Test 10: answer key

Question 1 · 2 marks · Chapter 4: Audit Evidence · medium

Scenario. CA Leena is auditing Meridian Traders for FY 2025-26. She issued positive external confirmations to 40 trade receivables and to the bank. Results: 22 agreed, 5 showed timing differences where customers paid before year-end but the entity recorded receipts after year-end, 4 requests were returned undelivered, 6 did not reply, 3 reported genuine differences, and 2 replies were received by the entity instead of the auditor. CA Leena also proposes negative confirmations for remaining small balances.

How should the four confirmation requests returned undelivered be classified under SA 505?

1. They are exceptions that must be projected to the entire receivables population.
2. They are non-responses; the auditor should perform alternative procedures. (correct answer)
3. They are valid positive confirmations if the entity confirms mailing was attempted.
4. They are timing differences requiring adjustment of the receivables balance.

Answer: B — They are non-responses; the auditor should perform alternative procedures.

Working. Step 1: Identify the nature of the returned request. Step 2: Apply SA 505 definition of non-response. Step 3: Plan alternative procedures such as subsequent receipts or shipping records.

Explanation. SA 505 treats a request returned undelivered as a non-response, not as an exception. The auditor must perform alternative procedures to obtain relevant and reliable evidence. Projecting an undelivered request to the population is incorrect because no response was received. A reply received by the entity is not a direct response to the auditor and is not automatically reliable. Timing differences require investigation, not automatic adjustment.

Where it goes wrong. Students often treat undelivered requests as exceptions or as evidence of misstatement, instead of non-responses requiring alternative procedures.

Authority. SA 505: External Confirmations, paras 7-8 and definitions; ICAI Study Material, Paper 5, Chapter 4

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

What is the most appropriate response to the five timing differences reported by debtors?

1. Treat each difference as a misstatement and request adjustment without further work.
2. Ignore the differences because cash was received before the year-end.
3. Investigate each difference; if the entity's cut-off is correct, no misstatement arises. (correct answer)
4. Replace all positive confirmations with negative confirmations for these debtors.

Answer: C — Investigate each difference; if the entity's cut-off is correct, no misstatement arises.

Working. Step 1: Compare confirmation date and receipt date. Step 2: Examine bank receipts and cut-off records. Step 3: Conclude whether the recorded balance is misstated.

Explanation. An exception indicates a difference between the confirmation and the entity's records. The auditor must investigate the reason. A timing difference may be caused by cash in transit or cut-off and may not represent a misstatement if the entity's records are correct. Automatic adjustment or automatic acceptance is inappropriate. Negative confirmations are not a substitute for resolving positive confirmation exceptions.

Where it goes wrong. Students often equate every confirmation difference with a misstatement and overlook cut-off and timing explanations.

Authority. SA 505: External Confirmations, paras 7-8; SA 500: Audit Evidence, para 7

Question 3 · 2 marks · Chapter 4: Audit Evidence · hard

Two positive confirmation replies were received by the entity rather than by CA Leena. What should she do?

1. Accept them if management confirms that the replies were not altered.
2. Classify them as exceptions and project them to all receivables.
3. Use them as valid positive confirmations because customers signed them.
4. Seek direct replies to the auditor; if not received, perform alternative procedures. (correct answer)

Answer: D — Seek direct replies to the auditor; if not received, perform alternative procedures.

Working. Step 1: Check whether the response was sent directly to the auditor. Step 2: Re-request direct confirmation. Step 3: Perform alternative procedures if no direct reply is received.

Explanation. An external confirmation must be a direct written response to the auditor. A reply received by the entity is not direct and may be altered or filtered. The auditor should request that the confirming party respond directly. If a direct response is not obtained, alternative procedures are required. Treating the reply as an exception and projecting it is not the correct response.

Where it goes wrong. Students assume a signed customer reply is reliable even if it was routed through the client.

Authority. SA 505: External Confirmations, para 7 and definition of external confirmation; SA 500: Audit Evidence, para 7

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

When may negative confirmations be used as the sole substantive procedure?

1. Low assessed risk, many small homogeneous balances, low expected exception rate, and no reason recipients would disregard requests. (correct answer)
2. High assessed risk with few large balances and no expected exceptions.
3. When management requests negative confirmations and internal controls are weak.
4. When positive confirmations are prohibited by law and balances are material.

Answer: A — Low assessed risk, many small homogeneous balances, low expected exception rate, and no reason recipients would disregard requests.

Working. Step 1: Assess risk. Step 2: Assess population homogeneity and size. Step 3: Assess expected exceptions and likelihood of disregard. Step 4: Apply all conditions cumulatively.

Explanation. SA 505 permits negative confirmations as the sole substantive procedure only when all specified conditions are present: low risk, large number of small homogeneous balances, very low expected exception rate, and no circumstances suggesting recipients would disregard requests. High risk, few large balances, weak controls or material balances do not meet the conditions. Management request is not a criterion.

Where it goes wrong. Students often focus only on low risk or large population and ignore the other cumulative conditions.

Authority. SA 505: External Confirmations, para 15; ICAI Study Material, Paper 5, Chapter 4

Question 5 · 2 marks · Chapter 9: Special Features of Audit of Different Types of Entities · medium

Scenario. CA Rohan audits Sunrise Recreation Club. Entrance fees are credited to income, subscriptions in arrears include old balances, sports equipment is depreciated, and bar sales are substantial. The management asks which audit procedure is least appropriate for checking irrecoverable member dues.

Which procedure is least appropriate for checking irrecoverable member dues of the recreation club?

1. Review members register, ageing of subscriptions, recovery steps and write-off approvals.
2. Confirm each small cash bar sale with members at the year-end. (correct answer)
3. Examine minutes for write-off approvals and subsequent receipts after year-end.
4. Compare arrears with prior year and inspect correspondence with defaulting members.

Answer: B — Confirm each small cash bar sale with members at the year-end.

Working. Step 1: Identify assertion for irrecoverable dues. Step 2: Select procedures that test recoverability and approval of write-offs. Step 3: Reject procedures unrelated to the assertion.

Explanation. Irrecoverable member dues are checked through the members register, ageing, recovery correspondence, subsequent receipts and write-off approvals. Confirming each small cash bar sale with members is not an appropriate procedure for member dues, and it is impractical and unrelated to recoverability of subscriptions. Bar sales are substantiated through cash and inventory controls, not by confirming every small sale.

Where it goes wrong. Students may choose a detailed procedure without linking it to the specific assertion of valuation and recoverability of member dues.

Authority. ICAI Study Manual, Paper 5, Chapter 9: Audit of Club; SA 500: Audit Evidence

Question 6 · 2 marks · Chapter 5: Audit of Items of Financial Statements · medium

Scenario. TechNova Ltd capitalises all costs of a software project from commencement. It incurred Rs 40 lakh on research, Rs 60 lakh on development after technical feasibility, and Rs 10 lakh on training. It also carries goodwill acquired in a business combination and does not amortise it, stating that the goodwill has an indefinite life. The auditor is examining recognition, amortisation and impairment.

How should the Rs 40 lakh research cost and Rs 60 lakh development cost be treated under AS 26?

1. Capitalise both research and development if the project is technically feasible.
2. Expense both because software is internally generated and cannot be capitalised.
3. Expense research; capitalise development only if all AS 26 recognition criteria are met and cost is measurable. (correct answer)
4. Capitalise research and expense development until the software is sold.

Answer: C — Expense research; capitalise development only if all AS 26 recognition criteria are met and cost is measurable.

Working. Step 1: Split research and development phases. Step 2: Expense research. Step 3: Test development costs against all AS 26 criteria before capitalisation.

Explanation. Under AS 26, research expenditure is expensed when incurred. Development expenditure can be capitalised only if the entity demonstrates all recognition criteria, including technical feasibility, intention and ability to complete, probable future economic benefits, availability of resources and reliable measurement of cost. Internal generation does not by itself prohibit capitalisation. Capitalising research is not allowed.

Where it goes wrong. Students often capitalise all project costs once technical feasibility is established, ignoring the research phase and cumulative criteria.

Authority. AS 26: Intangible Assets, paras 41-43; ICAI Study Material, Paper 5, Chapter 5

Question 7 · 2 marks · Chapter 5: Audit of Items of Financial Statements · medium

How should the Rs 10 lakh training cost be treated?

1. Capitalise training as directly attributable to bringing the software to use.
2. Include training in cost if it is incurred before commercial launch.
3. Defer training cost and amortise it over the software's useful life.
4. Expense training when incurred; it is not necessary to bring the asset to intended use. (correct answer)

Answer: D — Expense training when incurred; it is not necessary to bring the asset to intended use.

Working. Step 1: Classify training cost. Step 2: Compare with AS 26 directly attributable cost examples. Step 3: Expense the amount when incurred.

Explanation. Training costs are not directly attributable to bringing the intangible asset to the condition necessary for its intended use. AS 26 excludes staff training costs from capitalisation. They should be expensed when incurred. Deferring or amortising training cost is not appropriate because it does not create an identifiable intangible asset controlled by the entity.

Where it goes wrong. Students often capitalise training as part of project cost because it is incurred before launch.

Authority. AS 26: Intangible Assets, para 29 and examples of costs; ICAI Study Material, Paper 5, Chapter 5

Question 8 · 2 marks · Chapter 5: Audit of Items of Financial Statements · hard

Management says acquired goodwill has an indefinite life and need not be amortised. What should the auditor require under AS 26 and AS 28?

1. Require amortisation over useful life and assess impairment; AS 26 does not permit indefinite-life non-amortisation. (correct answer)
2. Accept because acquired goodwill has an indefinite life.
3. Treat goodwill as a capital reserve and exclude it from amortisation.
4. Write off the entire goodwill amount directly in the profit and loss account in the year of acquisition.

Answer: A — Require amortisation over useful life and assess impairment; AS 26 does not permit indefinite-life non-amortisation.

Working. Step 1: Determine whether goodwill is acquired or internally generated. Step 2: Apply AS 26 amortisation requirements. Step 3: Assess impairment indicators under AS 28.

Explanation. Under AS 26, an intangible asset with a finite useful life is amortised over that life. An indefinite-life claim does not remove the need to amortise and test for impairment under the applicable framework. Internal goodwill is not recognised, but acquired goodwill is subject to amortisation and impairment assessment. Full write-off in the acquisition year or reclassification to capital reserve is not the default treatment.

Where it goes wrong. Students may accept management's indefinite-life assertion because goodwill is often described as having no physical life.

Authority. AS 26: Intangible Assets, paras 63-64 and 72; AS 28: Impairment of Assets; ICAI Study Material, Paper 5, Chapter 5

Question 9 · 2 marks · Chapter 5: Audit of Items of Financial Statements · hard

The auditor finds that capitalised software is not in active use and no economic benefits are expected. What is the most appropriate response?

1. Accept capitalisation if costs are documented and approved.
2. Reclassify software to property, plant and equipment without further procedures.
3. Assess impairment and possible derecognition; amortisation alone is not sufficient. (correct answer)
4. Defer amortisation until the software is sold or licensed.

Answer: C — Assess impairment and possible derecognition; amortisation alone is not sufficient.

Working. Step 1: Assess future economic benefits. Step 2: Test recoverable amount and impairment. Step 3: Consider derecognition and reporting effects.

Explanation. If an intangible asset is not in active use and future economic benefits are not expected, the auditor should assess impairment and whether the asset should be derecognised. Amortisation alone does not address the loss of value. Documentation and approval do not prove recoverability. Reclassification to PPE is not appropriate because software not integral to hardware remains an intangible asset.

Where it goes wrong. Students may focus only on amortisation and ignore impairment and derecognition.

Authority. AS 26: Intangible Assets, para 87 and impairment guidance; AS 28: Impairment of Assets; ICAI Study Material, Paper 5, Chapter 5

Question 10 · 2 marks · Chapter 2: Audit Strategy, Audit Planning and Audit Programme · medium

Scenario. During audit of Orion Ltd, CA Meera finds many deviations in sales approval controls. The original audit program planned limited substantive testing. She updates the program to expand substantive testing and records the reasons for the change.

What is the most appropriate action when control testing reveals many deviations from the original plan?

1. Keep the approved audit program unchanged because changes after commencement are prohibited.
2. Update the plan and program and document significant changes and the reasons. (correct answer)
3. Change the program only after obtaining approval from those charged with governance.
4. Do not document changes if the revised evidence is sufficient.

Answer: B — Update the plan and program and document significant changes and the reasons.

Working. Step 1: Evaluate deviations. Step 2: Revise nature, timing and extent of procedures. Step 3: Document significant changes and reasons.

Explanation. SA 300 requires the auditor to update and change the overall audit strategy and audit plan as necessary during the audit. Significant changes and their reasons must be documented under SA 230. An approved program is not frozen. Approval from those charged with governance is not required for audit program changes, and undocumented changes are not acceptable.

Where it goes wrong. Students think audit programs are fixed once approved and miss the requirement to document changes.

Authority. SA 300: Planning an Audit of Financial Statements, para 10; SA 230: Audit Documentation, para 8; ICAI Study Material, Paper 5, Chapter 2

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

Scenario. Bharat Finance Ltd has total assets of Rs 200 crore, financial assets of Rs 120 crore, gross income of Rs 80 crore and income from financial assets of Rs 36 crore. It also has group investments. CARO 2020 reporting on NBFC registration and Core Investment Company criteria is being considered.

On the given figures, is Bharat Finance Ltd required to obtain NBFC registration under section 45-IA of the RBI Act?

1. No; both the 50 percent asset test and 50 percent income test must be met. (correct answer)
2. Yes; financial assets exceed 50 percent of total assets.
3. Yes; financial income is at least 40 percent of gross income.
4. No; financial assets are below 75 percent of total assets.

Answer: A — No; both the 50 percent asset test and 50 percent income test must be met.

Working. Step 1: Compute financial assets divided by total assets. Step 2: Compute financial income divided by gross income. Step 3: Apply both thresholds cumulatively.

Explanation. The principal business test requires both conditions: financial assets exceeding 50 percent of total assets and income from financial assets exceeding 50 percent of gross income. Here financial assets are 60 percent, but financial income is only 45 percent. Therefore, the company does not meet the 50-50 test on the given figures. Exceeding only the asset test is not sufficient.

Where it goes wrong. Students often apply only the asset test and ignore the income test.

Authority. CARO 2020, clause (xvi); RBI Act, 1934, section 45-IA and 50-50 principal business test; ICAI Study Material, Paper 5, Chapter 8

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

If Bharat Finance Ltd met both 50 percent tests but had no RBI registration, what should the CARO 2020 auditor report?

1. Report only whether CIC registration under the Companies Act was obtained.
2. Report only whether stock audit was conducted.
3. Report only whether the internal audit report was considered.
4. Report whether registration under section 45-IA of the RBI Act was obtained and, if not, the non-compliance. (correct answer)

Answer: D — Report whether registration under section 45-IA of the RBI Act was obtained and, if not, the non-compliance.

Working. Step 1: Determine whether 50-50 test is met. Step 2: Check RBI registration. Step 3: Report registration status and non-compliance under clause (xvi).

Explanation. CARO 2020 clause (xvi)(a) requires the auditor to report whether the company is required to be registered under section 45-IA of the RBI Act and, if so, whether registration has been obtained. If registration is not obtained, the non-compliance is reported. CIC registration, stock audit and internal audit are separate matters and do not replace this reporting requirement.

Where it goes wrong. Students confuse NBFC registration under the RBI Act with CIC criteria or other CARO clauses.

Authority. CARO 2020, clause (xvi)(a); RBI Act, 1934, section 45-IA

Question 13 · 2 marks · Chapter 8: Audit Report · hard

Which of the following is not a criterion for classification as a Core Investment Company?

1. Holds not less than 90 percent of net assets in shares or securities of group companies.
2. Does not carry on any financial activity other than permitted exceptions.
3. Has net owned funds below two crore rupees. (correct answer)
4. Is an NBFC registered with the RBI and belongs to a group.

Answer: C — Has net owned funds below two crore rupees.

Working. Step 1: Recall CIC criteria. Step 2: Compare each option. Step 3: Identify the capital-based statement as outside CIC criteria.

Explanation. CIC criteria focus on group investment, the 90 percent net assets test, restriction on other financial activities and NBFC status. Having net owned funds below Rs 2 crore is not a CIC criterion; it is also inconsistent with the general NBFC net owned funds requirement. Therefore, option (c) is not a CIC criterion.

Where it goes wrong. Students may mix NBFC capital requirements with CIC classification criteria.

Authority. CARO 2020, clause (xvi)(c); RBI Core Investment Company directions; ICAI Study Material, Paper 5, Chapter 8

Question 14 · 2 marks · Chapter 8: Audit Report · medium

The group has two Core Investment Companies. What does CARO 2020 require the auditor to report?

1. Report the number of CICs in the group and whether each fulfils CIC criteria. (correct answer)
2. Report only the consolidated net worth of the CICs.
3. Ignore because CICs are exempt from CARO reporting.
4. Report only when the group has more than three CICs.

Answer: A — Report the number of CICs in the group and whether each fulfils CIC criteria.

Working. Step 1: Identify number of CICs in group. Step 2: Apply clause (xvi)(d). Step 3: Report number and CIC criteria status.

Explanation. CARO 2020 clause (xvi)(d) requires the auditor to state whether the group has more than one CIC and, if so, indicate the number of CICs in the group. Reporting only net worth or applying a threshold of more than three CICs is incorrect. CICs are not generally exempt from this CARO reporting requirement.

Where it goes wrong. Students may think CIC reporting applies only to very large groups or only to net worth.

Authority. CARO 2020, clause (xvi)(d); ICAI Study Material, Paper 5, Chapter 8

Question 15 · 2 marks · Chapter 10: Audit of Banks · hard

Scenario. CA Farah audits a branch of National Bank. While examining bills discounted, she finds bills drawn by one party on another where there is no genuine trade and the drawee has weak financials. The branch has discounted the bills and classified them as standard.

What is the most appropriate audit response to the discounted bills suspected to be accommodation bills?

1. Treat as standard if goods are hypothecated to the bank.
2. Assess whether bills are accommodation bills; examine trade documents and drawee solvency, then classify and provide per RBI norms. (correct answer)
3. Rely on the sanctioned limit and ignore end-use because the bill is discounted.
4. Mention only in the LFAR without affecting asset classification.

Answer: B — Assess whether bills are accommodation bills; examine trade documents and drawee solvency, then classify and provide per RBI norms.

Working. Step 1: Examine bill documents and trade evidence. Step 2: Assess drawee solvency and accommodation bill indicators. Step 3: Apply RBI classification and provisioning norms.

Explanation. Accommodation bills lack genuine trade and carry higher credit risk. The auditor should examine trade documents, drawee solvency and the nature of the transaction, and then apply RBI norms for classification and provisioning. Hypothecation, sanctioned limit or LFAR disclosure alone does not cure the risk or determine classification.

Where it goes wrong. Students may rely only on security or sanction limits and overlook the genuineness of the underlying trade.

Authority. RBI prudential norms on income recognition, asset classification and provisioning; ICAI Study Material, Paper 5, Chapter 10