Mahindra deposed that departure must have been made for some reasons which the senior-in-charge, Mr. Rajadhyaksha, must have given to him; but he could not recollect what the reason was due to passage of time. The second complaint is that posting to cost ledger was not at all checked and in support of the submission, reliance is placed on the fact that on checking of various items in the audit programme, the members of the audit team used to put their initials opposite the item and in respect of item of posting to cost ledger, there are no initials but only letter "s" is written. Mr. Cooper is right in his submission that the initials of the audit team are made against various items in the audit programme except this entry. Mahindra claimed that the entire audit work was carried out as per the programme and the assertion was made because of the initials made by the audit team against the items. In my judgment, the mere fact that against one of the items, the full initials are not written by the member of the audit team cannot lead to conclusion that the item was not attended to. It is possible that the member of the audit team might have forgotten to put his full initials against the item and it would be hazardous to jump to the conclusion that the item was not checked only because of some slip of a member of the audit team.
84. Mr. Cooper then submitted that the auditors checked posting of calculations to summary but did not bother to further check whether the entries are posted in general ledger. Learned counsel urged that it was the practice of the auditors to put a tick when an entry in a particular ledger is checked and there are no tick marks in the general ledger to indicate that posting of entries from calculations to summary in exhibit "E" and thereafter in the general ledger was checked. Learned counsel further submitted that the tick mark indicating checking of the entries would be crossed if the entry is further posted in other accounts and checked by the auditors. Mr. Cooper pointed out that there are no tick marks on raw materials, finished goods and sales control account and that indicates that the auditors did not carry out the audit programme by examining the entries in this account. In this connection, Mahindra in paragraph 51 of his evidence expressed his inability to state that what is the significance of the tick marks and its crossing out. Mahindra had to concede that there are no tick marks in respect of raw materials, finished goods and sales control account. Relying upon the admissions made by Mahindra in this connection in paragraph 51 of evidence, it was urged by Mr. Cooper that the auditors failed to carry out the audit programme which demanded checking of various control accounts. In this connection, the defendants produced on record exhibit 11, which is a chart maintained by the defendants prescribing rules for effecting tick marks during the audit. These rules, which appear to have been prepared in January, 1951, do not assist in ascertaining the exact significance of the tick marks, but it cannot be denied that there are no tick marks whatsoever on raw material, finished goods and sales control account, and also in the general ledger to indicate that the entries posted in calculation to summary in exhibit "E" were further posted in general ledger. In this connection, reference is also required to be made to exhibit 8 and exhibit 10. Exhibit 8 and exhibit 10 are notes prepared during the investigative audit. Exhibit 8 refers to the comments on "material usage variance account" and, inter alia, recites that the figures in costs journal voucher sheets were subsequently inserted. It further recites that the audit team was informed by the company that the cost ledger was rewritten with the altered figures and the original sheets were destroyed. The cost ledger is in loose sheets and has been bound at a later date. Exhibit 8 further recites that the company has, subsequent to the original audit, altered the figures in the costs journal, voucher sheets, summary and the material usage variance control account in the cost ledger. Exhibit 10 is also a note prepared in the investigative audit and, inter alia, recites that after checking of the control account during the original audit, the work-in-progress control account entries and the material usage variance control account entries were altered. It further recites that the cost journal voucher sheets were altered. Exhibit 8 and 10 are the notes prepared by Mahindra himself and the witness deposed that the notes are prepared on the information supplied by the management of the plaintiffs during the investigative audit. These two documents which came into existence during the investigative audit clearly indicate that the staff of the plaintiffs have altered the documents after the regular audit was over. The claim of Mahindra that the staff told him about such alteration during the investigative audit could well be accepted as Mr. Parish in the affidavit filed in the proceedings under section 633 of the Companies Act in this court has stated in unmistakable terms that Ramamurthi, the officer-in-charge of the accounts, had submitted before him that he had falsified auditor's initials and markings. Taking all these circumstances into consideration, it is difficult to hold that the auditors did not carry out the audit programme at the time of regular audit.
85. It is necessary in this connection to make a reference to exhibit "C" which is a "material usage variance account". Serious arguments were advanced by Mr. Setalvad claiming that this document was substituted by the plaintiffs at the later stage and a false claim is made that this account was not checked by the auditors at the time of regular audit. The account as produced by the plaintiffs reads as under :
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Date | Particulars | Vr. No.| Folio | Debit | Credit 1973-74 | | | | |
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Rs. P. Rs. P.
Sept.30 OJE 1 26,327.02 12,982.18
Oct. 31 2 34,252.93 25,520.20
Nov. 30 3 5,131.32 42,755.32
Dec. 31 4 19,521.32 43,702.62
Jan. 31 5 80,323.56 82,061.60
Feb. 28 6 40,109.42 38,310.50
Mar. 31 7 3,555.88 39,754.83
Apr. 30 8 1,520.11
May 31 9 13,391.72
June 30 10 24,220.37 1,10,538.78
July 31 11 2,45,372.90
Aug. 31 12 76,526.16 1,47,132.16
------------ -------------
3,09,967.98 8,03,042.92
Balance : 4,93,074.94
Mat.Price variance 600.01
M.P.V. adjusted 20,79,230.00
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86. A bare perusal of this document indicates that the entries for the months of September, October and November, 1973, were scored out and rewritten with a view to show further increase in the material usage account. Mr. Setalvad urged that this document was substituted by the plaintiffs and is not one which was checked by the auditors at the time of the regular audit. Mr. Cooper did not dispute that exhibit "C" was tampered with. A bare perusal of the document indicates that apart from scoring of the entries, figures written initially were rubbed out and fresh figures were written. Mr. Cooper urged that if this was the document which was available at the time of the original audit and the auditors have failed to examine the same, then it is gross negligence and in case the document was in existence and seen by the auditors, and still suspicion was not aroused, then it is a clear case of deliberate failure of duty. Before considering whether the document was shown to the auditors or not, it would be appropriate to refer to some evidence on this aspect which is relevant.
87. Kelkar in paragraph 7 deposed that the plaintiffs used to maintain general ledger and the entries in the material usage variance account were posted from the costs journal. The cost journal voucher register is maintained in the accounts section and the entries in the register are made at the end of every month. In cross-examination, in paragraph 25 of the evidence. Kelkar stated that the entries in exhibit "C" are in the handwriting of Ramamurthi and it is Ramamurthi who had written both entries which were scored out and rewritten. Kelkar denied that exhibit "C" was not shown to the auditors at the time of regular audit, but admitted that he had not personally shown exhibit "C" to the defendants. Mahindra in paragraph 8 of his evidence stated that exhibit "C" was never shown at the time of the original audit and him claim was based on the ground that posting ticks of the auditors are not made on the entries and also because the final figure in this account does not tally with the figure which was written in the long form report to the board of directors. The third reason furnished by Mahindra is that the break-up stated in paragraph 6(c) of long form report is not seen in exhibit "C". It must be stated at once that in paragraph 46 of the evidence in cross-examination., Mahindra gave up the third reason furnished. The two reasons furnished by Mr. Mahindra about absence of tick marks and the final figure in exhibit "C" not tallying with the figure reported in the long form report can well be accepted. It is difficult to believe that any auditor with some sense would not notice the doubtful nature of exhibit "C" where not only the entries have been scored out and rewritten, but some of the entries have been rubbed out and the document gives a highly suspicious look. The absence of tick marks by the auditors in this document is one of the important circumstances to indicate that exhibit "C" was not shown to the auditors at the time of regular audit. In the long form report dated October 28, 1974, made by the auditors to the board of directors, a copy of which is at page 110 of volume 10 of the compilation of the defendants, the amount in respect of the direct materials-quantity variance (favourable) is shown as Rs. 6,84,345. This figure could have been gathered by the auditors only from the material usage variance account. If exhibit "C" is perused and the entries as originally made and not scored out are taken into consideration, then the total amount of the credit is Rs. 4,15,724.49, while if the corrected entries are taken into consideration, the total amount of credit Rs. 4,93,074.94. Either of these figures does not tally with the figure of Rs. 6,84,345 mentioned in the long form report, and, therefore, Mr. Setalvad is right in his contention that exhibit "C" was never shown to the auditors at the time of regular audit, but some other document was shown which was subsequently removed by inserting exhibit "C". This conclusion is inevitable in view of the fact that it is an accepted position that the record of the plaintiffs was not properly maintained. A reference can be usefully made in this connection to the 15th annual report and paragraph 10 of the plaint. A reference can also be made to the queries made by the Registrar of Companies, Bombay, to the board of directors and item 3A there of reads as under :
"The books of account specially relating to the sales and production record have not been properly maintained in terms of the provisions of section 209(1) of the Companies Act, 1956, thereby contravening the provisions of the said section."
88. The answer given by the plaintiffs is as follows :
"In paragraph 3A of your letter, you say the company's books of account, specially relating to sales and production, have not been properly maintained thereby contravening section 209(1) of the Companies Act. This involves penalty under section 209(5). That the company's books and records, especially with relation to sales and production, were not properly maintained clearly appears from the special investigative report of Messrs. A. F. Ferguson & Co. and was brought to the attention of members additionally by note 1.7 to the 1974-75 accounts at page 33 of the printed booklet."
89. The relevant portion of the inquiries made by the Registrar and the reply given by the plaintiffs are at pages 81 and 111, respectively, of volume 12 of the compilation of the defendants. In this connection, it must also be remembered that the plaintiffs were unable to explain whether exhibit "C" was substituted or whether exhibit "C" was in existence initially and was tempered with subsequent to the date of regular audit. This aspect is important, because the document exhibit "C" is coming from the custody of the plaintiffs and it is necessary for the plaintiffs to explain how exhibit "C" came into existence. It is futile for Mr. Cooper to express his inability to point out as to whether exhibit "C" was tampered with and if so at what stage. It is impossible to record a finding that exhibit "C", which was tampered with according to the plaintiffs, was shown to the auditors at the time of regular audit. In my judgment, the claim of Mr. Mahindra that it was not shown is more preferable to that of Kelkar. It would not be out of place to point out that it is difficult to give any credence to the testimony of Kelkar because Kelkar was not only working as an assistant of Ramamurthi at the relevant time, but had also a hand in preparing duplicate set of documents. Kelkar had admitted in his evidence that he was instrumental in preparing invoices and delivery challans and not entering the same in the register. The deposition unmistakably shows that Kelkar was fully conscious of the manipulation of accounts done by Ramamurthi with the assistance of other staff members and probably at the dictation of the managing director. In these circumstances, it is not possible to place any reliance upon exhibit "C" and conclude that the material usage variance account was not checked by the auditors at the time of regular audit.
90. These are the circumstances pointed out by Mr. Cooper in support of the claim that the auditors were negligent in carrying out their duties at the time of the regular audit. In my judgment, these circumstances, either taken individually or cumulatively, do not establish that the auditors were negligent in the performance of their work. The circumstances, which according to Mr. Cooper should have aroused the suspicion of the auditors, did not arouse the suspicion of the board of directors or the directors in the board ignored the same. In this connection, it would be appropriate to refer to the evidence of Alpaiwalla to the effect that when during the investigative audit undertaken at the instance of Mr. Parish in respect of the financial accounts of the year 1974-75, it was noticed that there are some irregularities in the maintenance of the accounts, a decision was taken by the auditors to extend the investigative audit to cover the accounts of the financial year 1973-74 also. Mr. Alpaiwalla deposed in paragraph 7 of his evidence that when the decision to extend the investigative audit was communicated to the plaintiffs, Mr. Parish telephoned him advising to avoid it, if possible. Mr. Alpaiwalla further deposed that the financial controller, Mr. Yien, also gave him the same advice but he declined to heed that advice after taking an opinion from the senior counsel of this court. Mr. Alpaiwalla further deposed that after receipt of the advice of counsel, Mr. Yien told him that the decision to extend investigative audit for the financial year 1973-74 would have serious repercussions. There is hardly any cross-examination of Alpaiwalla of this count and I do not see any reason to discard the statement of Alpaiwalla in this connection. This circumstance clearly establishes that Mr. Parish and Mr. Yien and probably the holding company, who were fully aware of the affairs of the plaintiff company were reluctant to allow the auditors to make detailed investigation about the financial accounts of the year 1973-74 for the reasons best known to them. It seems that as a hind-sight and with a view to find some scape-goat for their own defaults, the plaintiffs have instituted the present suit against the auditors. In my judgment, it is not possible to hold that the manipulation of accounts could not have been detected by Mr. Parish and Mr. Yien when the holding company had absolute control over every action of the plaintiffs, and the holding company was kept posted of each transaction carried out by the plaintiff company. It also cannot be overlooked that even before the financial year 1973-74 was over, Mr. Parish had found out that the managing director, Hegde, was acting contrary to instructions and the settled practice of the holding company in operating the affairs of the plaintiffs. In spite of this notice, Mr. Parish never felt it necessary to doubt the veracity of the balance-sheets and the accounts submitted by the plaintiffs for the financial year 1973-74. In my judgment, it is only an after-thought to find some scape-goat for the alleged loss suffered by the plaintiff company which has given rise to filling of this suit.
91. While holding that the professional man is guilty of negligence, the court must expect strong and conclusive evidence and it would not be fair to rely upon some stray circumstances giving faint suspicion that the professional man may not have taken absolute care in the performance of his duties. The court cannot loose sight that the professional man has to take decision by taking into consideration several circumstances while discharging his function and it would be erroneous to rely upon some observations in a book to claim that the professional man failed to carry out what was expected of him. Take for instance, a case of a medical practitioner, who has to take a decision as to which medicine is to be administered to the patient by taking into consideration several factors, like the constitution of the patient, the history of his illness, the mental condition and whether the medicinal treatment suggested could be afforded by the patient. The medical man exercises his best judgment assessment while treating a patient and it would be extremely harsh if the medical practitioner is called upon to explain at a later stage with reference to some medical book as to why a particular treatment was administered to the patient. Theory may be fine, but its application in actual practice is not necessarily the same, and the professional man has to adjust his professional work in accordance with the facts and circumstances of the particular case. In my judgment, the evidence led by the plaintiffs in the present case falls far short of the requisite proof to prove that the auditors were guilty of negligence in the discharge of their duties. My findings, therefore, on issues Nos. 1, 4 and 5 are in the negative.
92. Issues Nos. 3 and 6. - These issues deal with the damages alleged to have been suffered by the plaintiffs because of the failure of the defendants to properly carry out the audit work for the financial year 1973-74. In paragraph 12 of the plaint, it is claimed that following the publication of the report prepared by the defendants, the credibility, prestige and goodwill of the plaintiffs suffered a severe setback and the price of the plaintiffs' shares of face value of Rs. 10 each had fallen steeply and was quoted at Rs. 7.25 per share in the market. In paragraph 22 of the plaint, the plaintiffs have set out the break-up of their claim in respect of damages. At the outset, it must be pointed out that the plaintiffs did not lead any evidence in respect of the claim for excess sales tax paid and loss of excise rebate, which are items (iii) and (iv) in paragraph 22. Mr. Cooper, with his usual fairness, conceded that the plaintiffs are not even pressing the claims under these items. As regards the claim in item (v) for the loss of reputation, goodwill, dislocation of business and extra expenditure incurred as a result thereof, the plaintiffs have claimed an amount of Rs. 25 lakhs. By filing inventories, the defendants sought particulars and the plaintiffs filed the affidavit of Balbir Onkar Singh, the Chief executive of the plaintiffs, on August 29, 1979, and the quantum of loss in respect of item (v) has been stated as (i) loss of reputation Rs. 2 lakhs; (ii) loss of goodwill Rs. 2 lakhs; and (iii) loss on account of dislocation of business Rs. 1 lakh. An amount of Rs. 20 lakhs was claimed towards loss of interest and extra expenditure incurred. Now, the only evidence as regards loss of reputation is of Kelkar, who deposed that the company's reputation suffered due to the inflation of sales and the Income-tax Officer raided the premises and seized the books. In cross-examination at paragraph 41 of the evidence, Kelkar admitted that the publication of the investigative audit report led to wide prejudicial publicity in the newspaper. Save and except this statement, the plaintiffs have led no evidence to establish the damage suffered for loss of reputation or goodwill or dislocation of business. It is therefore, obvious that the plaintiffs have miserably failed to establish any damage on this count. Mr. Cooper, realising the lack of evidence, submitted that the plaintiffs should be awarded token or nominal damages.
93. The remaining two claims are in respect of excess income-tax paid by the plaintiffs and excess surtax paid by the plaintiffs for the year ending August 31, 1974, on the basis of the inflated profits shown by the company. The assessment order was passed by the Income-tax Officer, Companies Circle V(3), Bombay, on September 25, 1975, and the total income computed for the assessment year 1975-76 (financial year 1973-74) was Rs. 77,89,870. According to the plaintiffs, the correct income should have been computed at Rs. 32,95,421 and due to the inflated profits, income of Rs. 44,94,449, which was not the actual income during the relevant year, was included. The plaintiffs claim that the excess tax which was required to be paid was Rs. 28,31,504. The plaintiffs, through defendant No. 1, filed appeal No. AAC/F/CCV-308/1975-76 before the Appellate Assistant Commissioner of Income-tax on November 19, 1975, challenging the order of assessment on some grounds which are not relevant for the purpose of this suit. On June 1, 1976, additional grounds were filed, inter alia, claiming that the amount of Rs. 44,94,449 should not have been included as profits for the relevant year, and therefore, the plaintiffs were over-assessed. The Appellate Assistant Commissioner was requested to direct the Income-tax Officer to reduce the business income by Rs. 44,94,449. By an order dated August 11, 1976, the Appellate Assistant Commissioner declined permission to raise the additional grounds. The plaintiffs thereupon preferred appeals to the Tribunal which was numbered as ITA No. 2009 and 2010 (BOM)/1976-77. The Tribunal, by order dated September 30, 1977, allowed the appeal holding that the additional grounds should be permitted to be raised by the Appellate Assistant Commissioner and remitted the matter back to the appellate authority for disposal on merits. Against the order of the Tribunal, the Revenue sought a reference to the High Court and the Tribunal referred the matter on April 27, 1978, and the said reference is still pending hearing.
94. On December 8, 1982, the plaintiffs addressed a letter to the Commissioner of Income-tax, Bombay City (V), making a proposal for settlement of the dispute. The plaintiffs agreed to give up the additional grounds raised in the appeal and conceded the point of taxability of Rs. 44,94,449 in the assessment year 1975-76. The proposal made by the plaintiffs was accepted by the Revenue on December 15, 1982. Mr. Cooper submits that in view of this settlement, the plaintiffs were losers of an amount of Rs. 8,30,513, calculations of which are set out at page 70 of volume "G" of the compilation of the plaintiffs. Mr. Cooper submits that the plaintiffs are entitled to this amount as damages suffered due to the negligence of the auditors. It is not possible to accept the claim of learned counsel. The proposal for settlement was made by the plaintiffs to the Commissioner of Income-tax for factors which were totally unconnected with the alleged negligence of the auditors. In fact, a favourable order was secured by the plaintiffs from the Tribunal and the mere fact that proceedings were pending in reference in this court was not enough for the plaintiffs to settle the dispute with the Income-tax Authorities. As a result of the settlement, the plaintiffs might have suffered some loss, but that cannot be traced to alleged negligence of the auditors. Mr. Satish Pradhan was examined by the plaintiffs on this count and the witness deposed that the reason which prompted the company to suggest settlement was that the assessment proceedings of the plaintiffs remained pending for a considerable period due to pendency of reference with the result that large amount remained outstanding. Mr. Pradhan also deposed that the Income-tax Officer had made demands for huge amount of Rs. 43 lakhs in respect of the next assessment year and the company had not enough funds to meet that liability. Mr. Pradhan stated that but for the settlement, the working of the company would have come to a halt. It is, therefore, obvious that the plaintiffs settled their claim with the Income-tax Authorities for reasons which had no connection whatsoever with the alleged negligence of the auditors. In my judgment, the plaintiffs could not claim the amount which was lost by the plaintiffs due to settlement, even assuming that the defendants were negligent in the discharge of their duties and that resulted in damages to the plaintiffs.
95. Mr. Cooper also made a claim that the interest at the rate of 16-1/4% per annum should be awarded to the plaintiffs on the amount of damage claimed in the suit. It hardly required to be stated that interest cannot be awarded on the amount of damages for a period prior to the date of the suit. The plaintiffs would be entitled to interest only after the quantum of damages are ascertained at the hearing of the suit. In view of my finding that the defendants were not negligent in the discharge of their duties, the question of ascertainment of damages really does not arise, but even if I would have held that the defendants were negligent, still the amount of damages would have been merely token or minimum. Accordingly, my findings on issues Nos. 3 and 6 are in the negative.
Issue No. 2 : Mr. Setalvad did not dispute the accuracy of the figures set out in paragraph 11 of the plaint, and, therefore, the answer to this issue is in the affirmative.
Issue No. 7 : This issue does not survive in view of my findings on other issues.
96. Before parting with the case, I must place on record my appreciation of the excellent assistance received from counsel on both the sides and the fair manner in which the respective view were presented. But for the able assistance rendered by both counsel and their assistants, it would not have been possible to conclude the hearing of this suit in 19 days.
97. Accordingly, the suit is dismissed with costs.
98. Two advocates certified in accordance with rule 606(3) of the Original Side Rules.
99. Suit dismissed.