Indian bankruptcy Code 2016 is set to be a game changer providing an efficient framework to deal with business failures.  The Code deals with insolvency and liquidation proceedings in a time bound and efficient manner in order to maximize best possible value of stress assets.

Sections 43 to 51 and Section 66 of the Code stipulate that Resolution Professional (RP) have to file avoidance of specified transactions with the adjudicating authority. Specific transactions includes preferential, undervalued, extortionate credit and fraudulent or wrongful transactions carried out with an intent to defraud creditors.

Forensic Audit

Section 43 Preferential Transactions 

A corporate debtor shall be deemed to have given a preference, if—

(a) there is a transfer of property or an interest thereof of the corporate debtor for the benefit of a creditor or a surety or a guarantor for or on account of an antecedent financial debt or operational debt or other liabilities owed by the corporate debtor; and

(b) the transfer under clause (a) has the effect of putting such creditor or a surety or a guarantor in a beneficial position than it would have been in the event of a distribution of assets being made in accordance with section 53.

Relevant period

A preference shall be deemed to be given at a relevant time, if—

(a) It is given to a related party, during the period of two years preceding the insolvency commencement date; or

(b) a preference is given to a person other than a related party during the period of one year preceding the insolvency commencement date.

Audit Approach

> Review of related parties loans and advances repaid during the review period and comparison with payments made to secured lenders during the same period, in order to identify preferential payments, if any.

> Review of all assets transferred to creditors, secured/unsecured lenders during review period.

> Review of unsecured loans repaid during the review period and comparison with payments made to secured lenders during the same period, to identify preferential payments, if any.

> Review and analysis of journal registers to identify adjustment entries in nature of inter debtor creditor adjustments.

> Review of non-consortium bank accounts to ascertain whether any receipts have been diverted to specific creditors during the review period.

> Conduct age analysis on creditors to identify whether specific creditors have been made preferential payments.

Section 45 Undervalued transactions

A transaction shall be considered undervalued where the corporate debtor —

(a) makes a gift to a person; or

(b) enters into a transaction with a person which involves the transfer of one or more assets by the corporate debtor for a consideration the value of which is significantly less than the value of the consideration provided by the corporate debtor, and such transaction has not taken place in the ordinary course of business of the corporate debtor.

Relevant period

(i) such transaction was made with any person within the period of one year preceding the insolvency commencement date; or

(ii) such transaction was made with a related party within the period of two years preceding the insolvency commencement date.

Audit Approach

> Review of product wise and customer wise gross profit/loss ratio in order to identify loss making products and customers.

> Analysis of transactions with related parties vis a vis for outside entities to verify transactions have been carried out at arm’s length price.

> Benchmarking such transactions carried out by the company with peer companies to comment on whether they were carried out at arm’s length.

> Review of ledger accounts (discounts, rebates, material rejection, etc.) to identify adjustments in debtor accounts, highlighting subsequent reduction in sales consideration.

> Review of key ledgers such as gift, promotion, staff welfare.

> Background check and site visit of suspected entities/parties.

Section 50 Extortionate credit transactions

A transaction shall be considered an extortionate credit transaction under section 50(2) where the terms-

(1) require the corporate debtor to make exorbitant payments in respect of the credit provided; or

(2) are unconscionable under the principles of law relating to contracts.

Relevant period

Two years preceding the insolvency commencement date

Audit Approach

> Review financial or operational debt raised during the period within two years preceding the insolvency commencement date.

> Review Terms & conditions of such debt (interest rate, repayment terms, security interest etc.) to determine if the same is exorbitant in nature.

> Review whether the parties who provided the loan are genuine parties or are in related parties floated by promoters.

Section 66 fraudulent trading or wrongful trading

If during the corporate insolvency resolution process or a liquidation process, it is found that any business of the corporate debtor has been carried on with intent to defraud creditors of the corporate debtor or for any fraudulent purpose, the Adjudicating Authority may on the application of the resolution professional pass an order that any persons who were knowingly parties to the carrying on of the business in such manner shall be liable to make such contributions to the assets of the corporate debtor as it may deem fit.

Audit Approach

Following are the possible modus operandi of fraudulent and wrongful trading, auditor needs to exercise extra due diligence in order to ascertain transaction under section 66 of the code:

> Availing of credit facilities by overstating assets, sales, income and profit by submitting false/manipulated financial statement.

> Drawing from cash credit account by submitting false/inflated/manipulated stock statements.

> Assets to be financed not purchased and funds borrowed from bank mis-utilised / misappropriated for the purpose other than for which bank has sanctioned the funds.

> Disposal/removal of assets pledged/ hypothecated/ mortgaged, without knowledge of bank.

> Utilization of short term working capital for long term purposes, not in conformity of sanction terms.

> Transferring borrowed funds to subsidiaries/group companies or other corporate for non-business purposes or in contravention of sanction terms.

> Sale to related parties and subsequent debtor written off.

Other Aspects:

Forensic auditors need to check following aspects while conducting transaction audit under IBC:

> Money trail analysis of all bank accounts of the corporate debtor in order to understand nature of flow of transaction.

> Identify hidden bank account used by CD for diversion of funds, if any.

> Detailed analysis of financial statements of the company and comment on suspicious areas of manipulation, if any.

> Excessive provisioning / write offs / losses which are not in the ordinary course of business and are unusual in nature.

> Non-recurring expenditure incurred by the company.

> Check whether revenue is booked as per the applicable GAAP

> Non- moving creditors & debtors.

> Physical verification and valuation of inventory.

> Background check of major customers and vendors of the company to establish if they are the shell companies of the promoter.

Author Bio

Qualification: CA in Job / Business
Company: N/A
Location: New Delhi, IN
Member Since: 12 Sep 2019 | Total Posts: 2

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June 2021