Auditing loans to directors means testing both the loans the company openly records as such against the restrictions in section 185 of the Companies Act, and separately searching for loans that are not recorded as loans at all — expense advances that are never settled, and director current-account balances that only ever run one way. The second category is where most of the real risk sits, because it is designed, deliberately or not, to avoid looking like what it is.
Section 185 at a working level
Section 185 restricts a company from advancing loans, giving guarantees, or providing security in connection with loans to its directors and to certain persons connected with a director, subject to specified exceptions. The exact scope of "connected person", the exemptions available (including for loans to a managing or whole-time director under a scheme applicable to all employees, or to a wholly-owned subsidiary), and the conditions attached to each exemption have been amended more than once since the section commenced.
Treat the specifics of section 185 — who exactly is covered, which exemptions currently apply, and on what conditions — as something to verify against the current statute and rules for the year under audit, not as fixed knowledge to carry forward from a prior engagement. A private company exemption that applied in one year may have conditions that no longer hold in a later year.
Why disguised loans are the bigger risk
A loan booked openly as "loan to director" in the trial balance is, in a sense, the easy case — it is visible, and the only question is whether section 185 permits it and whether it is disclosed correctly. The harder case is money that functionally behaves like a loan to a director but is booked somewhere a loan-testing procedure would never look.
- Expense advances given to a director for travel or business expenses, never settled by submission of bills, and simply rolled forward or written off at year end.
- A director's current or drawings account in the books of a proprietorship-style private company that only ever increases, with no repayment pattern, functioning as an open-ended loan.
- Personal expenses of a director or a family member paid directly by the company and booked to a general expense head rather than to a director's account at all.
- Salary or consultancy fees paid substantially in advance of the period they relate to, with no contractual basis for the advance.
- Payments to a vendor that is, on closer inspection, controlled by a director or close relative, where the "purchase" has no corresponding delivery of goods or service.
Testing approach
- 01Extract every ledger with a director or KMP name, under any headNot just loan and advance accounts. Search the general ledger for director and KMP names across expense advance accounts, staff imprest accounts, and miscellaneous debtor heads, since this is precisely where disguised balances are booked to avoid the loan account.
- 02Age every director-linked balanceAn expense advance outstanding for more than a normal settlement cycle — a few weeks to a quarter, depending on the entity's own policy — with no bills submitted is functioning as a loan regardless of what the ledger head is called.
- 03Check the direction of movement on current accountsPlot the balance through the year. A current account that moves in both directions, with the director sometimes owing the company and sometimes the reverse, is a working relationship. One that only ever grows in the director's favour is a one-way flow that needs a harder look.
- 04Test whether interest is charged, and at what rateAn interest-free or below-market loan to a director, whether formally booked as a loan or sitting as a drifting current account, still needs to be identified as a related-party transaction and disclosed on its actual terms, including a nil or below-market rate.
- 05Trace vendor payments to entities connected to a directorCross the vendor master against the related-party list built during identification work. A "purchase" from a director-controlled entity with no supporting delivery evidence is worth scrutinising as a possible disguised loan or diversion of funds rather than a genuine purchase.
- 06Confirm board and, where applicable, shareholder approval for any loan that is not clearly exemptWhere section 185 does not provide an exemption, check that the approval the section requires was actually obtained and minuted, in the same way section 188 approvals are tested.
| Ledger head | What to check |
|---|---|
| Staff/employee advances | Isolate advances to directors and KMP from genuine staff advances; age separately |
| Travel and conveyance expense | Look for round-sum advances charged to expense with no settlement trail |
| Sundry debtors / miscellaneous receivables | Director or KMP names appearing outside the expected loan account |
| Director's current account (closely held companies) | Direction and trend of the balance through the year, not just the closing figure |
| Prepaid salary/consultancy | Advances with no contractual basis, rolled forward year on year |
A balance that gets cleared by a single large entry in the days immediately before year end, and reappears shortly after, is a classic sign of a balance being temporarily squared off for the audit. Compare the closing balance to the average balance through the year, not just to the position on the balance sheet date.
Disclosure testing
Once identified, these balances need the same disclosure treatment as any related-party loan: the relationship, the nature and terms (including interest rate and repayment terms, or the absence of either), the maximum amount outstanding during the year, and the closing balance. The maximum-during-the-year figure is often missed when testing is anchored only to the closing trial balance.
How we think about this
Finding every ledger line with a director or KMP name across the whole chart of accounts, and tracking the direction and ageing of every such balance through the year, is a search-and-compute problem that should run exhaustively and the same way every time. Deciding whether an advance that has sat unsettled for three months is a process delay or a disguised loan is a judgement the auditor has to make, informed by that complete picture rather than a sample of it.
This is practical guidance written for audit teams, not an authoritative statement of any standard or statute. Standards, forms and timelines change. Check the current text issued by the ICAI and the relevant authority before relying on anything here in an audit file.
Related resources
- Related parties & disclosuresCommon-control entities: why they raise audit riskA promoter running several unlisted entities under common control creates a structure where money, not just transactions, can move without much friction. That is the risk to test for.
- Related parties & disclosuresSection 188 compliance: what an auditor checksSection 188 approval is a governance fact to verify against minutes, not an assumption to carry forward from last year's file.
- Related parties & disclosuresUndisclosed related parties: red flags to test forThe counterparties that most need scrutiny are the ones nobody flagged as related. Here is what actually surfaces them.
- Related parties & disclosuresRelated-party disclosure checklist for financial statementsA related-party note that lists transactions but not relationships, or balances but not terms, is an incomplete disclosure even if every number in it is correct.
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