Test 7: answer key

Question 1 · 2 marks · Chapter 7: Completion and Review · medium

Scenario. During final audit of Meridian Traders Ltd, CA Rao accumulates misstatements: an incorrect invoice amount of ₹12 lakh (factual), a warranty provision estimate considered too low by ₹9 lakh (judgmental), and a projected misstatement of ₹6 lakh from sampling. Materiality for the financial statements is ₹20 lakh and performance materiality is ₹12 lakh. Management corrects only ₹5 lakh of the factual misstatement. The audit strategy is being reconsidered.

How should CA Rao classify the three accumulated misstatements in Meridian Traders Ltd?

1. ₹12 lakh as projected, ₹9 lakh as factual and ₹6 lakh as judgmental
2. ₹12 lakh as judgmental, ₹9 lakh as projected and ₹6 lakh as factual
3. ₹12 lakh as factual, ₹9 lakh as judgmental and ₹6 lakh as projected (correct answer)
4. ₹12 lakh as factual, ₹9 lakh as projected and ₹6 lakh as judgmental

Answer: C — ₹12 lakh as factual, ₹9 lakh as judgmental and ₹6 lakh as projected

Working. Step 1: Identify the known incorrect invoice as factual. Step 2: Identify the estimate difference as judgmental. Step 3: Identify the sampling extrapolation as projected. Step 4: Match the amounts to the respective categories.

Explanation. A factual misstatement is a specific identified difference such as an incorrect invoice amount. A judgmental misstatement arises from management estimates, such as the warranty provision being considered too low. A projected misstatement is the auditor's estimate of misstatement in a population based on sampling. Hence ₹12 lakh is factual, ₹9 lakh is judgmental and ₹6 lakh is projected.

Where it goes wrong. Students often treat all sampling-related differences as factual and all estimate differences as projected.

Authority. SA 450: Evaluation of Misstatements Identified during the Audit, para 5; ICAI Study Material, Chapter 7: Completion and Review

Question 2 · 2 marks · Chapter 7: Completion and Review · hard

The uncorrected misstatements aggregate to ₹22 lakh against materiality of ₹20 lakh. What is the most appropriate response of CA Rao?

1. Rely on performance materiality and make no change to the audit plan
2. Revise the audit strategy and plan and request management to examine and correct the misstatements (correct answer)
3. Ignore projected misstatement and consider only factual misstatement
4. Communicate the matter to TCWG only after the auditor's report is issued

Answer: B — Revise the audit strategy and plan and request management to examine and correct the misstatements

Working. Step 1: Compute uncorrected factual ₹12 lakh minus ₹5 lakh corrected = ₹7 lakh. Step 2: Add judgmental ₹9 lakh and projected ₹6 lakh = ₹22 lakh. Step 3: Compare with materiality ₹20 lakh. Step 4: Apply SA 450 revision and communication requirements.

Explanation. SA 450 requires the auditor to consider whether the overall audit strategy and plan need revision when the aggregate of misstatements approaches or exceeds materiality. The uncorrected aggregate of ₹22 lakh exceeds ₹20 lakh, so the auditor should revise the plan and request management to examine the class of transactions and correct misstatements. Performance materiality does not permit ignoring the aggregate.

Where it goes wrong. Students may think performance materiality of ₹12 lakh alone governs and no revision is needed.

Authority. SA 450: Evaluation of Misstatements Identified during the Audit, paras 10 and 11; SA 320: Materiality in Planning and Performing an Audit

Question 3 · 2 marks · Chapter 7: Completion and Review · medium

How should CA Rao communicate uncorrected misstatements to those charged with governance?

1. Communicate uncorrected misstatements and request correction, identifying material ones individually (correct answer)
2. Communicate only those above performance materiality and omit the remaining items
3. Obtain written representation first and then avoid communication to TCWG
4. Report only in the auditor's report and not to those charged with governance

Answer: A — Communicate uncorrected misstatements and request correction, identifying material ones individually

Working. Step 1: Identify uncorrected misstatements. Step 2: Assess materiality individually and in aggregate. Step 3: Communicate to TCWG and request correction. Step 4: Identify material uncorrected misstatements individually.

Explanation. SA 450 requires the auditor to communicate with those charged with governance regarding uncorrected misstatements and the effect they may have on the opinion. Material uncorrected misstatements must be identified individually. The auditor should request that they be corrected. Communication cannot be replaced by a written representation or by reporting only in the auditor's report.

Where it goes wrong. Students may confuse the representation letter with the required TCWG communication.

Authority. SA 450: Evaluation of Misstatements Identified during the Audit, para 16; SA 260: Communication with Those Charged with Governance

Question 4 · 2 marks · Chapter 7: Completion and Review · medium

What written representation should CA Rao request regarding the uncorrected misstatements?

1. A representation that all misstatements have been corrected before the report date
2. A representation that uncorrected misstatements are material but no adjustment is needed
3. No representation is needed because TCWG has already been informed orally
4. A representation that uncorrected effects are immaterial individually and in aggregate, with a summary attached (correct answer)

Answer: D — A representation that uncorrected effects are immaterial individually and in aggregate, with a summary attached

Working. Step 1: Identify uncorrected items. Step 2: Request management representation on immateriality. Step 3: Attach summary. Step 4: Do not treat oral TCWG communication as a substitute.

Explanation. SA 450 requires the auditor to request a written representation from management and, where appropriate, TCWG that they believe the effects of uncorrected misstatements are immaterial individually and in aggregate. A summary of such items is included in or attached to the representation. Oral communication to TCWG does not replace this requirement.

Where it goes wrong. Students may think a written representation is needed only for corrected items or only when misstatements are material.

Authority. SA 450: Evaluation of Misstatements Identified during the Audit, para 17; SA 580: Written Representations

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

Scenario. The Local Fund Audit Wing audits Varanasi Municipal Corporation. The auditor finds delays in depositing property tax collections, weak budgetary control over grants, and no assessment of whether civic works delivered value for money. The municipal council asks what the external audit is expected to report.

What is the external auditor of Varanasi Municipal Corporation expected to report on?

1. Whether the municipal council should increase property tax rates for the next year
2. Fairness of financial statements, control weaknesses, legal adherence and value for money (correct answer)
3. Certification of every property tax assessment before the tax is collected
4. Approval of civic priorities and finalisation of the municipal budget

Answer: B — Fairness of financial statements, control weaknesses, legal adherence and value for money

Working. Step 1: Recall objectives of local body audit. Step 2: Exclude rate setting, budget approval and executive certification. Step 3: Select the reporting package that matches audit objectives.

Explanation. The objectives of audit of local bodies include reporting on the fairness of financial statements, strengths and weaknesses of financial control, adherence to legal and administrative requirements, value for money and detection and prevention of error, fraud and misuse of resources. The auditor does not set tax rates, certify every assessment or approve the budget.

Where it goes wrong. Students may confuse audit reporting with executive or legislative functions of the municipality.

Authority. ICAI Study Material, Chapter 9: Audit of Local Bodies; SA 200: Overall Objectives of the Independent Auditor

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

Scenario. Innovate Labs Ltd, a listed company, proposes to issue sweat equity shares to its CTO for technical know-how, redeem preference shares by creating a capital redemption reserve, buy back equity shares, and apply securities premium for specified purposes. The board asks the auditor to verify compliance with the Companies Act, 2013.

Which condition must be satisfied for Innovate Labs Ltd to issue sweat equity shares validly?

1. An ordinary resolution and a valuation by an independent valuer alone
2. A board resolution with no disclosure of current market price or consideration
3. A special resolution specifying shares, current market price, consideration and class, with SEBI compliance if listed (correct answer)
4. A special resolution only if the shares to be issued are preference shares

Answer: C — A special resolution specifying shares, current market price, consideration and class, with SEBI compliance if listed

Working. Step 1: Identify sweat equity shares as equity shares. Step 2: Check Section 54 conditions. Step 3: Require special resolution with specified details. Step 4: Apply SEBI regulations for listed company.

Explanation. Section 54 permits sweat equity shares of a class already issued if authorised by a special resolution. The resolution must specify the number of shares, current market price, consideration, if any, and the class or classes of directors or employees. For listed companies, the issue must comply with SEBI regulations. Sweat equity shares are equity shares, not preference shares.

Where it goes wrong. Students may think an ordinary resolution or a mere board resolution is enough.

Authority. Companies Act, 2013, Section 54; ICAI Study Manual, Chapter 5: Share Capital

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

Innovate Labs Ltd redeems preference shares out of profits. What is the correct requirement for capital redemption reserve?

1. Create CRR equal to the nominal amount redeemed out of profits before redemption (correct answer)
2. Create CRR equal to only the premium payable on redemption
3. CRR is optional whenever a general reserve already exists
4. Create CRR after redemption out of revaluation reserve

Answer: A — Create CRR equal to the nominal amount redeemed out of profits before redemption

Working. Step 1: Identify redemption out of profits. Step 2: Compute nominal value redeemed. Step 3: Create CRR for nominal value before redemption. Step 4: Exclude premium and revaluation reserve.

Explanation. Where redeemable preference shares are redeemed out of profits, a capital redemption reserve equal to the nominal amount of shares redeemed must be created. The reserve is created before redemption and is not optional merely because a general reserve exists. Revaluation reserve is not a free reserve for this purpose.

Where it goes wrong. Students may think CRR equals the premium or can be created after redemption from any reserve.

Authority. Companies Act, 2013, Section 55; ICAI Study Manual, Chapter 5: Reserves and Surplus

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

Which statement about the proposed buyback by Innovate Labs Ltd is correct?

1. Buyback may exceed 25 percent of paid-up capital and free reserves without any resolution
2. Buyback may be funded from capital redemption reserve in all circumstances
3. Buyback does not require cancellation or extinguishment of the shares bought back
4. Buyback is subject to the 25 percent limit of paid-up capital and free reserves and prescribed resolution (correct answer)

Answer: D — Buyback is subject to the 25 percent limit of paid-up capital and free reserves and prescribed resolution

Working. Step 1: Recall Section 68 limits. Step 2: Check resolution requirement. Step 3: Check cancellation requirement. Step 4: Exclude capital redemption reserve as an unrestricted source.

Explanation. Section 68 governs buyback and imposes limits and procedural requirements, including the 25 percent limit of aggregate paid-up capital and free reserves and the prescribed board or special resolution depending on the size. Shares bought back must be cancelled or extinguished. Capital redemption reserve is not freely available for buyback in all circumstances.

Where it goes wrong. Students may remember only the 25 percent limit and ignore resolution, cancellation or funding restrictions.

Authority. Companies Act, 2013, Section 68; ICAI Study Manual, Chapter 5: Share Capital

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

Which proposed application of the securities premium account by Innovate Labs Ltd is permissible under Section 52?

1. Payment of dividend to equity shareholders and writing off preliminary expenses
2. Writing off preliminary expenses and buyback under Section 68 (correct answer)
3. Payment of dividend and issue of bonus shares only
4. Writing off preliminary expenses and payment of managerial remuneration

Answer: B — Writing off preliminary expenses and buyback under Section 68

Working. Step 1: Recall permitted uses under Section 52. Step 2: Test each option. Step 3: Exclude dividend and managerial remuneration. Step 4: Select the combination of permitted uses.

Explanation. Section 52 permits securities premium to be applied for issuing fully paid bonus shares, writing off preliminary expenses, writing off expenses or commission or discount on issue of shares or debentures, providing for premium payable on redemption of preference shares or debentures, and buyback under Section 68. It cannot be used to pay dividends or managerial remuneration.

Where it goes wrong. Students may treat securities premium as a free reserve available for dividends.

Authority. Companies Act, 2013, Section 52; ICAI Study Manual, Chapter 5: Share Capital

Question 10 · 2 marks · Chapter 1: Nature, Objective and Scope of Audit · medium

Scenario. At a board meeting of a listed company, the CEO asks why the statutory auditor cannot give absolute assurance that the financial statements are free from material misstatement. The auditor explains that audit evidence is persuasive rather than conclusive and that audit risk cannot be reduced to zero.

Which statement most appropriate explains why an audit provides reasonable assurance and not absolute assurance?

1. The auditor tests every transaction, so audit risk is eliminated in practice
2. Absolute assurance is given whenever internal controls are strong
3. Management judgment and practical and legal limits make audit evidence persuasive, not conclusive (correct answer)
4. Future events are fully predictable from past data and internal records

Answer: C — Management judgment and practical and legal limits make audit evidence persuasive, not conclusive

Working. Step 1: Recall inherent limitations. Step 2: Exclude absolute assurance and full testing claims. Step 3: Identify the combination of judgment and practical limits. Step 4: Select the statement consistent with SA 200.

Explanation. Audit risk cannot be reduced to zero because financial reporting involves management judgment, audit procedures are subject to practical and legal limitations, audit is not an investigation, information relevance declines over time, and future events are uncertain. Therefore, audit evidence is persuasive rather than conclusive and audit provides reasonable, not absolute, assurance.

Where it goes wrong. Students may think strong internal controls or full transaction testing eliminate inherent limitations.

Authority. SA 200: Overall Objectives of the Independent Auditor, paras 5 and A1-A10; ICAI Study Material, Chapter 1: Inherent Limitations of Audit

Question 11 · 2 marks · Chapter 10: Audit of Banks · medium

Scenario. CA Meera audits City Bank branch. A borrower has non-funded facilities: a bank guarantee of ₹80 lakh and a letter of credit of ₹120 lakh. Margin is 25 percent on the bank guarantee and 10 percent on the letter of credit. Margin money deposits are ₹20 lakh and ₹12 lakh respectively. One bank guarantee is invoked and one letter of credit is devolved; the borrower fails to reimburse the bank.

Which set of documents should CA Meera examine while verifying issuance of the bank guarantee?

1. Sanction, application, guarantee agreement, margin and security documents (correct answer)
2. Only the borrower's oral request and the ledger posting in the books
3. Only the bank's internal note and the borrower's KYC file
4. Only the borrower's annual financial statements and tax returns

Answer: A — Sanction, application, guarantee agreement, margin and security documents

Working. Step 1: Classify bank guarantee as non-funded. Step 2: Identify issuance documents. Step 3: Include sanction, agreement, margin and security. Step 4: Exclude inadequate single documents.

Explanation. A bank guarantee is a non-funded facility. The auditor should examine the sanction, borrower application, guarantee agreement, margin money and security or counter-guarantee documents. Oral requests, internal notes alone or financial statements alone do not establish the bank's contingent obligation and compliance with sanction terms.

Where it goes wrong. Students may treat the bank guarantee as a funded advance and look only at ledger postings.

Authority. ICAI Study Material, Chapter 10: Audit of Banks, Non-Funded Loans; RBI prudential norms on non-funded facilities

Question 12 · 2 marks · Chapter 10: Audit of Banks · medium

How should CA Meera verify the margin money held against the non-funded facilities?

1. Allow the borrower to adjust margin money before expiry of the facility
2. Check the margin deposit and lien, and verify compliance with the sanctioned margin (correct answer)
3. Treat margin money as optional for all bank guarantees and letters of credit
4. Recognise margin money immediately as bank income at the time of deposit

Answer: B — Check the margin deposit and lien, and verify compliance with the sanctioned margin

Working. Step 1: Identify margin as security. Step 2: Verify deposit and lien. Step 3: Compare with sanctioned margin. Step 4: Exclude income recognition and free withdrawal.

Explanation. Margin money is security held by the bank and should be substantiated through deposit records, lien marking and compliance with the sanctioned margin. It is not income at deposit. It cannot be freely withdrawn by the borrower before expiry. The auditor should ensure the margin is adequate and properly secured.

Where it goes wrong. Students may view margin money as a customer deposit available for immediate withdrawal.

Authority. ICAI Study Material, Chapter 10: Audit of Banks, Advances and Non-Funded Facilities; RBI guidelines on margin and security for non-funded facilities

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

The letter of credit has devolved and the borrower has not reimbursed the bank. How should the branch treat the devolved amount?

1. Keep it as a non-funded contingent liability until the facility expires
2. Classify it as a standard asset for twelve months without reference to recovery
3. Classify it as a loss asset immediately in every case without further assessment
4. Record it as a funded advance and classify it as NPA where recovery is not forthcoming as per norms (correct answer)

Answer: D — Record it as a funded advance and classify it as NPA where recovery is not forthcoming as per norms

Working. Step 1: Identify devolution event. Step 2: Convert non-funded exposure to funded advance. Step 3: Apply overdue and recovery norms. Step 4: Classify NPA where criteria are met.

Explanation. A letter of credit is non-funded until devolution. On devolution, the bank's payment creates a funded exposure. If the borrower fails to reimburse and the amount is overdue or recovery is not forthcoming, it must be classified as an NPA as per RBI norms. It is not kept as a contingent liability or automatically treated as a loss asset in every case.

Where it goes wrong. Students may continue to treat the devolved letter of credit as a contingent liability.

Authority. ICAI Study Material, Chapter 10: Audit of Banks, Non-Funded Loans and NPAs; RBI prudential norms on income recognition, asset classification and provisioning

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

The bank guarantee has been invoked and the bank has paid the beneficiary, but the borrower has not reimbursed the bank. What is the correct treatment?

1. Continue as a contingent liability and standard asset because no loan account exists
2. Classify as standard for ninety days irrespective of recovery from the borrower
3. Treat as a funded advance and classify as NPA based on record of recovery; it is no longer contingent (correct answer)
4. Write off the amount directly without classifying it as an NPA

Answer: C — Treat as a funded advance and classify as NPA based on record of recovery; it is no longer contingent

Working. Step 1: Identify invocation and payment. Step 2: Convert contingent liability to funded advance. Step 3: Apply NPA criteria based on recovery. Step 4: Exclude direct write-off and standard classification.

Explanation. Invocation of a bank guarantee converts the bank's contingent obligation into a funded exposure when the bank pays the beneficiary. If the borrower fails to reimburse and the amount is overdue, it must be classified as an NPA based on record of recovery. It is not kept as a contingent liability and cannot be written off without following provisioning norms.

Where it goes wrong. Students may think invocation does not affect asset classification until a formal loan account is opened.

Authority. ICAI Study Material, Chapter 10: Audit of Banks, Non-Funded Loans; RBI prudential norms on asset classification

Question 15 · 2 marks · Chapter 8: Audit Report · medium

Scenario. During the audit of a company covered by Section 135 of the Companies Act, 2013, the auditor finds an unspent CSR amount relating to an ongoing project and another unspent amount not relating to an ongoing project. The auditor must report under CARO 2020 clause (xx) on transfer to the special account and the Schedule VII fund.

What should the auditor report under CARO 2020 clause (xx) on the unspent CSR amounts?

1. Ongoing project unspent amount to special account within 30 days; other unspent to Schedule VII fund within six months (correct answer)
2. All unspent amounts to the Schedule VII fund within 30 days of the year end
3. All unspent amounts retained in general reserve until the next financial year
4. Ongoing project unspent to Schedule VII fund within six months; other unspent to special account within 30 days

Answer: A — Ongoing project unspent amount to special account within 30 days; other unspent to Schedule VII fund within six months

Working. Step 1: Identify ongoing project amount. Step 2: Apply 30-day special account rule. Step 3: Identify non-ongoing amount. Step 4: Apply six-month Schedule VII fund rule.

Explanation. CARO 2020 clause (xx) requires reporting on transfer of unspent CSR amounts. For an ongoing project, the unspent amount must be transferred to the special account under Section 135(6) within 30 days of the year end. For amounts not relating to an ongoing project, transfer to the Schedule VII fund under Section 135(5) is required within six months. Retaining the amount in general reserve is not compliant.

Where it goes wrong. Students often interchange the 30-day special account rule for ongoing projects with the six-month Schedule VII fund rule.

Authority. CARO 2020, clause (xx) of paragraph 3; Companies Act, 2013, Section 135(5) and Section 135(6)