Some of the frauds which audit may fail to disclose unless stocks are checked are the following:
- Suppose there are two cotton mills : Alfa and Beta, and have a common managing director. The mill Alfa closes its accounts on December 31, and mill Beta, on March 31. Further, suppose that when the accounts of Mill Alfa for the year ended December 31, 2000 are prepared in January 2001, the managing director of the mill decides to transfer a part of the profits earned to mill Beta To give effect to such a design, mill Alfa enters into an agreement in February 2001, with mill Beta but ante-dates the agreement to November, 2000. It provides that mill Alfa shall purchase 5,000 bales of cotton at Rs. 195, per bale from mill Beta. On the basis of this agreement a book entry showing that 5,000, bales have been purchased in November, 2000, is recorded in the books of the mill Alfa for the year ended 31st December, 2000, and their price is credited to the account of mill Beta, corresponding entries are recorded in the books of account of mill Beta. In pursuance of the entry 5,000 bales of cotton are included in the closing stock of mill Alfa valued at Rs. 190 per bale, the supposed market price. As a result the profit of mill Alfa are reduced Rs. 25,000. Subsequently on 28-2-2001another contract is entered into mill Alfa to sell 5,000 bales of cotton to mill Beta Rs. 185 per bale. The corresponding entries are duly recorded in the books of mill Beta. The net effect of both of these entries is that the profits of mill Beta are increased Rs. 50,000 for the year ended 31-3-2001and those of mill Alfa, for the year ended 31-12-2000 are reduced Rs. 25,000 and the same amount those of the year ended 31-12-2000 also. In fact, neither any bales of cotton are received the mill Alfa from mill Beta nor they are sold back to Beta. Also neither any price is paid mill Beta on purchasing the bales nor any sale price is received on the bales being sold back. Students will observe that the foregoing transactions have been represented merely book entries, as contemplated clause (b) of Sub-Section (IA) of Section 227 of the Companies Act, 1956. Such a fraud may not be discovered, unless the auditor checks entries of purchases and sales of the bales of cotton in the stock books of the respective mills or carefully takes note of the associated nature of the companies and diligently scrutinises transactions of the subsequent period.
- A commercial concern dealing in mill stores enters in its accounts several invoices showing that it has purchased mill stores from a number of suppliers. All the purchases have been made for cash and the entries are duly supported printed invoices showing the names and addresses of the suppliers that are false. All the payments have been duly acknowledged the parties. The auditor of the concern, not suspecting any mala fides, accepts the invoices as correct without tracing the purchases into the stock book. In fact, no mill stores had been purchased and the transactions entered into merely to reduce profits. The fraud remained undetected due to the failure of the auditor to trace the purchases into the stocks of the concern and preparing a stocktally of goods purchased and sold.
- There have been several cases in the past wherein it has been found during liquidation proceedings that the management has overvalued its closing stock to show a profit larger than what the company has actually earned. In all these cases, fraud would have been detected if the auditor had verified the quantities and value of stocks at the close of the year. All these cases related to the period before the Companies Act was amended in 1956. Therefore, the auditor escaped liability for professional misconduct. Until then it was possible for the auditor to accept the value of stock declared the management. But this is not possible now. Under the present circumstances, a duty is cast on the auditor to verify the closing stock in the manner stated in Chapter 6.
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