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Accounting and the law


Learning objectives

In this chapter you will learn about the following:

  • Financial reporting under company law
  • Contents of director’s report and director’s responsibility statement
  • Accounting requirements for foreign companies having business presence in India
  • Branch and subsidiary level reporting
  • Preservation of financial records
  • Legal relevance of accounting and auditing standards
  • Requirement and location
  • Rights of directors and shareholders vis-à-vis financial reports
  • Statutory and internal audit
  • Auditors and their interface with the company
  • Supervisory framework of the Audit Committee of directors
  • Companies that are required to undertake cost-audits
What this chapter does not teach:
It is very important for you to understand what is outside the scope of this chapter:
  • Book-keeping and how to record transactions
  • Accounting principles or the standards themselves


Financial statements of a business are useful for making decisions by investors as well as decision makers in a business. Inaccurate, non-standardized, false or misleading accounting impacts managerial decision-making and also prevents investors and other stakeholders from relying on financial statements, which can make raising investment, or exiting from a business (by selling one’s stake) more difficult. 

 entrepreneur must have an idea of how the law treats the accounting process for two reasons – he may be personally liable for inaccuracies or misstatements in financial reports, which could lead to heavy penalties or imprisonment. Further, financial statements of a business are useful for making investment decisions by investors as well as decision makers in a business. False or misleading accounting will prevent investors and other stakeholders from relying on financial statements, which can make raising investment, or exiting from a business (by selling one’s stake) more difficult. Also, every investor will obtain contractual indemnity from the company as well as the founders/ promoters to the effect that the financial statements provided to them are accurate and are not misleading or fraudulent. If at any stage inconsistencies or mismanagement creeps into accounting, the same can have terrible repercussions for the business as investors, lenders, regulators or partners of other kinds may have to be monetarily compensated to the tune of the economic harm suffered as a result of this. For example, if the misstatement has an impact of overstating profits and hence on the valuation, an investor can claim indemnity – he will be compensated to the tune of the excess amount invested on account of the higher valuation, as compared to what he would have invested if the valuation was lower. 


An indemnity refers to reimbursement for a loss. An indemnity clause in a contract requires that loss caused to an investor or lender out of particular actions (as specified in that contract) of the company/ founders must be made good. However, an investor/ lender is not permitted to gain or make a profit from an indemnity clause. If an investor would have made a profit of Rs. 200, had an investment been successful, but owing to fraud by a director, he suffers a loss of Rs. 300, he must be indemnified by Rs. 300 only to reinstate him to his initial position (and not 300 + 200 = Rs. 500).


Case study of HP’s acquisition of Autonomy

Accurate and fair accounting is extremely important for M&A transactions – in the past few years, HP found out huge discrepancies in the accounts of a company called Autonomy, for which it had paid  11 billion US dollars. As per reformulated accounts post the acquisition, it was found that the profits were overstated by 5 times the amount! HP had to writedown its value by 8.8 billion dollars. You can read more about it here.

In this chapter we will discuss financial statements and reporting obligations of businesses, responsibilities of directors and interface of company management with various ‘checkpoints’ in the system to detect and prevent fraud, such as auditors and the Audit Committee of the Board. We will also examine shareholders and directors overarching rights pertaining to access to the company’s financial records. 

It is crucial for professionals, entrepreneurs or those working with start-ups (or for that matter, any other business) in advisory or consultant capacity to understand the legal aspects and repercussions of accounting.

Broadly speaking, legal provisions may govern the following:
  • Maintenance of accounts and preparation of financial statements such as profit and loss account, balance sheet, etc., any disclosures in financial statements
  • Filing of financial statements and reports before various authorities
  • Auditing
We have covered some of the most important legal provisions related to accounting, reporting and auditing requirements below.

Accounting and reporting requirements under the Companies Act, 2013 and tax laws

a. Accounting Standards

India follows two sets of accounting standards which are applicable on different categories of companies as per the applicable law –

  1. Accounting standards under Companies (Accounting Standards) Rules, 2006: Companies which are not required to mandatorily follow Ind As or those who have not adopted the Ind As standards voluntarily are required to follow the accounting standards laid down under Companies (Accounting Standards) Rules, 2006. The Institute of Chartered Accountants of India (ICAI), which is the body that governs Chartered Accountants, has issued thirty five Accounting Standards under Companies (Accounting Standards) Rules, 2006, which contain the guidelines for recording or accounting treatment of different types of transactions.
  2. Indian Accounting Standards (Ind AS): Under the Companies Act, 2013, new accounting standards known as Indian Accounting Standards (Ind AS) will be applicable on different categories of companies in a staggered manner. The new Ind AS standards can be accessed here. The new accounting standards are similar to the International Financial Reporting Standards, making the new accounting system at par with the global norms.
Applicability of Ind AS on different categories of companies
  1. From 1st April 2015 – All companies can adopt the standards on a voluntary basis
  2. From 1st April 2016 – Mandatory adaptation of the standards by all companies having net worth more than INR 500 crores, public listed companies or those who are in the process of listing (either in India or abroad) having net worth more than INR 500 crores and their subsidiary, holding, joint-venture or associate companies.
  3. From April 2017 – Mandatory adaptation of the standards by all public listed companies or those who are in the process of listing (either in India or abroad), all private companies  having net worth more than INR 250 crores but less than INR 500 crores and their subsidiary, holding, joint-venture or associate companies.

Exceptions: All companies listed on SME Exchange, Insurance companies, banking and non-banking finance companies are exempt from the applicability of the provisions of the Ind AS Rules till further notifications by the respective sectoral regulators.

As per Section 129 of the Companies Act, 2013 every profit and loss account and balance-sheet of a company must comply with these accounting standards, and any deviations from them must be specifically disclosed, along with reasons for the deviation and the financial effect of such a deviation. A list of accounting standards is attached in the Annexure A to this note. 


b. Financial statements

The Companies Act, 2013 also specifies the format of the balance sheet and profit and loss account. The balance sheet must be prepared as per Schedule III (Part I) and the profit and loss account as per Schedule II (Part II) respectively (the formats are provided in Annexure B and C of this note).

Please note: Financial statements, auditor’s report and Board’s report of companies whose financial years commenced before 1 April 2014, need to file the report according of the rules and provisions of the Companies Act, 1956.

Auditor’s report

As per Section 143 of the Companies Act, an auditor is required to make a report on the accounts (including the balance sheet, profit and loss account and any documents annexed to the financial statements) of the company. All companies are required to submit their annual accounts with the audit reports to the Registrar of Companies (ROC). The auditor of a company must make his observations while preparing his report. Some of the items are listed below, to give an indication: 


(a) whether he has sought and obtained all the necessary information and explanations needed for the audit of the company
(b) whether, in his opinion, proper books of account as required by law have been kept by the company and proper returns have been received from branches not visited by him;

(c) whether the report on the accounts of any branch office of the company audited by a person other than the company’s auditor has been sent to him in a proper format
(d) whether the company’s balance sheet and profit and loss account dealt with in the report are in conformity with the books of account and returns;
(e) whether, the financial statements comply with the accounting standards;
(f) the observations or comments of the auditors on financial transactions or matters which have any adverse effect on the functioning of the company;
(g) whether any director is disqualified from being appointed as a director
(h) any qualification, reservation or adverse remark relating to the maintenance of accounts and other connected matters

Under the Companies (Auditor’s Report) Order, 2003, under the old Companies Act, certain categories of companies which meet a prescribed threshold, were required to mention 21 matters in the auditor’s report till the financial year 2013-14. Under the new Companies Act, the auditors are required to state on only 13 different matters and will be applicable from the financial year 2014-15. However, in absence of a expressed repeal provision there is no clarity whether the existing rules under the Companies (Auditor’s Report) Order, 2015 will be applicable on the companies meeting the thresholds under the 2015 Order. The Companies (Auditor’s Report) Order, 2003 (see the list of exemptions below to find out which companies the order does not apply to) specifies a list of 21 items on which the auditor of a company must make his observations while preparing his report. Some of the items are listed below, to give an indication:
  • whether the company is maintaining proper records showing full particulars, including quantitative details and situation of fixed assets;
  • if a substantial part of fixed assets have been disposed off during the year, whether it has affected the going concern;
  • whether physical verification of inventory has been conducted at reasonable intervals by the management; 
  • if there is an adequate internal control procedure commensurate with the size of the company and the nature of its business, for the purchase of inventory and fixed assets and for the sale of goods and whether there is a continuing failure to correct major weaknesses in internal control, etc.
Exemptions – The order does not apply to the following entities:
  1. A non-profit company
  2. A bank
  3. An insurance company
  4. Any other company, if (all four conditions below must be satisfied):
  1. its paid up capital and reserves is less than fifty lakh rupees;
  2. if it has not accepted any public deposit; and
  3. its outstanding loans from any bank or financial institution are less than ten lakh rupees; and
  4. its turnover is less than five crore rupees.
Non-profit companies are exempted from the auditor’s report order - even if non-profit companies satisfy the conditions under point (iv) above, the auditor’s report order will NOT apply to them.

Cost records and audit

Ordinarily, companies are not required to audit the cost of their inputs, materials or labour. However, companies in certain sectors (predominantly related to manufacturing, logistics, infrastructure, etc.)  are required to maintain particulars related to utilisation of material or labour or other items of cost. These records are also required to be audited by a cost auditor.

An indicative list of sectors is provided below (for the full list of sectors see the text of the rules):
  • defence goods,
  • port services,
  • aeronautical services,
  • telecommunication services,
  • electricity generation,
  • distribution and supply sector,
  • steel,
  • roads and other infrastructure projects,
  • drugs and pharmaceuticals,
  • fertilisers,
  • sugar and industrial alcohol;
  • petroleum products, rubber and allied products,
  • companies operating in areas involving public interest (including hospitals,
  • diagnostic centres, clinical centres or test laboratories),
  • production of medical devices
Compliance requirements: The cost auditor is required to submit his report within 180 days from the end of the financial year in Form No. CRA-3. A company on which such rules apply, must submit the Cost Report along with full information and explanation on every reservation or qualification to the MCA within 30 days from the date of receipt from the cost auditor in Form No. CRA-4.

c. Foreign companies

In addition to reporting under the Companies Act and to the Income Tax authorities, foreign companies operating in India are also required to file annual activity certificates with the Reserve Bank of India.

d. Listed companies – additional requirements

Companies which are listed on a stock exchange enter into an agreement with the stock exchange called the Listing Agreement. The format for the Listing Agreement is prescribed by the Securities and Exchange Board of India (SEBI), the securities regulator. The Listing Agreement requires companies to send annual returns, profit and loss account and balance sheet, auditor’s report and other statements to the stock exchange and the shareholders. It also requires companies to prepare and furnish financial statements i) on a quarterly basis (which may be unaudited), within 45 days of the end of the quarter, ii) on an annual basis (audited), within 60 days of the end of the financial year.

e. Disclosures in respect of amounts owed to SMEs

As per the Micro, Small & Medium Enterprises Development Act (MSMED Act), every buyer who is required to get his annual records audited, and who purchases goods or avails services from a micro, small or medium enterprise (micro, small or medium enterprises are defined under the MSMED Act – to qualify as a MSME, a business needs to register itself as an MSME) and is required shall furnish along with the accounts:

a) The principal amount and interest due or remaining unpaid to any supplier (which is a micro, small or medium enterprise) at the end of the accounting year,

b) Interest paid under the MSMED Act along with any other default payment,

c) The amount of interest due and payable for delay in payment,

d) The amount of interest accrued and remaining unpaid,

e) The amount of further interest due and payable even in the succeeding year(Section 22, MSMED Act.) shall also be produced.

Any buyer not complying with these requirements is to be punished with a fine of not less than ten thousand rupees. (Section 27(2), MSMED Act.)

Given below is a sample disclosure under the Notes to Accounts as per the Micro, Small and Medium Enterprises Development Act, 2006:

Disclosure under the Micro, Small and Medium Enterprises Development Act, 2006:

  1. There is no payment due to suppliers as at the end of the accounting year on account of principal and interest.
  2. No interest was paid during the year in terms of section 16 of the Micro, Small and Medium Enterprises Development Act, 2006 and no amount was paid to the suppliers beyond the appointed date.
  3. No interest is payable at the end of the year other than interest under Micro, Small and Medium Enterprises Development Act, 2006.
  4. No amount of interest was accrued and unpaid at the end of the accounting year.

As per the information available with the company, there were no transactions with micro, small and medium enterprises, as defined under the Micro, Small and Medium Enterprises Development Act, 2006.

Permitted method of accounting under income tax law

The Income Tax Act, 1961 also discusses the relevance of the accounting method employed, for computing income from a business, a profession, or any income classified under the act as an ‘income from other sources’. As per Section 145 of the Income Tax Act, such income must be computed as per a method of accounting regularly employed by the tax payer. Even if the accounts maintained by the tax-payer are correct and complete, if the Assessing Officer (AO) (i.e. the Income Tax Officer who is in charge of assessing the income of the business) is not able to determine the actual income, he can determine the income using any other method.  

Audit (under tax law) - The Income Tax Act also prescribes auditing requirements for business/ profession (applicable to all businesses) if:

  • in case of a business - its turnover or gross receipts exceed INR 40 lakhs
  • in case of a profession - income from the profession is above INR 15 lakhs in a year

g. Limited Liability Partnerships

Limited Liability Partnerships are also required to file their annual financial statements with the ROC. Audit requirements for an LLP as per LLP Act have already been discussed before. For the sake of summary, an LLP must audit its accounts if:

  • its turnover in a financial year exceeds forty lakh rupees, or
  • its capital contribution exceeds twenty five lakh rupees 

Sector regulations on companies – e.g. banking, insurance, securities, etc.

Businesses operating in specific industry sectors may have to comply with the regulations of the sectoral regulator. For example, banks need to comply with the directions of the Reserve Bank of India (RBI) while preparing their financial statements. The RBI releases a master circular every year relating to disclosures in financial statements by banks. As per the Master Circular titled Disclosure in Financial Statements – Notes to Accounts dated 2nd July 2012 (the latest master circular), banks are required to make specific disclosures on a number of issues relating to their operations – such as their accounting policies, capital, investments, assets, derivatives, risk management, exposure to real estate, exposure to capital market, etc. These disclosures must be made in a specific section of the financial statements called ‘Notes to Accounts’.

Similarly, insurance companies and entities operating in the securities market must be compliant with applicable regulations of the Insurance Regulatory and Development Authority (IRDA) and the Securities and Exchange Board of India (SEBI) respectively.


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