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Identification and Calculation of Funds Diversion for Bank Audit

kotte murali krishna 
on 31 March 2021

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A. Diversion of Short Term (Cash Credit Limits) Loans

Whenever an Auditor finds any new investments of either long term or short term of unrelated assets on the face of company Balance Sheet during audit, there is a need to verify and confirm the source for the investment.

In case new investment is not supported by long term source then there is a need to verify whether any short-term funds of bank Cash Credit limits or any other short-term funds are diverted and used for long term purpose or for short term purpose of investment in unrelated assets/operations of the company.

Definition of Funds diversion/Syphoning of Funds as given by RBI:

"Utilization of short-term working capital loan funds for long term purpose not inconformity with the terms of sanction". Or

"Should be construed as diversion of funds occurred if any funds borrowed from banks are utilized for purposes unrelated to the operations of the borrower".

Identification of Funds Diversion

Any investment made or payment of long-term debt over and above the cash profit earned for the year and not supported by any capital receipt during the year is the amount of short-term loan diverted and utilized for long term purpose/short term purpose of unrelated operations of the company.

Means of Diversion of short-term funds

  • Making payments to capital goods suppliers from CC limits when there was shortfall in term loan sanctioned by banks for setting up a new
  • Meeting company’s margin money from CC limits for Expansion, Modernization and Technical up gradation of existing
  • Investment in Subsidiary/Group companies.
  • Investment in capital market or
  • Payment of long-term debt from the existing CC limits of over and above the cash profit earned for the year.
  • Purchase of immovable properties/assets for personal

Practice of funds diversion

  • It is generally happening that the banks will not sanction the term loan as applied by the borrower due to various The company cannot compromise the project cost at this juncture as all the plans are approved by the concern authorities by that time. The promoters will accept the sanction letter as it is with lower term loan limits, keep the capital goods suppliers wait till the commercial operations are commenced and CC limits are released by the bank. The company will pay to the waiting capital goods suppliers from Cash Credit limits to the extent of shortfall in term loan sanctioned by the bank.
  • When the company goes for expansion, modernization and technical up gradation of existing unit, the company needs to bring in their margin money of project cost which the company needs to bring in separately in case internal accruals are not sufficient to meet the margin money. The company will meet the margin money of project cost by paying from existing CC limits.
  • The companies invest in its Subsidiary/Group companies by diverting the existing Cash Credit
  • For decades together there has been practice of willful defaulters diverting existing CC limits for investment in Capital Market or
  • The term loan installments shall be payable from the cash profits earned for the year. But when the net cash profits are not sufficient to pay the term loan installments, the companies tend to pay the term loan installments from existing Cash Credit limits which otherwise should be paid from earnings for the
  • It is general practice that the companies divert the Cash Credit limits for purchase of immovable properties of land and buildings for their personal

Audit Procedure & Reporting

When the auditor finds any capital investment or investment in unrelated current or non-current assets during the year from the balance sheet, the auditor needs to check and confirm whether the investment is sourced by any capital receipt of loan or equity, reserves, or any other instrument. In case the investment in the capital asset or unrelated investment is not supported by any source of capital receipt or reserves for the year, check whether cash profits earned for the year has permitted the company for investment or not. In case there has been no source of additional capital receipt during the year, it means that the company has diverted the short-term loan for long term purpose. The other basic indication of funds diversion is getting Current Ratio less than one. The Current Ratio less than 1.33 indicates that the company has not brought in their margin money to the extent of less than 0.33. And the Current Ratio less than one indicates that the company has diverted the working capital loans for long term purpose to the extent of less than one current ratio. This indication has an exception when the diverted money is reported under the head "Other Advances" in the company balance sheet as the auditor may not find a new investment from the face of company balance sheet. The unidentified investment disclosed under this head influences calculation of current ratio.

B. Diversion of Term Loans Relevant Provisions

The banks/FIs sanction the term loan to meet the cost of project for setting up a new unit or for expansion, modernization and technical up gradation of existing unit. The banks fund the cost of machinery and the cost of civil works of project after appraising its techno economic viability. The item wise list of plant and machinery with names of suppliers and their cost as per proforma invoices and the civil estimates as given by engineer will be submitted to the bank along with project report. The bank sanctions the loan component of project cost as per appraisal and the margin money of the project cost will be brought in by the company as per terms of sanction letter.

The banks will disburse the term loan by opening a term loan account wherein the company need to deposit the margin money. The bank would make direct payments to the machine suppliers as approved in the appraisal report as and when the company wants to make after depositing margin money in respect of that particular machinery.

In case of civil works, the company will start construction works and after a sizable work is done, the bank empaneled engineer will value the work done and the bank will disburse its loan component by debiting to term loan account opened in the name of the company. The bank would also insist for CA certificate for the proposed investment by the company in the project before disbursement of loan. The same procedure will be followed by the bank till the total loan in respect of civil works is disbursed.

The diversion of term loan for other purpose does not arise when the banks directly make the payments to the machine suppliers and disburses cost of civil works after the company invests its margin money and certified by empaneled engineer and by the CA.

Identification and Calculation of Funds Diversion for Bank Audit

Practice of funds diversion

It is in the case of expansion, modernization and technical up gradation of existing unit, sometimes the banks instead of making direct payment to capital goods suppliers, would credit the sanctioned term loan to the existing Cash Credit limits by debiting the term loan account in which case the disbursement of sanctioned term loans would be in the hands of company and not in the hands of banks. In this situation, there is a possibility for diversion of term loan for some other purpose. The company may even use the CC limits to meet the margin money for cost of expansion which otherwise shall be brought in by the company as per terms of sanction.

 

Audit Procedure & Reporting

The same procedure as given for identification of short-term loans for long term purpose may be followed as the diversion of term loan takes place when the sanctioned term loans are disbursed by crediting to Cash Credit Account.

 

Calculation of Funds Diversion

The auditor can use the following App link for calculation of short-term loans diverted for long term purpose:

Link: https://play.google.com/store/apps/details?id=com.fund.diversion

Note: The above link has a limitation of calculation of funds diversion when the diverted loan is reported under the head "Other Advances" as the auditor may not find any direct investment made during the year from the face of company balance sheet.


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