1. This case has been referred to us under the Chartered Accountants Act, 1949. It arises out of a complaint dated 4-4-1951 made by the Registrar of Companies, Bombay, against the respondent, a chartered Accountant to the Council of the Institute of chartered Accountants of India, that as the Auditor of the Rural Bank of India Ltd., Karwar, he was guilty of professional misconduct. On receipt of the complaint, the Secretary to the Council forwarded a copy of it to the respondent who filed a written statement on 7-5-1951. There was an inquiry by the Disciplinary Committee. The Committee reported that the respondent was guilty of gross negligence in the discharge of his duties. The findings of the Council, on a consideration of the report of the Disciplinary Committee, are as follows :
Shri P. M. Hegde had failed to discharge his duty to the share-holders :
(1) by not verifying the cash on hand at the head office on the date of the balance sheet in each of the years in question;
(2) by not reporting to the share-holders on the non-compliance of the provisions of Section 101 (2-B), Companies Act; and
(3) by not making proper enquiries regarding the financial position of Best Security Trust Ltd., with a view to satisfying as to its capacity for making large investments and verifying the fact whether the fixed deposit receipts of that company held as security by the Bank were worth their face value and were sufficient cover for the loans;
And therefore he was guilty of gross negligence in the discharge of his duties as auditor of Rural Bank of India, Ltd., Karwar.
2. The events which led up to the complaint are as follows : The Rural Bank of India Ltd., was incorporated on 10-7-1944, with its head office at Karwar. The prospectus inviting applications for shares from the public was filed on 10-8-1944. The certificate for the commencement of business was issued on 13-10-1944, after the Bank had filed a statement with the Registrar of Companies, Bombay, under Section 103, Companies Act, along with a statement under Section 277 (1) of the Act. It was stated that 29502 shares of Rs. 10 each were subscribed for, and the first allotment of shares had been made on 6-10-1944. Out of these, 12500 shares were allotted to one K. G. Shaw, and 15000 to one Mascarenhas, and 19933 shares to a Limited company called Best Security Trust Ltd.
One Mr. P. X. Gracious, who was the promoter of the Bank, was also appointed its managing director. He also happened to be the general manager of the Best Security Trust Ltd., which had its registered office at his residence. The respondent was the auditor of the Bank from August 1944 and made reports on the balance sheets of the Bank as on 31-10-1945, 31-12-1946. 31-12-1947, 31-12-1948, and 31-12-1949. The report attached to each of these balance sheets was more or less as prescribed in Section 145 (2), Companies Act, with the further statement that the cash and securities had been verified by him.
The Registrar of Companies, Bombay, suspected that all was not well with the affairs of the Bank, made enquiries, and on the information furnished in response to his inquiries, he came to the opinion that the affairs of the Bank were in an unsatisfactory state, and hence he submitted a report to the Government of Bombay in pursuance of Section 137 (5), Companies Act. He suggested that Messrs. D. B. Kulkarni and Co., Registered Accountants, Belgaum, may be appointed Inspectors to properly examine the accounts of the Bank. Thereupon, the Government of Bombay appointed the said Messrs. D. B. Kulkarni and Co., as inspectors for the purpose of investigating the affairs of the Bank since its inception and registration in 1944. Messrs. Kulkarni and Co., made an investigation in pursuance of the direction from Government and sent a report on 13th March 1949, in which they pointed out that several irregularities and violations of mandatory and other provisions of law had occurred.
The managing director, Mr. P. X. Gracious, made several admissions on which mainly the report of Messrs. Kulkarni was based. Mr. Gracious admitted 'inter alia' that he did not receive actual cash from all the share applicants including the large amounts due for the shares allotted to Mr. Shaw and Mr. Mascarenhas and to the Best Security Trust Ltd. He also admitted that imaginary deposits were created in the books of the Best Security Trust Ltd., that no such deposits had ever been received, and these imaginary deposits were made use of for the purchase of shares of the Bank. It was also not disputed that the Bank had on several occasions debited to the accounts of certain persons loans which were bogus. The Best Security Trust Ltd. had been utilised to 'window-dress' most of the bogus entries. The Government wanted further information on some matters, and Messrs. Kulkarni and Co. made a further report on 12th October 1950. Thereupon, the Government of Bombay permitted the Registrar of Companies, Bombay, to lodge a complaint against the respondent on 4-4-1951, as already mentioned.
3. The complaint unfortunately does not appear to have been drafted as a complaint directed against the auditor. It recites the various irregularities and even frauds which had been discovered by Messrs. Kulkarni and Co., and winds up in the following manner :
I submit that the frauds have been so primitive and glaring that it is difficult to conceive that the auditor failed to see them. The only other alternative conclusion would be that the Auditor may have connived at these frauds, and may have been wilfully a party to certifying false accounts from 1945 to 1949.
4. We must say at the outset that in this case we are not called upon to decide whether the directors of the Bank, and in particular the managing director, Mr. Gracious, was or was not guilty of fraud and misfeasance. We are only called upon to decide whether the auditor was guilty of gross negligence in the discharge of his duties as auditor in having appended an unqualified report to the balance sheets for the several years. It is, therefore, necessary and useful to concentrate on the specific charges brought home to the respondent and examine the facts and circumstances bearing on them.
5. The first specific charge against the respondent is that he did not verify the cash in hand on the dates of the balance-sheets in respect of the periods referred to above. It was his duty to verify the cash in hand on the date of closing, the verification taking the form of actual cash count. The respondent stated that he verified the cash in hand on the several dates he visited the Bank for audit in each of the years, but these dates were later than the dates of the balance-sheets concerned. In respect of the balance sheet as on 31st October 1945, he actually checked the cash on 31st December 1945. In respect of the balance sheet as on 31st December 1945, he made check on 28th January 1947, and in respect of the balance sheet as on 31st December 1947, on 13th March 1948, in respect of the balance sheet as on 31st December 1948 on 26th March 1949, and for the subsequent balance sheet on 14th February 1950.
He admitted that he had not verified the intermediate transactions between the several dates of the balance sheets and the dates on which he actually checked the cash. The following statement shows the disparity between the cash balances disclosed in the balance sheets and the actual amounts of cash found by the respondent at the head office on the several dates he made the check :
Date Cash on hand as Cash actually foundper balance sheet on the date of check31-10-1945 50144 4 4 4030-13-631 12-1940 197189-11 2 15642-14-831-121947 278104 8 4 9563-7-381.12.1948 337505-11 3 6407 3 331.12.1949 206516-5 6 17166-5-9.
Mr. Rajah Aiyar, learned. counsel for the respondent pointed out that the figures of the cash found on check represented only the cash at the head office and not at the branches. But it was not suggested that the disparity is explained by this fact. For example, it was not suggested that in respect of the cash balance of Rs. 197189 contained in the balance sheet as on 31st December 1946, though only 15000 odd were found at the head office on 28th January 1947, more than a lakh of rupees would be found in the several branches. As Lord Alverstone C. J. observed in - London Oil Storage Co. Ltd. v. Seerar Haslock and Co. Dicksee's Auditing, p. 633 at p. 637 (A) :
It cannot be disputed that when an auditor returns to the share-holders an entry of cash in hand he must have taken reasonable steps to ascertain that the cash was in hand.
Cash in hand is verified either by production of actual cash balance or if the date of the accounts has gone by, by exhaustively vouching the cash account upto the date of audit and then counuug the balance of cash in hand.
It is, of course, obvious that in the case of cash at distant branches a satisfactory certificate from responsible officers of the branches that the balance exists may generally be accepted in lieu of actual counting. Mr. Rajah Aiyar put forward an explanation to account for the large cash balance shown in the several balance sheets. He said that it was a common practice among banks to call in the, loans at or about the time of the close of the accounting year and a return of such moneys called in after the date of the balance sheet. If this be so, it becomes all the more important that the auditor should check the actual cash on the date as on which the balance sheet is prepared. This date is a certain date and the auditor generally would have been appointed long before this date.
In our opinion, it is the duty of the auditor, except in special circumstances, to verify the cash in hand on the material date. It is only then that any fraudulent device on the part of the Bank officials to make false-credit entries can be found out. To allow bogus cash entries to swell up the cash balance on the date as on which the balance sheet is prepared will be completely misleading the share-holders, by covering up the real financial position of the company. The respondent admittedly did not verify the cash on the material date, and even when at a later date he made a check he did not examine the intermediate transactions. We, therefore, agree with the finding of the Council that 'the respondent who was required to satisfy himself by actual verification that the cash did exist on the date of the balance sheet before he expressed his opinion that the balance sheet and profit and loss account exhibited a true and correct view of the bank's affairs, had failed in his duty to satisfy that the asset was there.'
6. The next charge is that the respondent failed to report to the share-holders on the non-compliance of the provisions of Section 101 (2-B) of the Indian Companies Act. That provision runs as follows :
All moneys received from applicants for shares shall be deposited and kept in a scheduled bank as defined in the Reserve Bank of India Act, 1934 until a return in accordance with the provisions of Sub-section (4) or until the certificate to commence business is obtained under Section 103.
It is now admitted that the company did contravene the above provision. It is not as if the respondent was unaware of the fact. He conceded that he had noticed this defect at the time of the audit and even asked the managing director to explain. The explanation given was that the scheduled bank was 100 miles away, that it could be reached only by bus, and that within a Week the certificate to commence business would be obtained.
Even assuming that the managing director did give this explanation, it was the duty of the respondent to have mentioned that there was non-compliance with the statutory direction. It was not in his power to accept the explanation given by the managing director. Indeed, if as a reasonable man he had not been convinced by his explanation, and we think as a reasonable man he should not have been, the very failure to deposit the moneys should have roused his suspicion, and very probably a searching inquiry would have revealed the fact which was revealed at the inquiry made by Messrs. Kulkarni and Co.. namely, that the major allotees of the shares had not paid a pie for the large number of the shares allotted to them.
7. The next charge is that the respondent failed to make proper inquiries regarding the financial position of Best Security Trust Ltd., with a view to satisfy himself as to its capacity for making large investments and verifying the fact whether the fixed deposit receipts of that company held as security by the Bank were worth their face value and were sufficient cover for the loans, one J. B. Almeida was granted a loan of Rs. 50.000 against a fixed deposit receipt of Best Security Trust Ltd. for Rs. 66,000 and Joseph Almeida was granted a loan of Rs, 70 000 against a similar deposit receipt of Best Security Trust Ltd., for Rs. 1,10000. The balance due from them as on 31st October 1945. the date of the first balance sheet was Rs. 49 940-4-7 and Rs. 74.800-9-4 respectively. Both the accounts were closed on 14th October 1948 by alleged realisation of the two fixed deposit receipts.
R.M. yaz was another debtor to whom a loan was originally granted for Rs. 1,00,000 and subsequently the amount was raised to Rs. 1,50,000 against the fixed deposit receipt of Best Security Trust Ltd. for Rs. 2,00,000. The amount due in respect of this loan account varied from Rs. 1,00,000 to Rs. 1,49,000 odd during the relevant years. Besides these, there was a loan account in the name of the Best Security Trust Ltd. itself. The company was granted a loan of Rs. 1,00,000 and thereafter the overdraft was increased to Rs. 3,00,000 against a fixed deposit receipt for an amount of Rs. 3,00,000 which had been deposited with the Bank. It was evident, therefore, that very large amounts had been advanced by the Bank on the security of fixed deposit receipts issued by the Best Security Trust Ltd. and moneys had been advanced to the Best Security Trust Ltd. itself to the maximum limit of the alleged fixed deposit with the bank.
It was, we think, the duty of the respondent as auditor to have made enquiries as to the antecedents and solvency of the Best. Security Trust Ltd. before he could certify to the extent of the securities held by the Bank. Even a very slight enquiry would have revealed to him the fact that this company was really intended to serve for ''window-dressing.' The respondent would have learnt that the managing director of the bank was the general manager of the company and that his brother was the director of the company and that the office of the company was situated in the residence of the managing director of the bank. He would have also found out that the capital of this company was the magnificent sum of Rs. 1,000.
All these facts must certainly have roused the suspicion of the respondent, and he should have -insisted on the production of satisfactory proof that the fixed deposit receipts of the company were really valuable and that the Best Security Trust Ltd. had actually deposited cash with the bank. It suffices to mention one more fact which appears to our mind to be so suspicious that even ordinary laymen would have noticed it. On 26th October 194-1, the Best Security Trust Ltd., contained a receipt for a deposit of Rs. 1.00,000. On the same day, the company borrowed from the Bank Rs. 90,000 and on the next day Rs. 10,000. And the most curious part of the transaction is that the fixed deposit carried only interest at five per cent., whereas the Bank charges nine per cent, on the overdraft amounts.
In plain words, this transaction comes to this. A man having with him liquid cash to the extent of Rs. 1,00,000 instead of utilising the money puts it in the bank on fixed deposit at fire per cent, interest and borrows next day Rs. 1,00,000 and agrees to pay four per cent, more towards interest on the amount borrowed. It is as if he is paying interest to the bank on his own moneys. This curious state of affairs is not confined to the transactions of the Best Security Trust Ltd. It is also a feature of the other transactions connected with the fixed deposit receipts of the Best Security Trust Ltd. There also, the deposits carry interest at five per cent., whereas the overdraft carries interest at nine per cent. It is not as if the overdraft is for temporary accommodation, Here is a case of continuous liability to the Bank. Even Mr. Rajah Aiyar was unable to give us any convincing reason for this method of transacting business. In our opinion, even a cursory examination of the accounts of the Bank should have roused the suspicions of the respondent and he should have made further enquiries as regards the status and financial capacity of Best Security Trust Ltd.
8. In arriving at this conclusion, we have not been influenced by the facts which came to light when Messrs. Kulkarni and Co. carried out an investigation into the affairs of the bank; for we recognise the importance of guarding ourselves against approaching the matter in the light of subsequent knowledge (Vide Salter J, in the - Calne Gas Co v, Curtis Dicksee's Auditing p. 725 at p. 730 (B) ). In the course of his arguments, Mr. Rajah Aiyar tried to reduce the duty of an auditor to an arithmetical level. He said that all that the auditor is expected to do is to verify if the figures set out in the balance sheet tally with the figures found in the accounts of the Bank. We have no hesitation in rejecting this conception of an auditor's duty. In - Leeds Estate, Building & Investment Co. v. Shepherd (1887) 38 Ch D 787 (C). Stirling J. observed thus :
It was in my opinion the duty of the auditor not to confine himself merely to the task of verfying the arithmetical accuracy of the balance sheet, but to inquire into its substantial accuracy, and to ascertain that it contained the particulars specified in the articles of association (and consequently a proper income and expenditure account) and was properly drawn up, so as to contain a true and correct representation of the state of the company's affairs.
In Halsbury's Laws of England, Second Edn. Vol. V at page 385, we find the following :
It is the duty of an auditor to verify not merely the arithmetical accuracy of the balance sheet but its substantial accuracy, to see that it includes the particulars required by the articles and by statute, and contains a correct representation of the state of the company's affairs. While, therefore, it is not his duty to consider whether the business is prudently conducted, he is bound to consider and report to the shareholders whether the balance sheet shows the true financial position of the company. To do this he must examine the books and take reasonable care to see that their contents are substantially accurate.
In - In re London and General Bank (No. 2) 1895 2 Ch 673 Lindley L. J. after stating that the business of the auditor is to ascertain and state the true financial position of the company at the time of the audit, and that his duty is confined to that, asked the question, How is he to ascertain that position? and answers it thus :
The answer is, by examining the books of the company. But he does not discharge his duty by doing this without inquiry & without taking any trouble to see that the books themselves show the company's true position. He must take reasonable care to ascertain that they do so. Unless he does this his audit would be worse than an idle farce... But his first duty is to examine the books, not merely for the purpose of ascertaining what they do show, but also for the purpose of satisfying himself that they show the true financial position of the company.
The learned Lord Justice also discusses what is not the auditor's duty. He says :
An auditor, however, is not bound to do more than exercise reasonable care and skill in making enquiries and investigations....What is reasonable care in any particular case must depend upon the circumstances of that case. Where there is nothing to excite suspicion very little enquiry will be reasonably sufficient, and in practice I believe businessmen select a few cases at haphazard, see that they are right, and assume that others like them are correct also. Where suspicion is aroused more care is obviously necessary; but still, an auditor is not bound to exercise more than reasonable care and skill, even in a case of suspicion, and he is perfectly justified in acting on the opinion of an expert where special knowledge is required.
'The decision of the Court of Appeal in - In re Kingston Cotton Mill Co., No. 2 1896 2 Ch 279 (E) is a leading authority on the subject. Lindley L, J. therein reiterated what he had said in - 1895 2 Ch 673 (D)'. Lopes L. J. summarised the duties of an auditor thus :
It is the duty of an auditor to bring to bear on the work he has to perform that skill, care and caution which a reasonably competent, careful and cautious auditor would use. What is reasonable skill, care and caution must depend on the particular circumstances of each case. An auditor is not bound to be a detective, or, as was said, to approach his work with suspicion or with a foregone conclusion that there is something wrong. He is a watch-dog, but not a bloodhound...If there is anything calculated to excite suspicion he should probe it to the bottom; but in the absence of anything of that kind he is only bound to be reasonably cautious and careful.
The duties of an auditor were set out in the same way in another leading case, viz., - In re City Equitable Fire Insurance Co., Ltd. 1925 Ch 407 (P). It is sufficient to refer to the following passage from the judgment of Pollock M. R. in that case;
What is the standard of duty which is to be applied to the auditors? That is to be found, and is sufficiently stated, I think, in - 1896 2 Ch 279 (E)'. As I have already said it is quite easy to charge a person after the event and say : 'How stupid you were not to have discovered something which, if you had discovered it would have saved us and many others from many sorrows.' But it has been well said that an auditor is not bound to be a detective or to approach his work with suspicion or with a foregone conclusion that there is something wrong. 'He is a watchdog, but hot a blood-hound'. That metaphor was used by Lopes L. J. in - 1895 2 Ch 279 (E)'.
Perhaps, casting metaphor aside, the position is more happily expressed in the phrase used by my brother Sargant L. J. who said that the duty of an auditor is verification and not detection. 'The Kingston Cotton Mill case (E) is important, because expansion is given to those rather epigrammatic phrases, Lindley L. J. says : 'It is not sufficient to say that the frauds must have been detected if the entries in the books had been put together in a way which never occurred to any one before suspicion was aroused. The question is whether, no suspicion of anything wrong being entertained, there was a want of reasonable care on the part of the auditors in relying on the returns made by a competent and trusted expert relating to matters on which information from such a person was essential.
9. In our opinion, the facts disclosed in this case justify us in holding that the respondent, has not discharged the duties which lay on him I as an auditor. We do not say that it was the I duty of the respondent to . have discovered the fiaud, if any, of the managing director or the other directors of the Bank. Nor is it necessary to find that the respondent would have discover-ed the window-dressing transactions find devices resorted to by the directors. But we do think that there was enough appearing on the face of! the accounts to provoke suspicion, and once suspicion was aroused, it was his duty to have made inquiries. It is particularly so as regards the financial status and capacity of Best Security Trust Ltd.
We cannot sufficiently emphasise the importance of auditors realising their responsibilities not only to the company but to the public. Such responsibilities are all the greater in the case of banks. 'In dealing with bank accounts, and all other accounts of a similar nature, the auditor must never forget that his responsibilities are not confined to safeguarding the interests of the proprietors. His report carries great weight with the public. It is not, of course, suggested that he guarantees the safety of the customers' deposits; but he would reasonably be blamed if, after he had signed without remark the usual auditor's report on an apparently sound balance sheet, the bank were afterwards discovered to be insolvent'. (Dicksee's Auditing, 17th Edn., page 97).
10. We, therefore, agree with the Council of the Institute of Chartered Accountants that the respondent failed to discharge his duty as an auditor of the Rural Bank of India Ltd., and he was guilty of gross negligence. At the same time, we also agree with the Council that there has been no conduct on the part of the respondent which involves moral turpitude. It may be that the respondent was suffering under a wrong notion as to the duties of an auditor. Though the Council has been zealous of maintaining the highest standards of integrity and efficiency among chartered accountants, we cannot say that every member of the profession has become familiar with the standards which they have to maintain. Taking these circumstances into consideration, we think that it is sufficient if we administer a severe warning to the respondent that in future audits he should keep in mind his duties as an auditor and intimate him that any similar conduct on his part in the future would entail grave and adverse consequences on him.