Repo (Repurchase Options)

Repo (Repurchase Options)
(Concept , Impact Analysis on Economy & Trends)



Technical Definition :


Repo is a financial agreement used primarily in the government securities dealt in money market or capital market whereby a dealer or other holder of such government securities sells the securities and agrees to re-purchase them at an agreed future date at an agreed price which will provide the lender with an extremely low risk return.

Reverse Repo is simply the same repurchase agreement from the buyer’s viewpoint, not the sellers. Hence, the seller executing the transaction would describe it as a “repo”, while the buyer in same transaction would describe it as a “reverse repo”.

So, Repo and Reverse Repo are exactly the same kind of transaction, just described from opposite viewpoints.



Understanding the Concept in Indian Economy Context :


Repo Rate is the rate at which the banks borrows from RBI. Whenever the banks have any shortage of funds to meet their current demand and term liabilities, they can borrow from RBI.

Reverse Repo Rate is the rate at which RBI borrows money from banks.

Repo Rate is the thus, the difference between borrowed and paid back cash expressed as percentage.


Differentiation from Loan Concept :


Although, the actual effect of whole transaction is identical to a cash loan, while using the “repurchase” terminology, the emphasis is placed upon the current legal ownership of the collateral securities by the respective parties.



Forms & Types of Repo Agreements/ Auctions :


Forms of Repo :

• Specified Delivery : It requires the delivery of pre specified bond at the onset and at maturity of the contractual period.

• Tri-party : This utilizes a tri-party clearing agent or bank and is more efficient.

• Held in Custody : This form is quite rare in development markets primarily due to risks associated with its nature.

Types of Repo Maturities :

• Overnight Repo : refers to one day maturity transaction.
• Term Repo : refers to a repo with specified end date.
• Open Repo : simply has no end date.


Securities settled in Repo Transactions/Auctions :

All transferable Government of India dated securities and Treasury Bills.

Minimum amount of Repo Transactions/Auctions :

Bids will be received for a minimum amount of Rs.5 crore and in multiples of 5 crore thereafter.

Participants in Repo Transactions/Auctions :

• All Scheduled Commercial Banks (excluding RRBs).
• Primary Dealers maintaining SGL and Current A/c with RBI.


Impact Analysis on Indian Economy :

The changes in Repo Rates or Reverse Repo Rates are likely to have impact across the sectors and can be enumerated as follow:

• Financial Sector - Banking / Credit System / Markets – Debt or Equity
• General Economy
• Industrial Sector
• Corporate Sector
• External Sector
Impact on Financial Sector – Banking / Credit / Markets (Debt or Equity)


The Central Bank of India (RBI) manages short – term falls and surpluses in the banking system through its LAF(Liquidity Adjustment Facility), whereby it borrows and lends money at fixed rates under the repo and reverse repo facilities.

Since, RBI technically has unlimited capacity to lend and borrow rupees, the repo and reverse repo rate act as a ceiling and a floor rate for the interest rates.

When RBI cuts the repo rate, it is in effect sends the signal that short term rates are too high and should come down. The central bank has been traditionally using the repo to signal short term rates and the bank rate to indicate its view on long term rates.

However, with the longer –term interest rates being increasingly driven by short-term money markets, the repo signal has been used to nudge banks to bring down their Benchmark Lending Rates.


Regulation of Money Supply / Liquidity in Monetary - Credit System :

To temporarily expand the money supply, the RBI decreases repo rates which will help banks to get money at cheaper rates while to contract the money supply, it increases the repo rates which makes the borrowings expensive.

Repo is the injection of liquidity by the RBI while Reverse Repo is the absorption of liquidity by RBI.

Due to this fine tuning of RBI using tools of CRR, Bank Rate, Repo Rate and Reverse Repo Rate, banks adjust their lending or investment rates, hence, infusing or diffusing liquidity in the Monetary and Credit system.

Impact on Markets (Debt /Equity) :

Bond Markets will be the biggest beneficiary as the rate cut will make it easier for banks to borrow short term money and invest in government securities at a marginal spread.

The rupee will weaken in the foreign exchange markets as Indian debt will be become less attractive for foreign investors.

The impact on Stock Market will be mixed as Equities are largely driven by portfolio flows, which in turn are largely unaffected by the central bank’s monetary measures.

Other Impacts :

Reduction in Repo Rates may lead to cut in :

• Floating Home Loan Rates / Consumer Loan Rates.
• BPLR (Benchmark Prime Lending Rates).
• May usher in a lower rate regime if liquidity stays easy.

While, Rising Interest Rates would mean higher EMI payments, this would, in turn affect consumer durable companies as well as financing companies.


Impact on General Economy

The interest rate hike will bring a general slow down in the economic activity as higher cost of funds would result in reduced consumption and investment expenditures. As a result, the aggregate demand will also get a hit.

Impact on Industrial Sector

The interest rate hike will increase the cost of raw materials and thus, high cost of funds which will result in reduced industrial investment. This could adversely affect the Greenfield projects.

Impact on Corporate Sector

With increase in rates, due to higher raw material cost and fuel cost, corporate profits are likely to go down. Reduced bottom line of corporate sector implies lower plough back of profits.

Impact on External Sector

Higher Interest Rates leading to Higher Interest Costs will adversely affect the competitiveness of the Indian Exports.

Changes in Repo Rates or Reverse Repo Rates could reduce the differential between the Fed Fund Rates (USA) and EU Main Operation Refinancing rates. Expectedly this could lead to higher capital inflows into India, leading to strengthening of the Balance of Payments situation.







Trends in Reverse Repo Rates (Year 2000 - 2008) :

Following is the chronology of Repo Rates since June 2000. The central bank of India (RBI) holds daily repo and reverse repo acutions as part of its Liquidity Adjustment facility. (Exemplary table attached in Annexure I).
-------------------------------------------------------
RATE (percent) EFFECTIVE DATE (Source : RB I)
-------------------------------------------------------
7.50 03-11-2008
8.50 24-06-2008
8.00 11-06-2008
7.75 30-03-2007
7.50 31-01-2007
7.25 30-10-2006
7.00 25-07-2006
6.75 08-06-2006
6.50 24-01-2006
6.25 26-10-2005
6.00 31-03-2004
7.00 19-03-2003
7.10 07-03-2003
7.50 12-11-2002
8.00 28-03-2002
8.50 07-06-2001
8.75 30-04-2001
9.00 09-03-2001
10.00 06-11-2000
10.25 13-10-2000
13.50 06-09-2000
15.00 30-08-2000
16.00 09-08-2000
10.00 21-07-2000
9.00 13-07-2000
12.25 28-06-2000
12.60 27-06-2000
13.05 23-06-2000
13.00 22-06-2000
13.50 21-06-2000
14.00 20-06-2000
13.50 19-06-2000
10.85 14-06-2000
9.55 13-06-2000
9.25 12-06-2000
9.05 09-06-2000
9.00 07-06-2000
9.05 05-06-2000
Annexure – I

Policy Rates & Reserve Ratios
(As on 09/11/08)



Policy Rates


Bank Rate : 6%

Repo Rate : 7.50%

Reverse Repo Rate : 6%



Reserve Ratios



Cash Reserve Ratio : 5.50%

Statutory Liquidity Ratio : 24%



(Source : www.rbi.org.in)



















Annexure – II (RBI Circular on Repo Dated November 3rd, 2008)


RBI/2008-2009/257
FMD.MOAG. No.28/01.01.01/2008-09
November 3, 2008

All Scheduled Commercial Banks (excluding RRBs) and Primary Dealers


Dear Sir,

Liquidity Adjustment Facility – Repo and Reverse Repo Rates


1.As already announced on November 1, 2008, the Reserve Bank has decided to reduce the fixed repo rate under the Liquidity Adjustment Facility (LAF) by 50 basis points from 8.0 per cent to 7.5 per cent with effect from November 3, 2008, in view of the ebbing of upside inflation risks as also to address concerns relating to the moderation in the growth momentum.

2. The reverse repo rate under LAF remains unchanged at 6.00 per cent.

3. All other terms and conditions of the current LAF Scheme remain unchanged.

Special Economic Zone units to be surveyed for Service Tax Compliance

Special Economic Zone units to be surveyed for Service Tax Compliance

SEZ units providing taxable services to recipients outside the special economic zones (SEZ) are under Government scanner. The revenue department officials have been directed to submit by October 31 a report on whether such units were discharging their service tax obligations or not. The report is to be submitted to the Director-General of Service Tax. The Central Board of Excise & Customs (CBEC) directive to survey the SEZ units follows a recent report of the Comptroller and Auditor General (CAG) which highlighted that certain SEZ units in Chennai and Kochi were providing taxable services such as manpower supply services, technical testing and analysis service to units / persons outside the zone without payment of service tax.

Taxable services received by SEZ units and SEZ developers for consumption within the SEZ are exempt from service tax. However, service tax is applicable on taxable services provided by SEZ units, except in situations where specifically exempted. In a communiqué to its field formations, the CBEC has said they should ensure that SEZ units, providing taxable services to any person for consumption in domestic tariff area, should register with the jurisdictional service tax authorities and discharge their service tax liability. Meanwhile, The Central Board of Excise and Customs has also clarified that Special Economic Zone units claiming refund of service tax should register with the jurisdictional service tax authorities.

“EARLY INVESTMENT-BETTER INVESTMENT”

INTORDUCTION:



Responsibility increases with the age and the capability of bearing the risk decreases. The capability of bearing highly strong risk is more incase of young persons and it will be very less in case of people who are about to retire or retired persons. Based on this, an investor has to make a plan for the investment.



Let us have a look at the investment portfolio based on ages.



According to the changing scenario, a lot of investment avenues have emerged to invest money .Out of that some may be of risky securities and some are risk less securities which provides returns to the investors at a given level of risk. At the time of preparing investment plan, age of the investor plays an important role. He is required to consider age, family and other factors at the time making investment .For example, an investor who has retired can make an investment in risk less securities which gives him a fixed income .In case if the time of retirement is more (young), they can make investment in risky securities where the return is also very high along with the risk.



The below table tells how to make an investment by taking in to consideration the factors like age, family , other constraints and so on. Basing on the needs and requirements, an investor can make modifications in the investment .the capability of taking risk differ from one investor to another investor. For Example, if an investor has more no of dependants, his capability of taking risk will be low and vice versa.



Investment avenues can be classified as Gold, Bullion, Fixed Income Securities, Equities and Mutual Funds .Among those Gold and Bullion are considered to be as highly liquid securities ,which also includes savings accounts of the bank. After shares, Fixed Income Securities and Mutual Funds play an important role in investment. Along with these, those investment securities which are prone to less risk also need to be given much importance.



I Age : 22-30 years

It is an age where the investor is single or married having no children. The number of dependents on the investor is also less where there will be a chance to mobilize more savings for the future. Annual income and the risk bearing capability of the investor will also be high. At this time, it is better to make investment in equity shares for a long time i.e. for 5 years. For an investor with in an age group of 22-30 years, the investment portfolio as follows:





22-30 years of age
%

Cash ,Bullion
10

Fixed Income Securities
30

Equity Markets
40

Mutual Fund-Equity Growth
20






II Age: 31-45 years

A stage where the number of dependants will be more children an other responsibilities will arise. More focus will be on protection of investment rather than on returns .The risk bearing capability of the investor will also decreases to certain extent . For the investor more priority will be towards children studies and mobilization of future savings and so on.



31-45 years of age
%

Cash ,Bullion
10

Fixed Income Securities
40

Equity Markets
30

Mutual Fund-Equity Growth
20






III Age: 45-60years

At this stage, more focus of the investor will be towards mobilizing of savings for higher education and marriage of children.He also focuses on future savings to lead his retirement life.Risk bearing capability of the investor will be zero and depending upon his needs ,he is required to change the investment portfolio accordingly.



45-60 years of age
%

Cash ,Bullion
10

Fixed Income Securities
50

Equity Markets
20

Mutual Fund-Equity Growth
20














III Age: Above 60 years

At this stage investor is more focused on enjoying his life with family or doing a part time leisurely work. The risk bearing capability is zero .For an investor at this time, it is better to hold less equity investments and hold more of fixed income securities to earn a fixed income which also ensures liquidity.





Above 60 years of age
%

Cash ,Bullion
10

Fixed Income Securities
70

Equity Markets
10

Mutual Fund-Equity Growth
10






Conclusion: Like this the investment portfolio changes depending upon the age of the investor The proportionate of investment may not be exactly but it may vary depending on the other constraints that are taken in to consideration by the investor.



“EARLY INVESTMENT-BETTER INVESTMENT”



For Example: An investor goal is to mobilize 10 lakhs after 20 years. For one year from now he has to make an investment of Rs14000/- Per annum. If he is willing to make investment after 10 years, he has to make an investment of nearly Rs 60000/- per annum. So get ready for savings at an early stage.

Minister Pranab to talk to PM on SEZ tax tangle

External Affairs Minister Pranab Mukherjee, who heads an Empowered Group of Ministers (EGoM) on special economic zones (SEZs), is likely to consult Prime Minister Manmohan Singh to resolve the dispute between finance and commerce ministries over tax exemption for export profits from the zones.



The EGoM has failed to arrive at a decision on the Income Tax Act’s Section 10 AA, which provides tax exemption on profits earned by units in SEZs.



While the commerce ministry wants export profits to be determined on the basis of the turnover of an SEZ unit, the finance ministry wants to take into account the company’s total turnover, including from the non-SEZ units. This, according to the commerce ministry, would reduce the exemption that was promised earlier.



The SEZ Act of 2005 provides the zones 100 per cent income tax deduction on export profits in the first five years of operation. But Section 10 AA says the export profit has to be taxed in proportion to the unit’s contribution to the company’s turnover.



Companies argue that the export profit of an SEZ unit should be computed in proportion to the turnover of the unit and not the entire company. This is because the present arrangement eats into the income tax deduction.



According to sources, the commerce ministry has been arguing that this is an anomaly, while the finance ministry says this is a conscious decision. “The finance ministry told the EGoM that the present arrangement will discourage shifting of existing work by companies to their SEZ units.



But the commerce ministry is saying there have been no cases of misuse,” said the source.

IT SEZs must wait for 100% tax exemption

IT may be a long wait for IT SEZs which are looking forward to a review of section 10AA (7) of the Income Tax Act for enjoying 100% tax exemption on profits.



The empowered group of ministers (eGoM) on special economic zones (SEZs), which met on Thursday, has not only deferred a decision on the need for a review, it is also now clear that a change in the section can only happen through an amendment to the Act. Since the Act can be amendment only by Parliament, any change in the current provisions could take several months.



Section 10 AA (7) of the Income Tax Act states that only a proportion of profits of a SEZ unit, based on the proportion of export sales from the unit to the total turnover of the parent company, will be exempt from taxation.



Under the SEZ Act, profits earned by the unit are 100% tax-exempt in the first five years and 50% tax-exempt for the next five years. Units are also eligible for 50% tax exemption on reinvested profits for another five years. “Section 10AA (7) is an aberration and that needs to be corrected

How to Calculate Sensex

The Sensex , an abbreviation of the BSE sensitive index, is a market capitalisation-weighted index of 30 stocks representing a sample of large, well-established and financially sound companies. It is the oldest index in India and has acquired a unique place in the collective consciousness of investors. The index is widely used to measure the performance of the Indian stock markets. Sensex is considered to be the pulse of the Indian stock markets as it represents the underlying universe of listed stocks on The Stock Exchange, Mumbai. Further, as the oldest index of the Indian stock market, it provides time series data over a fairly long period of time (since 1978-79). Sensex is not only scientifically designed but also based on globally accepted construction and review methodology. Sensex Calculation Methodology As per the methodology, the level of index at any point of time reflects the free-float market value of 30 component stocks relative to a base period. The market capitalisation of a company is determined by multiplying the price of its stock by the number of shares issued by the company. This market capitalisation is further multiplied by the free-float factor to determine the free-float market capitalisation. The base period of Sensex is 1978-79, and the base value is 100 points. This is often indicated by the notation 1978-79=100. The calculation of Sensex involves dividing the free-float market capitalisation of 30 companies in the index by a number called the Index Divisor. The Divisor is the only link to the original base period value of the Sensex. It keeps the index comparable over time and is the adjustment point for all index adjustments arising out of corporate actions, replacement of scrips etc. During market hours, prices of the index scrips, at which latest trades are executed, are used by the trading system to calculate the Sensex every 15 seconds and disseminated in real time.

Lehman Brothers - How ?

Lehman decided to play chicken with the market and they lost. In whats been likened to Black Monday (1987) today around 5,000 UK-based employees will lose their jobs as 158-year-old investment bank Lehman Brothers filed for bankruptcy protection under Chaper 11 of the US Bankruptcy Code. All of the employees in Londons Canary Wharf, as well as those at Lehman Brothers subsidiary, Capstone Mortgage Services in High Wycombe, are likely to find themselves out of a job. Ill now try to move into another industry, said one. Its a far cry from a year ago, when the bank was valued at some $47bn and was the largest trader on the London Stock Exchange. Eleventh hour discussions with Barclays and Bank of America faltered yesterday when it became clear the US government could not guarantee the troubled banks assets. It is, of course, the majority of Lehman Brothers 25,000 employees who stand to lose the most, along with 411,000 shareholders, George Soros among them he was among those who expected a rebound and doubled his shares in Lehman earlier this year. The Bank of England has made 5bn available and the European Central Bank added 30bn euros to keep liquidity flowing in the City. In a refreshing act of solidarity, 10 leading banks, including Credit Suisse, Citigroup and Deutsche Bank, are pooling their money to create an emergency borrowing fund of $70bn. Dr Housing Bubble blames Lehmans sub-prime mortage exposure. It is up in the air whether they held onto to these assets because of a foolish investment move or whether there simply wasnt a market for these assets. Plenty accuse CEO Richard Fuld (apparently nicknamed the Gorilla) of hubris, as well as for waiting too long to write off these bad bets. Greenlight Capitals outspoken David Einhorn raised alarm bells earlier this year about the banks lack of transparency when it came to declaring its liabilities. Other than the charismatic value of the leadership and maybe the popularity of the company, Lehmans exposures are worse than Bear [Stearn]s on an apples-to-apples basis, he told a reporter in June. It makes me rather sad to see this organisation brought to its knees as a result of what Ill call a lack of control, poor management of internal risk and ultimate self-interest, former Lehmans employee Walter Gerasimowicz told Bloomberg. (Its unfortunate, under the circumstances, that Fulds board positions include one for a charity called Robin Hood, targeting poverty in New York City.) The Reasoned Sceptic plays no favourites in apportioning blame. Lehman, Bear Stearns and Merrill Lynch all exhibited horrifically bad risk management in a sea of financial excess and excess capacity. Blame here goes straight to the board, then, whose members include Sir Christopher Gent. But theres a silver lining, says Anatole Kaletsky, arguing that the financial transactions between banks and hedge funds have less effect on the availability of credit to non-financial businesses than might be imagined. Had the US government bailed out Lehman or Merrill Lynch, there wouldve been a massive regulatory overhaul to appease taxpayers for having to take on the banks risks. As it is, the longer term effects are likely to be less drastic, argues Tracy Corrigan. But as investment banks cede supremacy to the commercial concerns, will the star system with its high bonus culture and short-term focus also go the way of the dinosaur?

Sub Prime Meaning

Sub-Prime Crises
Meaning of SubPrime :Meaning of sub prime commonly used where bank is landing a person at little bit higher rate than normal(prime) rate due to
• Loan to that person is little bit more risky than normal
• Person does not satisfy the condition for taking the loan
• less income than required
• Ratio of loan repayment /income is adverse
• Property involved is in area where rates of property is volatile and not stable
• Risk is high of repayment or some what speculative.
In brief they are landing to a person who is not otherwise eligible as per normal banking condition at higher rates.It does not mean that they are landing to any body without checking any thing but with a knowledge that risk is there, and due to more risk involved , they charge more interest from the party.These Type of loan generally mortgaged by Property or other assets.



If a lay man read this than he can also predict that the bank doing such practices will sooner or later have losses..........?but why the best brain of the world(so called) in US are unable to predict the crises. And Bank/companies which has never shown losses in their history of 140 years ,sank in one quarter losses..



Refinancing:Means bank giving loans directly to the customer,takes loan from other big company on the guarantee that they will pay back the money,as soon as it is received from the client.



Securitization :simple meaning of the securitization is giving loans out of balance sheet and have more cash to give more loan by transfer the mortgaged loans to special purpose vehicles (SPY) created for this purpose by the big houses. After securitization of mortgage assets ,Loan given will not shown in balance sheet and after securitisation of loans banks have good capital adequacy ratio and solvency margins, can give more loan ,but servicing/default risk of all loan remains with the institute and does not transfer to the SPV.



Step by step of reason of Crises
• The bank/companies which are giving loan at sub prime rates ,are small in the size.
• They have more specific information about the consumer and lend money to them on consideration other than financial .
• Then they have refinance their loans from the other big houses like Lahman ,Merrill lynch,AIG or other in the market
• With the money refinanced from the big company they gives more loan and so on
• They have given loan much more than what they have actually owned.
• Rates of property in USA is going south.And interest rates were going up.
• Some client which have Purchased property on loan for capital appreciation/or on the basis of some speculation like future increase in income , in the property was not able to return the loan
• Banks enforcing the foreclosures and taken the properties from the client or properties has been put to sale in the declining price market,Feeding more stock(property for sale) in the market and leads to further price fall
• Small companies collapses on default of some major customers as they are not able to manage cash flows.
• After default from customer they are unable to service the funds refinanced from big company.
• As I have explained above sub prime loans are more risky than normal ,this whole process of collapsing is so fast and have much cascading effect .
• The securitisation of laons also have a role as after securitization of laons companies have more clean balance sheet and one can not judge the Inherent risk involved in that due to less disclosures norms and other reasons.
• And we have now much longer list of casualties like Lahman Bros,Merill Lynch,AIG,Bear stearn,Fannie Mae and Freddie Mac...........and so on .This is not end of story more will come.
and more reason which leads to the crises is securitization ,simple meaning of the securitization is giving loans out of balance sheet and have more cash to give more loan by transfer the mortgaged loans to special purpose vehicle (SPY) prepared for this purpose by the big houses. After securitization of mortgage assets ,Loan given will not shown in balance sheet and after than they have good capital adequacy ratio and solvency margins, can give more loan ,but servicing/default risk of all loan remains with the institute and does not transfer to the SPV.

EXPOSURE DRAFT STANDARD ON INTERNAL AUDIT (SIA)

EXPOSURE DRAFT
STANDARD ON INTERNAL AUDIT (SIA)

COMMUNICATION WITH MANAGEMENT

The Committee on Internal Audit of the Institute of Chartered Accountants of
India invites comments on the Exposure Draft of the Standard on Internal Audit
(SIA), Communication with Management. Comments are most helpful if they
indicate the specific paragraph(s) to which they relate, contain a clear rationale
and, where applicable, provide a suggestion for alternative wording. Comments
should be submitted in writing to the Secretary, Committee on Internal Audit, The
Institute of Chartered Accountants of India, C-1, Sector-1, NOIDA-201 301 so as
to be received on or before November 17, 2008. Comments can also be sent
by e-mail at cia@icai.org.

Introduction
1. This Standard on Internal Audit provides an overarching framework for the
internal auditor’s communication with management and identifies some specific
matters to be communicated with the management as described in the terms of
the engagement.
2. In performing such an activity the internal auditor should :
a. Communicate clearly the responsibilities of the internal auditor, and an
overview of the planned scope and timing of the audit with the management;
b. Obtain information relevant to the internal audit from the management;
c. Provide timely observations arising from the internal audit that are significant
and relevant to their responsibility as described in the scope of the
engagement to the management; and
d. Promote effective two-way communication between the internal auditor and
the management.

Matters to be Communicated

The Internal Auditor’s Responsibilities in Relation to the Terms of
Engagement
3. The internal auditor’s responsibility for the performing the audit, in
accordance with the terms of engagement.
Planned Scope and Timing of the Audit
4. Communication regarding the planned scope and timing of the internal
audit may:
a. Assist the management to understand better the consequences of the
internal auditor’s work, to discuss issues of risk and materiality with the
internal auditor, and to identify any areas in which they may request the
auditor to undertake additional procedures; and
b. Assist the internal auditor to understand better the entity and its
environment.
5. Care is required when communicating to management about the planned
scope and timing of the audit so as not to compromise with the effectiveness of
the audit. For example, communicating the nature and timing of detailed audit
procedures may reduce the effectiveness of those procedures by making them
too predictable.
6. Matters communicated may include:
• How the internal auditor proposes to address the significant risks of material
misstatement, whether due to fraud or error.
• The internal auditor’s approach to internal control relevant to the internal
audit.
• The application of materiality in the context of an internal audit.
7. Communication with management, may assist the internal auditor to plan
the scope and timing of the audit. It does not change the internal auditor’s sole
responsibility to establish the overall audit strategy and the audit plan, including
the nature, timing and extent of procedures necessary to obtain sufficient
appropriate audit evidence.

Significant Findings from the Internal Audit

8. Paragraph 25 of the SIA – 4, “Reporting”, states:
“25. The internal audit report contains the observations and comments of
the internal auditor, presents the audit findings, and discusses
recommendations for improvements. To facilitate communication and
ensure that the recommendations presented in the final report are practical
from the point of view of implementation, the internal auditor should
discuss the draft with the entity’s management prior to issuing the final
report. The different stages of communication and discussion should be as
under:
Discussion Draft - At the conclusion of fieldwork, the internal auditor should
draft the report after thoroughly reviewing his working papers and the
discussion draft before it is presented to the entity’s management for
auditee’s comments. This discussion draft should be submitted to the entity
management for their review before the exit meeting.
Exit Meeting - The internal auditor should discuss with the management of
the entity regarding the findings, observations, recommendations, and text
of the discussion draft. At this meeting, the entity’s management should
comment on the draft and the internal audit team should work to achieve
consensus and reach an agreement on the internal audit findings.
Formal Draft - The internal auditor should then prepare a formal draft,
taking into account any revision or modification resulting from the exit
meeting and other discussions. When the changes have been reviewed by
the internal auditor and the entity management, the final report should be
issued.
Final Report - The internal auditor should submit the final report to the
appointing authority or such members of management, as directed. The
periodicity of the Report should be as agreed in the scope of the internal
audit engagement. The internal auditor should mention in the Report, the
dates of discussion draft, exit meeting, Formal Draft and Final Report.”



The Communication Process

Establishing the Communication Process

9. Clear communication of the internal auditor’s responsibilities, the planned
scope and timing of the internal audit, and the expected general content of
communications helps establishing the basis for effective two-way
communication.
10. Matters that contribute to effective two-way communication include:
• The purpose of communications should be clear, which make the internal
auditor and the management better placed to have a mutual understanding
of relevant issues and the expected actions arising from the communication
process.
• The form in which communications will be made.
• The person(s) in the internal audit team and the representative of the
management, will communicate regarding particular matters.
• The internal auditor’s expectation that communication will be two-way, and
that the management will communicate with the internal auditor, matters
they consider relevant to the internal audit, for example, strategic decisions
that may significantly affect the nature, timing and extent of internal audit
procedures, the suspicion or the detection of fraud, and concerns with the
integrity or competence of senior management.
• The process for taking action and reporting back on matters communicated
by the auditor and the management.
Forms of Communication
11. Effective communication may involve structured presentations and written
reports as well as less structured communications, including discussions. The
internal auditor may communicate matters other than those described in the
terms of engagement, either orally or in writing.
12. In addition to the significance of a particular matter, the form of
communication (e.g., whether to communicate orally or in writing, the extent of
detail or summarization in the communication, and whether to communicate in a
structured or unstructured manner) may be affected by such factors as:
a. Whether the matter has been satisfactorily resolved.
b. Whether management has previously communicated the matter.
c. The size, operating structure, control environment, and legal structure of the
entity.
d. In the case of an internal audit of a specific aspect of an operation, whether
the internal auditor also audits the entire operation or the entity.
e. The expectations of those charged with governance, including arrangements
made for periodic meetings or communications with the auditor.
f. The amount of ongoing contact and dialogue the internal auditor has with
those charged with governance.
g. Whether there have been significant changes in the membership of a
governing body.



Timing of Communications

13. The appropriate timing for communications will vary with the circumstances
of the engagement. Relevant circumstances include the significance and nature
of the matter, and the action expected to be taken by those charged with
governance. For example:
• Communications regarding planning matters may often be made early in
the audit engagement
• It may be appropriate to communicate a significant difficulty encountered
during the audit as soon as practicable.
• Similarly, it may be appropriate to communicate material weaknesses in the
design, implementation or operating effectiveness of internal control that
have come to the auditor’s attention as soon as practicable.
• Communications regarding independence may be appropriate whenever
significant judgments are made about threats to independence and related
safeguards.
• The exit meeting may also be an appropriate time to communicate findings
from the audit.

Adequacy of the Communication Process

14. The internal auditor need not design specific procedures to support the
evaluation of the two-way communication with the management, rather, that
evaluation may be based on observations resulting from audit procedures
performed for other purposes. Such observations may include:
• The appropriateness and timeliness of actions taken by the management in
response to matters raised by the internal auditor. Where significant
matters raised in previous communications have not been dealt with
effectively, it may be appropriate for the internal auditor to inquire as to why
appropriate action has not been taken, and to consider raising the point
again. This avoids the risk of giving an impression that the internal auditor
is satisfied that the matter has been adequately addressed or is no longer
significant.
• The apparent openness of the management in their communications with
the internal auditor.
• The apparent ability of the management to fully comprehend matters raised
by the internal auditor, for example, the extent to which the management
probes issues and questions recommendations made to them.
• Difficulty in establishing with those charged with governance, a mutual
understanding of the form, timing and expected general content of
communications.
• Whether the two-way communication between the internal auditor and
those charged with governance meets applicable legal and regulatory
requirements.
15. Inadequate two-way communication may indicate an unsatisfactory control
environment and influence the internal auditor’s assessment of the risks of
material misstatements. There is also a risk that the internal auditor may not
have obtained sufficient appropriate audit evidence to support his findings or
opinion.

Documentation

16. Where matters required by this SIA to be communicated are
communicated orally, the internal auditor shall document them, and when and to
whom they were communicated. Where matters have been communicated in
writing, the auditor shall retain a copy of the communication as part of the
internal audit documentation.

Effective Date

17. This SIA is effective for all internal audits undertaken on or after

Checklist for Audit Report under CARO

Preliminary
A. For all representations made to the auditors on the basis of which the checklist is filled up, written confirmation from the client should be obtained, so far as is practicable.
B. All certificates, representations, working papers on the basis of which checklist has been completed should be attached to this checklist and suitably referenced.
C. Detailed working note as to why auditors have come to such conclusion should invariably be attached to this statement.
D. All important observations must be properly documented and cross-linked to the individual working papers.
E. Where there are exceptions; i.e., adverse conclusions, such facts should be adequately highlighted.
F. Signature of the Auditor should contain the name of the proprietor / partner and his membership No. of ICAI.
G. Applicability
Verify that CARO is applicable to the company
Exclusions
1. a banking company
2. an insurance company
3. a company under section 25 of the Companies act
4. private limited company having :
i. turnover of less than Rs. 5 crores,
ii. paid-up capital and reserves not > Rs. 50 lakhs,
iii. loan outstanding less than Rs. 10 lakhs from banks and FI,
iv. not accepted public deposits.
(In other words, CARO applicable when ANY
of the above condition is not fulfilled ) If
CARO is not applicable to the company, state
the fact in the main report.
1. Fixed Assets
1.1.1 Does the company maintain fixed asset register / Cards
1.1.2 Do these give the following particulars
i. Description of the Asset;
ii. Accounts Classification;
iii. Location;
iv. Identification No;
v. Quantity;
vi. Original Cost;
vii. Depreciation rate, amount;
viii. Details regarding disposal;
ix. Year of purchase
x. Adjustment for revaluation (including AS 11 effect)
1.1.3 Does the company maintain proper records showing full
Particulars including quantitative details and situation of fixed assets
1.2.1 Has physical verification of the assets been conducted
based on written instructions by the management at
reasonable intervals. If yes:
i. What is the frequency thereof?
ii. What is the percentage in the value thereof?
iii. Is there sufficient evidence thereof?
1.2.2. Have the results of the verification been reconciled with
the fixed asset record and if so:
i. Has a list of discrepancies been prepared and placed
on audit file?
ii. Are these discrepancies significant?
iii. How have the discrepancies been dealt with the accounts?
1.2.3. Did the auditors observe all or any part of the verification?
1.2.4. Has the asset register been reconciled with the financial
records?
1.3
a) Whether there have been sale / disposal of fixed assets of the company?
b) What is percentage of fixed assets sold/disposed off?
c) What is the quantum of reduction in production capacity by such sale?
d) Whether the concept of ‘going concern’ has been affected by such reduction in production capacity?
e) If not, give reasons. Also, refer to checklist on AAS 16
2 Inventories
2.1.1 List out the intervals at which physical verification is
conducted for
i. Raw and packing materials
ii. Finished goods
iii. Stores and spare parts
iv. Consumables and others
2.1.2 Has the inventory at year end been physically verified by
the management?
2.1.3 Are comprehensive written stock taking instructions
Issued – Statement on auditing practices Appendix A. Obtain a copy thereof? If not, obtain a note on procedures of verification.
2.1.4 Whether auditors were present for physical verification?
2.1.5 Has due cognizance been taken of cut off procedures in
Physical verification and valuation of inventories?
2.2.1 Are the procedures of physical verification followed by
the management, reasonable and adequate?
2.2.2 What is the percentage in value covered in the course of
verification?
2.3.1 Whether proper stock records are maintained?
2.3.2 Whether they are properly maintained in adequate details?
2.3.3 Verify the report of variations between book record and
physical stock. Are the discrepancies material?
3. Loans given by the company
3.1.1. Has the company granted any loans, secured or unsecured
to companies, firm or other parties listed in the register maintained u/s 301.
3.1.2 Has a list of such loans granted by the company been
scrutinized and a list of loans to parties mentioned in the
aforesaid registers separately obtained? The list should
contain the following:
i. Name of the party
ii. Relationship with the company
iii. Amount
iv. Year end balance
Cross check the list of such loans obtained in (b) above,
with the register maintained by the company under section
301 of the Companies Act, 1956.
3.1.3 Has a list of such loans giving details of terms and
conditions been placed on file? Give No. of parties and
amounts of transactions.
( Maximum balance outstanding at any time during the
year for each party should be considered)
3.2.1 Obtain details of the rate of interest and the terms and
conditions of such loan. Factors to be considered to evaluate terms:
i. repayment
ii. rate of interest
iii. restrictive covenants
iv. financial standing and ability to borrow / lend
v. nature of security
vi. availability of alternative sources of finance
vii. urgency of borrowing
viii. purpose of the loan
ix. prevailing market rate of interest
3.2.2. Obtain in writing from the management their explanations
as to why the terms obtained are not prejudicial to the interests of the company in those instances where better terms could have been obtained.
3.2.3. Check that loans and advances made on the basis of security have been properly secured.
3.2.4. If the terms of the loan given are prima facie prejudicial, has written explanation been obtained from the company as to why it should not be so considered?
3.3.1 Whether the principal and / or interest are being regularly
paid? Identify by scrutiny of the schedules of sundry
debtors and loan and advances forming part of balance
sheet and the ledger balances whether any advances have
been given for a figure which is far in excess of the value
of the orders or for a period which is far in excess of the
normal trade practice or any other debit balances could
tantamount to loans or advances in the nature of loans.
3.3.2 Test check the repayments of the principal amounts with the stipulation to ensure that the party is repaying the principal amounts as stipulated. Extent of check :
3.3.3 Test check the receipt of interest with the stipulation so as to ensure that such interest repayments are regular. Extent of check :
3.3.4 Identify the Loans & Advances in the nature of loans where no stipulation has been made for repayments of the principal amount or for payment of interest.
3.3.5 Ensure that where no repayments of the principal amounts or payments of interest have been stipulated, the auditor has indicated in the report that he has not made any specific comments because the terms of repayment and/or interest have not been stipulated.
3.3.6 Obtain and report information as below for loans given
a) Name of the party
b) Relationship with the company
c) Overdue principal
d) Overdue interest
e) Year end balance
3.4.1 Obtain a list of overdue amount of more than Rs. 1 lakh
per party – obtain the note regarding steps being taken for recovery of the amounts and whether they are adequate and reasonable. If not, obtain explanation from management.
3.4.2 Verify the steps taken by the company as listed above and make your comments where the steps taken do not look reasonable and ask for company’s response thereto. Reasonable steps for Recovery include: Amounts involved, issue reminder/s, sending legal notice, facts and circumstances of each case should be considered and in absence of legal steps, auditor must satisfy himself that reasonable steps have been taken.
3.4.3 Can you conclude after considering the above and taking appropriate evidence on records that reasonable steps have been taken by the company?
3.5 Loans taken by the company
3.5.1 Has the company taken any loans, secured or unsecured
from companies, firms or other parties listed in the register
maintained u/s 301 of the Companies Act. Give No. of
parties and amount involved in transactions. (Maximum
balance outstanding at any time during the year for each
party should be considered )
3.5.2 Obtain a list of such loans containing details of terms and conditions for our records. Obtain a list of :
1) Name of the party
2) Relationship with the company
3) Amount
4) Year end balance
3.6.1 Are the rate of interest and other terms on which these
loans have been taken prima facie prejudicial to the
interest of the company with regard to comparative terms
for :
a) security offered
b) rate of interest
c) terms of repayment
d) loan given by the company
e) other conditions attached
Obtain in writing from the management their explana-
-tions as to why the terms obtained are not pre-judicial
to the interests of the company in those instances where
better terms could have been obtained.
3.7.1 Obtain a list in detail or category wise of loans and
advances in the nature of loans which have been taken.
3.7.2 Scrutinize the schedule of loans and advances forming part of the balance sheet in order to ensure the completeness of the list of loans and advances in the nature of loans given.
3.7.3 Identify by the scrutiny of the schedules of sundry debtors and loans and advances forming part of balance sheet and the ledger balances whether any advances have been given for a figure which is far in excess of the value of the orders or for a period which is far in excess of the normal trade practice or any other debit balances which could tantamount to loans or advances in the nature of loans.
3.7.4 Test check the repayments of the principal amounts with the stipulation to ensure that the party is repaying the principal amounts as stipulated. Extent of check :
3.7.5 Test check the receipt of interest with the stipulation so as to ensure that such interest payments are regular. Extent of check :
3.7.6 Identify the loans and advances in the nature of loans where no stipulation has been made for repayments of the principal amount or for payment of interest.
3.7.7 Ensure that where no repayments of the principal amounts or payments of interest have been stipulated, the auditor has indicated in the report that he has not made any specific comments because the terms of repayment and/or interest have not been stipulated.
3.7.8 Obtain and report information as below for loans given
a) Name of the party
b) Relationship with the Company
c) Overdue principal
d) Overdue interest
e) Year end balance
4. Internal Controls systems
4.1 Obtain a note on the internal control system relating to
purchase of fixed assets and inventories and for the sale of goods and services. Also refer checklist on AAS 6
4.2 Has the system as explained been followed during the year?
4.3 Obtain the internal audit reports of the current and previous years and list out the major weakness of continuing nature that has not been rectified, if any. Here the weaknesses known to the management continues to persist in spite of steps taken by the management. Where management has not taken steps the report should state the same.
4.4 As per auditor’s evaluation of the systems existing during the year, is the internal control over the purchase of these assets and sale of goods adequate in relation to the size of the company and nature of its business. Where any weakness that is capable of resulting in breach of internal controls is considered to be a major weakness and therefore comes within the ambit of reporting.
Whether any major weakness in Internal Control reported in earlier year? If Yes, whether those weaknesses rectified or are still continuing. Obtain a note from the management. Whether additional area of major weakness noticed during the year and reported to the management ?
5 Transactions with related parties as per Register of
Contract u/s 301
5.1.1. Has a list of all parties entered in the register under
section 301 been obtained?
5.1.2. Whether transactions that need to be entered into a register in pursuance of section 301 of the Act have been so entered. Obtain a written representation from management concerning the completion of the entries in the register u/s 301.
5.1.3. Examine procedure followed for identifying the parties and the transactions.
5.1.4. Obtain a list of the firms or companies or other parties where directors are interested.
5.1.5. Obtain a party-wise statement showing the following details of all transactions with the parties identified in step above:
a) Purchase / Sale contracts reference, date and value
b) Purchase / selling rates
c) Value of purchases / sales made in the year under the contract
Trace transactions in the books of account.
5.1.6. Cross check the list obtained in step (d) above, with the disclosure under section 299(3) and the register maintained by the company under section 301(1) of the Companies Act, 1956 for firms, or companies or other parties in which directors are interested. Review Form 24AA to ensure compliance with sections 297 and 299.
5.1.7. Review last year’s working papers to confirm whether data given in step 5.1.2 is correct.
5.1.8. Enquire as to the affiliation of directors and key management personnel and officers with other entities.
5.1.9. Obtain list of principal shareholders from the share register.
5.1.10. Review the entity’s income tax returns and other information supplied to regulatory agencies such as details shown in 3CD in respect of payments to specified person.
5.1.11. Cross check all these information with disclosures made on related party transactions in the notes to accounts.
5.1.12. Review the joint venture and other relevant agreements entered into by the entity.
5.1.13. Whether the contracts and arrangements referred to in section 301 have been entered in the register?
5.2.1 Examine the statement obtained in step 5.1.4 above by
reference to the register of contracts maintained under
section 301(1) of the Companies Act, 1956. Consider for
examination the transaction of all such concerns exceeding
an aggregate value of Rs. 5,00,000 each.
Obtain list of all purchases of any goods or materials
aggregating during the year to Rs. 5,00,000 or more in
respect of each party?
Obtain list of all sales of any goods or materials or
services aggregating during the year to Rs. 5,00,000 or
more in respect of each party?
Ensured that the prices paid/received in above two lists
are reasonable as compared to the prices of similar items
supplied by/to other parties by :
Comparing the rates at which purchase/sales have been
from/to other parties.
Comparing the other terms of purchases/sales such as
terms of credit, delivery period, quality of the product,
reliability of the source of supply; etc?
Quotation Analysis, reasons for not taking the lowest /
highest prices. Identify the contracts or arrangements
where the supply is from only one source or from more
than one source and the prices paid for such transactions
are reasonable as compared to other prices.
Also identify the cases where the supply is from only one
source or more than one source without any price
comparisons with alternative parties.
(Obtain quotation/price list, if possible, as audit evidence)
In the light of above, can we say that the prices paid / recd
for each transaction in respect of each party in a financial
year aggregating to Rs. 5,00,000 or more are reasonable?
In case of sole suppliers, reasonableness can be ascertained
with reference to list prices of the supplier, other trade terms
etc.

6. Deposits from the public
6.1 Has the company accepted deposits including loans from the
public within the meaning of the provisions of section 58-A
Ensure that the company is not a private limited company
which has restrictions on acceptance of deposits.
6.2 If such deposits have been considered as exempt u/s 58-A,have you placed on file reasons for the same?
6.3 Has the company complied with the provisions of sections 58A and 58AA and Rules framed there under and also guidelines issued by RBI?
6.4 If not, has the nature of contraventions been placed on the file and accordingly disclosed in the report.
6.5 Whether any order passed by the Company Law Board, National Company Law Tribunal or Reserve Bank of India or any court or any other Tribunal for non-compliance? If yes, whether the directions are complied with? List out any contravention and report the same.
7. Internal Audit System
7.1 Is the paid-up share capital and reserves of the company at
the commencement of the financial year in excess of Rs. 50
Lakhs; or Does the average annual turnover (for the 3
financial years immediately preceding) of the company
exceed Rs. 5 crores.
7.2 If yes, does the company have an internal audit system
i. In the form of outside firm(s) of chartered accountants
ii. In the form of its own audit department
7.3 Has internal audit programme been reviewed. Was it drawn in consultation with statutory auditors?
7.4 Is the coverage of internal audit adequate?
7.5 Are the persons carrying out the internal audit adequately qualified for the job?
7.6 To whom do the internal auditor report?
7.7 Have the internal audit reports been perused and management replies given on points of defaults and whether they have been duly acted upon?
7.8 In view of what is stated above is the internal audit system of the company commensurate with its size and the nature of its business.
8. Cost records
8.1 Has maintenance of cost records been prescribed for any of
the activities of the company
8.2 If so, whether the records have been verified to form a prima facie opinion thereon.
8.3 Having regard to the above, can it be concluded that prima facie the prescribed records have been maintained.
8.4 Has cost audit been prescribed in respect of these records and if so, have reports been perused.
9.1 Statutory dues
9.1.1 Obtain a statement ( for Provident Fund, Investor Education
and Protection fund, Employees’ State Insurance, Income tax,
Sales tax, Wealth tax, Service tax, Customs duty, Excise duty,
Cess and any other statutory dues) showing the following
details :
a) Name of the statute
b) Nature of the dues
c) Amount
d) Date of deduction
e) Due date
f) Date of deposit
g) Amount of deposit
h) Month wise deductions and contributions to Provident Fund and ESIC
9.1.2 Verify the details obtained in step (a) above with the relevant
records. Extent of check:
9.1.3 In the case of delays, are they significant? Ensure where the
company has not been regular in depositing the dues that the
extent of the arrears of such dues, if any, have been indicated
in the report by the auditor. Further ensure that the period to
which the arrears relate and, wherever possible, the fact of
subsequent clearance or otherwise have been indicated in the
report by the auditor.
9.1.4 Have the arrears been cleared? If not, have the amounts of
arrears been disclosed in the report?
9.1.5 Has the company been regular in deduction and/or deposit of
statutory dues in all cases? Ensure that management represen
-tation is obtained specifying amounts that are considered
disputed, containing a list of cases and the amounts in respect
of statutory dues which are undisputed and outstanding for >
6 months from the date they become payable.
9.2 Undisputed statutory dues
9.2.1 Obtain list of taxes/duties outstanding as at year end in respect
of :
a) Income Tax
b) Wealth tax
c) Sales tax
d) Custom Duty
e) Excise duty
f) Service tax
g) Interest tax
h) VAT
i) Others (specify)
9.2.2 In respect of undisputed amounts, identify those outstanding
for over six months as at year end.
9.2.3 Ensure proper disclosure of these items.
9.2.4 Where liability is disputed obtain a file note detailing the status.
9.3 Disputed Statutory dues
9.3.1 Obtain list of all disputed statutory dues whether provided
Or not in following format
Name of statute
Nature of dues
Year(s) to which it pertains
Amount (Rs.)
Forum where dispute is pending
10. Sick Industry
10.1
a) Has the Company been registered for a period of seven or
more years?
b) Are the accumulated losses of the company at the year end equal to or more than 50% of its net worth and
c) Has the company suffered cash losses in the concerned financial year and in the immediately preceding financial year?
10.2 Where the company is a sick industrial company, is a detailed
note justifying the preparation of accounting on a going concern basis placed on file?
11. Dues to financial institutions
11.1 Obtain a list of dues payable during the year to
a) Financial Institutions
b) Bank
c) Debenture holders
11.2 Whether theses dues have been paid in time? List all defaults in any payments showing the period of default and amounts.
12. Secured Loans and advances granted
12.1 Whether the company has granted any loans or advances on
the basis of security by way of pledge of share and securities?
12.2 Whether adequate documents and records are maintained for each such loan?
12.3 Whether the shares and securities held in Company’s name or are in possession of company-obtain confirmation letters from the parties who have pledged the security?
12.4 If proper documents or records are not available obtain explanation from the company – List of the Deficiencies.
13. Chit Fund, Nidhi or Mutual Benefit Company
13.1 Whether the net-owned funds to deposit liability ratio is more
than 1:20 as on the date of the balance sheet?
13.2 Whether the company has complied with the prudential norms
on income recognition and provisioning against sub-standard
/default/loss assets?
13.3 Whether the company has adequate procedures for appraisal of credit proposals/requests, assessment of credit needs and repayment capacity of borrowers?
13.4 Whether the repayment schedule of various loans granted by the nidhi is based on the repayment capacity of the borrower and would be conducive to recovery of the loan amount?
14. Investment Company
14.1 Is the company dealing or trading in shares, securities,
debentures and other investments?
14.2 Have proper records been maintained of transactions and contracts? Identify the records maintained by the company for recording the dealings/trading, transactions in shares, securities, debentures and other investments such as contracts etc, and ensure its adequacy?
14.3 Have timely entries been made in such records?
14.4 Have shares, securities, debentures and other investments been held in the name of the company?
14.5 If not, has company been exempted u/s 49 of the Companies Act?
14.6 Also refer to the RBI directions as Auditor’s report on NBFCs issued on 2nd January 1998.
15. Guarantees given by company
15.1 Obtain a list of all guarantees given by company on behalf of
others to any bank or financial institutions showing
a) Loan Amount
b) Period
c) Maximum liability as guarantor
d) Whether any security
e) Other terms and conditions
15.2 Whether any of the terms and conditions are prejudicial to the
interest of the company? If yes, ask for explanation from the
company;
15.3 Verify that parties on whose behalf the guarantees have been
given are financially capable of handling the liabilities
15.4 If not, obtain written clarification from the management why
the guarantee is not prejudice to the interest of the company.
16. Term Loans
16.1 If the company has obtained any term loans during the year or
earlier year, obtain a list of loans and the purpose for which
obtained as per the sanctions letter.
16.2 Verify that the loans are applied for the purpose for which they
were obtained
16.3 If any of the loan still remains to be applied; whether the same
has been kept separately in bank for future application?
16.4 Obtain confirmation from company that it shall be applied for
the same purpose for which they have been obtained.
17. Source of Funds and its application
17.1 Prepare a Cash Flow statement showing sources of funds and
application of funds segregating short-term funds and
investments and long term funds and investments.
17.2 List out Long-term funds
a) Long Term Investments
b) Short term Funds
c) Cash generation during the year
d) Change in the working capital
17.3 Whether long term investments match with total of long-term
funds and cash generation during the year?
17.4 Comment on whether the long term funds have been applied
for long term investments or not? If any adverse comment
discuss with the management.
18. Preferential Issue
18.1 Whether the company has made any preferential allotment of
shares to parties and companies covered register maintained
under sec. 301? Obtain the terms of the issue and the price at
which it is issued;
18.2 Whether proper resolutions have been passed and consent of
appropriate authority such as SEBI obtained?
18.3 Whether the price at which shares are issued has been arrived
at taking into account the market value of the shares of the
company?
Whether the issue price is unreasonable as compared to the
market value? Give % of issue price to market value;
18.4 If the issue price looks unreasonable ask for an explanation
from the company why it is not prejudicial to the interest of
the company;
Securities and debentures
19. Whether the securities have been created in respect of
debentures issued? Has the charge created been registered with
the ROC?
20. Verify from the Director’s Report whether the management has
disclosed on the end use of money realized by public issues.
21. Frauds
21.1 Whether any fraud committed anywhere has been noted during
The audit? Whether full investigation has been carried out?
21.2 Whether the company has filed any complaint with the police
or criminal case registered against any person for any fraud
committed. Get a list of cases filed from the company;
21.3 Whether any other party has filed any criminal case or
complaint against the company for any fraud or cheating?
21.4 Whether any time during the year or period of audit any report
of fraud committed by company reported in press has been
noticed?
21.5 Collect the details of all such frauds by or against the company
together with the amount involved.

Special Economic Zones (SEZ) are likely to get total exemption from tax on their profits soon

The next meeting of the empowered group of ministers (EGoM), scheduled to take place on

Friday, would take up the issue of totally exempting the export profits of SEZ units from income

tax for a tax holiday period of five years.



Among other controversial matters that are on the agenda is the definition of what constitutes a

‘vacant’ land and in this context whether it should withdraw the approval given to Adani

Group’s multi-product SEZ at Mundra in Gujarat and Essar’s steel SEZ for alleged violation of

the rules regarding vacancy of land. Also on the table are categorizing SEZs as core sector

projects, exempting SEZ units from Minimum Alternate Tax (MAT), doing away with export

duty on supply of steel to SEZs, as well as extending Cenvat credit facility to SEZ developers,

sources said.



At present, the particular provision that deals with this issue of tax on export profits of SEZ units

is Section 10AA of the Income Tax Act. This Section accords income tax exemption to the SEZ

Units on the export income. But, as per the Section, export turnover of the unit is divided by the

total turnover of the assessee while calculation of exemption from export profit.

Important Changes in ROC annual filing

As you all are aware that Annual Filing Forms to be filed with the ROC i.e. FORM-23AC, FORM-23ACA, and FORM-20B have been revised w.e.f. 28.09.2008, and version of some other Forms i.e. FORM-66, DIN-3, FORM-1, FORM-18, FORM-32, and FORM-1A have been changed w.e.f. same date.



There are some important points to be noted here before filing of Annual Return and

Balance sheet of the company to avoid additional charges:



1. Every Auditor/ Auditor Firm of the company is requiring giving intimation of his/ its

appointment/ re-appointment to the ROC by filing FORM-23B ON-LINE. (No ROC fee

applies) before filing of BALANCE SHEET. It is important to be noted here that FORM-

23B has to be digitally signed by AUDITOR only. All Auditor/ Auditor Firms are now

requiring having Digital Signatures for filing of FORM-23B.



2. Secondly, Auditor is require to receive an intimation of his appointment from all the

company concerned in which he has been appointed or re-appointed as an Auditor, which

shall be attached with FORM-23B to be filed with the ROC by auditor.



3. SRN (Service Request Number) of Form-23B filed with the ROC is MUST to be

mentioned in FORM-23AC for filing BALANCE SHEET.



1. Some of the new changes have been made in FORM-23AC for Filing of Balance Sheet, i.e. SRN (Service Request Number) of FORM-66 (In those cases where Compliance Certificate is required to be filed) is required to be mentioned in FORM-23AC.



2. DIN No. of Directors is required to be mentioned in FORM-23AC, who has signed the

BALANCE SHEET/ DIRECTOR REPORT.



3. SRN (Service Request Number) of Form-23B filed with the ROC is MUST to be

mentioned in FORM-23AC for filing BALANCE SHEET.



4. FORM-23AC is required to be Certified (Digitally Signed) by Practicing CS/CA along

with Director of the company.



5. FORM-23ACA is required to be Certified (Digitally Signed) by Practicing CS/CA along with Director of the company.



6. DIN No. of all Directors who are directors as on Date of AGM is required to be

mentioned in FORM-20B.



7. Detail of all Directors who ceased to be directors since the date of LAST AGM is

required to be mentioned in FORM-20B.



8. In case of Listed company Name and C.P. No. of Practicing C.S.



4. FORM-20B is required to be Certified (Digitally Signed) by Practicing CS/CA along

with Director of the company.

Measuring “Skill” and Earning “Return”.

As an investor, this one is going to be a tough call. You want to invest Rs 10,000 today in a mutual fund. Where should you invest? Should you invest in the fund that has given investors a higher return? Or should you invest in the fund which has a better fund manager? You might ask “Is it not that the fund which has performed better have the better manager?” Well, the answer surprisingly is “No.”

To understand that you must get to know two more “rates of return”. Let me explain them with an example

Scene 1: Mr. X, Mr. Y and Mr. Z are the chief investment officers (CIO) of three funds namely Fund X, Fund Y and Fund Z respectively. Each of these funds began on 1st Jan 2006 with a portfolio of Rs 100 crore. A year later the value of their portfolio fell by 50%. That is, on 1st Jan 2007 it stood at Rs 50 crore. This means that the performance of all three CIOs in the first year has been identical. Now suppose in the second year the portfolio appreciated by 100%. That is, on 1st Jan 2008 it stood at Rs 100 crore. This means that the performance of all three CIOs the second year has been identical. Hence, across two years, all three of them have performed alike.

Scene 2: Let’s tweak the scene a bit. Suppose at the end of year 1 when the market had fallen, investors of Fund X thought that this was the right time to invest further and that they poured an additional Rs 50 crore into Fund X. So on 1st Jan 2007 the Fund holds the initial Rs 50 crore plus the additional Rs 50 crore, adding to Rs 100 crore. This Rs 100 crore doubles in the second year to touch Rs 200 crore. In essence a total investment of Rs 150 crore has grown to Rs 200 crore generating a positive IRR.

Now turn to Fund Y. Suppose at the end of year 1 the investors of Fund Y decided to adopt a wait and watch attitude. Hence they decided to keep off the market. So on 1st Jan 2007 the Fund holds the initial Rs 50 crore only. This doubles in value in the second year to touch Rs 100 crore. In essence, across two years, a total investment of Rs 100 crore has stagnated at Rs 100 crore giving a zero IRR

Finally, let’s look at Fund Z. Suppose at the end of Year 1 the investors of Fund Z felt that it was time to partially exit the market and hence withdrew Rs 25 crore. So on 1st Jan 2007, the fund whose value had like others depleted to Rs 50 crore paid Rs 25 crore and has Rs 25 crore only for investment. This Rs 25 crore doubles in value in the second year to touch Rs 50 crore. In essence a total investment of Rs 75 crore has fallen to Rs 50 crore generating a negative IRR.

The bottom line: Fund X has given the best return, Fund Y the second best return and Fund Z the least return. This however does not mean that CIO Mr. X is more skilled than CIO Mr. Y and that CIO Mr. Y is more skilled than CIO Mr. Z. Remember the performance of the three CIOs is identical because in the first year their value went down by 50% and in the second year it rose by 100%.

Yet their IRRs are different; the first was positive, the second zero and the third turned out to be negative. This had to do with the intervening inflows and outflows of cash. Additional moneys came to Fund X at the right time and additional moneys went out of Fund Z at the wrong time affecting the overall return. The moral: Fund returns are a function of fund manager’s skills and the time when investors pour money.

So what does this mean?

This brings us to a crucial point. That we must make a distinction between the skills of the manager and the returns earned. The return relevant to measure skill is called time-weighted rate of return. In this case we ignore the intervening inflows and outflows of cash. We merely look at how Rs 1 has progressed over a period of time. In our example, in the case of each of the funds, the Rs 1 invested in time zero became Rs 0.50 in time 1 and ended as Rs 1 at end of second year, leading to nil over-all return.

The return relevant to measuring returns earned is called rupee-weighted rate of return. It considers the intervening inflows and outflows of cash and is the same as IRR. This in our example was highest in the case of X, second highest in the case of Y and least in the case of Z

DURATION AND INTEREST RATE RISK

When you buy a bond you are subject to interest rate risk. Interest rate risk is the risk associated with changes in market interest rates after the bond has been issued.

For instance, suppose after a bond has been issued at a coupon of 10%, the interest rates in the market go up to 11% or fall down to 9%. This causes risk to the investor. Here risk means that the terminal value of his investment undergoes a change

To understand this we must appreciate two facts.

One, the annual interest received will be reinvested at market interest rate. Two, when this rate increases the value of the bond will fall. However, the terminal value of the interest reinvested will go up because annual interest is now reinvested at higher rates. Similarly if the current yield falls, the value of the bond will go up but the terminal value of the interest reinvested will fall because they are now reinvested at lower rates. This changing value is what we call risk.

Let me explain with a couple of linked examples.

Case 1: You buy a 5 year bond with a face value of Rs 100, a coupon rate of 10% and redemption at par. This means that you will get Rs 10 every year for five years. At the end of the 5th year you will receive the redemption price of Rs 100

Now if the going yield is 10% it means that you can reinvest your interest amounts at 10%. If you do reinvest for the balance period of the bond you will end up having Rs 161.05 on maturity.

Suppose as soon as you bought the bond, the going yield drops to 9%. The maturity value of your investment will now be Rs 159.85. The drop in interest rate has hurt you. Alternatively if the going yield increased to 11%, the maturity value of your investment will be Rs 162.28. The increase in interest rate has helped you.

Case 2: Now let us say that when you bought the bond you decided you will keep it for 3 years only. That means that the first year interest will be invested for 2 years, the second year’s interest for 1 year etc. If the yield is 10%, the price of the bond at the end of the third year when you wish to sell would be Rs 99.95. Remember, the market price of a bond at any point in time is the present value of the future cash flows associated with the bond discounted at the desired yield.. Annual interest amounts would have been invested to mature at the end of the third year from the date of purchase of the bond. The total money, including reinvested interest, that you will receive at maturity (3rd year) will be Rs 133.05.

Suppose after you buy the yield falls to 9%. The price of the bond on sale after three years will fetch Rs 101.68. The total money including reinvested interest that you will receive on maturity is Rs 134.46. You have gained the difference between 134.46 vs. 133.05. Alternatively, if the yield after you bought went up to 11% the price of the bond on sale after three years will fetch Rs 98.33. The total money including reinvested interest that you will receive after three years is Rs 131.75. You have lost the difference between 133.05 vs. 131.75

Computing duration

Well, you have had a whole lot of numbers. So what are the conclusions?

One, when interest rate increases, the 5 year investor gains and the 3 year investor loses. There must therefore be some number of years at which the increase in interest rate neither leads to a win or a loss. Two, when interest rate falls, the 5 year investor loses and the 3 year investor wins. There must therefore be some number of years at which the fall in interest rate neither leads to a win nor a loss.

This some number of yeas is called the Duration of the bond. By buying bond for that duration you eliminate interest rate risk. i.e. there will be no change in terminal value based on interest rate movements.

Here’s the most critical question. How do we compute duration? Do we have to work in the elaborate manner shown above. Luckily no. A few quick steps and you get the duration

1. Compute the present value of the cash flows by discounting at current yield
2. Aggregate the result
3. Calculate the ratio of the present value of each year to the aggregated value.
4. Multiply this ratio with the number of years
5. Aggregate the result in (d)

In our example the duration is about 4.18 or 4 years. That is, in the given example, a 4-years investor is insulated from interest rate risk.

Picking the Right Stocks

Picking the Right Stocks

After assessing that an economy is worth investing in, one needs to decide which industry to park his money. For, while the economy may be doing outstandingly well, not every industry in the economy would be good bargain buys. Here is a list of 15 factors that you like to take a look in your search for the right industry

1. Sales: It is Sales that brings in profit to an industry. What is important is not the absolute level of sales but its growth trend. While there is nothing like an “ideal growth” because growth is also a function of the base level of sales (given the mathematics of a low base, the growth levels tend to be high, when sales levels are low) and while it can differ from industry to industry, Sales should grow at-least at 2 times the Inflation levels. Sales (market share) is the key metric for FMCG industries.

2. Return on Capital Employed: Look at the ROCE in the industry. ROCE measures how productively money is used. Capital employed is the sum of equity funds and loan funds. Return refers to EBIT. Hence ROCE here is pretax ROCE. Again, while this can vary from industry to industry, it makes little meaning in investing in an industry whose ROCE is less than 15%.

3. Competition: While competition pushes an organization to stretch and is hence welcome, but an overhang of it would lead to unhealthy practices such as price cuts and unrealistic cost reductions. Price cuts merely transfer the profit margin from the industry competitors to the customer. Competition eats into profits and can over time erode profitability and converts the industry into a commodity. Price driven competition can often threaten the very survival of an industry. The airlines industry comes as too close an example.

4. Critical cost component: Getting to know what that critical cost component is important. You must also know whether the industry has control over that component. For instance, for the tobacco industry, indirect tax is a critical cost component. The industry has no control over it. For some industry, imported raw material may be the key cost component.

5. Technology: Technology is the new mantra. Technology has done wonders to the way that we live and the way that we transact business. Mobiles, Internet and e-commerce have all revolutionized our lives. Any industry that does not embrace technology is doomed. If an industry is still old fashioned and keeps away from technology, you must keep away from that industry.

6. Governmental promotion: Governmental support can go a long distance in propelling the growth of an industry. The Information Technology industry is the best example of this with it having flourished thanks to a series of governmental concessions such as tax sops, cheap land allocation and most importantly non interference in its functioning (!). You would love an industry that has such pampering and backing.

7. Skilled manpower: Does the industry enjoy technically skilled manpower. It’s important to figure out what is driving success. Skilled manpower helps to maintain product quality and offer customized products, thereby resulting in better customer satisfaction. The mammoth growth of the IT –ITES industry in India is not merely on account of cost arbitrage but efficiency arbitrage as well with a slew of well trained, English speaking, high on IQ manpower being available.

8. Constant Innovation: Does the industry constantly reinvent itself. This is more critical in the case of industries which experience rapid changing technology/customer expectations have to spend huge sums of money in constantly upgrading to newer product versions. Industries such as Pharmaceutical and Consumer electronics spend huge sums of money towards R&D to ensure that their products stay “latest”.

9. Supply side constraints: Some industries perennially face lack of supplies at reasonable prices, which hamper their ability to exploit favorable market conditions. Take the fact that the demand for crude has opened up a huge market for oil exploration companies. But worldwide shortages of drilling equipments like rigs and offshore diving vessels have slowed down the exploration activity.

10. Commoditized products: Where the products sold by players in an industry are not unique, then customers make their choices purely based on pricing. For example, agro based industries like sugar, cotton are price takers, since customers try to pull down the prices close to the cost of production.

11. Regulatory constraints: A highly regulated industry generally has very little scope to enjoy pricing independence and margin improvement. For example, despite strong customer base and established products, the cigarette industry struggles to protect its margins as the government constantly toys with excise duty on cigarettes.

12. Cyclical demand: If the demand is highly cyclical, the margins come under pressure since the industry has to constantly spend cash to “be on alert” should an opportunity come. For instance, the demand for drilling equipments is cyclical. However, manufacturers of these equipments would have to continue incurring maintenance capex to keep their production facilities in shape, till the next wave of demand comes through.

13. Growing domestic demand: An industry that enjoys a growing domestic demand is insulated from happenings in the global market place including exchange rates. Currently, FMCG, Retail and Real estate enjoy this advantage.

14. Expanding export market: This is not to belittle an export driven industry. Such industries generally enjoy higher margins due to their relatively lower cost base. In addition, export markets of developed countries are huge in size, offering potential for the exporter to grow his sales rapidly. Companies such as TCS and Infosys have been able to maintain high sales growth and decent margins for the last several years because of the export factor.

15. Macro trends: Rising interest rates, unfavourable currency movements, change in fiscal policies etc can impact industries. Rising interest rates have slowed down growth of banking industries as credit intakes slow down. SImiliarly, recent depreciation of rupee have had negative impact on industries like paint that rely on imported raw materials.

At the end of this you are for sure not going to be an “industry” specialist buy you would have got a good understanding of what to look for in an industry.

Picking the Right Company

After you have decided that the economy is good investing in and after you have identified the right industry to park your money, you should lay your hands on the right company. As Peter Lynch says, “Identifying the right industry but the wrong company, is like marrying into the right family but the wrong girl.”

Here are eight financial and three non-financial parameters that you should look into when you invest in a company.

Return on Capital employed: This refers to the amount earned by the company on the total funds employed in business. The capital means both equity capital and loan capital. Equity capital would of-course included reserves as well. Return would mean profit after tax plus interest on long term funds, adjusted for tax. This measures the productivity of money and is the closest measure of finding out the underlying economics of the business. The higher the ROCE, the better for the investor. At minimum, ROCE should be equal to the Weighted Average Cost of Capital (WACC) of the company. The WACC is the rate of return that equity shareholders and debt holders put together want to earn.

Return on equity: Return on equity measures the total return earned on the shareholders fund invested. It is the ratio of profit after tax to shareholders funds. Over the long term, the value of a company would move in lock step with the return on equity. The higher the ROE, the better for the investors. Generally, ROE is higher than ROCE since the cost of debt is generally lower than ROCE thus resulting in equity holders enjoying a higher share in the total returns pie.

Historical sales growth: This is an indicator of how the company has been able to grow its business over the long term. This, compared with the industry growth rate would give an indication of whether the company is increasing its market share or not. Also, this would help in finding out whether the business is in growth or maturity phase. This will also you to understand the seasonality of the business and accordingly interpret the growth of recent past.

Free cash flows to shareholder: Business is not about booking accounting profit; hence cash surplus is more important than accounting surplus. Free cashflow is found out by deducting the upcoming maintenance capital expenditure from the cash from operations. A business might be earning lots of profits, but if a large portion of it are to be spent in maintaining the fixed assets, then the “real returns” to shareholders will be less. Thus, the higher the free cash flows, the better for the investor.

Debt/equity ratio: This compares the debt employed in the business relative to the equity component. Also called leverage, this can help magnify the return to the shareholder and is invariably used for that purpose. However high leverage would create problems for the company, especially when there is a business slowdown. Though there is no hard and fast rule of what is the ideal debt/equity mix, a debt /equity ratio of higher than 2 is considered risky.

Working capital: In simple terms, working capital refers to the amount of cash required by the company to run its day to day business. The need for working capital arises since there is a time lag between business expenses and realization from customers. Higher working capital means that cash is locked in unproductively. The ratio of sales to working capital is important. Higher this ratio the better because it implies that there is a bigger bang being got for every rupee of working capital

Profitability margins: Margins refer to the difference between sales and cost. Margin is an indicator of the value add provided by the business to the customer.. Consistently higher margins imply that the business has the ability to pass on the hike in cost to the customers. Some of the crucial margin numbers that you should chase are Gross Margin, EBIT margin and Net margin. Gross margin is the ratio of gross profit to sales where gross profit is the difference between sales and manufacturing cost. EBIT margin is the ratio of operating profit to sales where operating profit is profit before interest and taxes. Of-course in the end the ratio of net profit to sales is crucial

Degree of exposure to macro factors: An investor should be aware of the exposure of the company to macro factors like exchange rates, interest rates, inflation etc. For instance, depreciation of the rupee is good for exporters, whereas it increases the cost of imported goods for importers. Similarly, a company with high amount of borrowing at floating rates would see an increase in interest cost if the PLR is increased.

Non financial factors

Quality of management: Management is the trustee of the shareholders funds and is responsible to run the business in the best interests of the shareholders. A good management consistently displays two traits. One, employing the shareholders funds in “high return” projects after careful analysis. And two, linking the rewards of the management closely with that of the shareholders. Investors should carefully study management guidance, managerial remuneration policy etc to see whether management actually acts in the interest of the shareholders.

Competitive advantage and its durability: You should carefully understand the unique selling proposition of the company that will help the company to sustain in today’s highly competitive environment. This can be in the form of established brands (for FMCG, fashion businesses), patents & Intellectual property rights (for pharma, technology companies), location (for hotels, retailers), cost of funds ( for banks, NBFCs), quality of manpower (for software companies). If the company does not enjoy any unique advantage, then it becomes highly vulnerable to competition and is likely to make lots of compromises like price cut etc in order to ensure its sustenance.

Accounting policies: You should understand key accounting policies to find out whether they are reasonably conservative. A very aggressive accounting policy is not good as it might temporarily inflate the profits and cause fluctuations in earnings. A few common accounting manipulations include capitalizing expense; making inadequate provisions; non disclosure of off- balance sheet commitments (like contingent liabilities, hedging contracts etc); big bath accounting (namely booking fictitious expenses when PE of the company is low and reversing them when PE multiple improves; not routing expenses through income statement (directly adjusting losses against reserves).

Now that you have a clue to how company analysis is done at a broad level, you should be able to pick stocks.

The Portfolio Mix

There are a host of investment options to choose from.

Bank deposits are safe. As safe as a bank is the obvious dictum. They offer liquidity. And today they give you 10% per annum. Under the inflation rate for sure, but that’s an aberration.

Then there are the fixed maturity plans from mutual funds. More tax efficient than banks because they are listed in the stock exchange they also offer upto 12% return For sure, better than the bank.

The public provident fund is by far the best pick under the Section 80 C scheme. It gives you tax rebate and so to that extent axes taxes. Of-course of later there have been questions on how safe are our provident funds but remember they are backed by the government. If the country’s finances go kaput then no investment is worth it!

Savings account is a slot where you need to park some money. After all, you will require money at call or at short notice. A sudden emergency here or a sudden emergency there and it wouldn’t pay to appear to be strapped for cash.

No one can forget gold. The yellow metal’s steady performance and its record of being man’s best friend in moments of calamity makes it a needed pick in any portfolio.

Equity, with its heady prospects of giving out attractive returns should be the pick of the pack. History records that India’s Sensex has given an average return of 16% per annum across the last 17 years. That’s impressive by any standards considering that Sensex represents equity as a class and does away with issues like being able to pick good stocks at right times. What it implies is that if you invested in the Sensex, each month, month on month during the 204 months (17 years) you would have earned 16% per annum compounded.

If you fight shy of investing in equity because you either don’t have the expertise to invest or don’t have the time or inclination to do so but still believe in the equity story you have mutual funds of the growth variety to fall back upon.

While these will form part of your portfolio there are two more about which you cannot afford to forget.

The first is property. Once upon a time people invested in just one house. They looked at it as an emotional investment. Today with growing disposable income that practice has changed. People are buying houses early and they are buying more. Property prices too are shooting rapidly. Every portfolio should overtime have an exposure to real estate. Real estate mutual funds (REIT) are also on the way.

The next one is not an investment but should form part of your repertoire of choices. “Life Insurance”. Every young man and woman should buy insurance for an amount that will help the heirs maintain the present standard of living should something unfortunate happen to the bread winner. Of-course as you grow older or progress in your career your assets increase and your needs decrease. So it is quite possible that a time would arise when you would no longer need insure. That’s the time when you should kick out of it.

And may be overtime you should also look at international investments.

The accompanying table gives a broad indication of a portfolio mix for people in different age groups. Financial prescription, like medical prescription, has to be tailored for individual temperament and needs. But this can be a good starting point. By establishing portfolio you can cut risk and look forward to healthy returns.