The Companies Act, 2013The Companies Act, 2013

Scrutiny, Inspection & Investigation –

Technical Aspects

CA Manmohan JunejaRegistrar of Companies

NCT of Delhi and Haryana

Structure of Presentation Structure of Presentation

Legal ProvisionsWhy inquiry , Inspection or InvestigationDetecting non compliancesTypes of non compliances Fraud and punishment for fraudsHow , why and who commit frauds Types of fraudsLogical conclusions

Legal Provisions Legal Provisions ……..

• Chapter XIV of the Companies Act, 2013

• Sections 206 to 229 .

• Section 90 .

• Section 457 .

• Section 447, 448 and 449

Section 206 – Inquiry Inquiry –– calling of further calling of further information and Inspectioninformation and Inspection-- Power Of Registrar..

Opinion of the Registrar

On Scrutiny of any document filed by the Company ;oron any information received by him

Registrar can call by written notice: ◦ To Furnish in writing such information or

explanation ◦ To produce such documents

Within the time and to the extent specified in notice

Inquiry Inquiry ……..

Duty of the Company and its officers to furnish information and to produce documents

[Section 206(2)]

Past employees are also duty bound if so called by Registrar by notice in writing

Section 206(3): If no information is furnished after first notice or on

examination ROC forms an opinion that the information furnished is incomplete or

an unsatisfactory state of affairs exists. Registrar can :

Call for information: or

to produce record for inspection

• ROC to record reasons before action under Section 206(3)

Section 206(4)Section 206(4): Inquiry on information of : Inquiry on information of Fraudulent or Unlawful State of Affairs Fraudulent or Unlawful State of Affairs

On the basis of information available with ROC.

Representation made to ROC by any person.

The business of the Company is carried on for a

fraudulent or unlawful purpose.

Not in compliance with the provisions of the Act.

Grievance of Investors are not addressed.

• ROC to inform the Company of the allegations made against

it by written order may Call for information or carry on any

inquiry as he deems fit.

Opportunity of being heard to the Company is mandatory for action under Section 206(4)

The Central Govt. can also direct the Registrar or an Inspector appointed to carry out inquiry under Section 206(4)

Punishment for fraud under Section 447

◦ Where the business of the Company has been or is being carried out:

For a fraudulent purposeUnlawful purposeEvery Officer of the Company who is in default shall be punishable for fraud under Section 447

Power Of The Central Govt. To Order Inspection [Section 206(5) And (6)]

◦ In addition to the powers of the Registrar, the Central Govt. may direct inspection of Books and papers of the Company by an Inspector

◦ Central Government may, by special or general order, authorize any Statutory Authority to carry out the Inspection of Books of Accounts of a Company or class of Companies

◦ Such Authorities may be like RBI, in case of NBFCs, NHB, in case of Housing Finance Company etc.

Penal Provisions [Section 206(7)]Disobedience of Inquiry Orders

◦ Company and every officer in default with

fine upto Rs. 1 Lac

◦ If default continues, additional fine which may

extent to Rs. 500/- for every day after the

first during which the default continues

Conduct Of Inspection And Inquiry (Section 207)

◦ Duty of every Director, Officer or other employee to produce all

such documents and furnish such statements etc. in such form as

required and render assistance

◦ Registrar/IO empowered to take copies, mark identification

◦ The Registrar/IO empowered with powers of Civil Court under the

Code of Civil Procedure, 1908 in the matters:

Discovery and production of Books of Account and records

Summoning and enforcing the attendance of persons and

examination of oath and inspection of any Books and records at

any place

Penal Provisions On Disobedience of Inspection [Section 207(4)]

Every Director or the Officer of the Company punishable with imprisonment which may extent to one year; AND

Fine which shall NOT be less than Rs. 25,000/- but may extent to Rs. 1 Lac

On conviction such Director or Officer shall be deemed to have vacated his office as such; AND

Disqualify from holding an office in any Company

Report On Inspection (Section 208)

◦ Report must on Inquiry (Section 206) and Inspection

(Section 207)

◦ The Registrar/Inspector is duty bound to submit report

to Central Govt. along with documents

◦ Empowered to recommend investigation into the affairs

of the Company with reasons

Search And Seizure (Section 209)

◦ In case of belief of possibility of destruction, mutilation, alteration of evidences/ Books/records, Registrar/Inspector empowered to search and seizure after taking approval from Special Court:

Records relating to Company, KMP, Director, Auditor, Company Secretary in practiceSeek search and seizure into any place or places where such Books or papers are kept. Power to keep such seized records upto 180 days and return but empowered to call for further period of 180 days by an order in writingEmpowered to keep copies before return of recordsThe provisions of Cr. PC apply to such search and seizure

Investigations [Section 210]

o Central Govt. on forming opinion may order investigation:

o On receipt of report of Registrar or Inspector under Section 208

o On intimation of special resolution passed by a Company

o In Public interest

o Central Govt. shall order investigation:

o On order passed by a Court; or

o the Tribunal

o The Central Govt. may appoint one or more Inspector to investigate

into the affairs of the Company and report in the manner as directed

by Central Govt.

Investigations By SFIO

◦ SFIO gets a statutory status and organization structure [Section 211]

◦ Central Govt. empowered to order investigations by SFIO:

On receipt of report of the Registrar/Inspector under Section 208

On intimation of special resolution passed by a Company

In Public interest

On request from any Department of the Central Govt. or State Govt.

Investigations By SFIO

• The Director, SFIO to designate Inspectors

• Once investigation is ordered by CG for SFIO no

other agency to investigate matters under this Act

and shall transfer the relevant records to SFIO

• 15 offences made cognizable and no person accused

of such offences shall be released on bail or on his

own bond unless PP is given an opportunity to oppose

the application for such release [Section 212(6)]

• Powers of arrest with SFIO [Section 212(8)]

Investigation In Other Cases: [Section 213]

◦ Investigations on orders by Tribunal

◦ Tribunal may pass order on applications by specified

number of members

◦ On allegations of fraudulent activities of the Company

or unlawful purposes or other matters specified under

Section 213(b)

Investigation of Ownership of Company [Section 216]Investigation of Ownership of Company [Section 216]

• Central Govt. empowered to appoint Inspectors to investigate and report on

matters relating to Company and its membership to determine true persons:

Who are or have been financially interested in the success or failure,

real or apparent

Who are or have been able to control or to materially influence the

policy of the Company

• Such investigation may be ordered by Central Govt. on orders by Tribunal

• CG may define scope of the investigation, define period or limit investigation to

matters with particular shares or debentures

Imposition Of Restrictions Upon Securities [Section 222]

◦ Tribunal is empowered (for investigations under

Section 216 into ownership) to put restrictions

upon on securities for period not exceeding three

years

◦ Default attracts major penalties under Section

222(2)

Other Provisions relating to Investigations Other Provisions relating to Investigations

• Procedures/powers of the Inspector is defined under Section 217

• Protection of employees during investigation is provided under Section 218

• Inspector is empowered to conduct investigation into affairs of the related Companies with prior approval of Central Govt.

• Inspector are empowered for seizure of documents during investigations [Section 220]

• Freezing of assets of the Company in inquiry and investigation by Tribunal, on reference by:

Central Govt. or

in reference to inquiry or investigation or

on any complaint made under Section 244 or

on any complaint from creditor having Rs. 1 Lac amount outstanding or

Non-disclosure Of Information In Certain Cases [Section 457]

◦ Notwithstanding anything contained in any other law, the Registrar or any Officer of the Govt. or any other person shall be compelled to disclose to any Court, Tribunal or other Authority the source from where he got any information which;

has lead the CG to order an investigation under Section 210 or

is or has been material or relevant in connection with such investigations

Why Inquiry Why Inquiry …………• Strengthen Information In registry or to fill the missing gaps/incomplete

filings .

• Financial statements/documents indicate prima-facie non compliances like

variances in dates/financial data

• Audit Qualifications.

• When there are doubts on existence of the company

• Redress grievances raised by investors/depositors/other stakeholders .

• References from other regulators/ departments

• Verify facts on the basis of investor complaints or otherwise .

• Financial statements indicate too good or too bad financial position -

exceptional/irrational changes in financial results or state of affairs

• Verify the utilization of IPO/FPO proceeds as per stated objects

Why InspectionsWhy Inspections…….. .. • Refusal /disobedience of the scrutiny /inquiry

orders .• Inquiry indicates need for deeper examination

of the Books of Account like volume of records • Need to verify the disclosures in Financial

statements with the Books and records.• Collection of evidence • Recording of statements • Physical verification of Registered or other

offices of the company .• Higher Number or frequency of investor

complaints .

Why Investigations Why Investigations ……....• Normally the similar reasons but where larger

interests of number of investors or stakeholders are affected .

• Larger Public issues – issues of revenue etc

• Inquiry indicates elements of fraud.

• Specific issues are to be examined instead of general examination of books and records –Targeted Surgery

Nature of Non CompliancesNature of Non CompliancesSecretarial :

Statutory Registers /Books either are not maintained or are in complete .

Filing of statutory documents with ROC/MCA.

Secretarial compliances in calling and holding of meetings , notices , certifications , passing of proper resolutions , agreements etc

Accounting : Compliance of Format and contents –Accounting Principles and polices

Accounting Standards

Audit , Cost Audit Rules

• Corporate Governance Norms and certifications

Non Compliances /Violations/Red flagsNon Compliances /Violations/Red flags

Default/delay in filing of due documents Not maintaining registered officeNon maintenance/incomplete secretarial recordsNon holding/delayed holding of meetings Filing of documents with incomplete informationNon compliances of Accounting StandardsFinancial Statements not prepared on the prescribed formatIncomplete/no prescribed disclosures givenShifting of registered office without intimationAbnormal related party transactions

Non compliances vs. FraudsNon compliances vs. Frauds……..

A Non Compliance can be an innocent mistake without any intention to harm the organisation or any of it stakeholders.On the Contrary , Fraud encompasses an array

of irregularities and illegal acts characterized by intentional deception. It can be perpetrated for the benefit of or to the detriment of the organization and by persons outside as well as inside the organization .A non compliance can also “ indicate” a potential Fraud if is corroborated with array of events with “ mens- rea” or guilty mind.

What is Fraud What is Fraud ……....Black’s Law DictionaryIntentional perversion of truth

False representation of a matter of factWhether by words or conductFalse, misleading, concealment of that which should have been disclosed

For the purpose of inducing anotherIn reliance upon perversion of truth To part with some valuable thing belonging to him or to surrender a legal right

Fraud Defined Under Companies Act, 2013Fraud Defined Under Companies Act, 2013

• Explanation to Section 447 , Fraud in relation to affairs of the

company/body corporate includes :

Act of omission , concealment of any fact ;or

Abuse of position committed by any person or other

person with connivance

• With intent to deceive, to gain undue advantage from or

injure the interests of the company or its shareholders or

creditors any other person

• Whether or not there is any wrongful gain or wrongful loss

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Perspectives On Fraud: Perspectives On Fraud: Prosecutors, Regulators & LawyersProsecutors, Regulators & Lawyers

By the Corporation

Corporation as “victimizer”

Corporation benefits:

◦ Financially

◦ Other

Corporation subject to potential civil and/or criminal liability

Against the Corporation

Corporation as victim

Corporate risks:

◦ Financial

◦ Legal, and

◦ Reputation

Potential civil recovery

by Corporation

How Do People Commit Financial How Do People Commit Financial Statement Fraud?Statement Fraud?

Playing the accounting system

Beating the accounting system

Going outside the accounting

system

Detecting Financial Statement Detecting Financial Statement Fraud and Non ComplacenciesFraud and Non Complacencies

Detecting Financial Statement Fraud

1. Management & Board 2. Relationships With Others

3. Organization & Industry 4. Financial Results & Operating Characteristics

Financial Statement FraudsFinancial Statement FraudsRevenue/Accounts Receivable Frauds Inventory/Cost of Goods Sold Frauds Understating Liability/Expense Frauds (Enron).Overstating Asset Frauds (WorldCom)Overall Misrepresentation. (Satyam)

Revenue Related Financial Revenue Related Financial Statement FraudsStatement Frauds

By far, the most common accounts manipulated when perpetrating financial statement fraud are revenues and/or accounts receivable.

Accounts Receivable xxx

Revenues xxx

(Income Assets )

Overstating InventoryOverstating InventoryThe second most common way to commit financial statement fraud is to overstate inventory.Beginning Inventory OK

Purchases OK

Goods Available for sale OK

Ending Inventory High

Cost of Goods Sold Low

Income High

Understating Liability FraudsUnderstating Liability Frauds(3(3rdrd Most Common)Most Common)

Not recording accounts payableNot recording accrued liabilitiesRecording unearned revenues as earnedNot recording warranty or service liabilitiesNot recording loans or keep liabilities off the booksNot recording contingent liabilities

Asset Overstatement FraudsAsset Overstatement Frauds(4(4thth Most Common)Most Common)

Overstatement of current assets (e.g. marketable securities)

Overstating pension assets

Capitalizing as assets amounts that should be expensed

Failing to record depreciation/amortization expense

Overstating assets through mergers and acquisitions

Overstating inventory and receivables (covered earlier)

Disclosure FraudsDisclosure FraudsThree Categories of Disclosure Frauds:

1. Overall misrepresentations about the nature of the

company or its products, usually made through news

reports, interviews, annual reports, and elsewhere

2. Misrepresentations in the management discussions and

other non-financial statement sections of annual

reports, 10-Ks, 10-Qs, and other reports

3. Misrepresentations in the footnotes to the financial

statements

Current Executive FraudCurrent Executive Fraud--Related ProblemsRelated Problems

Misstating Financial Statements:

Executive Loans and Corporate Looting:

Insider Trading:

IPO Favoritism:

CEO Retirement Perks:

Related Party Contracts (Consulting Contracts, Use of Corporate Planes, etc.)

Who Commits Financial Statement Who Commits Financial Statement Fraud ?Fraud ?

Promoters

Senior management

Mid- and lower-level employees

Organized criminals

Why Do People Commit Financial Why Do People Commit Financial Statement Fraud?Statement Fraud?

To conceal true business performance

To preserve personal status/control

To maintain personal income/wealth

Tax/duty/cess evasion

Money laundering

Why Senior Management Will Why Senior Management Will Overstate Business Performance?Overstate Business Performance?

To meet or exceed the earnings or revenue growth expectations of stock market analysts

To comply with loan covenants

To increase the amount of financing available from asset-based loans

To meet a lender’s criteria for granting/ extending loan facilities

To meet corporate performance criteria set by the parent company

Why Senior Management Will Why Senior Management Will Overstate Business Performance?Overstate Business Performance?

To meet personal performance criteria

To trigger performance-related compensation or earn-out payments

To support the stock price in anticipation of a merger, acquisition, or sale of personal stockholding

To show a pattern of growth to support a planned securities offering or sale of the business

Why Senior Management Will Why Senior Management Will Understate Business Performance?Understate Business Performance?

To defer “surplus” earnings to the next accounting period.

To take all possible write-offs in one “big bath” now so future earnings will be consistently higher.

To reduce expectations now so future growth will be better perceived and rewarded.

To preserve a trend of consistent growth, avoiding volatile results.

To reduce the value of an owner-managed business for purposes of a divorce ­settlement.

To reduce the value of a corporate unit whose management is planning a buyout

Effects of Financial Statement FraudEffects of Financial Statement Fraud

Undermines the reliability, quality, transparency, and integrity of the financial reporting process

Jeopardizes the integrity and objectivity of the auditing profession, especially auditors and auditing firms

Diminishes the confidence of the capital markets, as well as market participants, in the reliability of financial information

Makes the capital markets less efficient

Effects of Financial Statement Effects of Financial Statement FraudFraud

Adversely affects the nation’s economic growth and prosperity

Results in huge litigation costs

Destroys careers of individuals involved in financial statement fraud.

Causes bankruptcy or substantial economic losses by the company engaged in financial statement fraud

Effects of Financial Statement FrauEffects of Financial Statement Fraudd

Encourages regulatory intervention

Causes devastation in the normal operations

and performance of alleged companies

Raises serious doubt about the efficacy of

financial statement audits

Erodes public confidence and trust in the

accounting and auditing profession

Role of Auditors Role of Auditors ……Recent Experiences Recent Experiences

Failed to accept responsibility for fraud detection

If auditors aren’t the watchdogs, then who is?

Became greedy-Millions per year per partner compensation wasn’t enough; High rise in remuneration seen in few years .

Audit became a loss leader

◦ Easier to sell lucrative consulting services from the inside

A few auditors got too close to their clients

Entire community of auditors is been seen with awe and suspicion due to malpractices of a few.

Interesting TimesInteresting Times……Number and size of accounting mis-statements financial statement frauds are increasingNumber and size of frauds against organizations are increasingSome recent frauds include several and a complex web of accounting jugglery . Many investors have lost confidence in credibility of financial statements and corporate reportsFaith on the established systems of checks and Balances , Like independent Audit and independent Directors is somewhat shaken requiring the need to re-look at such systems. Good economy masks problems…With increasing stock prices, increasing profits and increasing wealth for everyone, no one worries about potential problems.

Logical Conclusions Logical Conclusions • Registry is updated • Grievances are redressed .• Offences are made good by :

By making missed compliances .Recovery of assets/properties.Removal from positions/restoring positions.

• Wrong doers are punished for non compliances :Conviction by imposing Financial penalties/fines only

Conviction by fine or imprisonment or both Compounding of offencesPunishment for fraud as per section 447

• Winding up or seeking relief from oppression or both

THANKS

Transaction Accounts Involved Fraud Schemes1. Estimate all uncollectible accounts receivable

Bad debt expense, allowance for doubtful accounts

1. Understate allowance for doubtful accounts, thus overstating receivables

2. Sell goods and/or services to customers

Accounts receivable, revenues (e.g. sales revenue) (Note: cost of goods sold part of entryh is included in Chapter 5)

2. Record fictitious sales (related parties, sham sales, sales with conditions, consignment sales, etc.)3. Recognize revenues too early (improper cutoff, percentage of completion, etc.)4. Overstate real sales (alter contracts, inflate amounts, etc.)

3. Accept returned goods from customers

Sales returns, accounts receivable

5. Not record returned goods from customers6. Record returned goods after the end of the period

4. Write off receivables as uncollectible

Allowance for doubtful accounts, accounts receivable

7. Not write off uncollectible receivables8. Write off uncollectible receivables in a later period

5. Collect cash after discount period

Cash, accounts receivable

9. Record bank transfers as cash received from customers10. Manipulate cash received from related parties

6. Collect cash within discount period

Cash, sales discounts, accounts receivable

11. Not recognize discounts given to customers

Revenue-Related Transactions and Frauds

Inventory/Cost of Goods Sold FraudsInventory/Cost of Goods Sold FraudsTransaction Accounts Involved Fraud Schemes

1. Purchase inventory Inventory, accounts payable

1. Under-record purchase2. Record purchases too late3. Not record purchases

2. Return merchandise to supplier

Accounts payable, inventory

4. Overstate returns5. Record returns in an earlier period (cutoff problem)

3. Pay vendor w ithin discount period

Accounts payable, inventory, cash

6. Overstate discounts7. Not reduce inventory cost

4. Pay vendor w ithout discount

Accounts payable, cash Considered in another chapter

5. Inventory is sold; cost of goods sold is recognized

Cost of goods sold, inventory

8. Record at too low an amount9. Not record cost of goods sold nor reduce inventory

6. Inventory becomes obsolete

Loss on w rite-dow n of inventory, inventory

10. Not w rite off or w rite dow n obsolete inventory

7. Inventory quantities are estimated

Inventory shrinkage, inventory

11. Over-estimate inventory (use incorrect ratios, etc.)

8. Inventory quantities are counted

Inventory shrinkage, inventory

12. Over-count inventory (double counting, etc.)

9. Inventory cost is determined

Inventory, cost of goods sold

13. Incorrect costs are used14. Incorrect extensions are made15. Record f ictitious inventory

OPEN SOURCE INTELLIGENCEOPEN SOURCE INTELLIGENCE

We are living in an era of information explosion .

Lot of information about any subject is available form

open sources , in particular the internet media .

There are varies sites where information, ratios and

research on the corporate financial results is available .

Media reports are also very important input into

detection of corporate non compliances and fraud .

Voluntarily winding up not to stop investigation [Section 226]

Legal Advisors and Bankers not to disclose certain information [Section 227]:◦ Legal Advisor are not required to disclose privileged

communication made to him in that capacity except as respects the name and address of his client

◦ Bankers are not required to disclose any information as to the affairs of any of their customers other than such Companies, Body Corporate or Person

Investigation of Foreign Companies [Section 228] – All provisions of investigations apply mutatis mutandis to Foreign Companies

o Penalty for furnishing false statement, mutilation, destruction of documents [Section 229]:

◦ Penalty for fraud as provided under Section 447:On providing false explanation or information Making or party in making a false entry in any document concerning the Company/Body CorporateOn destruction, mutilation, falsification, concealing or tampering or unauthorized removing or party thereto of any property, assets or affairs of the Company or Body Corporate

o Investigation of beneficial ownership of shares in certain cases [Section 90]

◦ Central Govt. is empowered to appoint Inspectors to investigate and report as to beneficial ownership with regard to any shares or class of shares

◦ All provisions of investigations under Section 216 shall apply to such investigation

Financial Statement FraudFinancial Statement FraudSection 448Section 448

Falsification, alteration, or manipulation of material financial records, supporting documents, or business transactions

Material intentional omissions or misrepresentations of events, transactions, accounts, or other significant information from which financial statements are prepared

Deliberate misapplication of accounting principles, policies, and procedures used to measure, recognize, report, and disclose economic events and business transactions

Intentional omissions of disclosures or presentation of inadequate disclosures regarding accounting principles and policies and related financial amounts

Punishable as per section 448 same punishment under section 447 for fraud.