Conducting a Statutory Audit of Reserves and Surplus in India [Company Law]
Conducting a statutory audit of Reserves and Surplus for an Indian company involves a thorough examination of the various components of this section in the balance sheet. Reserves and Surplus represent the accumulated profits and funds set aside for specific purposes and are crucial indicators of a company’s financial health. This guide provides detailed directions for auditing Reserves and Surplus under Indian laws, addressing common queries and confusions related to this balance sheet item.
Understanding Reserves and Surplus
The ICAI’s Glossary of Terms Used in Financial Statements defines the term ‘Reserve’ as “the portion of earnings, receipts or other surplus of an enterprise (whether capital or revenue) appropriated by the management for a general or a specific purpose other than a provision for depreciation or diminution in the value of assets or for a known liability.”
Components:
- Capital Reserve: Created from capital profits, not available for distribution as dividends.
- Securities Premium Reserve: Amount received in excess of the face value of shares, utilized as per specific regulations.
- Revenue Reserve: Created from revenue profits and available for distribution as dividends.
- General Reserve: A type of revenue reserve not earmarked for a specific purpose.
- Retained Earnings (Surplus): Accumulated net profits after dividends are paid.
- Special Reserves: Any other reserves that are required to be created under provisions of other laws in India. For e.g. reserve created under section 45-IC of the RBI Act by NBFCs
Reserve and Surplus will fall into the category of account balances at period end as per SA 315, hence following assertions need to be used to identify any potential misstatement:
- Existence
- Rights and Obligations
- Completeness
- Valuation and allocation
Step-by-Step Guide to Auditing Reserves and Surplus
1. Verifying the Opening Balances
Document Verification:
- Previous Year’s Financial Statements: Verify the closing balances of reserves and surplus from the previous year’s audited financial statements.
- Audit Reports: Review previous audit reports for any qualifications or observations related to reserves and surplus.
Procedures:
- Compare the opening balances in the current year’s financial statements with the closing balances of the previous year.
- Ensure that any adjustments or restatements have been properly authorized and disclosed.
2. Examining Transactions Affecting Reserves and Surplus
Journal Entries and Ledgers:
- Journal Entries: Verify all journal entries affecting reserves and surplus for accuracy and proper authorization.
- Ledger Accounts: Review the ledger accounts for each type of reserve and surplus.
Procedures:
- Ensure that transfers to and from reserves are approved by the board and documented in meeting minutes.
- Verify that any appropriations, transfers, or adjustments are in accordance with company policies and regulatory requirements.
3. Auditing Capital Reserves
Source and Utilization:
- Capital Gains: Verify the source of funds transferred to capital reserves, ensuring they are from capital gains.
- Utilization: Check that capital reserves are not used for dividend distribution.
Procedures:
- Examine sale deeds, revaluation surplus records, and other documents to confirm the legitimacy of capital gains.
- Ensure compliance with legal restrictions on the utilization of capital reserves.
4. Auditing Securities Premium Reserve
Source and Utilization:
- Issue of Shares: Verify the premium amount received during the issuance of shares.
- Utilization: Check that the securities premium reserve is used only for purposes permitted under Section 52 of the Companies Act, 2013, such as issuing fully paid bonus shares, writing off preliminary expenses, etc.
Procedures:
- Review share issuance documents and bank statements for premium amounts received.
- Verify expenditures and allocations against the securities premium reserve to ensure compliance with permitted uses.
5. Auditing Revenue Reserves
Creation and Utilization:
- Profit Allocation: Verify the transfer of profit to revenue reserves from the profit and loss account.
- Distribution: Check the utilization of revenue reserves, ensuring compliance with company policies and regulatory guidelines.
Procedures:
- Review profit and loss appropriation accounts to confirm transfers to revenue reserves.
- Ensure that any distribution from revenue reserves is properly authorized and documented.
6. Auditing General Reserve
Source and Utilization:
- Transfer from Profits: Verify the amounts transferred from profits to the general reserve.
- Utilization: Check that the general reserve is utilized as per the board’s decisions and company policies.
Procedures:
- Examine board resolutions and meeting minutes for approvals related to the transfer to and utilization of the general reserve.
- Cross-check with the profit and loss appropriation accounts.
7. Auditing Retained Earnings (Surplus)
Accumulation and Utilization:
- Net Profit: Verify the accumulation of net profit after tax and dividend distributions.
- Distribution: Ensure that any distribution from retained earnings is properly authorized.
Procedures:
- Review profit and loss statements for net profit figures.
- Verify board approvals and AGM minutes for dividend declarations and other appropriations from retained earnings.
Compliance with Laws
Companies Act, 2013:
- Section 52: Compliance regarding the utilization of the securities premium reserve.
- Section 123: Provisions related to declaration and payment of dividends, ensuring adequate reserves.
Procedures:
- Ensure compliance with relevant sections of the Companies Act regarding reserves and surplus.
Compliance with Schedule III of Companies Act, 2013:
As per schedule III of Companies Act, 2013 following are the disclosure and other requirements:
- Reserves and Surplus shall be classified as
- Capital Reserves
- Capital Redemption Reserve (Section 55 and 69 of the Act)
- Securities Premium
- Debenture Redemption Reserve (Section 71 of the Act)
- Revaluation Reserve
- Share Option Outstanding Account
- Other Reserves (Specify the Nature)
- Surplus i.e., Balance in statement of Profit and Loss disclosing allocations and appropriations such as dividend, bonus shares and transfer to/ from reserves
- Additions and deductions since the last Balance sheet to be shown under each of the specified heads
- Reserve specially represented by earmarked investment shall be termed as a “Fund”
- Debit balance of Profit and Loss shall be shown as a negative figure under the head “Surplus”. Similarly, the balance of “Reserves and Surplus”, after adjusting negative balance of surplus, if any, shall be shown under the head “Reserves and Surplus” even if the resulting figure is in the negative.
Common Queries and Confusions Regarding Reserves and Surplus
- Difference Between Capital Reserve and Revenue Reserve: Capital reserves are created from capital profits and are not available for dividend distribution, whereas revenue reserves are created from operational profits and can be distributed as dividends.
- Utilization of Securities Premium Reserve: Confusion often arises around the permitted uses of the securities premium reserve. It can only be used for specific purposes like issuing fully paid bonus shares, writing off preliminary expenses, and others specified under Section 52 of the Companies Act, 2013.
- Transfer to General Reserve: There may be questions about the necessity and timing of transferring profits to the general reserve. While it is not mandatory, it is a prudent practice for financial stability and future contingencies.
- Retained Earnings vs. General Reserve: Retained earnings represent accumulated profits not distributed as dividends, while the general reserve is a portion of retained earnings set aside for specific or general purposes as decided by the board.
- Compliance with Dividend Distribution: Confusion can occur regarding the conditions under which dividends can be declared. Companies must ensure adequate profits and reserves and comply with Section 123 of the Companies Act, 2013.
Practical Cases and Examples in Auditing Reserves and Surplus
Case 1: Incorrect Classification of Reserves
Scenario: A company incorrectly classified a portion of its revenue reserves as capital reserves, which led to non-compliance with dividend distribution regulations.
Audit Findings:
- The auditor identified the misclassification during the review of financial statements.
- The misclassification resulted in unauthorized use of capital reserves for dividend distribution.
Resolution:
- The company reclassified the reserves correctly in the financial statements.
- Steps were taken to ensure compliance with dividend distribution regulations in the future.
Lessons Learned:
- Accurate classification of reserves is crucial for compliance and financial integrity.
- Regular audits help in identifying and rectifying such misclassifications.
Case 2: Unauthorized Use of Securities Premium Reserve
Scenario: A company utilized its securities premium reserve for purposes not permitted under Section 52 of the Companies Act, 2013, such as operational expenses.
Audit Findings:
- The auditor found discrepancies during the review of the utilization of the securities premium reserve.
- The use of funds for operational expenses was unauthorized and non-compliant.
Resolution:
- The company rectified the error by reallocating funds from appropriate reserves.
- Policies were put in place to ensure compliance with Section 52 in the future.
Lessons Learned:
- Strict adherence to regulatory provisions regarding the utilization of specific reserves is necessary.
- Regular monitoring and internal controls can prevent such issues.
Case 3: Inadequate Disclosures of Reserves
Scenario: A company failed to provide adequate disclosures regarding the movements and utilization of reserves in its financial statements, leading to stakeholder confusion.
Audit Findings:
- The auditor noted the lack of detailed disclosures in the notes to the financial statements.
- This omission was flagged as a significant issue affecting transparency.
Resolution:
- The company revised its financial statements to include detailed disclosures about the movements and utilization of reserves.
- Improved internal processes for future compliance were implemented.
Lessons Learned:
- Transparency and detailed disclosures are vital for stakeholder confidence and regulatory compliance.
- Regular audits help ensure comprehensive and accurate financial reporting.
Conclusion
Auditing Reserves and Surplus is a meticulous process that ensures the financial integrity and regulatory compliance of a company. By following a structured audit approach, addressing common queries, and incorporating practical cases, auditors can provide valuable insights and assurance. Enhancing the blog with interactive elements will make it more engaging and informative, providing readers with a comprehensive understanding of the audit process for Reserves and Surplus in Indian companies.
Author
CA Sourabh Kothari (C.A., B.Com)
He is currently working as Partner – Risk and Transaction advisory with a renowned firm in Jaipur having experience in Internal Audit, IFC Audit, Business consultancy, Due Diligence and Management consultancy.
E-mail: Sourabh.kothari@jainshrimal.in | LinkedIn: Sourabh Kothari