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Unit 9: Audit of Limited Companies

Who can be Auditor: Section 226 of the Companies Act, 1956 deals with the qualification of Notes
company auditors? It intends to ensure that the auditors are independent of the companies they
audit. A body corporate cannot be appointed as an auditor because it has a limited liability.
Clause (b) of sub-section (3) of Section 226 of the Act disqualifies an officer or employee of the
company from being appointed as its auditor. According to a clarification of the Department of
Company Affairs the legal position is as follows:
“Where the chartered accountant is employed whole-time, he is an employee of the company. In
other cases, generally speaking there would appear to be only a contract for service and not a
contract of service between the company and chartered accountant. In Dhrangadhra Chemicals
Works v. State of Saurashtra (1957 S.CA, p. 216) the Supreme Court has laid down that the prima
facie test for determination of the relationship between master and servant is the existence of the
right in the master to supervise and control the work done by the servant not only in matter of
directing that work the servant is to do, but also the manner in which he shall do his work, or to
borrow the words of Lord Uthwatt, the proper test is whether or not the hirer had authority to
control the manner of execution of the act in question. Applying this test in any case, where the
chartered accountant is consulted only professionally on income tax matters by a company, he
can not be said to be an officer or employee of the company.”

“A Chartered Accountant’s main business is to render professional service for reward like a
lawyer or a doctor. Where such service is rendered professionally and not as an officer or
employee of the company, a chartered accountant is not disqualified under Section 226(3) (b) of
the Companies Act, 1956.”
It is, however, clear that there is no prohibition on a relative of a director or a partner of such
relative to be appointed as an auditor. The provisions of Section 297(1) would also not apply to
the appointment of such a person as an auditor because an audit is in the nature of rendering
personal service obtained not on the basis of the lowest tender but on account of professional
expertise irrespective of cost involved. However, the appointment of an auditor who is a relative
of a director or a firm of auditors in which a director of the company or his relative is a partner
would be an office of profit under Section 314 requiring the consent of the company by a special
resolution, if the total monthly remuneration exceeds prescribed limits (Section 314). Prior
consent of the company and approval of Central Government (Company Law Board) would
also be required in appropriate cases. Moreover, a chartered accountant in practice shall be
deemed to be guilty of professional misconduct under the Chartered Accountants Act, 1949 if he
expresses his opinion on the financial statements of any enterprise, in which he, his firm or a
partner in his firm or any of his relatives have a substantial interest, unless he discloses the
interest also in his report. The term “relatives” is to be construed with reference to Section 6 of
the Companies Act. Similarly, the expression “substantial interest” is to have the same meaning
as is assigned thereto under Explanation 3 to Section 13 of the Income Tax Act, 1961. Further,
clause (d) of sub-section (3) of Section 226 of the Act states that a person indebted to the company
for an amount exceeding 1,000 or a person who, has given any guarantee or provide any
security in connection with the indebtedness of any third person to the company for an amount
exceeding 1,000 is not qualified for appointment as an auditor. Some special situations are
discussed below:

(a) In this context, a question may come up as to whether such indebtedness would arise in
cases where, in accordance with the terms of appointment by a client, the auditor recovers
his fees on a progressive basis as and when a part of the work is done without waiting for
the completion of the whole job. According to the Research Committee of the Institute “a
question often arises as to whether indebtedness arises in cases where in accordance with
the terms of his engagement by a client (e.g. resolution passed by the general meeting) the
auditor recovers his fees on a progressive basis as and when a part of work is done without
waiting for the completion of the whole job. In these circumstances, where in accordance

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