FINAL GROUP - IV PAPER - 17

COST AUDIT & OPERATIONAL AUDIT

The Institute of Cost and Works Accountants of India 12, SUDDER STREET, KOLKATA - 700 016

First Edition : January 2008 Second Edition : March 2009

Published by: Directorate of Studies The Institute of Cost and Works Accountants of India 12, SUDDER STREET, KOLKATA - 700 016

Printed at : Repro India Limited, 50/2, TTC MIDC Industrial Area, Mahape, Navi Mumbai - 400 710, India

Copyright of these Study Notes in reserved by the Institute of Cost and Works Accountants of India and prior permission from the Institute is necessary for reproduction of the whole or any part thereof.

CONTENTSPage No. Study Note - 1 Basic of Cost Audit 1.1 1.2 1.3 1.4 1.5 Nature and Scope of Cost Audit Provisions Under Companies Act Relating to Maintenance of Cost Records and Cost Audit Cost Auditor - Appoinment, Rights and Responsibilities Planning and Structuring the Cost Audit 1.5.1 1.5.2 1.5.3 1.5.4 1.5.5 1.5.6 1.5.7 1.5.8 1.5.9 1.5.10 1.5.11 1.6 1.7 Appendix I - A Appendix I - B Appendix I - C Appendix I - D Appendix I - E Appendix I - F Appendix - II (A) Appendix - II (B) Appendix - II (C) Appendix - II (D) Appendix - II (E) 10 15 26 36 38 39 40 43 44 45 46 47 48 49 50 52 1 2

Specimen Question with Answer Self-examanation Quaestion

Study Note - 2 Cost Audit Report Rules, 2001 2.1 2.2 2.3 2.4 2.5 Provision of Cost Audit Report Rules 2001 Cost Audit Report Rules, 2001 (With Authors Comments) Form II - The Cost Audit Report Annexure the Cost Audit Report Proforma 53 54 54 61 68 112

Page No. 2.6 2.7 2.8 2.9 2.10 2.11 2.12 Review of Cost Audit Report by the Company Cost Audit Branch Disposal of Cost Audit Reports by theCentral Government Other End Users of Cost Audit Report Disclosure of Information and Condentiality Appendix I (Cost Audit Report Rules 2001) Specien Question With Answer Self Examination Question 116 118 119 120 121 154 162

Study Note - 3 Cost Accounting Record Rules 3.1 3.2 3.3 3.4 3.5 Procedure for Precription of Cost Accounting Record Rules General Provision Under the Various Cost Accounting Record Rules Cost Accounting Record (Telecommunication)Rules, 2002 Specimen Question With Answer Self-examination Question 165 166 185 233 251 255

Study Note - 4 Cost Accounting Standards 4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9 4.10 Cost Accounting Standards - Backgrounds and History Federal nancial Accounting Standards Government Accounting standards Advisory Board in India Cost Accounting Standard Board in India Cost Accounting Standards Cost Accounting standards vs Cost Accounting Record Rules Compliance of Cost Accounting Standards Preface Cost Accounting Standards Board Cost Accounting Standard 1 : Classication of Cost Cost Accounting Standard 2: Capacity Determination 257 258 264 267 268 268 270 270 271 274 289

Page No. 4.11 4.12 4.13 4.14 4.15 4.16 4.17 Cost Accounting Standard 3 : Overheads Cost Accounting Standard 4: Cost of Production for Captive Consumption Cost Accounting Standard 5: Determination of Average (Equalized) Cost of Transportation Draft Cost Accounting Standard 6: Determination of Arms Length Price Draft CAS - 7 Minstry of Finance and Company Affairs Self-examination Question 329 347 362 363 319 310 296

Study Note - 5 Basics of Internal Audit and Opertional Audit 5.1 5.2 5.3 5.4 5.5 5.6 5.7 5.8 5.9 5.10 5.11 Concept of Internal Control Origin of Internal Auditing Operational Audit Budgetary Control System Capacity Utilization Inventory Control Management Informational System Nature and Scope of Management Audit Audit of Management Process and Functions Specimen Question with Answer Self Examination Question 365 366 381 388 390 392 394 396 397 403 416 423

Study Note - 6 Management Audit in different Function 6.1 Corporate Culture and Objectives 427 428

Page No. 6.2 6.3 6.4 6.5 6.6 6.7 6.8 6.9 Corporate Services Audit Audit of Social Responsibility of Management - Invironmental Polution Control Audit checks of Different Functions Corporate Divisions / department / functions Corporate Governance and Audit Committe Audit Committees and Corporate Governance Confederation of Indian Industries (CII) Code for Desirable Corporate Governance Self-examination Question 480 500 440 442 466 472 477 433

Study Note - 7 Various Types of audit and Their Process 7.1 7.2 7.3 7.4 7.5 7.6 7.7 7.8 7.9 7.10 7.11 7.12 7.13 7.14 7.15 Due Diligence Audit SOX Audit Energy Audit Productivity audit Inventory Audit VAT Audit Computation of Tax Liability Under VAT Special audit of Excise and Customs Records by cost Accountant Legal Position of Special Audit Reports Environment Audit Relevant Provision Under the Indian Constituion Powers of Environment Control Authorities (Extracts From Environment (Protection) Act, 1986 Audit Under ERP Environment Bank Audit 537 538 540 503 504 505 507 511 513 517 519 521 531 534 536

Audit When Goods are Manufacutred in Customs Bonded Warehouse 529

Page No. 7.16 7.17 7.18 7.19 Concurrent Audit Central Excise Circular No. - 821/18/2005 Dated 07.11.2005 Extracts from Central Excise Act, 1944 Self-examination Question 541 541 543 544

Study Note - 8 Fields for Practicing Cost Accountants 8.1 8.2 8.3 8.4 8.5 8.6 8.7 Evaluation Cost and Management Accounting Fields for Practising Cost Accountants Other Services World Trade Organisation (WTO) Anti-dumping Processing - Introduction Assessment and Quantication of Losses Under Marine, Fire and Accident Polocies Specimen question with Answers 606 614 547 548 548 558 561 565

Study Note - 9 Professional Ethics 9.1 9.2 9.3 9.4 9.5 9.6 9.7 9.8 9.9 9.10 Professional Value and Ethics Misconduct for Cost Accountants - Introductions Constitution of Disciplinary Directorate, Board of Discipline and Disciplinary Committee Procedure of Enquring into Misconduct Procedure for Filing Complaint Penalties for Miscoduct Board of Discpline Disciplinary Committee IFAC Guidelines for Professional Values and Ethics Professional Behaviour 618 620 621 625 626 628 630 634 615 616 617

Page No. 9.11 9.12 9.13 9.14 Self Regulation Guidelines Guidelines for Advrtisement by Cost Accountants in Practice Specimen question With Answer Self-examination Question 651 653 681 681

Study Note - 10 Auditing and Assurance Standards 10.1 10.2 10.3 10.4 10.5 10.6 10.7 10.8 10.9 Need for Oversight - an Introduction Lack of Clarity in Accounting Statements Assurance Services The Cost and Assurance Standards Board (CAAB) Quality Review Board (QRB) Review Procedure to be Followed by the Quality Review Board ICWAI as IFAC Member Steps Taken by the International Auditing and Assurance Standards Board (IAASB) to Improve the Clarity of its Standards (Clarity Project) 691 Appendix - A 693 694 697 698 701 10.10 Appendix - B 10.11 Appendix - C 10.12 Appendix - D 10.13 Appendix - E 683 684 685 685 687 688 690 690

STUDY NOTE - 1

Basics of Cost AuditThis Study Note includes: Nature and Scope of Cost Audit Provisions under Companies Act relating to maintenance of Cost Records and Cost Audit Cost Auditor Responsibilities Appointment, Rights and

Planning and structuring the Cost Audit

Basics of Cost Audit 1.1 Nature and Scope of Cost Audit

1.1.1 Origin of Cost Audit1.1.1.1 Methods and techniques of cost accounting and audit of cost accounts in India can be traced back to the year 1925, when large number of rms were given contracts by the Government of India on cost plus basis and the Government started verifying and investigating the cost structure of such rms. 1.1.1.2 Need for large scale industrialization immediately after the independence required lot of concessions and facilities to the entrepreneurs to establish industrial undertakings for production of common mans goods and essential services. Power, electricity and other inputs were provided at concessional rates. Liberal nances were provided by the banks and other nancial institutions. Land was made available with all infrastructures. Transport facilities were also provided. However, there were only very few industrial groups and it was a suppliers market in almost all the areas. There were many bureaucratic hurdles in opening of new industries along with need for licenses and permits. Imports were mostly prohibitive due to scarce foreign exchange and very high rate of custom duties on imports. Therefore, consumers had very few choices and there were often complaints of excessive pricing, which encouraged smuggling and other malpractices like underinvoicing of imports to save custom duties or over-invoicing of exports to get higher export benets. The high prices were often justied on the basis of higher indigenous cost of production. Thus the government felt the need for price controls. 1.1.1.3 The investigations of Dalmia-Jain group of companies further brought out the need for more effective audit. Thus cost audit gained recognition, both as an effective tool of cost-control in the hands of management to control costs and produce at competitive rates and also as a monitoring mechanism on behalf of other stakeholders including the consumer and the government. Cost Audit as a tool in the hands of Management enabled them to identify the inefciencies. It acts as a review of the activities of the various cost centers of the company and points out the avoidable wastages and losses. The expertise and experience of the Cost Auditor helps them in knowing the exact areas having the scope for cost control and cost reduction through inter-rm comparison with standard industrial norms or peers in the industry. Government in turn ensured that the consumers are able to obtain their requirements at a fair price and do not pay for the inefciency of manufacturers. 1.1.1.4 Consequently, the Companies Act, 1956 was amended in the year 1965 to incorporate the provisions relating to the maintenance of Cost Accounting Records and Cost Audit. These amendments were made on the basis of recommendations from the Vivian Bose Commission, Dutta Commission and the Shastry Committee.

1.1.2 Introduction to Cost Audit1.1.2.1 Cost audit is the audit of cost records. According to Chartered Institute of Management Accountants, London (CIMA), cost audit is the verication of the correctness of cost accounts and of the adherence to the cost accounting plan. In other words, cost audit is the verication of the cost of production of any product, service or activity on the basis of accounts maintained by an enterprise in accordance with the accepted principles of cost accounting. This denition of Cost Audit is relevant to the voluntary Cost Audit without any statutory backing.2

Cost Audit & Operational Audit1.1.2.2 The Institute of Cost and Works Accountants of India on the other hand, denes cost audit as a system of audit introduced by the Government of India for the review, examination and appraisal of the cost accounting records and attendant information, required to be maintained by specied industries. Thus the concept and scope of cost audit as dened in India is more specic and lays emphasis on the evaluation of the efciency of operations and the propriety of management actions as introduced by the Government of India for specied industries. In this sense, cost audit in India appears to be synonymous with efciency audit mainly as a guide for management policy and decision making besides being a barometer of actual performance. 1.1.2.3 The justication for mandatory Cost Accounting and Cost Audit provisions has been very well explained in the Parliamentary Debate that led to the adoption of Companies Amendment Bill, 1965 incorporating the provisions related to Sections 209 (1) (d) and 233B. Smt. Tara Ramchandra Sathe (MP for Maharashtra) stated during the relevant Rajya Sabha Debate as under: What is Cost Audit? The Cost Audit is quite different from the Financial Audit. It is to see whether the labour is efcient or not, whether the industry has provided efcient labour or the labour which is required by that industry is less than what is required, whether every material and every part of the machinery is used to the optimum, whether any material is wasted, etc. As we all know, we are short of material, there is so much material which is imported, when we are short of foreign exchange. In these circumstances, it is very essential that there should be cost audit. In fact, it should be introduced in almost all the industries, but the Government is trying this in certain cases only. So by this we will know whether there is a proper utilization of the material or not. It is very essential, no doubt, and in factories and industries, everywhere, this cost audit should be emphasized. (Proceedings of Rajya Sabha, 14th September, 1965: Columns 3944 and 3945). 1.1.2.4 Thus Cost Audit in India refers to the statutory Cost Audit of the selected companies covered under the relevant provisions of the Companies Act, 1956. These requirements are mandatory and non-compliance may invite penal provisions also.

1.1.3 Relevance of Cost Audit1.1.3.1 In the initial years, Cost Audit was taken merely as a tool for price control mechanism for consumer and infrastructure industries in India. The main objective of Cost Audit when statutorily introduced under the provisions of Companies Act, 1956 was to meet the Government requirements for regulating the price mechanism in core industries like Cement, Sugar, Textiles and consumer industries like Vanaspati, Formulations and Automobiles. The objective was to provide an authentic data to the Government to regulate the demand and supply in the country through a price control mechanism. 1.1.3.2 The liberalization of the economy and consequential globalization has further enhanced the need for authentic data. Therefore, the Cost Audit Report Rules have been amended from time to time to ensure that the comprehensive authentic information is available in the format required. The basic structure of the cost audit was laid down by the Cost Audit (Report) Rules, 1968 as prescribed under the relevant provisions of Companies Act, 1956. They were superceded by the Cost Audit (Report) Rules 1996, which were notied vide GSR 511(E) dated 5.1.1996. These Cost Audit (Report) Rules 1996 were also subsequently superceded by the Cost Audit Report Rules 2001, which were notied vide GSR 294(E) dated 27.12.2001.3

Basics of Cost Audit1.1.3.3 The necessity for and utility of properly documented information is more keenly felt now than ever before. In most parts of the world, free competition co-exists with appropriate rules and regulations to ensure free trade and absence of unfair practices. Therefore, in the present competitive scenario of globalization, the Cost Audit Reports have assumed greater importance and signicance being the important source of reliable and authentic feedback to the government and its various departments and agencies. It may be claried here that the Cost Audit Reports do not only contain merely the cost details, but are full of information related to all aspects of business organization which, if harnessed properly can provide a comprehensive analysis about the company, the industry and the economy as a whole. The Cost Audit Report serves as an effective tool of information in the hands of directors on the Board ensuring good corporate governance. 1.1.3.4 In an environment of increasing foreign trade under WTO regime, dumping of products at very low prices have become a serious issue in the international trade. This dumping of products, often well below the cost price, if not properly countered may harm the indigenous industry. The cost records and the cost audit report play a very critical role in defense of local industry to substantiate their fair approach against any allegation of dumping. Similarly, when dumping allegations are levied against the exports by the Indian companies to any foreign company, the Cost Audit Reports can provide the valuable feedback to protect the interest of Indian companies. 1.1.3.5 The practice of selling below cost to ward off competition attracts the penal provisions of the Competition Law. This necessitates the availability of authentic cost details of the products marketed by industry and business houses to determine normative pricing or fair pricing. In fact, Competition Law to be effective against any anti-competition activity presupposes the availability of reliable and authentic cost data. 1.1.3.6 The transfer pricing issue has gained considerable momentum in international scenario. Cost Audit Report Rules 2001 include the provisions to take care of this aspect in right perspective. The fundamentals of transfer pricing are based on arms length throughout the world. The cost details form the very basis of determining arms length transfer pricing policy of any country. An audited cost records and the resultant Cost Audit Report becomes a majorsource of information, which can be effectively used by both Indirect and Direct Tax Authorities. The Central Excise Authorities also use Cost Audit Reports for verifying claim of the companies relating to ex-factory prices of the excisable goods especially in the case of inter-unit transfers. 1.1.3.7 The Tariff Commission relies on authenticity of the cost audit reports and makes use of these reports extensively in xation of tariffs for the products covered under Cost Accounting Records Rules. The Cost Audit Reports are also made use of by the respective administrative Ministries of Government of India for xation of administrative prices and working out subsidy, etc. Fertilizer Industry Coordination Committee (FICC) under the Department of Fertilizers and the Directorate of Sugar under Ministry of Food use Cost Audit Reports extensively in taking decision with respect to the Industries under their purview. The Cost Audit Reports relating to Bulk Drugs and Formulations are used by the National Pharmaceutical Pricing Authority for xation of prices of various drugs and formulations covered under the Drug Price Control Order, 1995. 1.1.3.8 The Cost Audit Reports have great potential in government procurements especially in case of non-competitive procurements. There are no effective anti-trust laws in India. This always leaves a scope for the traders/suppliers to charge exorbitant prices from the government supplies. For

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Cost Audit & Operational Auditexample, Clayton Act in USA clearly provides that any discrimination in price, services or facilities shall be unlawful in USA. It also prohibits the discrimination in rebates, discounts or underselling in particular localities. This Act further provides that any differential in prices etc., shall have to be justied on the grounds of differences in the cost of manufacture, sale or delivery resulting from the differing methods or quantities in which such commodities are sold or delivered and the burden of rebutting the prima-facie case shall be upon the person charged with a violation of this act. The Clayton Act also provides that it shall be unlawful for any person to induce or receive a discrimination in price, which is prohibited under the act. In other words, each seller of product or service can charge a uniform price only in the USA. However, this is not the case in India, where each purchaser may be charged a differential price by the supplier or the trader. A signicant portion of the government budget is spent every year on procurements, where reasonability of purchase price is always an issue. Therefore, Cost Audit Reports can always ll the vacuum in government procurements ensuring reasonability of prices. Similarly in USA, an Incurred Cost statement is made with respect to major projects funded out of Government budgets. This incurred cost is nothing but Cost Audit Report. 1.1.3.9 In addition to above, Government has been giving various incentives for exports by the Indian Industries. These incentives are mainly to refund the taxes paid in the country to provide level playing eld to the Indian Industry. Similarly many of the exporters import duty - free material for exports after further processing, where actual productivity is a major issue. Cost Audit Reports provide not only the actual amount of various taxes paid by any unit but also provide the actual productivity and wastage. Thus Cost Audit Reports can benet the Indian Industry to get at par with global competitors.

1.1.4 Features of Cost Audit1.1.4.1 The cost audit of the companies under the relevant provisions of the Companies Act, 1956 has the following features: (i) (ii) Assessing compliance of the relevant cost accounting records rules as applicable to the product under review; Study of the costing system to assess whether it is adequate for the cost ascertainment of the product under review;

(iii) Evaluation of the operating and other efciencies of the organization under audit with special reference to the product under review; to ensure the submission of necessary details required under the Cost Audit Report Rules, 2001 as amended from time to time. (iv) Submission of Cost Audit Report in the format prescribed. 1.1.4.2 Since cost audit is carried out under the various provisions of the Companies Act, 1956, a thorough and comprehensive knowledge of the Indian Companies Act including various rules prescribed thereunder and the circulars issued by the Ministry of Corporate Affairs is essential for conducting an effective Cost Audit.

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Basics of Cost Audit 1.1.5 Objectives of Cost Audit1.1.5.1 Cost Audit has both general and social objectives. The general objectives can be described to include the following : Verication of cost accounts with a view to ascertaining that these have been properly maintained and compiled according to the cost accounting system followed by the enterprise. Ensuring that the prescribed procedures of cost accounting records rules are duly adhered to. Detection of errors and fraud. Verication of the cost of each cost unit and cost center to ensure that these have been properly ascertained. Determination of inventory valuation. Facilitating the xation of prices of goods and services. Periodical reconciliation between cost accounts and nancial accounts. Ensuring optimum utilization of human, physical and nancial resources of the enterprise. Detection and correction of abnormal loss of material and time. Inculcation of cost consciousness. Advising management, on the basis of inter-rm comparison of cost records, as regards the areas where performance calls for improvement. Promoting corporate governance through various operational disclosures to the directors.

1.1.5.2 Among the social objectives of cost audit, the following deserve special mention : Facilitation in xation of reasonable prices of goods and services produced by the enterprise. Improvement in productivity of human, physical and nancial resources of the enterprise. Channelising of the enterprise resources to most optimum, productive and protable areas. Availability of audited cost data as regards contracts containing escalation clauses. Facilitation in settlement of bills in the case of cost-plus contracts entered into by the Government. Pinpointing areas of inefciency and mismanagement, if any for the benet of shareholders, consumers, etc., such that necessary corrective action could be taken in time.

1.1.6 Scope of Cost Audit1.1.6.1 Section 227(2) of the Companies Act, 1956, requires the auditor of a company to state whether the accounts in his opinion give a true and fair view of the state of the companys affairs in the case of the balance sheet and of the prot or loss for its nancial year in the case of the prot and loss6

Cost Audit & Operational Auditaccount. Therefore, statutory nancial audit of a company conducted by the Chartered Accountant is an essential annual feature of all the companies registered under the provisions of Companies Act, 1956. The Board of Directors of every company has a statutory obligation to place its audited annual accounts viz. Prot and Loss Account and Balance Sheet before the shareholders in the Annual General Meeting, duly certied by a Chartered Accountant appointed as an Auditor under the provisions of Section 224 of the Act. However, there is no corresponding statutory provision for compulsory annual audit of cost accounts of a company covered under Section 209(1)(d) of the Companies Act or under relevant Cost Accounting Records Rules. 1.1.6.2 One of the pre-requisites of cost audit is the maintenance of cost accounting records by the company. Section 209(1)(d) makes it obligatory for a company pertaining to any class of companies engaged in production, processing, manufacturing or mining to maintain such particulars relating to utilization of material or labour or to other items of cost as may be prescribed, if such class of companies is required by the Central Government to include such particulars in the books of accounts. The rules provide that only those companies, which are covered under Section 209(1)(d) of the Companies Act and a specic Cost Audit Order has been issued with reference to a specied product by the Cost Audit Branch of Ministry of Corporate Affairs are required to get their cost accounts audited with respect to that specic product. Moreover, Cost Audit Report is not placed before the shareholders during the Annual General Meeting. 1.1.6.3 The Central Government prescribes the separate cost accounting records for each class of companies i.e. companies manufacturing a particular class of product or activity like Cement, Steel, Chemicals and Electricity etc. and these are called the Cost Accounting Records Rules for that specic industry or class of companies. When cost accounting records/formats are prescribed, they apply to those companies engaged in the manufacture of a particular product or activity. In the case of companies engaged in production or processing of other products or activities also in addition to production, processing or manufacture of the specied product, the records will have to be maintained only for the manufacture of particular product for which rules are issued and not necessary for other products. A company manufacturing bulk drugs, formulation and watches need not necessarily maintain cost accounting records in respect of watch making activity if no statutory rules are prescribed for watch making activity. The detailed provisions relating to the manner of prescription of cost accounting records, selection of the product, the contents of the rules and the list of products/ industries covered by the statutory rules under Section 209(1)(d) of the Companies Act have also been explained in Study Notes 2 and 3. Thus Cost Audit u/s 233B does not embrace a particular activity of the company unless a separate cost accounting record rule is already notied for that particular activity under Section 209(1)(d) detailing the nature of cost accounting records to be maintained. 1.1.6.4 The legal provisions relating to statutory cost audit are applicable only to companies registered under the provisions of Companies Act, 1956. Therefore, cost audit is not applicable to other enterprises like partnership, cooperative societies, etc. The Cost Audit is conducted by a Cost Accountant in practice within the meaning of the Cost and Works Accountants Act, 1959. The cost auditor is appointed by the Board of Directors of the company with the previous approval of the Central Government. The report of cost auditor is to rendered to the Central Government with a copy to the Company.

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Basics of Cost Audit 1.1.7 Cost Audit and Efciency Audit1.1.7.1 Efciency Audit is systematic appraisal of management methods and is intended to assess the actual performance levels relative to applicable peer benchmarks or internal standards (e.g., protability or stated business plan objectives etc.). The process is also designed to identify opportunities to ensure performance benets. It aims at identifying efciency and productivity improvement opportunities so that the resources ow into the most remunerative channels to ensure the optimum returns. 1.1.7.2 The parameters of measuring efciency include overall rate of return, capacity utilization, utilization of national, nancial, physical and human resources, cash ow performance and the pay back period of the entire organization. Thus efciency audit seeks to evaluate the overall organizational efciency. 1.1.7.3 The cost audit report also mainly the comment on the efciency of the company namely, utilization aspect of the factors of production. To enable the cost auditor to make efciency audit, Section 209 (1) (d) of the Companies Act provides for records of utilization of material, labour and other items of cost. Since a proper appraisal of the extent of efciency of utilization of factors of production is possible in cost audit, it may appropriately be called efciency audit. 1.1.7.4 The cost audit as efciency audit can also be understood from the fact that cost audit reports enable the determination of accurate costs of production of various products, services and activities with a view to compare the same with the comparable gures of the earlier years and those of the peers or benchmarks in the industry. It seeks to identify the areas of inefciency or poor decision making to ensure diversion of funds to most optimum channels. The information regarding exact unit costs after proper allocation of overheads, capacity utilization, per unit consumption of major raw materials (including power and fuel), man-hour productivity, idle hours or un-productive manpower wastage etc. serve as basis for efciency audit and helps in xing appropriate prices of goods and services produced by the company to ensure optimum returns. The detailed nancial analysis of the company in cost audit report like determination and comparison of different ratios like prot as % of capital employed, prot as % of net sales, value addition, current asset as % of current liabilities, prot as % of capital employed etc. help in assessing the operational efciency and comparing the nancial health of the undertaking with the peers or others in the industry aiming at bringing all round efciency.

1.1.8 Cost Audit and Propriety Audit1.1.8.1 Propriety audit stands for verication of transactions in the best interest of the public, commonly accepted customs and standards of conduct. The term propriety has been dened by Kholer as that which meets the tests of public interest, commonly accepted customs and standards of conduct and particularly as applied to professional performance, requirements of Government regulations, and professional codes. The tests boil down to consideration of nancial prudence and economy, instead of too much dependence on documents, vouchers etc. It shifts the emphasis to nd the wisdom and appropriateness of expenditure, rather than verifying whether it has been duly authorized or evidenced by proper vouchers etc. 1.1.8.2 In other words, the propriety audit seeks to ensure that the planned expenditure would yield the optimum returns and there is no other better alternative available. It seeks to ensure that the8

Cost Audit & Operational Auditexpenditure is not only appropriate to the circumstances of each case, it has indeed achieved the objectives for which it has been incurred. The audit of public sector undertakings as undertaken by the Comptroller and Auditor-General of India is the best example of propriety audit. 1.1.8.3 The Cost Audit Reports can be termed as propriety audit as these reports seeks to ensure that actual expenditure at each stage is appropriate and optimum returns have been achieved. The cost auditor always aims at ensuring that the actual expenditure should not be prima facie more than what the occasion demands. The cost auditor has to report on matters which appear to him to be clearly wrong in principle, cases where the companys funds have been used in a negligent or inefcient manner, arms length pricing of related party transactions, etc. These are the areas where the propriety aspect is involved and therefore cost audit may be in the nature of propriety audit.

1.1.9 Cost Audit and Management Audit1.1.9.1 Cost audit report and the information to be furnished therein is prescribed by the Central Government. However, most of the information contained in the cost audit report is relevant for making managerial decisions. Normally a management audit is an audit for the management and by the management. Such audit looks into the economy and the effectiveness of performance of various activities of an organization. Cost audit also looks into the effectiveness of performance and efciency in various areas such as capacity, input costs of materials, utilities and other controllable areas so far as the manufacturing aspect is concerned. Detailed information on these areas has to be given in the cost audit report by the cost auditor comparing it with the standards and past actuals wherever necessary. Since Cost Audit is very useful to the management as it points out areas where performance can be improved, it can be called an audit for the management. Though cost audit is not done at the behest of the management, it does not change its character from being a management tool.

1.1.10 Cost Audit and Social Audit1.1.10.1 Social audit is generally dened to be the audit of data or information depicting social performance of a business in contrast to its normal economic performance as measured in nancial audit. 1.1.10.2 A lot of research and experimentation are being conducted to device techniques or models, which can measure the contribution of an enterprise to the society. These developments result from an increasing realization of the fact that business undertakings have social responsibilities also and that the performance as a whole should be seen in this context. 1.1.10.3 Social performance is discharged by providing some social amenities for the use of community as a whole e.g. provision of a hospital, a recreation club, a temple, etc. As provision of such amenities involves diversion of prots earned by the business for charitable or philanthropic purposes, it is advisable to conduct an audit of such expenses spent on welfare which are in no way related to the main task of business of production or marketing of goods/services and earning prots. Such activities, which apparently are not directly connected with the main business activity, help the business to create a favorable image for the business and those at the helm of affairs.

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Basics of Cost Audit1.1.10.4 Cost audit provides an adequate information on the cost of production, selling price and margin of prot in respect of each item of product covered by cost audit. This information is very useful to the Government in regulating the prices of essential commodities. Therefore, cost audit can be said to subserve the interest of the community by facilitating the review of prices to be charged to the customer. A review by the government results in fair prices to the consumers which is a major social objective which cost audit is subserving. Thus cost audit is also a social audit.

1.2

Provisions Under Companies Act Relating to Maintenance of Cost Records and Cost Audit

1.2.1 The statutory provisions relating to maintenance of cost accounting records and cost audit were initially introduced by the Companies (Amendment) Act, 1965. Section 209(1)(d) deals with the provisions relating of maintenance of cost accounting records and Section 233B deals with the audit of cost accounts in the certain cases. The amended Section 233B provides that the cost audit can be conducted only by those cost accountants, who are not whole time employees elsewhere. These provisions also provides for a ceiling on the number of cost audits that can be carried out by a cost accountant or a rm of cost accountants. These provisions are explained in detail as under:

1.2.1 Maintenance of Books of Accounts (Section 209(1)(d))1.2.1.1 Section 209 deals with the books of accounts required to be maintained by the company. Section 209(1) requires that every company is required to maintain at its registered ofce proper books of accounts with respect to: (a) (b) (c) (d) all sums of money received and expended by the company and the matters in respect of which the receipt and expenditure take place: all sales and purchases of goods by the company; the assets and liabilities of the company; and in the case of a company pertaining to any class of companies engaged in production, processing, manufacturing or mining activities, such particulars relating to utilization of material or labour or to other items of cost as may be prescribed, if such class of companies is required by the Central Government to include such particulars in the books of account: Provided that all or any of the books of account aforesaid may be kept at such other place in India as the Board of Directors may decide and when the Board of Directors so decides, the company shall, within seven days of the decision, le with the Registrar a notice in writing giving the full address of that other place. 1.2.1.2 The Central Government has so far prescribed separate Cost Accounting Records Rules with respect to 44 classes of products or activities, which have been explained in detail in subsequent chapters. These Rules require the books of account to be kept in a manner that the cost of production and cost of sales during the nancial year can be properly calculated in the formats prescribed for the respective industries. The books of accounts should also provide all the details required with respect to other elements of cost such as materials, wages, stores and overheads etc. However, most of these rules provide exemptions to small scale units having total annual turnover of less than Rs. 10 crores. In other words, Section 209(1)(d) deals with the maintenance of cost records and provides that in the case of a company (pertaining to any class of companies), which is engaged in either10

Cost Audit & Operational Auditproduction or processing or manufacturing or mining activities, the company will also be required to maintain such particulars in its books of accounts relating to utilization of material or labour or to other items of cost as may be prescribed by the Central Government. 1.2.1.3 Section 209(2) provides that where a company has a branch ofce, whether in or outside India, the company shall be deemed to have complied with the provisions, if proper books of account relating to the transactions effected at the branch ofce are kept at that ofce and proper summarized returns, made up to dates at intervals of not more than three months, are sent by the branch ofce to the company at its registered ofce or the other place referred to in sub-Section (1). 1.2.1.4 The reading of Section 209(1), prima facie stipulates that the cost accounting records are to be maintained in the registered ofce of the company. However, a reasonable interpretation of Section 209(2) provides that maintenance of records at the factory, or other locations with periodical returns to registered ofce may also satisfy the letter and spirit of law. However, it may be claried here that cost records are generally never exclusively maintained at the factory. Since marketing costs, administrative costs and other items of expenses incurred in corporate, registered and sales ofces are also subject matter of cost accounting records and cost audit, these post manufacturing expenses including marketing would be incurred in places other than the factory. 1.2.1.5 Section 209(3) requires the books to give a true and fair view of the state of affairs of the company and to explain its transactions. Books are to be kept on `accrual basis and according to double entry system of accounting. 1.2.1.6 Section 209(4) provides that the books of account and other books and papers shall be open to inspection by any director during business hours. 1.2.1.7 Section 209(4)(a) provides that the books of accounts of every company relating to a period of not less than eight years immediately preceding the current year together with the vouchers relevant to any entry in such books of account shall be preserved in good order. However, in case of a company incorporated less than eight years before the current year, the books of account for the entire period preceding the current year to be preserved. 1.2.1.8 Section 209(5) provides that if any of the persons referred to in sub-Section (6) of Section 209 fails to take all reasonable steps to secure compliance by the company with the requirements of Section 209 of the Companies Act or has by his own willful act been the cause of any default by the company, he shall, in respect of each offence, be punishable with imprisonment for a term which may extend to six months, or with ne which may extend to ten thousand rupees, or with both. This sub-Section further provides that no person shall be sentenced to imprisonment for any such offence, unless it was willfully committed. 1.2.1.9 Section 209(6) claries that the persons referred to in sub-Section (5) of Section 209 for punishment are as under: (a) (b) Where the company has a managing director or manager, such managing director or manager and all ofcers and other employees of the company; and Where the company has neither a managing director nor manager, every director of the company.

1.2.1.10 Section 209(7) provides that if any person, not being a person referred to in sub-Section (6), having

11

Basics of Cost Auditbeen charged by the managing director, manager or Board of Directors, as the case may be with the duty of seeing that requirements of this Section are complied with, makes a default in doing so, he shall, in respect of each offence, be punishable with imprisonment for a term which may extend to six months, or with ne which may extend to ten thousand rupees, or with both. 1.2.1.11 These rules require the books of accounts to be kept in a manner that the cost of production and cost of sales of each item (as covered in Section 209(1)(d)) produced or manufactured during the year can be determined in the prescribed format i.e., separate gures for materials, wages, overheads etc. 1.2.1.12 If a company is engaged in manufacture of production of products or activities other than those class of industries as are covered under Section 209(1)(d) also, the cost records may not be maintained for such other products or activities as are not covered under the provisions of cost accounting records rules.

1.2.2 Audit of Cost Accounts in Certain Cases (Section 233 B)1.2.2.1 The Section 233(B) of the Companies Act, 1956 provides that where in the opinion of the Central Government it is necessary so to do in relation to any company required under clause (d) of the sub-Section (1) of Section 209 to include in its books of account the particulars referred to therein, the Central Government may, by order direct that an audit of cost accounts of the company shall be conducted in such manner as may be specied in the order by an auditor who shall be a cost accountant within the meaning of the Cost and Works Accountants Act, 1959. 1.2.2.2 Section 233B(2) provides that the auditor under Section 233B shall be appointed by the Board of directors of the company in accordance with the provisions of sub-Section (1B) of Section 224 and with the previous approval of the Central Government. It further provides that before the appointment of any auditor is made by the Board, a written certicate shall be obtained by the Board from the auditor proposed to be so appointed to the effect that the appointment, if made, will be in accordance with the provisions of sub-Section (1B) of Section 224. 1.2.2.3 Section 233B(3) provides that the audit conducted by the auditor under this Section (cost audit by Cost Accountant) shall be in addition to an audit conducted by an auditor appointed under Section 224 (Financial Audit by Chartered Accountant). 1.2.2.4 Section 233B(4) provides that a cost auditor shall have the same powers and duties in relation to an audit conducted by him under this Section as an auditor of a company has under sub-Section (1) of Section 227 (nancial audit) and such (cost) auditor shall make his report to the Central Government in such form and within such time as may be prescribed and shall also at the same time forward a copy of the report to the company. 1.2.2.5 Section 233B(5)(a) provides that a person referred to in sub-Section (3) or sub-Section (4) of the Section 226 shall not be appointed or re-appointed for conducting the audit of the cost accounts of a company. Section 226 of the Companies Act provides qualications and disqualications of auditors. Sub para (3) of the said Section provides that the following are not qualied for appointment as Auditor of a company: (a) a body corporate;

12

Cost Audit & Operational Audit(b) (c) (d) an ofcer or employee of the company; a person who is a partner, or who is in the employment, of an ofcer or employee of the company; a person who is indebted to the company for an amount exceeding one thousand rupees or who has given any guarantee or provided any security in connection with the indebtedness of any third person to the company for an amount exceeding one thousand rupees; a person holding any security of that company after a period of one year from the date of commencement of the Companies (Amendment) Act, 2000. (Explanation: security means an instrument which carries voting rights); The sub-Section (4) of Section 226 provides that a person shall also not be qualied for appointment as auditor of a company if he is, by virtue of sub-Section (3), disqualied for appointment as auditor of any other body corporate which is that companys subsidiary or holding company or a subsidiary of that companys holding company, or would be so disqualied if the body corporate were a company. In other words, if a person is disqualied under any of the aforesaid classes from being appointed as an auditor of any company or body corporate, he cannot be appointed as auditor of its holding company, subsidiary or cosubsidiary; and A person, who is in full time employment elsewhere. Sub Para (4) of Section 226 provides that if anybody is disqualied for being appointed as auditor under Section 137, he cannot be appointed as auditor for its holding company, subsidiary or co-subsidiary. 1.2.2.6 Section 233B(5)(b) provides that a person appointed under Section 224 as an auditor of a company shall not be appointed or re-appointed for conducting the audit of the cost accounts of that company. 1.2.2.7 Section 233B(5)(c) provides that if a person, appointed for conducting the audit of cost accounts of a company, becomes after his appointment, to any of the disqualications specied in clause 5(a) or 5(b) above, he shall on and from the date on which he becomes disqualied, shall cease to conduct the audit of the cost accounts of the company. 1.2.2.8 Section 233B(6) provides that upon receipt of an order under Section 233B(1), it shall be the duty of the company to give all facilities and assistance to the person appointed for conducting the audit of the cost accounts of the company. 1.2.2.9 Section 233B(7) provides that the company shall, within thirty days from the receipt of a copy of the report referred to in Section 233B(4), furnish the Central Government with full information and explanations on every reservation or qualication contained in such report. 1.2.2.10 Section 233B(8) provides that if, after considering the report referred to in Section 233B(4) and the information and explanations furnished by the company under Section 233B(7), the Central Government is of opinion that any further information or explanation is necessary, the Government may call for such further information and explanation and thereupon the company shall furnish the same within such time as may be specied by that Government.

(e)

(f)

(g)

13

Basics of Cost Audit1.2.2.11 Section 233B(10) provides that the Central Government may direct the company whose cost accounts have been audited under this Section to circulate to its members, along with the notice of the annual general meeting to be held for the rst time after the submission of such report, the whole or such portion of the said report as it may specify in this behalf. 1.2.2.12 Section 233B(11) provides that if default is made in complying with the provisions of this Section, the company shall be liable to be punished with ne which may extend to fty thousand rupees and every ofcer of the company who is in default, shall be liable to be punished with imprisonment for a term which may extend to three years, or with ne which may extend to fty thousand rupees or with both. 1.2.2.13 Based on the aforesaid provisions, the main features of the Cost Audit Section 233(B) are now summarized as under: (a) (b) (c) (d) Cost audit is to be conducted only when the Central Government directs such an audit. [Sec. 233B(1)] The auditor for this purpose is to be appointed by the Board of Directors, with the previous approval of the Central Government. [Sec. 233B(2)] Cost audit is in addition to nancial audit, which is conducted by an auditor (nancial auditor) under Sec. 224. [Sec. 233B(3)] The cost auditor has same powers as nancial auditor has, under Sec. 227 (1). The cost auditor is to submit his report to the Central Government, in the form and within the time prescribed, with a copy to the company. [Sec. 233B(4)]. Persons referred to in sub-Section (3) or sub-section (4) of Section 226 shall not be appointed or re-appointed as cost auditor of the company. Similarly a person appointed under Section 224 (Financial Auditor) also cannot be appointed as the cost auditor of the company. [Sec. 233B(5)]. It is the duty of the company to give all facilities and assistance to the cost auditor. [Sec. 233B(6)]. The company shall within thirty days from the date of receipt of a copy of the report, furnish to the Central Government with full information and explanation on every reservation or qualication contained in the report. [Sec. 233B(7)]. The Central Government may call from the company further details which shall be provided within the specied time. [Sec. 233B(8)]. The Central Government may take appropriate action on the report as it may consider necessary. [Sec. 233B(9)]. The Central Government may direct the company to circulate to its members whole or part of the report with the notice of AGM to be held for the rst time after the submission of the report. [Sec. 233B(10)]. Penal action is for default in complying with the provisions of this Section. The company liable to ne extending to Rs. 50,000/- and every ofcer of the company who is in default shall be liable to be punished with imprisonment for a term which may extend to three years, or with ne which may extend to Rs. 50,000/- or with both.

(e)

(f) (g)

(h) (i) (j)

(k)

14

Cost Audit & Operational Audit

1.3

Cost Auditor Appointment, Rights and Responsibilities

1.3.1 Issue of Cost Audit Order1.3.1.1 Issue of Cost Audit Order is the rst step in Cost Audit of any company. The Central Government issues a specic order under Section 233(B)(1) of the Companies Act, 1956 on a particular company directing it to get its cost records audited by a practicing Cost Accountant indicating the product for which the order is issued and the period for which it is ordered. Therefore, the starting point for the cost audit exercise is the receipt of cost audit order by the company, specifying the year and the product for which such cost audit is to be conducted. However, the Cost Audit Branch has now been issuing Cost Audit Orders on regular basis to all the companies covered (i.e. every nancial year thereafter continuously until further orders.) This amounts to saying that once an order is issued, the cost audit is required to be done every year unless it is specically withdrawn. 1.3.1.2 It may be claried here that since the cost audit order issued by the Cost Audit Branch species the product, the Company need not have a cost audit for the product not specied in that order. Thus, if the company producing Sugar, Cement and Steel receives an order relating to Sugar for the year ending 31st March, 2009, then it need not get the cost records for products Cement and Steel audited under Sec. 233B for the year ending 31st March, 2009. Similarly for subsequent years also, it needs to get its cost records for Sugar only cost audited unless it gets a specic order on other products also.

1.3.2 Qualication of Cost Auditor1.3.2.1 Section 233(B) of the Companies Act, 1956 provides that the Central Government may, if it considers necessary, direct that the audit of cost accounts kept by a company for a specied product or activity under Section 209(1)(d) shall be conducted by an auditor who shall be a cost accountant within the meaning of the Cost and Works Accountants Act, 1959. In other words, the Sec. 233B(1), in so far as it relates to qualications of cost auditor provides that a person holding certicate of practice from the Institute of Cost and Works Accountants of India only can be appointed as a cost auditor. The cost auditor may be an individual cost accountant or a rm of cost accountants with at least two partners. A rm of cost accountants can be constituted with the previous approval of the Central Government/Institute as required under the regulation 113 of the Cost and Works Accountants Act, 1959 as amended from time to time and in which all the partners are cost accountants holding certicate of practice issued by the Institute of Cost and Works Accountants of India. Section 224 (1-B) of the Companies Act, 1956 further provides that a person can be appointed as a cost auditor only if he is not in full time employment elsewhere. 1.3.2.2 A proviso to Section 233B(1) lays down that if the Central Government is of opinion that sufcient number of cost accountants within the meaning of the Cost and Works Accountants Act, 1959 are not available for conducting the audit of the cost accounts of companies generally, the Government may, by notication in the Ofcial Gazette, direct that, for such period as may be specied in the said notication, such Chartered Accountant within the meaning of the Chartered Accountants Act, 1949, as possesses the prescribed qualications, may also conduct the audit of the cost accounts of companies. It may be claried here that the Central Government has not so far issued any notication under the above proviso.15

Basics of Cost Audit1.3.2.3 There are several members of the Institute of Cost and Works Accountants of India (ICWAI), who have qualied the examination of both the Institutes namely ICWAI and the Institute of Chartered Accountants of India and thus are eligible for membership as well as certicate of practice from both the Institutes. However, none of the members can hold certicate of practice in more than one Institute under the provisions of both the Institutes. Therefore, practically there is no possibility of any nancial auditor to practice as cost auditor or vice versa. 1.3.2.4 However, it is only in the background of the aforesaid proviso that Section 233B(5)(b) provides that a person appointed under Section 224 as an auditor of the company (nancial auditor) shall not be appointed or re-appointed for conducting the audit of the cost accounts of a company (cost auditor of the same company).

1.3.3 Disqualications of a Cost Auditor1.3.3.1 The disqualications of a person for being appointed or re-appointed for conducting the cost audit are detailed in sub-Sections (a), (b) and (c) Section 233 (5) of the Companies Act, 1956 detailed as under: (a) The sub-Section (5)(a) provides that a person referred to in sub-Section (3) or sub-Section (4) of the Section 226 shall not be appointed or re-appointed for conducting the audit of the cost accounts of a company. The sub-Section 5(b) provides that a person appointed under Section 224 as an auditor of a company shall not be appointed or re-appointed for conducting the audit of the cost accounts of that company. The sub-Section (5)(c) provides that if a person, appointed for conducting the audit of cost accounts of a company, becomes after his appointment, to any of the disqualications specied in clause 5(a) or 5(b) above, he shall on and from the date on which he becomes disqualied, shall cease to conduct the audit of the cost accounts of the company.

(b)

(c)

1.3.3.2 Section 226 of the Companies Act, 1956 provides for the qualications and disqualications of the auditors. Reading of sub-Section (3) of Section 226 implies that the following persons cannot be appointed or reappointed as cost auditor of a company (a) (b) (c) (d) a body corporate; an ofcer or employee of the company; a person who is a partner, or who is in the employment, of an ofcer or employee of the company; a person who is indebted to the company for an amount exceeding one thousand rupees or who has given any guarantee or provided any security in connection with the indebtedness of any third person to the company for an amount exceeding one thousand rupees; a person holding any security of that company after a period of one year from the date of commencement of the Companies (Amendment) Act, 2000. (Explanation: security means an instrument which carries voting rights);

(e)

16

Cost Audit & Operational Audit1.3.3.3 The sub-Section (4) of Section 226 provides that a person shall also not be qualied for appointment as auditor of a company if he is, by virtue of sub-Section (3), disqualied for appointment as auditor of any other body corporate which is that companys subsidiary or holding company or a subsidiary of that companys holding company, or would be so disqualied if the body corporate were a company. In other words, if a person is disqualied under any of the aforesaid classes from being appointed as an auditor of any company or body corporate, he cannot be appointed as auditor of its holding company, subsidiary or co-subsidiary; and 1.3.3.4 A person, who is in full time employment elsewhere [Section 224 (1B)]. If an auditor becomes disqualied after his appointment, under any of the above provisions he shall be deemed to have vacated his ofce.

1.3.4 Appointment of rm as Cost Auditor1.3.4.1 The rules provide that a person appointed as cost auditor should be a member of the Institute of Cost and Works Accountants of India and should also hold a certicate of practice. The term cost auditor refers to both, i.e., individual cost accountant as well as the rm of cost accountants also. 1.3.4.2 The Ministry of Corporate Affairs has specically claried (Appendix II-A) that the question of appointment of cost auditors in rms name for conduct of cost audit has been under examination in the department and it has been decided to approve the appointment of cost auditors in rms name under sub-Section (2) of Section 233-B of the Companies Act, 1956 if such a proposal is received from the Board of Directors of any company subject to the following conditions: (a) (b) All the partners of the rm are practicing cost accountants within the meaning of Sections 6 and 7 of the Cost and Works Accountants Act, 1959, and The rm itself has been constituted with the previous approval of the Central Government/ Institute as required under Regulation 113 of the Cost and Works Accountants Act, 1959 as amended from time to time.

1.3.4.3 The Government have also claried (Appendix II-B) that in case a rm of cost accountants is appointed as cost auditors, authentication of the cost audit report is to be done by the signature of any one of the partners of the rm in his own hand for and on behalf of the rm. The report should not be signed by merely afxing rm name. 1.3.4.4 In the case of rms appointed as cost auditors, each partner of the rm who is not in full time employment can hold appointment as cost auditor of the specied number of companies i.e. twenty companies for each such partner who is not in full time employment elsewhere. However, not more than ten such companies should have a paid up share capital of Rs. 25 lakhs or more.

1.3.5 Powers of the Cost Auditor1.3.5.1 Section 233B(4) of the Companies Act, 1956 gives the cost auditor same powers as the nancial auditor has under Section 227(1). In addition, Rule 6 of the Cost Audit Report Rules also requires the company and every ofcer thereof, including the persons referred to in sub-Section (6) of Section 209 of the Act to make available to the cost auditor, within 135 days from the close of the nancial year of the company, such cost accounting records, cost statements, other books and documents,

17

Basics of Cost AuditAnnexure and Proforma to the Report, duly completed as would be required for conducting the cost audit, and shall render necessary assistance to the Cost Auditor so as to enable him to complete the cost audit and submit his report within the time limit specied in rule 5. Section 233B(6) further provides that it shall be the duty of the company to give all facilities and assistance to the cost auditor so as to enable him to complete the audit and send the report within the prescribed time limit. 1.3.5.2 The powers of the cost auditor under sub-Section (1) of Section 227 are as under: Right to access at all times to the books and accounts and vouchers of the company, whether kept at the head ofce of the company or elsewhere. Entitled to require from the ofcers of the company such information and explanations as he may think necessary for the performance of his duties as an auditor.

1.3.6 Duties of the Cost Auditor1.3.6.1 The duties of the cost auditor are also similar to those of the (nancial) auditor of the company has under sub-Section (1) of Section 227 (Section 223B(4)).The duties of the cost auditor inter-alia include: (a) To ensure that the proper books of accounts as required by Cost Accounting Records Rules have been kept by the company so far as it appears from the examination of those books and proper returns for the purpose of his audit have been received from branches not visited by him; To ensure that the Cost Audit Report and the detailed cost statements are in the form prescribed by the Cost Audit Report Rules by following sound professional practices i.e. the report should be based on veried data and observations may be framed after the company has been afforded an opportunity to comment on them; The underline assumptions and basis for allocation and absorption of indirect expenses are reasonable and are as per the established accounting principles; If the auditor is not satised in any of the aforesaid matters, he may give a qualied report along with the reasons for the same; Sending the Report to the Cost Audit Branch within 180 days from the end of the nancial year with one copy to the company; Sending his replies to any clarication, that may be sought by the Cost Audit Branch on his report. Sending such replies within 30 days from the date of receipt of communication calling for such clarication.

(b)

(c) (d) (e) (f)

1.3.7 Ceiling on Number of Cost Audits1.3.7.1 The sub-Section (2) of Section 233B inter-alia provides that before the appointment of any auditor is made by the Board, a written certicate shall be obtained by the Board from the auditor proposed to be so appointed to the effect that the appointment, if made, will be in accordance with the provisions of sub-Section (1B) of Section 224.

18

Cost Audit & Operational Audit1.3.7.2 Section 224(1)(B) provides that no company or its Board of directors shall appoint or re-appoint any person who is in full time employment elsewhere or rm as its auditor if such person or rm is, at the date of such appointment or re-appointment, holding appointment as auditor of the specied number of companies or more than the specied number of companies. The proviso to Section 224(1B) further provides that the provisions of this sub-Section shall not apply, on and after the commencement of the Companies (Amendment) Act, 2000, to a private company. 1.3.7.3 Explanation I to the Section 224 provides that for the purposes of sub-Sections (1B) and (1C), specied numbers means : (a) in case of a person or rm holding appointment as auditor of a number of companies each of which has a paid-up share capital of less than rupees twenty-ve lakhs, twenty such companies; in any other case, twenty companies, out of which not more than ten shall be companies each of which has a paid-up share capital of rupees twenty-ve lakhs or more.

(b)

1.3.7.4 Explanation II to the Section 224 provides that in computing the specied number, the number of companies in respect of which or any part of which any person or rm has been appointed as an auditor, whether singly or in combination with any other person or rm shall be taken into account. 1.3.7.5 In view of aforesaid provisions, the ceilings on the number of cost audits can be claried as under: (a) In the case of rm of cost accountants: Twenty companies for each such partner of the rm who is not in full time employment. However, not more than ten such companies should have a paid up share capital of Rs. 25 lakhs or more; In the case of an individual cost accountant, who is not in full time employment: Twenty companies, out of which not more than ten should have a paid-up share capital of Rs. 25 lakhs or more.

(b)

1.3.7.6 It can be seen from above that Section 224(1B) and Explanation I to Section 224 refers to the ceilings for the number of companies and not to the number of cost audit orders or products. Therefore, if more than one products of a particular company are covered under cost audit for the same year, a cost auditor should count their number as one company only, since the audits for all the products relate to the same company despite the fact that separate cost audit orders have been issued with respect to each such product. Similarly, if that company appoints different cost auditors for different products, each auditor shall count the company as one company for counting their individual quota for number of audits. 1.3.7.7 It should be noted that the Companies (Amendment) Act, 2000 has inserted a provision (Explanation II) to Section 224, whereby the provisions of sub-section 1-B shall not apply to a Private Company. It means that for computing the limit on number of companies for audit, Private Companies should not be counted.

1.3.8 Number of Cost Audits at any Point of Time and Tenure of Cost Auditor1.3.8.1 As already stated above, Section 224(1)(B) provides a ceiling on number of audits that a person can hold on the date of appointment or re-appointment i.e. at any point of time. Section 233B(2)19

Basics of Cost Auditfurther provides that a written certicate shall be obtained from the cost auditor to the effect that the proposed appointment, if made, will be in accordance with the prescribed ceiling, before the appointment of any cost auditor is made by the Board. Therefore, it becomes important to know when the holding of appointment as cost auditor begins and when it ends. 1.3.8.2 The appointment of cost auditor is by the Board, subject to the approval of the Central Government. The question arises whether appointment begins from the date of the resolution of the Board or only after the approval of the Central Government i.e. date of approval. A clarication issued by the Company Law Board (Appendix II-C) states that the appointment of an auditor is complete only when the company intimates in writing to the cost auditor that he has been appointed (Refer circular no. 52-354 CAB-87 dated 30/8/88 The Management Accountant, October, 1988 issue Page 719 Appendix II-C). This is further amplied by the subsequent clarication reference No. 3/8/89-CL.V dated 5th March, 1990 (Appendix E) addressed to ICWAI claries that the number of companies in respect of which reports have not been submitted should be taken into account for the purposes of ceiling on cost audit. However, the clarication reference No. 35/1/90-CL III dated 2nd March, 1990 (Appendix II-D) to ICAI states that the auditors will take into account not only the actual appointments as auditors but also the proposed appointments in companies for which they have given their consent. But this clarication is applicable to Chartered Accountants only as no approval from Central Government is required in this case. Therefore, it may be advisable that the cost auditor takes into account the number of companies which had submitted applications in Form 23-C forwarding his name for appointment as the cost auditor. Otherwise the cost auditor may nd himself having agreed to be cost auditor of more than the permissible limit at any particular time. 1.3.8.3 The second issue relates to the time or date when his appointment comes to an end. In case of nancial auditor, the question is specically answered by Sec. 224(1), which provides that he shall hold ofce until the conclusion of next annual general meeting. However in case of cost audit, the cost auditor may have to provide clarication to the queries of Cost Audit Branch long after his submission of the report. The Cost Audit Branch on the other hand may have no clarication to seek. Therefore, Cost Audit Branch has claried (Appendix II-C) that ......it is claried that for the purpose of furnishing the certicate under sub-Section 2 of Sec. 233B of the Act, a cost auditor shall be deemed to have concluded his appointment as he renders a report to the Central Government in accordance with the Cost Audit (Report) Rules, with a copy to the company. The clarication further adds that His obligation to answer queries from the Cost Audit Branch arising out of review of cost audit report should not debar him from accepting another appointment as cost auditor (Appendix II-C).

1.3.9 Communication to Previous Auditor1.3.9.1 The rst schedule (Part I) of The Cost and Works Accountants Act, 1959, deals with Professional misconduct in relation to cost accountants in practice. This schedule provides that a cost accountant in practice shall be deemed to be guilty of professional misconduct if he accepts a position as a cost accountant previously held by another cost accountant in practice without rst communicating him in writing. 1.3.9.2 The Institute of Cost and Works Accountants of India (ICWAI) has also opined in this regard that communication means a letter addressed by the member who is appointed as cost accountant on fee basis to the member previously holding the position of cost accountant in the same company.20

Cost Audit & Operational AuditHowever, it may be added here that a categorical reply to said communication may not be essential pre-requisite for the acceptance of the appointment. The ICWAI has also claried that the words previously held imply any time previous to the offer of appointment to a new cost accountant.

1.3.10 Full Time Employment1.3.10.1 Section 224(1)(B) inter-alia provides that no company or its Board of directors shall appoint or re-appoint any person who is in full time employment elsewhere or rm as its auditor if such person or rm is, at the date of such appointment or re-appointment, holding appointment as auditor of the specied number of companies or more than the specied number of companies. Thus no person, who is in full time employment, can take up the practice as Cost Auditor under the provisions of Companies Act. This proviso was added vide Companies (Amendment) Act, 1988. However, the Companies Act has not dened the term full time employment. Therefore, the following guidelines could be helpful: (a) The Cost auditor should not be a whole time director of any company under the provisions of Section 269 of the Companies Act, 1956 or Secretary under provisions of Section 383A of the Companies Act, 1956. Since both these Sections refer to such director or secretary being in whole time employment, it may be difcult to substantiate to be in part time employment. Anyone receiving a salary and receiving provident fund contribution from his employer or getting such other benets or perquisites like Ex-Gratia or Bonus, House Rent Allowance etc. may amount to be in full time employment. Similarly, there is a separate head of income titled Salaries under the Income Tax Act. A person declaring income under that head may be termed to be in employment.

(b)

(c)

1.3.11 Penal Provisions for Companies and Cost Auditor1.3.11.1 Rule 8 of the Cost Audit Report Rules, 2001 provides the following penal provisions (i) If the company contravenes the provisions of Rule 6 or Rule 7 (of the Cost Audit Report Rules, 2001) the company and every ofcer thereof who is in default, including the persons referred to in sub-rule (6) of Section 209 of the Companies Act, 1956, shall, subject to the provisions of Section 233B of the Act, be punishable with ne which may extend to ve thousand rupees and where the contravention is a continuing one, with a further ne which may extend to ve hundred rupees for everyday day after the rst day during which such contravention continues; and Where default is made by the Cost Auditor in complying with the provisions of Rule 4 or Rule 5 (of the Cost Audit Report Rules, 2001), he shall be punishable with ne, which may extend to ve thousand rupees.

(ii)

1.3.12 Procedure for Appointment of Cost Auditor1.3.12.1 The sub-Section (2) of Section 233B provides that the cost auditor shall be appointed by the Board of directors of the company in accordance with the provisions of sub-Section (1B) of Section 224 and with the previous approval of the Central Government. It further provides that before the appointment of any auditor is made by the Board, a written certicate shall be obtained by the21

Basics of Cost AuditBoard from the auditor proposed to be so appointed to the effect that the appointment, if made, will be in accordance with the provisions of sub-Section (1B) of Section 224. 1.3.12.2 The cost audit order issued by the Cost Audit Branch under Section 233B of the Companies Act, 1956 normally provides that the application for the proposal for appointment of Cost Auditor for ONE TERM should be sent to this Department within forty-ve days of the date of this order. It also further provides that thereafter the application for the proposal for appointment of Cost Auditor should be sent to this Department within 45 days of the commencement of every nancial year. The fees payable for such application and the manner in which it is to be paid are also specied in that order. These forms are now e-led. All the relevant information and guidelines in this regard is available on the MCA portal www.mca.gov.in . 1.3.12.3 The cost audit orders issued, normally also state that a rm of cost accountants, whether proprietary or partnership, may be proposed, if such rm is constituted under regulations 108 and 113 of the Cost and Works Accountants Regulations, prescribed under the Cost and Works Accountants Act, 1959. Therefore on receipt of cost audit order by the company, the Board of Directors should select a cost accountant or a rm of cost accountants qualied to conduct the cost audit. The concurrence of the cost auditor is also obtained (Section 224(1B)) prior to passing the resolution. The Board of Directors then passes a resolution either at a meeting or through circulation appointing a cost auditor, subject to the approval of the Central Government. 1.3.12.4 The Board resolution normally authorizes the Secretary of the Company or a Director to make necessary application to the Central Government. This application is to be e-led in Form 23C (Appendix I-D) within the time limit specied in the cost audit order. The application should be accompanied by the requisite fees. 1.3.12.5 The Department of Company Affairs considers the application and accords approval of the appointment of the cost auditor. Normally, the Central Government approves the appointment of cost auditor unless he suffers from any disqualication under Section 224(1-B) or Section 233-B(5) of the Companies Act. The approval is communicated to the company and the copy of the approval is sent to cost auditor by the Central Government. However, the appointment of cost auditor is conrmed only when the Board of Directors informs the cost auditor that he has been appointed as the cost auditor with the approval of the Central Government. 1.3.12.6 Detailed forms/procedures relating to the appointment of the cost auditor, starting from issue of cost audit order to the time of approval of appointment of cost auditor is accorded by the Central Government, are given at the end of this Study Note detailed as under: Appendix 1-A Appendix 1-B Appendix 1-C Appendix 1-D Appendix 1-E Appendix 1-F Specimen of Cost Audit Order Format for Written Certicate u/s 233B(2)/224(1-B) in case of an Individual/ Firm Specimen Board Meeting Resolution regarding Cost Auditor Form 23-C Application for Appointment of Cost Auditor Approval for Appointment of Cost Auditor Intimation to the previous Cost Auditor

22

Cost Audit & Operational Audit

1.3.13 Written Certicate by the Cost Auditor1.3.13.1 Section 224(1)(B) provides that no company or its Board of directors shall appoint or re-appoint any person who is in full time employment elsewhere or rm as its auditor if such person or rm is, at the date of such appointment or re-appointment, holding appointment as auditor of the specied number of companies or more than the specied number of companies. The explanation to the said Section provides that maximum number of companies for which a person can be the auditor at a point of time cannot be more than twenty. 1.3.13.2 Proviso to sub-Section (2) of Section 233B further provides that before the appointment of any auditor is made by the Board, a written certicate shall be obtained by the Board from the auditor proposed to be so appointed to the effect that the appointment, if made, will be in accordance with the provisions of sub-Section (1B) of Section 224. 1.3.13.3 Therefore, Company should obtain a written certicate from the proposed cost auditor to the effect that the appointment, if made, will be in accordance with the provisions laid down by Section 224 of the Companies Act, 1956. A specimen copy of certicate by the Cost Auditor is given at Appendix I-B.

1.3.14 Board Resolution1.3.14.1 The sub-Section (2) of Section 233B inter-alia provides that the auditor under this Section shall be appointed by the Board of directors of the company in accordance with the provisions of subSection (1B) of Section 224 and with the previous approval of the Central Government. 1.3.14.2 The company has to make an application to the Central Government for obtaining an approval for an appointment of Cost Auditor in Form No. 23-C. As per clause 12, a certied copy of the resolution passed by the Board of Directors of the company sanctioning the proposal for which the Governments approval has been sought is to be attached along with Form 23-C. 1.3.14.3 Hence, it is imperative that a resolution has to be passed by the Board of Directors for the appointment of the Cost Auditor. Since, the appointment of the Cost Auditor is subject to the previous approval of the Central Government, the Board Resolution (Appendix I-C) should specically mention that, `subject to the approval of the Central Government and pursuant to the provisions of Section 233B of the Companies Act, 1956, Mr. / M/s ................ be and is hereby appointed as Cost Auditor(s).... 1.3.14.4 On receipt of approval of the Central Government (Appendix I-E), the company should send letter of appointment to Cost Auditor(s).

1.3.15 Form 23 Application to The Cost Audit Branch Requesting Approval of Cost Auditor1.3.15.1 The cost audit orders issued by the Cost Audit Branch normally mention that `the application in the prescribed form no. 23-C proposing for appointment of cost auditor for one term should be electronically lled at the website of department i.e., www.mca.gov.in within 45 days of the date of the order and thereafter within 45 days of the commencement of every nancial year. The application fee is payable along with form 23-C which is presently as under:

23

Basics of Cost AuditNominal Share Capital Rs. less than Rs. 25 lacs Rs. 25 lacs or more but less than Rs. 5 crores Rs. 5 crores or more Fees Payable Rs. 500 Rs. 1,000 Rs. 2,000

1.3.15.2 The payments can now be made through appropriate mechanisms electronic (credit card, internet banking) or traditional means (at the Bank counter). Electronic payments can also be made at Virtual Front Ofce (VFO). If the user selects the traditional payment option, the system generates a prelled challan in the prescribed format. Traditional payments through cash, cheque can be done at the designated bank branches using the system generated challan.

1.3.16 Approval of Cost Auditor by Central Government1.3.16.1 The powers of the Central Government are exercised by the Cost Audit Branch of the Ministry of Corporate Affairs, New Delhi for approving the appointment of Cost Auditor. After receiving Form 23-C with all particulars contained therein as per the check list, the approval letter is generally issued within a period of about two to three weeks.

1.3.17 Exemption from Cost Audit Orders1.3.17.1 Even though there is no provision in the Companies Act, 1956 for grant of year-to-year exemption from Cost Audit, the exemption from Cost Audit on year-to-year basis is granted by Cost Audit Branch in situations arising out of temporary closure of the company and/or its manufacturing facilities, negligible production/activity, etc. These exemptions are based on logic that exemptions can be accorded by the executive since the cost audit orders are also issued by the executive. 1.3.17.2 Applications for seeking exemption are required to be made to the Central Government, along with fee, as prescribed above for appointment of Cost Auditor. Following documents are required to be furnished along with application for exemption: Printed or attested true copy of complete Annual Report containing balance sheet and prot and loss account for the year for which exemption is being sought along with copies of the same pertaining to preceding two years. In case, exemption is being sought in the beginning of the nancial year, the printed or attested true copy of Complete Annual Report for last three years may be provided. An afdavit containing full facts of capacity utilization, turnover and nancial status of the company such as sick or not or such other grounds on the basis of which exemption is being sought, duly signed by two Directors of the company and authenticated by a Notary Public. A brief note/status report on steps taken by the management for revival of the company and/ or the said unit.

1.3.18 Withdrawal of Cost Audit Orders1.3.18.1 Even though there is no provision in the Companies Act, 1956 for withdrawal of cost audit order, the withdrawal of Cost Audit is considered in case of permanent closure or sale or merger/ amalgamation of production activities for the product under reference. These exemptions are based24

Cost Audit & Operational Auditon logic that approval for withdrawal can be accorded by the executive since the cost audit orders are also issued by the executive. 1.3.18.2 Following documents are required to be furnished along with application for withdrawal: Printed or attested true copy of complete Annual Report containing balance sheet and prot and loss account for the year for which exemption is being sought along with copies of the same pertaining to preceding two years (or immediate last three years). An afdavit containing full facts of capacity utilization, turnover and nancial status of the company such as sick or not, duly signed by two Directors of the company and authenticated by a Notary Public. Documentary evidences substantiating closure/winding-up, sale, merger, amalgamation, etc. e.g. Courts order, surrender of licenses, sale of plant and machinery, power disconnection, manpower reduction, etc.

1.3.19 Constitution / Reconstitution of Partnership Firm of Cost Accountants1.3.19.1 Only the members of the Institute i.e. AICWA or FICWA who have obtained Certicate of Practice and are engaged in full time practice are entitled to constitute/reconstitute a partnership rm of Cost Accountants. For this purpose, the following procedure have to be followed and the related conditions have to be complied with :1. 2. Application has to be made to the Council in Form L, which should be duly lled in and signed by all the partners, indicating the name and membership no. against each signature. The application should be accompanied by a copy of Deed of Partnership duly executed on a non-judicial stamp paper by all the partners and attested by at least two witnesses indicating their full names and addresses. The date of execution of the Deed and submission of Form L should pertain to a date on or after the date of purchase of the non-judicial stamp paper. A declaration in the Deed of Partnership is required from all the partners that they are fully engaged in the practice of profession of Cost Accountancy and engaged in no other occupation. The name of the partnership rm to be indicated in sl. no. 1 of Form L and Deed of Partnership should be in accordance with the provisions of Regulation 108 of the Cost and Works Accountants Regulations, 1959. Such a rms name should have the sufx & Associates or & Co. Prior to the approval of the Council, the use of any stamp/visiting card/letterhead or the like in any rm name is strictly prohibited. When a partnership rm is reconstituted on account of admission, retirement, death of partners or change of terms and conditions, etc., a fresh Deed of Partnership has to be duly executed by the existing partners, and copy of such Deed along with Form L has to be submitted to the Council for Reconstitution of the partnership rm. When a partnership rm is dissolved, a copy of Deed of Dissolution of Partnership duly executed by all the partners has to be submitted to the Council for its record.

3.

4.

5. 6.

7.

25

Basics of Cost Audit8. 9. 10. 11. Whenever there is a change in the address of the Head Ofce or Branch Ofce of the partnership rm, it is to be immediately intimated to the Council in Form L. The Head Ofce or any Branch Ofce, if any, of the rm should be headed by a person who is member of the Institute i.e. AICWA or FICWA. No Constitution or Reconstitution of partnership rm is valid unless it is approved by the Council of the ICWAI. If the partner of a rm gets engaged in any salaried employment, he should immediately retire from the partnership rm and intimate to the Institute immediately. Under such circumstances, the remaining partners may reconstitute the rm by executing a fresh Deed of Partnership and Form L.

1.4

Planning and Structuring the Cost Audit

1.4.1 Need for Planning an Audit1.4.1.1 (a) The Cost Auditor should always plan to conduct an effective cost audit in an efcient and timely manner. This is very necessary to attain objectives of the cost audit. Audit plan for new client will be generally more detailed than in case of a repeat audit. In case of new audit, the cost auditor has to collect all information about the company like nature of business, organization structure, key personnel, accounting system etc. Similarly, he has to also collect information about other peers in the industry, nature of problems etc. The details required shall be much less in case of a repeat audit. The proper planning helps in: (a) (b) (c) (d) (e) appropriate attention to all the areas for comprehensive audit; identication of key areas needing more attention; timely completion of work; optimum utilization of assistants; no overlapping and proper co-ordination between the work done by different assistants, other auditors and experts.

1.4.2 Elements of Planning1.4.2.1 Planning of cost audit involves: (a) (b) (c) (d) (e) Familiarization about the company and applicable cost accounting record rules; Collection of all relevant information; Evaluation of internal control procedures and the system; Preparation of appropriate cost audit programme; and Audit of working papers and cost sheets.

1.4.2.2 Familiarization about the Company and Applicable Record Rules 1.4.2.2(a)26

It is very necessary for the cost auditor to familiarize himself with the requirements of

Cost Audit & Operational AuditCost Accounting Records Rules for the class of the companies to which the company under audit belongs. Similarly, the disclosure requirements as contemplated under the Cost Audit Report Rules 2001 should also be seen before actually designing the cost audit programme. This is necessary to ensure that the audit programme includes the examination of all the relevant records required to be maintained. 1.4.2.2(b) In addition to these, the cost auditor should also familiarize himself with the company especially with respect to its organization, organization structure, product range, market share, major inputs, protability, nancial status, marketing set-up, method of inventory valuation and detailed cost accounting system etc. 1.4.2.3 Collection of All Relevant Informa