Preparing Foreign-Invested Entities for Annual Audit in India

May 7, 2013 Posted by India Briefing Reading Time: 6 minutes

By Manoj Kumar & Chris Devonshire-Ellis, Dezan Shira & Associates

May 7 – India is often perceived as an investment destination full of red tape and bureaucracy, yet in fact with some attention to detail, the legal and financial operational procedures can be relatively easily expressed – if you know what you are doing. As always, forearmed is forewarned, and any successful business should have its operational procedures laid down and working efficiently. Annual audit procedures help assess companies for purposes of taxable income, but they can also provide a working blueprint of the company which can help management evaluate company efficiencies and deficiencies.

In this article, we explain the procedures that a foreign-invested enterprise (FIEs) in India can expect to go through during the audit process, and outline some of the guidelines to prepare yourselves for the inevitable questions your auditors will have.

Firstly, it is important for FIEs about to be audited to make sure that the auditor is familiar with the company’s business operations. This means spending some initial time with your auditors explaining your regular business activities.

Briefing Your Auditor

To ensure you get the best possible feedback from your auditor, they should be given some brief background knowledge regarding the nature of your business, the activities you are carrying out, the procedures you follow while making purchases and sales, and to what extent you are following internal control procedures. This latter point your auditor will check as part of the “kick the tires” exercise, but it helps if you first explain to them how you think this operates. Their report – even if it contains criticisms – should help you better manage your business in the future and close any potential operational loopholes.

Identify the Production Process

You should provide your auditors with a list of the major raw material inputs you are using in production. They will want to note the steps you are following for the conversion of raw material into finished goods, as well as verify internal controls at the time of inputting raw material.

Opening Balances Verification

Your auditor will ask you to provide the opening balances report from your management accounts and will verify whether the opening balances have been carried forward correctly from the previous year’s audited financial statements. It is not uncommon for some minor adjustments to be necessary.

Vouching of Purchases

Your auditor will also ask to examine the purchasing procedures and may ask you to draft a flow chart explaining this – which is very relevant for their understanding of company operations. It is common for parasitical employees to insert favored suppliers into your supply chain in the form of family businesses or those paying back-hand commissions. Your auditors will want to conduct price surveys on your major purchases to ensure that you are not being overcharged for your most popular supplies.

They will also compare purchase vouchers with the pertinent taxable invoices received from the seller, and material received notes (MRNs) to confirm whether or not the quantities and amounts match. This requires a considerable amount of time. As such, it is recommended that you have a properly trained internal accounting team in place to satisfy this request and make it easier for your auditors to evaluate your paper trail.

Auditors will also check whether the rates of materials on invoices tally with purchase orders raised by the company, and whether the dates on MRNs relate to the current accounting period.

Vouching of Journal Vouchers, Tour Bills, Cash and Bank

You may also expect your auditor to verify whether the supporting bills tallied with the journal vouchers and the expenditures relate to the current period. While verifying the journal vouchers, the auditor will ensure that the appropriate tax deduction at source (TDS) was deducted wherever applicable; it is a relatively common internal mistake that TDS is not calculated. Again, the better your internal processes are, the easier it is to go through and pass an audit examination with confidence.

For travel and related expenses, your company should be prepared to provide supporting documentation. Executives racking up air miles and trips overseas may be asked to provide evidence of the necessity of these expenses in their job descriptions and employment terms, so be careful over this issue. Your auditors will want to verify whether these expenses are within the prescribed limits set for the position in question.

When dealing with cash purchases and petty cash, auditors will want to verify whether any cash payments have exceeded INR20,000 (in accordance with regulation Section 40A(3)) and also check for credit balances in cash. They may also spot-check for verification of cash, as well as check whether the Bank Reconciliation Statement is correct.

Reconciliations

During the course of the audit process, your auditors will want to reconcile the following items:

VAT returns with purchases and sales;
Provident fund contributions;
Professional tax contributions; and
Employee state insurance contributions.

These payments are statutory and applicable to all companies in India.

Inventory Stock Audit – Manufacturers

For manufacturing entities, you will need to demonstrate that your business maintained its RG 23 books and stock registers when manufacturing or processing materials. To do this, your auditors will need to ascertain whether the RG 23 A Part II / RG 23 C Part II are aligned with your purchase registers and that input credits have been recorded correctly.

The auditors will also verify your Personal Ledger Account (PLA) register to determine whether payments were made through PLA after considering your input credit, and will also carry out a Physical Stock Verification to ensure that the physical quantity of goods reconciles with the inventory register.

Miscellaneous

Rental Agreements
Has your office or factory rent been paid per the rental agreement? Are rental agreements up to date?

PAN Numbers for Contractors
Is your company maintaining photocopy PAN cards for contractors? Starting from the 2011-2012 accounting year, every company now has to maintain the PAN numbers of all persons who come under the TDS applicability for your company. If the PAN is not provided to the company who is deducting TDS, the company needs to deduct TDS at a rate of 20 percent – applicable for the time being as per the recent changes to the Finance Act.

Summary

For many executives who find themselves having to face unfamiliar audit and financial examination procedures, the annual audit process can appear a daunting proposition. Yet it is actually designed to fulfill two specific functions. Firstly, audits are conducted to ensure that your business is declaring the right amount of finances in the properly prescribed manner, so that the government can properly assess your business for any taxable income. It is important for foreign investors to note that not only can the Indian government levy fines for any untoward accounting behavior, but poor financial record keeping can now impact upon the liabilities of foreign executives and the head office in terms of compliance with other responsibilities, such as fulfillment of the U.S. Foreign Corrupt Practices Act regulations and similar legislation introduced in Europe.

Secondly, a good audit will identify areas of weakness and make recommendations as to where these should be resolved. Annual audits are also there to assist and provide tips on how to improve management practices, stay in compliance, and lessen the risk of financial troubles.

Finally, should your audit or procedures come up short, it may be time to examine your internal business processes, including the competency of the staff charged with carrying out the company’s operations. This will help ensure that your business operates to audit standards throughout all of its operations. The key to corporate success is a well run internal system, and your annual audit should help provide the guidelines on how to achieve this.

This article was originally published in the India Briefing Magazine, titled “An Introduction to Audit in India.” In this issue, we examine how India’s accounting standards differ from the globally accepted IFRS and IAS protocols, and outline the standard steps and procedures an Indian auditor will go through during the audit process and explain pre-audit preparations that can be carried out to make the process easier to follow and understand for foreign executives.

Dezan Shira & Associates is a specialist foreign direct investment practice, providing corporate establishment, business advisory, tax advisory and compliance, accounting, payroll, due diligence and financial review services to multinationals investing in emerging Asia. Since its establishment in 1992, the firm has grown into one of Asia’s most versatile full-service consultancies with operational offices across China, Hong Kong, India, Singapore and Vietnam as well as liaison offices in Italy and the United States.

For further details or to contact the firm, please email india@dezshira.com, visit www.dezshira.com, or download the company brochure.

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