Test 1: answer key

Question 1 · 2 marks · Chapter 11: Ethics and Terms of Audit Engagements · medium

Scenario. Zenith Automotive Ltd. is a manufacturer using an ERP-based inventory dispatch system. Its accounting policy recognises revenue only when control transfers to the customer on delivery. The ERP nevertheless posts sales automatically when the warehouse scans goods at dispatch. At year-end, some consignments dispatched on 29–31 March were delivered in April but were recorded as March sales. The proposed auditor is told that management accepts responsibility for preparing the financial statements and maintaining necessary internal control, but refuses unrestricted access to dispatch logs and warehouse personnel. The engagement is voluntary and no law or regulation requires the firm to accept the proposed restricted terms. The system also has shared privileged administrator IDs, no independent approval and testing of program changes, and backup restoration has not been tested.

Which conclusion should the proposed auditor reach under SA 210 in view of management’s refusal to provide unrestricted access?

1. Accept, since management has accepted preparation and internal-control responsibility, and document the restriction.
2. Decline unless access is restored, because access to relevant information and personnel is a precondition. (correct answer)
3. Accept after obtaining directors’ confirmations, since warehouse access is only an operational matter.
4. Accept with a disclaimer planned in advance, because the engagement letter records the restriction and its consequences.

Answer: B — Decline unless access is restored, because access to relevant information and personnel is a precondition.

Working. 1. Identify the missing precondition: unrestricted access to relevant information and personnel. 2. Ask management to remove the restriction and assess its response. 3. Since no law or regulation requires acceptance, decline the proposed engagement if access is not restored.

Explanation. SA 210 requires management to acknowledge responsibility for the financial statements, relevant internal control, and providing the auditor access to all relevant information, requested further information, and unrestricted access to persons from whom evidence is needed. Management’s refusal means the preconditions are not present. The auditor should discuss the matter and, because this voluntary engagement is not required by law or regulation, should not accept it unless the restriction is removed. Recording the limitation in an engagement letter does not cure the missing precondition.

Where it goes wrong. Assuming management’s acceptance of financial-statement preparation responsibility alone satisfies every SA 210 precondition.

Authority. SA 210: Agreeing the Terms of Audit Engagements, paras 6 and 8; ICAI Study Material, Paper 5, Chapter 11, pp. 11.16–11.22

Question 2 · 2 marks · Chapter 3: Risk Assessment and Internal Control · medium

For consignments delivered to customers after year-end but recorded as sales when dispatched, which assertion is most directly exposed to a risk of material misstatement?

1. Occurrence, because the recorded dispatch might not represent a completed sale to a customer.
2. Completeness, because dispatches might be omitted from the sales ledger.
3. Cut-off, because revenue is recorded before contractual control transfers on delivery. (correct answer)
4. Classification, because dispatches might be posted to an incorrect revenue account.

Answer: C — Cut-off, because revenue is recorded before contractual control transfers on delivery.

Working. 1. Read the contractual recognition point: delivery. 2. Compare it with the ERP trigger: dispatch. 3. Since dispatch occurs before delivery for the year-end consignments, sales may be recognised in the wrong period; assess the cut-off assertion.

Explanation. The relevant assertion is cut-off because transactions must be recorded in the correct accounting period. Zenith’s contractual policy transfers control on delivery, but the ERP records revenue at dispatch. Goods delivered after the reporting date have therefore been recognised prematurely in the current period. Occurrence may also warrant consideration, but the specific year-end timing mismatch makes cut-off the most direct assertion-level risk. SA 315 requires the auditor to relate identified risks to what can go wrong at the assertion level.

Where it goes wrong. Selecting occurrence merely because the customer has not yet received the goods, without identifying the period in which the transaction was recorded.

Authority. SA 315: Identifying and Assessing the Risks of Material Misstatement, paras 25–26; ICAI Study Material, Paper 5, Chapter 3, pp. 3.15–3.16

Question 3 · 2 marks · Chapter 3: Risk Assessment and Internal Control · hard

Which audit work most directly evaluates the general IT controls supporting Zenith’s automated dispatch processing?

1. Test access security, approved and tested program changes, and IT operations including backup restoration. (correct answer)
2. Inspect barcode validation, dispatch sequence checks, mandatory customer fields, and user-level transaction limits within the ERP application.
3. Reperform manual invoice matching and physical inventory counts at the reporting date.
4. Confirm customer balances and inspect credit notes issued after the reporting date.

Answer: A — Test access security, approved and tested program changes, and IT operations including backup restoration.

Working. 1. Classify the weaknesses: shared administrator IDs concern access security; absent change approval/testing concerns program changes; untested restoration concerns IT operations. 2. Obtain evidence through inspection, observation and reperformance. 3. Evaluate whether these controls support reliable automated processing.

Explanation. General IT controls are pervasive controls that support the effective functioning of application controls. They include access security, program-change controls, and data-centre or network operations such as backup monitoring and recovery. Testing privileged access, authorisation and testing of program changes, and restoration of backups directly addresses the weaknesses described. Barcode validations and sequence checks are application controls, not general IT controls. The auditor must understand and evaluate the relevant controls before deciding whether automated processing can be relied upon.

Where it goes wrong. Confusing business-process application controls, such as barcode validation, with the general IT controls that support their reliability.

Authority. SA 315: Identifying and Assessing the Risks of Material Misstatement; ICAI Study Material, Paper 5, Chapter 3, pp. 3.71–3.73

Question 4 · 2 marks · Chapter 3: Risk Assessment and Internal Control · hard

If testing confirms that developers can alter dispatch rules without approved or tested changes, what is the most appropriate audit response?

1. Continue relying on automated controls because their configuration is unchanged from the prior year.
2. Increase samples of approvals generated by the same system and retain the existing reliance.
3. Use management explanations to validate system reports without additional data testing.
4. Reassess reliance, test report completeness and accuracy, and expand substantive procedures as necessary. (correct answer)

Answer: D — Reassess reliance, test report completeness and accuracy, and expand substantive procedures as necessary.

Working. 1. Establish the general IT control deficiency and its effect on dispatch processing. 2. Reassess the related assertion-level risks and planned control reliance. 3. Test the completeness and accuracy of relevant reports and data. 4. Design further substantive procedures responsive to the revised risks.

Explanation. Ineffective general IT controls may undermine the reliability of automated application controls, system calculations and reports produced by the ERP. The auditor should reconsider planned reliance, assess the implications for the relevant risks, and test the completeness and accuracy of system-generated information used as audit evidence. Where reliance is not supportable, the auditor should modify the nature, timing and extent of further procedures, including additional substantive testing. Increasing samples from an unreliable system does not by itself address the underlying control failure.

Where it goes wrong. Believing that a larger sample from the same compromised system compensates for ineffective controls over program changes.

Authority. SA 315: Identifying and Assessing the Risks of Material Misstatement; SA 330: The Auditor’s Responses to Assessed Risks; ICAI Study Material, Paper 5, Chapter 3, pp. 3.71–3.73

Question 5 · 2 marks · Chapter 3: Risk Assessment and Internal Control · hard

Scenario. Coral Pharma Ltd. is a profit-oriented pharmaceutical company. At the planning stage, the auditor selects profit before tax as the benchmark and, exercising professional judgment, applies 5% to the forecast profit before tax of ₹8 crore, determining overall materiality of ₹40 lakh. Clinical trial expenses are separately disclosed and attract particular attention from investors and regulators. The auditor therefore sets specific materiality of ₹12 lakh and performance materiality of ₹8 lakh for that class. During the audit, reliable updated forecasts indicate that profit before tax for the year is likely to be ₹5 crore, with no evidence that the change is temporary or exceptional.

What should the auditor do after receiving the revised profit forecast of ₹5 crore, assuming the selected 5% benchmark percentage remains appropriate?

1. Revise overall materiality to ₹25 lakh, reassess the clinical-trial thresholds, and reconsider further audit procedures. (correct answer)
2. Retain overall materiality at ₹40 lakh, since materiality fixed at planning cannot be revised during the audit.
3. Set clinical-trial performance materiality equal to ₹25 lakh, since specific thresholds cannot remain lower than overall materiality.
4. Change only the clinical-trial threshold, since revised profit forecasts do not affect overall financial-statement materiality.

Answer: A — Revise overall materiality to ₹25 lakh, reassess the clinical-trial thresholds, and reconsider further audit procedures.

Working. 1. Recalculate overall materiality: ₹5 crore × 5% = ₹25 lakh. 2. Reassess whether the ₹12 lakh specific threshold remains appropriate for clinical-trial expenses. 3. Reconsider the ₹8 lakh performance materiality and the audit procedures. 4. Document the bases and revisions.

Explanation. Applying the auditor’s selected 5% to the revised profit forecast gives revised overall materiality of ₹25 lakh (₹5 crore × 5%). SA 320 requires materiality to be revised when new information or changed circumstances make the original amount inappropriate. The auditor should also reconsider the specific materiality of ₹12 lakh and performance materiality of ₹8 lakh for clinical-trial expenses, and determine whether the nature, timing and extent of further procedures remain appropriate. The auditor should document the revised amounts and judgments.

Where it goes wrong. Treating planning-stage materiality as immutable, or automatically setting specific materiality and performance materiality equal to overall materiality.

Authority. SA 320: Materiality in Planning and Performing an Audit, paras 10–13; ICAI Study Material, Paper 5, Chapter 3, pp. 3.23–3.28

Question 6 · 2 marks · Chapter 4: Audit Evidence · medium

Scenario. Vistara Electronics Ltd. has material trade receivables from a small number of large distributors, including balances subject to disputes and delayed reconciliations. The auditor assesses the risk of material misstatement in the receivables population as higher than low and has not obtained evidence that the relevant controls operated effectively. The auditor plans to obtain external confirmations for selected balances. Some customers do not respond to positive requests despite follow-up. Management also asks the auditor not to contact two major customers, stating that direct confirmation may strain commercial relationships.

Which confirmation design is most appropriate for selected large or disputed distributor balances where the auditor seeks persuasive direct evidence?

1. Send negative requests to every customer and treat silence as agreement with the recorded balance.
2. Send blank positive requests to major or disputed customers, retaining auditor control over dispatch and responses. (correct answer)
3. Send requests through management and accept customer replies collected by the sales team after management review and approval.
4. Send positive requests only to low-value accounts because large balances are supported by invoices.

Answer: B — Send blank positive requests to major or disputed customers, retaining auditor control over dispatch and responses.

Working. 1. Identify the balances with higher risk and material value. 2. Select the relevant distributors as confirming parties. 3. Use blank positive requests so each recipient supplies the balance. 4. Maintain auditor control over the confirmation process and evaluate each response.

Explanation. A positive confirmation request requires the confirming party to reply directly to the auditor in every case, either agreeing, disagreeing or supplying the requested information. A blank positive request asks the customer to state the balance rather than merely agree with an amount supplied by management, reducing the risk of an unverified agreement. This design is particularly useful for material or disputed balances. The auditor must retain control over selecting recipients, preparing and sending requests, and receiving responses.

Where it goes wrong. Assuming that a customer’s silence on a negative request provides evidence equivalent to a positive confirmation response.

Authority. SA 505: External Confirmations; ICAI Study Material, Paper 5, Chapter 4, pp. 4.47–4.48

Question 7 · 2 marks · Chapter 4: Audit Evidence · hard

May the auditor use negative confirmations as the sole substantive procedure for the remaining large population of receivables in the circumstances described?

1. Yes, because a large population permits negative requests even when assessed risk is elevated.
2. Yes, provided the request states the recorded balance and customers receive a reasonable response period.
3. Yes, because negative requests become persuasive when individual balances are relatively small.
4. No, because assessed risk is elevated and effective controls have not been evidenced. (correct answer)

Answer: D — No, because assessed risk is elevated and effective controls have not been evidenced.

Working. 1. Test the four SA 505 conditions. 2. The low-risk and effective-control condition is not met. 3. Therefore negative confirmations cannot be the sole substantive procedure, irrespective of population size. 4. Design additional procedures, including positive confirmations where appropriate.

Explanation. Negative confirmations provide less persuasive evidence than positive confirmations and cannot be used as the sole substantive procedure unless all specified conditions are met. These include low assessed risk and sufficient appropriate evidence that relevant controls operated effectively, a large population of small homogeneous items, a very low expected exception rate, and no reason recipients would disregard the requests. Vistara’s assessed risk is higher than low and effective operation of controls has not been established. The first condition is therefore absent, so negative requests cannot stand alone.

Where it goes wrong. Focusing only on population size while overlooking the cumulative nature of the conditions for sole reliance on negative confirmations.

Authority. SA 505: External Confirmations, requirements relating to negative confirmation requests; ICAI Study Material, Paper 5, Chapter 4, p. 4.51

Question 8 · 2 marks · Chapter 4: Audit Evidence · medium

Several customers have not replied to positive confirmations despite follow-up requests. Which response should the auditor adopt for those balances?

1. Treat silence as agreement after two reminders and clear the balances from the exception list.
2. Replace confirmation evidence with a management representation covering every unresponsive customer.
3. Examine subsequent receipts, shipping records and period-end sales documents for the unconfirmed balances. (correct answer)
4. Assume the balances are misstated and propose immediate write-offs without assessing other evidence.

Answer: C — Examine subsequent receipts, shipping records and period-end sales documents for the unconfirmed balances.

Working. 1. Record the result as a non-response, not as agreement. 2. Verify subsequent cash receipts and trace them to bank records and invoices. 3. Inspect shipping documents and sales around year-end. 4. Evaluate whether the combined evidence supports existence and valuation.

Explanation. A non-response to a positive confirmation does not itself provide audit evidence about the balance. After appropriate follow-up, the auditor should perform alternative procedures designed to obtain relevant and reliable evidence. For receivables, the ICAI material identifies examination of specific subsequent cash receipts, shipping documentation and sales near the period-end as examples. A management representation alone is not a substitute for sufficient appropriate audit evidence, and silence cannot be treated as customer agreement.

Where it goes wrong. Treating a non-response to a positive request as an implicit confirmation of the amount in the books.

Authority. SA 505: External Confirmations, requirements relating to non-responses and alternative procedures; ICAI Study Material, Paper 5, Chapter 4, pp. 4.48–4.50

Question 9 · 2 marks · Chapter 4: Audit Evidence · hard

How should the auditor respond when management refuses permission to confirm two major customer balances?

1. Ask for reasons, corroborate them, reassess risks, and perform suitable alternative procedures. (correct answer)
2. Accept the refusal when management cites customer sensitivity, and rely on the internally prepared ageing analysis.
3. Send the requests despite management’s instruction, then treat any resulting silence as confirmation.
4. Immediately disclaim an opinion without considering the reason or performing alternative procedures.

Answer: A — Ask for reasons, corroborate them, reassess risks, and perform suitable alternative procedures.

Working. 1. Obtain management’s stated reasons and corroborate them. 2. Reassess relevant risks, including possible fraud. 3. Perform alternative procedures. 4. If refusal is unreasonable or alternatives fail, communicate with those charged with governance and evaluate the effect under SA 705.

Explanation. SA 505 requires the auditor to inquire into management’s reasons for refusing confirmation and obtain evidence about their validity and reasonableness. The auditor must evaluate the effect on assessed risks of material misstatement, including fraud risk, and reconsider the nature, timing and extent of other procedures. Alternative procedures should then be performed to obtain relevant and reliable evidence. If the refusal is unreasonable or alternatives do not provide such evidence, the auditor communicates with those charged with governance and considers the implications for the audit opinion.

Where it goes wrong. Believing that a commercial-relations explanation automatically makes management’s refusal reasonable, or that refusal requires an immediate disclaimer.

Authority. SA 505: External Confirmations, requirements relating to management refusal; SA 260: Communication with Those Charged with Governance; SA 705: Modifications to the Opinion in the Independent Auditor’s Report; ICAI Study Material, Paper 5, Chapter 4, pp. 4.49–4.51

Question 10 · 2 marks · Chapter 6: Audit Documentation · hard

Scenario. Khandelwal & Co. issued its auditor’s report on 31 July 2026 and completed assembly of the final audit file on 20 September 2026. On 15 October 2026, the engagement partner becomes aware of information about a condition that existed at the report date and that, had it been known then, might have affected the auditor’s report. The partner determines that additional audit procedures are necessary to evaluate the matter. The firm’s retention policy follows SQC 1.

Which treatment most appropriate complies with SA 230 and SQC 1 after the partner discovers the post-report-date information?

1. Use the 60-day assembly period to complete omitted substantive work and replace unsupported conclusions.
2. Retain at least seven years, assemble within 60 days, and separately document later work. (correct answer)
3. Treat every fact discovered after the report date as administrative assembly and record no further details.
4. Delete original evidence after assembly, provided the revised final file is retained for seven years.

Answer: B — Retain at least seven years, assemble within 60 days, and separately document later work.

Working. 1. Calculate the assembly interval: 31 July to 20 September is 51 days, within 60 days. 2. Treat the 15 October matter separately from administrative assembly. 3. Document circumstances, additional procedures, evidence, conclusions and report effect, including preparer and reviewer details. 4. Retain the engagement file for at least seven years.

Explanation. The final file was assembled 51 days after the report date, within the ordinary 60-day period. That assembly is administrative and cannot be used to perform omitted audit work or draw new conclusions. The later matter must be dealt with separately. Where additional procedures or conclusions are required after the report date, SA 230 requires documentation of the circumstances, procedures performed, evidence obtained, conclusions reached and effect on the report, including when and by whom changes were made and reviewed. SQC 1 ordinarily requires retention for at least seven years.

Where it goes wrong. Confusing the administrative 60-day file-assembly period with authority to perform new audit procedures or alter conclusions without additional documentation.

Authority. SA 230: Audit Documentation, paras 13–16; SQC 1: Quality Control for Firms that Perform Audits and Reviews of Historical Financial Information, and Other Assurance and Related Services Engagements, paras 74, 75 and 82; ICAI Study Material, Paper 5, Chapter 6, pp. 6.9–6.10

Question 11 · 2 marks · Chapter 8: Audit Report · medium

Scenario. Falcon Steels Ltd. was sanctioned aggregate working capital limits of ₹8 crore by banks against hypothecation of its current assets during the year. Its quarterly stock and current-asset statements submitted to the banks report current assets of ₹12 crore, while the corresponding books of account show ₹9.5 crore. Separately, during the audit of Pragati Commercial Bank, the auditor reviews two ordinary term-loan accounts: principal or interest on one account has remained overdue for exactly 90 days, while the corresponding amount on another has remained overdue for 91 days. The bank also has two agricultural advances: a short-duration crop loan overdue for one crop season and a long-duration crop loan overdue for one crop season. The long-duration crop has a crop season exceeding one year.

Which CARO 2020 reporting requirement is triggered by Falcon Steels’ sanctioned working capital limits?

1. CARO 3(ii)(a), because the working-capital sanction test is part of physical inventory verification.
2. CARO 3(ii)(b), only when the outstanding borrowing at year-end exceeds ₹5 crore.
3. CARO 3(ii)(b), because ₹8 crore was sanctioned against current assets during the year. (correct answer)
4. CARO 3(i), because hypothecation automatically creates a title-deed verification requirement.

Answer: C — CARO 3(ii)(b), because ₹8 crore was sanctioned against current assets during the year.

Working. 1. Check the sanctioned aggregate limit: ₹8 crore, which exceeds ₹5 crore. 2. Confirm that the facility is secured by current assets. 3. Compare quarterly statements filed with lenders with the books. 4. Report details if they do not agree.

Explanation. CARO 2020 paragraph 3(ii)(b) applies where, at any point during the year, the company has been sanctioned aggregate working capital limits in excess of ₹5 crore from banks or financial institutions on the security of current assets. Falcon’s sanctioned limits are ₹8 crore and are secured by hypothecation of current assets, so the threshold and security conditions are met. The auditor must examine whether quarterly returns or statements filed with the lenders agree with the books and report details of any disagreement.

Where it goes wrong. Using the year-end outstanding borrowing instead of the sanctioned-limit test, or confusing paragraph 3(ii)(b) with the physical-verification requirement in paragraph 3(ii)(a).

Authority. Companies (Auditor’s Report) Order, 2020, para 3(ii)(b); Companies Act, 2013, section 143(11); ICAI Study Material, Paper 5, Chapter 8, pp. 8.75–8.76

Question 12 · 2 marks · Chapter 8: Audit Report · hard

What should the auditor report regarding the ₹12 crore reported to banks compared with the ₹9.5 crore recorded in Falcon Steels’ books?

1. Report only if the difference exceeds 10 percent, applying the inventory-count discrepancy threshold.
2. Report only the difference remaining after management provides a written representation to the auditor.
3. Treat ₹12 crore as correct because statements submitted to banks override the company’s books.
4. Report the ₹2.5 crore difference; clause 3(ii)(b) has no 10 percent tolerance. (correct answer)

Answer: D — Report the ₹2.5 crore difference; clause 3(ii)(b) has no 10 percent tolerance.

Working. 1. Calculate the difference: ₹12 crore − ₹9.5 crore = ₹2.5 crore. 2. Identify the applicable requirement as paragraph 3(ii)(b). 3. Since the quarterly statement is not in agreement with the books, disclose the details; do not apply the separate 10% test in paragraph 3(ii)(a).

Explanation. The difference is ₹2.5 crore (₹12 crore less ₹9.5 crore), and the quarterly statements do not agree with the books. Paragraph 3(ii)(b) requires the auditor to report details of such disagreement; it does not prescribe a 10% materiality or tolerance threshold. The 10% threshold belongs to paragraph 3(ii)(a), which concerns discrepancies noticed on physical verification of each class of inventory. A management representation does not remove the requirement to compare and report the mismatch.

Where it goes wrong. Importing the 10% physical-inventory discrepancy threshold in paragraph 3(ii)(a) into the separate quarterly-return comparison under paragraph 3(ii)(b).

Authority. Companies (Auditor’s Report) Order, 2020, para 3(ii)(a) and 3(ii)(b); ICAI Study Material, Paper 5, Chapter 8, pp. 8.75–8.76 and 8.102

Question 13 · 2 marks · Chapter 10: Audit of Banks · medium

Which of the two ordinary term-loan accounts at Pragati Commercial Bank meets the overdue criterion for NPA classification?

1. Both accounts, because 90 days overdue is sufficient for every term-loan classification.
2. Neither account, because NPA status begins only after the dues remain overdue for 120 days.
3. Only the 91-day account, because the term-loan test is more than 90 days. (correct answer)
4. Only the 90-day account, because the threshold is reached on the ninetieth day.

Answer: C — Only the 91-day account, because the term-loan test is more than 90 days.

Working. 1. Compare each overdue period with the strict threshold of more than 90 days. 2. Exactly 90 days does not satisfy it. 3. Ninety-one days exceeds it. 4. Classify only the 91-day term-loan account as NPA, subject to the other applicable account facts.

Explanation. For an ordinary term loan, the relevant overdue trigger is that interest and/or an instalment of principal remains overdue for a period of more than 90 days. Exactly 90 days does not cross the stated threshold, whereas 91 days does. Accordingly, only the second account meets the NPA overdue criterion on the facts given. The test is not 90 days or more and should not be confused with different treatment applicable to agricultural advances or with the out-of-order test for cash-credit and overdraft accounts.

Where it goes wrong. Reading “more than 90 days” as “90 days or more,” thereby classifying an account on the ninetieth day.

Authority. RBI (Commercial Banks – Income Recognition, Asset Classification and Provisioning) Directions, 2025, Chapter III, para 42(1), as updated on 1 October 2026; ICAI Study Material, Paper 5, Chapter 10, p. 10.27

Question 14 · 2 marks · Chapter 10: Audit of Banks · medium

Which agricultural advance should be classified as an NPA on the crop-season facts given?

1. Neither, because agricultural advances always use the ordinary 90-day overdue test.
2. The long-duration crop loan only, because one crop season applies to that category. (correct answer)
3. The short-duration crop loan only, because one crop season is sufficient for every crop category.
4. Both, because one overdue crop season makes every agricultural advance non-performing.

Answer: B — The long-duration crop loan only, because one crop season applies to that category.

Working. 1. Identify the crop category for each advance. 2. Apply two overdue crop seasons to short-duration crops and one to long-duration crops. 3. The short-duration loan has only one overdue season; the long-duration loan has reached its one-season threshold. 4. Classify only the long-duration loan as NPA.

Explanation. The agricultural-advance rule distinguishes short-duration and long-duration crops. An instalment on a short-duration crop loan must remain overdue for two crop seasons before the account is classified as NPA. For a long-duration crop loan, one crop season overdue is sufficient. Since the short-duration loan is overdue for only one crop season, it does not yet meet its threshold; the long-duration crop loan does. The crop season is the period up to harvesting as determined by the State Level Bankers’ Committee.

Where it goes wrong. Applying the same crop-season threshold to both categories, or substituting the ordinary term-loan 90-day rule for the agricultural rule.

Authority. RBI (Commercial Banks – Income Recognition, Asset Classification and Provisioning) Directions, 2025, Chapter III, paras 42(6)–42(7), as updated on 1 October 2026; ICAI Study Material, Paper 5, Chapter 10, p. 10.33

Question 15 · 2 marks · Chapter 11: Ethics and Terms of Audit Engagements · hard

Scenario. An audit firm is considering continuing as statutory auditor of a privately held company. The engagement partner has served on the engagement for eight consecutive years, creating a possible familiarity threat. The company proposes that the audit fee be payable only if the auditor issues an unmodified opinion or reaches a specified favourable audit finding. No exception under Regulation 192 of the Chartered Accountants Regulations applies to this ordinary statutory audit.

Which course of action most appropriate addresses the proposed fee and the engagement partner’s long association with the audit client?

1. Reject the contingent fee; address familiarity through rotation and independent review before continuing. (correct answer)
2. Accept both arrangements after disclosing the fee basis and obtaining management’s written representation.
3. Accept the contingent fee if the partner is rotated, since rotation removes every independence threat.
4. Retain the partner and fee because actual bias has not yet been demonstrated.

Answer: A — Reject the contingent fee; address familiarity through rotation and independent review before continuing.

Working. 1. Test the fee proposal under Clause 10 and Regulation 192: it is contingent on audit findings and no exception applies, so reject it. 2. Separately assess the familiarity threat from eight years of involvement. 3. Consider rotation and independent review. 4. Continue only if the threat is reduced to an acceptable level.

Explanation. A fee contingent on the audit opinion or a specified audit finding is prohibited for this ordinary statutory audit under Clause 10, and no applicable Regulation 192 exception is stated. Rotation cannot convert a prohibited fee arrangement into an acceptable one. Separately, eight years of involvement may create a familiarity threat under Section 540. The firm should evaluate the significance of that threat and apply safeguards such as rotating senior personnel and arranging an independent review. It may continue only if the threat is reduced to an acceptable level.

Where it goes wrong. Assuming that disclosure, management representation or partner rotation can cure a contingent-fee prohibition, or that long association is harmless until actual bias is proved.

Authority. ICAI Code of Ethics, 13th edition (2026), Volume I, First Schedule, Part I, Clause 10 and Regulation 192; ICAI Code of Ethics, 13th edition (2026), Volume II, Section 540, paras 540.2–540.3; ICAI announcement on the 13th edition of the Code of Ethics, effective 1 April 2026