Duty Department/Individual
Provides authorizations of employees and their pay rates – Human resources
Oversees employees’ working hours (time cards) – Timekeeping
Prepares the payroll register – Payroll
Prepares payment vouchers – Accounts payable
Approves the payments (signing checks) – Cash disbursement (CFO)
Records the payrolls – General ledger
Electronic Data Interchange – EDI is the communication of electronic documents directly from a computer in one entity to a computer in another entity.
The advantages of using EDI are:
An audit trail allows for the tracing of a transaction from initiation to disposition. One key element of an audit trail in transactions involving auditing electronic data interchange (EDI) is the activity log.
Completeness assertion for sales and receivables
Reconciling total amounts in subsidiary ledgers with the general ledger
Performing analytical procedures (e.g., comparing accounts receivable turnover with previous year)
Accounting for the numerical sequence of sales orders, shipping documents, and invoices
Tracing from sales invoices to shipping documents
Accuracy assertion for sales and receivables
Obtaining management representation letters
Evaluating disclosures about reportable operating segments (e.g., geographic areas)
Comparing general ledger balances with financial statement balances
Preparing bank reconciliations
Valuation and Allocation assertion for sales and receivables
Comparing aged accounts receivables schedule with the prior year’s
Tracing subsequent cash receipts
Reviewing delinquent customers’ credit ratings
Testing the allowance for credit losses and write-offs
Existence assertion for sales and receivables
Sending external confirmations
Vouching journals to shipping documents
Cutoff assertion for sales and receivables
Sales cutoff – Testing whether revenue is recognized in the appropriate period
— Tracing shipping documents to accounting records near year end
Cash receipts cutoff – Testing the recording of cash receipts and accounts receivable reduction
— Tracing daily remittance list to accounting records near year end
Rights and Obligation assertion for sales and receivables
Inquiring of management (e.g., whether the accounts receivable is pledged and factored)
Tracing cash receipts to deposits into bank accounts
Determining the right of return, expected returns, and actual returns
Occurrence assertion for sales and receivables
Vouching samples of recorded sales transactions to customer orders and shipping documents
Classification and understandability assertion for sales and receivables
Evaluating
— Classification of
–Sales (minus returns and allowances) as revenue
— Accounts receivables (minus allowance) as current assets
Disclosures of
— Accounting policies
— Pledges and factoring of accounts receivables
— Sales and receivables with related parties
Types of Controls and Scope
General controls – The organization’s entire processing environment
Application controls – Particular to each of the organization’s applications
Three Categories of Application Controls are:
Input controls
Processing controls
Output controls
Three types of controls classified by function are:
Preventive controls
Detective controls
Corrective controls
Input controls provide reasonable assurance that data submitted for processing are
Authorized
Complete
Accurate
Examples of Input Controls are:
Preformatting Entry in an online tax return
Edit (field) checks – Rejecting the input of letters for SSNs
Limit (reasonableness) checks – Rejecting working hours of over 100 per week
Check digits – Using algorithms to verify ID numbers
Record count – Matching the number of time clock cards with the number of payroll records processed
Financial total – Matching the sum of individual salaries with total salaries
Hash total – Matching the sum of individual SSNs with a predetermined total
Processing controls provide reasonable assurance about:
Processing controls provide reasonable assurance that
All data submitted for processing are processed
Only approved data are processed
Examples of processing controls.
Control Description /Example
Validation Rejecting transactions by vendors whose vendor numbers are not in the vendor master file
Completeness check – Rejecting records with missing data
Arithmetic controls – Zero-balance checking
Output controls provide assurance that processing was complete and accurate.
Control Description/Example
Audit trail Checking for the completeness of each process
Error listing Reporting all transactions rejected by the system
Three Objectives of Internal Control are:
Operations
—- Effectiveness and efficiency of operations
Reporting
— Reliability of financial reporting
Compliance
— Compliance with applicable laws and regulations
5 Components of Internal Control are:
Internal controls stop CRIME
Control activities Policies and procedures
Risk assessment process Identification and analysis of relevant risks
Information system Information systems and communication
Monitoring of controls Assessment of control effectiveness over time and corrective actions
Control environment Tone at the top and control consciousness of members
Internal controls provide only reasonable assurance, but not absolute assurance, that an entity’s objectives are met.
Inherent Limitations of Internal Control are:
Human error (e.g., faulty human judgment)
Collusion
Management override
Cost and benefit constraint
Documentation of Audit Plans include:
The overall audit strategy (basis of the audit plan)
Procedures to be performed
Risk assessment procedures
Further procedures
Other procedures
Involvement of specialists
Three aspects of audit procedures should be documented in audit plans are:
NET of procedures
N = Nature
E = Extent
T = Timing
Factors external auditors consider before using the work of internal auditors are:
The objectivity of the internal auditors
The level of competence of the internal audit function
Whether the internal audit function applies a systematic and disciplined approach
Factors auditors consider before using the work of a specialist are:
The auditor should evaluate whether the auditor’s or management’s specialist has the necessary
Competence,
Capabilities, and
Objectivity.
Transactions that may suggest related-party transactions are:
Exchanging property for similar property in a nonmonetary transaction
Borrowing or lending at rates significantly above or below market rates
Selling realty at a price materially different from its appraised value
Making loans with no scheduled repayment terms
Accounting estimates
The objective of the auditor is to obtain sufficient appropriate audit evidence about whether accounting estimates, including fair value accounting estimates, are reasonable and related disclosures are adequate. This is achieved by determining whether
Management has appropriately applied the applicable financial reporting framework
The methods for making the accounting estimates are appropriate and have been applied consistently
The estimates, individually or collectively, exhibit no significant management bias
[A] Pre-Engagement Acceptance Responsibilities
1) Preconditions for an Audit – Auditor to determine that management uses
2) Client Acceptance –
It is continuous evaluation of existing clients and evaluation of new clients
3) Engagement Letter –
Engagement Letter to include audit scope, limitations, expectations, fees and responsibilities of management for services
[B] Planning an Audit
Planning – Overall strategy for the audit (Size and complexity of the entity, Auditor’s experience and Auditor’s understanding and environment of the entity including internal control)
Audit Plan (Nature, timing and extent of procedures expected to reduce audit risk to an acceptably low level). Audit Plan includes a description of risk assessment procedures directed toward the risk of material misstatement. Risk assessment procedures are performed to obtain an understanding of the entity and its environment, including its internal control, to identify and assess the risks of material misstatements at the a) Financial statements as a whole and b) Relevant assertions
Supervision – 1) Directing the efforts of assistants in accomplishing the objectives of the audit ; 2) Determine if the objectives were accomplished. – a) Instructions ; b) Informed of problems encountered ; c) Reviewing the work ; d) Resolving differences of opinion
Differences of Opinion – a) Assistant to document his / her disagreement with the conclusion reached b) Document the basis of final resolution
Internal Audit Plans – Internal auditor’s work is more comprehensive. They are more detailed and cover areas that normally are not considered by the independent auditor
[C] Audit Risk and Materiality
[1] Audit Risk – Risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated
3 components of Audit Risk :
a) Inherent Risk – Susceptibility of an assertion to material misstatement in absence of related controls
b) Control Risk – Risk that internal control will not prevent or detect on a timely basis a material misstatement
c) Detection Risk – Auditor will not detect a material misstatement that exists. It is a function of audit effectiveness of an audit procedure and its application by the auditor.
[2] Materiality – Materiality is a matter of professional judgement about whether misstatements could reasonable influence the economic decisions of users as group.
Materiality – Planning Purpose :
1. Financial Statement level as a whole
2. Particular account balances, classes of transactions or disclosures
3. Performance Materiality
Audit Risk and Materiality have an Inverse Relationship
The risk of a large misstatement may be low, but the risk of a small misstatement may be high
Auditor is required to perform atleast one of the following:
a) Perform Effective Procedures
b) Perform Procedures nearer to year end
c) Increase the extent of certain procedures
[3] Evaluating Findings – Considers the individual and aggregate effects of misstatements. Likely misstatements not merely known misstatements.
[4] Documentation – Document a) Amount of Misstatement that are trivial ; b) All Misstatements accumulated ; c) Whether misstatements are corrected ; d) Basis of conclusion that the uncorrected misstatements are material
[D] Understanding the Entity and its Environment
1) Auditor to obtain a sufficient understanding of the entity and its environment including its internal control
2) Auditor need not acquire this understanding PRIOR to acceptance of the engagement
3) Knowledge may be obtained from a variety of sources :
a) Prior year working papers ; b) Inquiries of entity personnel ; c) Experience with the entity or its industry ; d) AICPA Accounting and Audit Guides, industry publication and periodicals etc.
4) Risk Assessment Procedures – a) Inquiries of management and others within the entity ; b) Analytical Procedures ; Observation and Inspection
[E] Analytical Procedures
1) Evaluation of financial information made by study of plausible relationship among both financial and non financial data
2) Significant differences between expectations and recorded amounts should be investigated and evaluated
3) Analytical Procedures are : 1) Required to be used as risk assessment procedures in PLANNING
4) PERMITTED but NOT REQUIRED to be applied as SUBSTANTIVE TESTS
5) REQUIRED to be used in the FINAL REVIEW STAGE of the audit
[F] Risk Assessment Procedures –
a) Improve the understanding of the client’s business and significant transactions and events since the last audit
b) Identify unusual transactions or events and amounts, ratios and trends that might indicate matters with audit planning implications
c) Auditor develops expectations of recorded balances from a) Comparable prior periods ; b) Budgets or Forecasts ; c) Relationship among data ; d) Information from Client’s Industry ; e) Related non financial information
d) Analytical Procedures applied as Substantive Tests : a) The nature of assertion ; b) Plausibility and predictability of relationship ; c) Availability and reliability of data ; d) Precision of the expectations
e) Analytical Procedures used in Final Review Stage – a) Assess conclusions and overall financial statement presentation ; b) Read financial statement and notes – (i) Adequacy of Evidence in response to unusual balances identified in planning or conducting the audit ; (ii) Unusual or unexpected balances not previously identified
[G] Ratio Analysis – a) Unexpected changes in ratios ; b) Potential explanation of changes in ratio
1) Current Ratio = Current Assets / Current Liabilities
2) Quick (Acid Test Ratio) = (Current Assets – Inventory)/Current Liabilities
3) Receivables Turnover = Net Sales / Average Net Receivables
4) Day’s Sales in Receivables = 365, 360, 300 / Receivables Turnover
5) Inventory Turnover = Cost of Goods Sold / Average Inventory
6) Day’s Sales in Inventory = 365, 360, 300 / Inventory Turnover
7) Total Assets Turnover = Net Sales / Total Assets
8) Debt to Equity Ratio = Total Debt / Total Equity
9) Times Interest Earned = (Net Income + Int Exp + Income Tax) / Interest Expense
10) Cost of Goods Sold = Cost of Goods Sold / Net Sales
11) Gross Margin Percentage = (Net Sales – Cost of Goods Sold) / Net Sales
12) Net Operating Margin Percentage = Operating Income / Sales
13) Return on Equity = Net Income / Total Equity
[H] Consideration of Fraud in a Financial Statement
1) Management is responsible for programs and controls that prevent, deter and detect fraud
2) Management and oversight authorities must set the proper tone and maintain a culture of honesty
3) Auditor cannot obtain absolute assurance that material misstatements will be detected because of characteristics of fraud and limitations of audit evidence
4) Properly planned audit may NOT detect a material misstatement resulting from fraud because of : a) Concealment aspects of fraudulent activity ; b) Control overriding by Management; c) Altering accounting records or withholding evidence ; d) Professional Judgement in identification and evaluation of fraud risks
5) Fraud differs from Error because it is intentional – a) Fraud involves pressures or incentives to commit fraud, perceived opportunity to do so and capacity to rationalize
6) Types of Fraud – a) Fraudulent financial reporting (Intentional misstatements or omissions to deceive users) ; b) Misappropriation of Assets (Theft, embezzlement that causes Financial Statements to be materially misstated)
7) Professional Scepticism – Auditor to a) Critically assess evidence ; b) continually question whether fraud has occurred ; c) Not accept unpersuasive evidence solely because management is believed to be honest
8) Assessment of Risks –
9) Evaluation of Audit Test Results – a) If discovered fraud is not material ; b) If discovered fraud is material or evaluation is impossible ; c) If the risk of fraud is significant.
10) Communication of Fraud – a) Inconsequential Fraud to appropriate level of management; b) Fraud involving senior management to those charged with governance
[I] Consideration of Laws and Regulations in an audit of financial statements
1) Noncompliance is a violation of laws or governmental regulations
2) Auditor to consider the laws and regulations that are having a direct and material effect on the financial statements
3) An audit provides NO assurance that they will be detected or that any contingent liabilities that may result will be disclosed
4) If the noncompliance a) has a material effect on the financial statements or b) The client does not take the remedial action , auditor express a Qualified or adverse opinion or withdraw from the engagement
5) Disclosure of possible noncompliance to outside parties is NOT the auditor’s responsibility
6) Auditor may need to disclose while : a) Complying with legal and regulatory requirements ; b) Communicating with successor auditor ; c) Responding to Subpoena ; d) Reporting to funding or other specified agency
AICPA Code of Professional Conduct has a set of specific mandatory rules describing minimum levels of conduct a member must maintain as a CPA Profession has a responsibility to the public. AICPA Code of Professional Conduct expects the CPA to honour public trust
Rules that are mandatory for all members are :
(a) Integrity and Objectivity
(b) General Standards
(c) Compliance with Standards
(d) Accounting Principles
(e) Acts Discreditable
(f) Forms of Organization and Names
Rules that are mandatory for members in Public Practice only are :
(a) Independence
(b) Confidential Client Information
(c) Contingent Fees
(d) Advertising and other form of fees
(e) Commission and Referral Fees
[1] Independence
Member in Public practice must be independent as required by standards setting bodies (AICPA, SEC, PCAOB, GAO)
– Independence in Mind (Intellectually Honest)
– Independence in Appearance (Free from any obligation to or interest in the client, management or owners)
Independence is impaired if Covered member has certain interests or relationships
Covered Member
Below are considered to be covered members:
Impairment of Independence
A covered member MUST NOT
Materiality is determined by aggregating the interests of the covered member and his / her immediate family
Independence is not impaired by Grandfathered unsecured Loans that are not Material to the covered member’s net worth or secured loans provided that the loans were obtained from a financial institution under its normal lending procedures, terms and requirements
Permitted Loans
Loans obtained under the normal lending procedures, terms and requirements:
Firm’s Independence is impaired if :
Firm’s Independence is NOT Impaired by providing the following services:
Independence is NOT Impaired for ATTEST engagements of NONISSUERS by :
Independence is NOT impaired if :
Unpaid fees owed by attest client to a covered member for professional service may impair independence.
[2] Integrity and Objectivity
Member shall :
a) Maintain Objectivity and Integrity
b) Free of Conflicts of Intersts
c) Not knowingly misrepresent facts
d) Not subordinate his / her judgements to others
[3] Professional Standards
A member shall :
a) Take Services which he can complete with Professional Competence
b) Exercise Due Professional Care
c) Adequately Plan and Supervise performance
d) Obtain Sufficient relevant date to provide reasonable basis for conclusion
* Compliance with standards
* Accounting Principles
[4] Other Responsibilities
Acts Discreditable :
1) Failure to return records upon requests
2) Discrimination and Harassment
3) Failure to follow the requirements of governmental bodies
4) Failure to follow applicable audit standards
Response to Requests for Records :
Client provided records must be returned even if:
a) Fees have not been paid
b) The state in which the member practices grants a lien on certain records
Type of Record Right to Withhold
Client provided record None
Working Papers Absolute
Member prepared Records If fee due
Supporting records If fee due
Advertisement and Other Forms of Solicitation
Member shall not seek to obtain clients by advertising or other forms of solicitation done in false, misleading and deceptive manner
Contingent Fee
Receipt of contingent fee is prohibited when auditors report will be used by third parties and the report does not disclose CPA’s lack of independence
Member shall NOT prepare for a contingent fee:
a) Original Tax Return
b) Amended Tax Return
c) Claim for a Tax Refund
Fees are not considerd to be contingent if :
a) They are fixed by public authorities (eg. courts)
b) In tax matters, they are based on the results of judicial proceedings or the findings of governmental agencies
[5] Other Pronouncements on Professional Responsibilities
Sarbenes-Oxley, PCAOB and SEC :
[1] Preapproval of Services : 1) Audit Committee must preapprove the services performed by accountants.
[2] Disclosure of Fees : An issuer must disclose in its proxy statement or annual filing fees paid for the accountant segregated into 4 categories : 1) Audit ; 2) Audit related ; 3) Tax ; 4) All other
[3] Rotation of Partners : The lead and concurring (reviewing) partner must rotate every 5 years with a 5 year time out period
Other partners must rotate every 7 years with a 2 year time out period
Auditors to maintain their audit working papers for 7 years
[4] Communication with Audit Committee : 1) All critical accounting policies and practices to be used ; 2) All material alternative treatments of financial information within GAAP discussed with the management ; 3) Ramification of the use of alternative disclosures and treatments ; 4) Treatment preferred by the accountant
[5] Material Departure from GAAP : is permitted when a) The financial statements or data would have been misleading without a departure from GAAP due to the unusual circumstances / new legislation or evaluation of a new form of business transaction exists
[6] Prohibited Non Audit Services : The firm is prohibited from certain non audit services to their attest clients, including 1) Management services ; 2) Booking ; 3) HR ; 4) Internal Audit ; 5) Appraisal or Valuation ; 6) Expert services ; 7) Broker-Dealer ; 8) Designing and Implementing financial information system ; 9) Investment banking or advisory ; 10) Hosting service ; 11) Expert witness
Conflict of Interest may be permitted in certain circumstances if DISCLOSURE is made to and CONSENT is obtained from the appropriate parties
[7] Audit Committee : Each member of the audit committee MUST BE INDEPENDENT member of the BOD and directly responsible for appointing, compensating and overseeing the work of the auditor and must have one member designated as financial expert
1) Unconditional Requirements – Use of word ‘Must’ – Auditor must comply with an unconditional requirement
2) Presumptively Mandatory Requirements Use of word – ‘Should’ .When an auditor decides that such a departure is necessary, he/she should perform alternative audit procedures to achieve intent of the requirement
3) Word – May / Might / Could – Actions and Procedures that the auditor should use professional judgement in determining whether to perform
Preparation – It is a non-attest service and the accountant need not (1) verify the accuracy or completeness of management information (2) obtain evidence to express an opinion or conclusion (c) report on the financial statements
Preparation of financial statements requires compliance with Statements for Accounting and Review Services
Compilation – It is presentation in statement form of information without expressing any assurance thereon. It requires the accountant to (a) Determine that he is independent (b) Report on statements (c) Disclaim any assurance (d) Disclose any lack of independence and (e) Associate his name with the statements
Review – Objective is to obtain Limited Assurance as a basis of reporting if any material modification should be made to the statements. (a) Performed primarily through inquiry and analytical procedures (b) It is also known as negative assurance (c) Review does not contemplate consider internal controls (d) Review does not contemplate tests of transactions and account balances (e) Review does not contemplate other auditing procedures (f) Must issue a report
CPA is engaged to issue an examination, a review or an agreed upon procedures report on the subject matter [point in time / period in time] which is the responsibility of another party. Example – (a) Historical or prospective performance or condition (b) Physical characteristics (c) Historical events (d) Analysis (e) Systems and Processes (f) Behavior
Independence is required for all attestation engagements. Written Assertion is required for Examination and Review but is not required for Agreed Upon Procedures. Opinion for is required for Examination and findings of specific procedure for Agreed Upon Procedures. Level of Assurance is High for Examination and Limited for Review. Working Papers are required for all attestation engagements.
Assurance Services – Provides independent and professional opinions that reduce information risk (risk from incorrect information). Assurance services do not include
Assurance services do not require written assertions, unless services fall under AICPA’s attestation standards.
Consulting Services – They are professional services that use practitioner’s technical skills, education, observation, experiences and knowledge of consulting process. Should inform client of significant engagement findings. Primary objective is to provide the client with better outcomes through recommendations based on objectives of the engagement.
Quality control applies to Firms practice as a whole.
6 Elements of Quality Control are (1) Tone at the Top (2) Relevant Ethical Requirements (3) Acceptance and continuance of clients and engagements (4) Personnel Management (5) Engagement Performance (6) Monitoring
Peer Review
It is necessary part of the practice monitoring requirement for AICPA membership
Sarbens Oxley Act 2002
SOX is applicable to audit of public companies. Provision of SOX relate to improving quality control of audit and financial reporting. It requires second partner review and approval of audit reports. Lead auditor and reviewing partner must be rotated off audit every 5 years. CEO and CFO must certify the appropriateness of the financial statements and disclosures
Public Companies Accounting Oversight Board (PCAOB)
Required for audit of an issuer. Objective of reviewer is to evaluate the significant judgements made and related conclusions reached. The reviewer should evaluate (a) Assessment of and responses to significant risks (b) Engagement completion document and whether unresolved matters are significant (c) Significant judgements about planning matters
Assurance Services differs from Consulting service in 2 ways:
Limited Liability Partnership [LLP] as a business vehicle has been recognised worldwide. Internationally in countries like UK, France, USA, Singapore, Japan, China, Canada, Germany etc., LLP is preferred as a business medium especially for the service sector, realty sector, Joint Ventures / Special Purpose Vehicles etc.
In India, LLP, a body corporate (which is hybrid of a company and a partnership) has been introduced through Limited Liability Partnership Act, 2008 [LLP Act]. Subsequently, in respect of registration and operational aspects under the LLP Act, the Limited Liability Partnership Rules, 2009 [LLP Rules] were notified by the Government.
Due to its organisational flexibility coupled with limited liability, LLP is beneficial not just to entrepreneurs, professionals and enterprises providing services but for other propositions as well. Before delving into it further, we briefly understand the salient features of LLP.
1 Select Partners / Designated Partners
2 Obtain DPIN
3 Check Name Availability
4 Draft LLP Agreement
5 File Incorporation documents
6 Issue of Certificate of Registration
LLP was expected to be the next popular business vehicle after the Company. However, the number of LLPs formed are not very encouraging. Some notable reasons for the same are:
• Lack of Privacy – Incorporation document, details of partners, accounts, SAS and annual return filed with ROC would be available for public inspection.
• No major tax advantage – The introduction of Alternate Minimum Tax [AMT] has dented the tax advantage of LLP.
• Binding Act of Partners – Any act of partner without the other partner, may bind the LLP.
• Extended liability of Partners – In cases of fraud etc., the liabilities of partners are extended to their personal assets. Further, for loans even banks insist personal guarantee of partners.
• Finance constraints – LLP cannot raise money from public. Also, banks are hesitant to provide finance to LLPs since LLPs do not provide sufficient protection as that in a company viz. Provision of filing charge, restriction on withdrawal of capital, requirement of statutory audit, restriction on related party transactions etc.
Despite the above, LLP still remains a viable medium in the long run due to its inherent flexible structure. Further, as the cost of running LLP is lower, small businesses which can be carried on with own funding can convert into LLP.
• Investment vehicle – LLP may hold the shareholding of family owned companies. Further, it may be easy to plan the affairs of the LLP as it is managed as per the LLP Agreement which also outlays the rights and duties of the partners.
• Alternate to forming a Subsidiary company – Incase of a business conglomerate, the flagship company may form an LLP for its ancillary businesses instead of a subsidiary company. LLP shall provide operational flexibility, lesser regulations to be complied as also save on the tax cost viz. Dividend Distribution Tax [DDT], deemed dividend provisions etc.
• Suited vehicle for businesses with potential lawsuits – As liability for repayment of debts and lawsuits incurred by the LLP lies on it and not on the partners, it provides an added layer of protection.
• Key Employee Benefit Enterprise – Business houses desiring to reward key employees, may entrust associated or ancillary business to employee constituted LLP. It will ensure efficient accomplishment of work and also some extra reward for employee groups.
• Concept Sale – LLP is suited where the promoter is desirous of setting up a business activity and after the activity gears up, selling it off. Change of hands become possible by making modifications in the LLP document without any need for other changes in registrations etc.
• Project Business – In a project where diverse skill sets are required, a typical need of entrusting the whole responsibility with one person gets addressed in the LLP mechanism.
• Civil Construction – LLP facilitates joining in by landlord for sharing in profits without accessing project risks.
• An LLP formed and registered under the LLP Act shall be taxed as a ‘firm’ under the Income-tax Act, 1961 [IT Act].
• LLP being a ‘firm’ would be liable to pay tax at the rate of 30% (plus EC and SHEC).
• From Assessment Year [AY] 2013-14, AMT is applicable to LLPs only if it has claimed any deduction u/s. 10AA or any section (other than section 80P) included in Chapter VI-A of IT Act
• Some tax advantages to LLP compared to a company are as under:
‣ Non-applicability of Dividend Distribution Tax;
‣ Non-applicability of Wealth Tax;
‣ Non-applicability of Deemed dividend provisions u/s. 2(22)(e) of the IT Act;
‣ LLP can claim interest upto 12% on capital and borrowings from partners subject to conditions u/s. 40(b) of the IT Act, irrespective of profit or loss during the given year;
‣ Working partners of LLP are eligible for remuneration subject to conditions u/s. 40(b) of the IT Act;
‣ Immunity from Capital gain tax on conversion of private companies and unlisted public companies to LLP if the conditions u/s. 47(xiiib) are complied with.
• Share of total income
‣ Post-tax profits profits distributed amongst partners of LLP (including company) are exempt from tax u/s. 10(2A) of the IT Act. Further, in case of a company such profit is also eligible to be excluded in computation of book profit u/s. 115JB for MAT purposes.
• Realignment of Profit sharing ratio [PSR]
‣ Realignment of PSR on admission of a new partner does not amount to ‘transfer’ u/s. 2(47) of the IT Act for capital gain purposes. This is because during the subsistence of partnership firm, partners do not have any defined share in the assets of the partnership.
• Introduction of Capital Assets by a Partner
‣ Any capital asset brought in by a partner would be liable to tax in his hands in terms of section 45(3) of the IT Act. The amount at which such capital asset is to be credited in books is governed by Rule 23 of the LLP Rules. The said Rule provides that the capital asset shall be valued by a practicing Chartered Accountant / Cost Accountant / Approved Valuer.
• Revaluation of Assets
‣ Revaluation of assets by LLP and credit of the revalued amount to the capital account of the partners does not entail to transfer u/s. 2(47) and so does not give rise to taxable capital gains. Further, such increased capital balances can be considered for calculating interest u/s. 40(b).
Section 55 read with Schedule II provide for conversion of a partnership firm into LLP. A partnership firm can be converted into LLP:
a) if the partners of the LLP into which the firm is to be converted comprises all partners of the general partnership firm and no one else;
b) All property, assets, interests, rights, privileges, liabilities, obligations and undertaking of the general partnership firm are transferred to LLP in accordance with Schedule II.
If the above conditions are satisfied, the conversion shall not be regarded as transfer and consequently provisions relating to transfer of capital asset are not triggered.
Speed Breakers on conversion of a general partnership firm into LLP
Though LLP enjoys the benefits of limited liability over general partnership firm, yet one must consider the below speed breakers before deciding on conversion of a firm into LLP:
• For tax purposes, no special benefit is given to LLP compared to a Firm;
• LLP has more disclosure requirements and compliances as compared to a Firm;
• Annual Statement of accounts and Solvency and Annual Return is required to be filed with the Registrar of LLP every year;
• Cost of formation/conversion of LLP is higher;
• Heavy penalties suffered by LLP incase of delayed filings;
• More Government intervention as compared to a firm;
• Applicability of stamp duty on conversion of a Firm to LLP is prone to litigation;
• Difficult to dissolve or wind-up as compared to a partnership firm.
Section 56 and 57 of the LLP Act read with Schedule III and IV provide for conversion of a private limited company and an unlisted public company respectively into LLP.
As per Schedule III and IV of the LLP Act, a private company and an unlisted public company may be converted into an LLP if the below conditions are fulfilled:
a) there is no security interest subsisting on the assets of the company at the time of application of conversion;
b) The partners of the LLP to which it converts consists of the shareholders of the company and no one else.
Further, to encourage certain companies to operate in LLP format section 47(xiiib) of the IT Act exempts the conversion subject to fulfilment of below mentioned conditions:
a) Eligibility criteria – Average annual total sales / turnover / gross receipts of the company does not exceed Rs. 60 lakhs in any 3 preceding previous years;
b) Conditions at Conversion stage –
1. All shareholders of the company before conversion become partners of the LLP and Capital/ Profit Sharing ratio in the LLP should be in same proportion as their shareholding in the company;
2. Shareholders of the company receive no consideration, other than share in contribution and PSR in LLP;
3. All Assets / Liabilities of the Company are transferred to the LLP.
c) Conditions after Conversion –
1. Erstwhile shareholders of the Company to retain atleast 50% PSR for 5 years from date of conversion;
2. No distribution of accumulated profits of the Company as on the date of conversion for 3 years from date of conversion.
If the above conditions are not satisfied then the provisions of section 47A(4) will apply and there will be capital gains tax in the hands of successor LLP / shareholder of predecessor company in the year in which any of the condition is violated.
• Accumulated losses / unabsorbed depreciation of the erstwhile company available for set-off to successor LLP
As per section 72A(6A) of the IT Act, the accumulated business loss and unabsorbed depreciation of the predecessor company as on the date of conversion shall be allowed to c/f. And set off by he successor LLP if all the conditions u/s. 47(xiiib) are satisfied.
• MAT credit u/s. 115JAA not available to successor LLP
MAT credit of predecessor company shall not be available to successor LLP. Thus, the company may first avail MAT credit before converting to LLP. The provisions of section 115JAA(7) shall apply regardless of conversion in compliance with the conditions specified u/s. 47(xiiib) or not.
Speed breakers on conversion of a company into LLP
Though LLP enjoys the benefits of operational flexibility, lesser compliance and tax cost, yet one must consider the below speed breakers before deciding on conversion of a company into LLP:
• Raising money through public is not possible;
• Lesser creditworthiness as compared to a company;
• Heavy penalties suffered by LLP incase of delayed filings;
• Applicability of stamp duty on conversion of a Company to LLP is prone to litigation;
• No provision relating to redressal in case of oppression and mismanagement.
The LLP form of business vehicle is gaining popularity as it is well addressing the issues of risk and succession for small businesses. However, Taxation of LLPs is an important issue to be considered both while forming new LLP or converting existing firms / private or unlisted companies into LLP especially in light of the conditions to be complied with over a period of 5 years.
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